Beware regulators rating shares

There is some concern in the Dubai financial community about recent plans by the Emirates Securities and Commodities Authority (ESCA) to produce “standard regulations controlling the valuation of shares and companies”.

Many have serious reservations whether this is the kind of activity a market regulator should be concerned with, and fear that it may lead to less independent and reliable corporate analysis in the UAE stock markets.

Without such information, the basic function of a stock market – the raising of capital and valuation of corporate assets – becomes impaired and artificial, and ultimately will drive away investors.

Do not misunderstand my point. I agree wholeheartedly UAE stock markets need accurate and timely information. This is the lifeblood of a free and healthy market. I applaud ESCA’s efforts to raise standards on the Dubai and Abu Dhabi markets, which can only help steer them towards the ultimate goal of being the premier financial market place in the Gulf. But interference by regulators on the process by which a company’s value is measured is not the way to do this. Investors can be deterred when they regard a market as over-regulated, and I think this is the danger of the ESCA proposals.

ESCA CEO Abdullah Al Turaifi said he was concerned about the large discrepancies and share-price valuations from global and domestic financial institutions, and is planning proposals to correct what he sees as a damaging situation. He was also worried stockbrokers trying to trade in shares would use the analysis produced by the firm’s own research department to persuade potential investors on a “buy” or “sell” position on a firm’s stock.

That last point is a real concern, and ESCA should establish rules for the setting up of “Chinese walls” between trading and research within domestic firms. (Most of the international brokers are familiar with such regulations because they are standard in the trading cultures of North America and Europe.)

In essence, ESCA should put the onus on the traders to show a transaction was not the result of a change of investment recommendation by an analyst, and vice versa – the research department must have the internal checks and audits that will allow it to act independently of sales.

Such systems are in place in the rest of the financial world, so there is no shortage of models for ESCA to emulate. They were reinforced in the wake of the dotcom crash of 2001, when it was proved conclusively that some analysts had given their own traders and “special” clients advance information on share valuations, especially in IPOs.

The strengthened rules have been enforced and observed, and have made share information more reliable and usable for traders in New York, London, Frankfurt, Tokyo and all the other great centres of share trading. But this is not my area of concern. What worries me is ESCA will begin to tell investment banks, stockbrokers and investors how to value shares, and in effect put the regulator’s own “buy” or “sell” stamp on the market. This is dangerous.

Sophisticated stock markets work by balancing the difference between capital supply and investor demand, and the two criteria that decide this are quality of information and investor intelligence. Today there are so many sources of information that might affect a share price that it is sometimes mind-boggling to consider. It is the job of intelligent investors to cut through this information overload and make an investment decision. To try to restrict or control the information itself would be a mistake.