Retroregulation

First, a great quote from Eric Falkenstein:

You might remember the SEC in penalizing famous frauds like Madoff, Bayou, and Wood River--after they were exposed as frauds by their own investors. These are the police who show up after you've tackled and hog-tied your intruder, and then take credit for putting him in jail.

In his post, Falkenstein also talks about the "flash order crash" of May 2006, when systems started failing because institutional restrictions on how trades are supposed to be routed were outdated and unprepared to deal with flash orders. The SEC's proposed solution: ban flash orders.

This illustrates two worst features of regulation: that it's always reactive, and that whenever that feature leads to widespread problems, the government answers simply by trying to outlaw the market invention that has exposed regulation's weakness. The first feature is unavoidable. The market will keep inventing things that regulators do not anticipate. But maybe the second one is not. Perhaps a scheme can be designed whereby the regulators are banned from banning things and are instead forced to improve their regulations when those are exposed as inadequate.