E-regulators should leave the Internet alone

By Matthew Lynn

LONDON (Bloomberg): It was only a matter of time before the mania for sticking the letter "e" in front of everything reached the financial watchdogs; after e-companies, e-brokers, and e- tailers, we must now get used to the concept of an e-regulator.

The word was floated by Howard Davies, head of the UK's Financial Services Authority, in a speech on the regulation of cyberspace at the annual conference of Britain's ruling Labour Party last month.

Davies' views illustrate how instinctively hostile many European regulators are to the raw and unfettered markets now emerging in the digital economy.

If Davies -- and his counterparts in Germany, France and Italy -- start trying to regulate the online world, the danger is that the new electronic businesses in Europe will fall even farther behind their U.S. rivals.

In his speech, Davies showed some understanding of the Internet's potential for consumers. "The Internet will bring cheaper transactions," he said. "It also brings good quality information within reach of many millions of investors and savers who previously found it impossible or too costly to access."

So far so good. The potential of the Internet to level the playing field between investors and their advisers by democratizing access to information is one of its greatest advantages, and it's reassuring that regulators are aware of it.

Yet Davies only thinks the Internet is a good thing up to a point. "While I constantly remind myself that this explosion of Internet-based financial services is fundamentally beneficial for consumers, I cannot help noticing that it also brings me, and my colleagues, a nagging headache," he said. "Why is that? Because we are already running into problems and encountering hazards for the unwary consumer."

Davies cited three main concerns. One is that banks from the wilder financial centers in the Caribbean are passing themselves off as banks authorized within the European Union, and luring deposits with promises of higher interest rates.

The second is that investment business is being transacted on the Internet by individuals and companies who aren't authorized to do so by regulators, and where investor protection safeguards, such as capital-soundness rules, aren't available.

His third concern is about chatrooms at financial-information Web sites that are used by investors to swap news and views on companies. "The innocent surfer has no way of knowing whether someone who posts a question about the prospects for a company is a party to a share-ramping scheme," Davies said.

Those are all reasonable points. The digital economy is a hazardous place, infested with e-crooks, e-sharks, and e-hustlers preying upon e-fools. Investors should tread the Web with the utmost caution.

But should it be regulated, and can regulation achieve anything but harm?

The point of regulation is to protect what Davies calls the unwary, and what the rest of us would call stupid people who don't know very much. Most of us understand that a bank in the Cayman Islands offering 20 percent interest on deposits isn't the same proposition as an account with Deutsche Bank.

Likewise, most of us will only buy mutual funds or trade securities through firms we know and trust, or have the credentials to show our money will be safe. And most of us know that information in Internet chatrooms isn't as reliable as what comes from mainstream news sources.

But it is by instinct that regulators regulate, and it is the risk of stupid people doing stupid things that is always the excuse for creating new regulations. What is overlooked is the cost.

The cost of stopping stupid people from doing stupid things is that you stop clever people from doing clever things.

So, for example, you could try to prevent offshore banks from offering deposit accounts over the World Wide Web. But that would keep intelligent, honest bankers in tax-free centers from using the Internet to offer bank accounts that are better than what most of us can get in our own countries.

Again, restricting the electronic sale of investment products to the large established banks risks destroying the potential of the Internet to bring new businesses with fresh ideas into the industry. The best ideas won't come from the authorized financial institutions, but from bright entrepreneurs. Likewise clamping down on chatrooms will restrict the availability of information to investors outside the big investment banks -- and widening the pool of information is one of the best ways of increasing the market's efficiency.

Investment business conducted over the Internet already has one investor-protection device built into it that is superior to anything that could be created by any e-regulator. The Web is about the best system for spreading information quickly. And there is no better way of stopping swindlers than by spreading the word about them -- that is why pool hustlers always move from town to town.

Ultimately, clever people can't be stopped from doing clever things. But they can be stopped from doing them in particular countries. The most damaging effect of an outbreak of e- regulation would be to send Europe's electronic entrepreneurs elsewhere.

The writer is a columnist for Bloomberg News. His opinions don't necessarily represent those of Bloomberg News.