Bad Rules

TR – Hello, I’m Tom Record and I’m here with Tom Morris. Welcome to Global Infusions, an investment podcast from the Liontrust Global Fundamental team that takes a long term view of today's stories.

Last month we chatted about travel – a topic that covered culture, weather, food, transport and more. This episode we’re chatting about regulation… and looking at some of the bizarre moments when regulators got it terribly wrong. If your taste buds are tickled or you have any questions for our next episode, please do send them in via your client contact or through liontrust.co.uk.

So sit back, grab a cup of tea and remember that when we talk about individual companies we are not making a recommendation to buy or sell shares and that some of these companies may not be held across Liontrust’s global fund range.

So Tom, regulators and watchdogs are there to protect us, but sometimes despite their best efforts, they fail.  Why don’t you start with a recent example?

TM – The example that leaps out to me, that we’re watching go wrong at the moment, is crypto, and in particular all the coins that were created, hyped, and then collapsed.

TR - So the so-called memecoins like Dogecoin and Shiba Inu and that sort of thing?

TM – Yes exactly – some of them claimed to have genuine uses in pretty spurious sounding apps, but to me they just looked a lot like a bunch of people trying to get rich quickly. Classic speculative bubbles based on coins that had no intrinsic value, that a lot of people were just buying in the hope they could sell them on to someone else for more shortly afterwards.

TR – I think I saw posters on the tube for some of them

TM – Yes there were lots of posters for various coins and of course social media was full of people pushing whatever coin they owned. My question is, why did regulators allow this to happen? Shouldn’t they have been protecting retail investors from schemes like this?

TR – In fairness, the crypto space did emerge and evolve pretty quickly, making it difficult for regulators to keep up.

TM – That's the heart of the matter really. I’m sure lots of people at the various financial and advertising regulators saw the problem, but the speed with which they were able to act was just too slow. The Advertising Standards Authority ruled in March this year that an ad campaign for Floki coin in November 2021, which used the slogan ‘Missed Doge, Get Floki’, had breached the rules, and said that it must not be shown again.

TR – The horse had already bolted though

TM – Yes it was too late. The price of Floki coin peaked in early November, around the time of the ad campaign, and has fallen 98% since then, a disaster for anyone who bought in.

TR – So what can be done about it?

TM – Well a fast-track regulatory process for new types of investment products would make sense. Some kind of rapid response mechanism that can be triggered where imminent harm to consumers seems likely. Younger people involved in government and with the watchdogs would likely help too.

TR – Yes – we’ve seen this in places like S Korea, where the fintech regulators see what’s happening around the globe and then give trailblazer licenses to a couple of companies to see if it will work, but in a more controlled environment. So, Tom – here’s a simple question for you – why are drug prices so high in the US?

TM – ah now I have done some work on the US healthcare system, and it absolutely blew my mind. It’s a crazy web of market structures that basically just incentivize everyone to inflate the price of everything.

TR – exactly, and on a top down level, partly because of regulation.

TM – Yes, regulations that ban the government from negotiating drug prices with the pharma companies for Medicare really just don’t make sense, but I can obviously see the need for a robust approvals regime for treatments and therapies, so you don’t get slightly mad doctors experimenting on you or your family.

TR – True, but there’s a disconnect between trying to let the ‘market’ decide pricing in the US and restricting the entrants to treatments for a disease. And sometimes the FDA can drag its feet – look at the Novavax covid vaccine that appears to have been delayed by something like a lack of effective lobbying at the FDA. Quite correctly, the FDA won’t approve drugs unless they give patients statistically better outcomes, but regulators have created a paradox of wanting competition but not allowing it.

TM – …and so prices are driven up even further

TR – and people can’t afford healthcare and so suffer. There’s some really interesting stuff on when Markets Fail from Michael Sandel at Harvard that’s worth a watch or read on this sort of thing. So, Tom, let’s move back to this side of the pond - what about failure from our protectors in the UK?

TM – Well perhaps the biggest regulatory failure of recent years has been the disaster around  electricity and gas utilities. I mean, failure is an understatement – it's been an absolute catastrophe.

TR – It certainly has – so let’s start on this hugely underreported scandal at the beginning – no one likes monopolies… so, competition was introduced to the market when the old electricity and gas supply monopolies were broken up at the end of the last century.

TM – Exactly, and for the first 10 years or so, we had sensible levels of competition – by 2010 we had 6 big suppliers and around 6 smaller ones, so 12 players in total.

TR – Sounds reasonable – then what happened?

TM – The regulator began allowing lots of new small suppliers to enter the market, with the aim of using increased competition to bring down prices and improve customer service. By mid-2018 there were about 70 players in the market. It’s worth saying that there was nothing wrong with that aim. Some of the larger suppliers had pretty terrible customer service, and the plan to introduce new, more nimble and customer focused competition might have worked.

TR – So why didn’t it work?

TM – The problem was that the regulator wasn’t really checking if all these new entrants were being run sensibly, and it turned out, a lot of them weren’t. So at this point we need to note that a lot of energy suppliers in the UK don’t produce any electricity or gas themselves, they buy it wholesale from companies that do, and then sell it on to retail customers. Sensible suppliers use hedges to lock in future prices for the wholesale energy they buy, to make sure that they can match their costs against their future revenues.

TR – So presumably these new entrants weren’t doing that expensive hedging?

TM – Exactly – a lot of the new companies were choosing not to hedge, and instead were just gambling that wholesale prices would stay low. This allowed them to undercut the pricing offered by a lot of the sensibly run established players, who tried to compete and saw their profits collapse as a consequence.

TR – And how does the price cap fit into all this?

TM – The price cap was another well meaning piece of regulation enacted a few years ago, designed to stop people on default tariffs from being egregiously overcharged. It is set every six months by the regulator at a level calculated based the forward price of wholesale energy, with the idea that it should allow a well hedged suppler to make a reasonable profit above their costs.

TR – But a lot of these new suppliers were not well hedged.

TM – And that was the problem. Wholesale prices have increased extremely sharply over the last year, but the price cap is only reviewed every six months. If an operator has hedged, that’s ok, but if they haven’t, they are left in a situation where their costs are exploding but they can’t increase their prices.

TR – And so they go bust.

TM – Yes – between July 2021 and May 2022, 29 suppliers failed. And it’s costing us all a fortune. 28 of them, serving 2.4m households, had their customers transferred to larger, safer operators, at an estimated cost of around £2.7bn, which will be recouped through a special charge on all our bills. One of the defunct suppliers, Avro Energy, had been started by a university student, which perhaps should have been a warning sign, and after going bust has left us with a bill of £700m.

TR – That’s terrible – but what about the 29^th operator that went bust?

TM – It gets even worse. Bulb energy was so big that other operators couldn’t cope with taking on its customers, so in the end it was nationalized, and is now run by the government, who are covering its gigantic losses. The National Audit Office reckon that it’s cost taxpayers about £900m so far, with another £1bn to be spent over the next year, making it the biggest state bailout since the global financial crisis.

TR – So the lesson really is that even well intentioned regulation can backfire spectacularly when it’s not thought through properly. Getting it right is tough. I remember years ago looking at Mexican telcos and in particular Carlos Slim’s Telmex.  A proper monopoly – whenever anyone tried to compete, Telmex would destroy the competition by hammering pricing in that locality.

TM – so very difficult to regulate.

TR – Yes, in the end, the regulator had to ban Telmex from lowering prices.

TM – So the opposite of what they really wanted

TR – Now we can’t talk about regulation without talking about payments – and in particular the treatment of credit card fees.

TM – Ah yes

TR – We had a whole episode on this last year, but it’s worth saying again how silly the EU and UK regulation is. Businesses are not allowed to explicitly charge customers the credit card fees that they pay. But those fees are still there, they just get hidden in the price!

TM – and of course that means that everyone ends up having to pay them, even if you’re not using a credit card.

TR – Exactly – and as lower income people tend to pay by cash, it’s really regressive.

TM – Agreed – Now the final example of regulation I wanted to highlight is also one related to the finance industry, in this case bank branches.

TR – Oh yes – banks are always trying to close them because usage is down so much, but they remain popular with older people, and so there’s often a fuss.

TM – Yes the UK regulator actually published new guidance last week saying that banks should take more care when closing branches to make sure that the wider impact on local communities isn’t too negative. Not an unreasonable stance. But my question is why the regulator is only concerned with banks that already have branches. Why isn’t it applying symmetrical pressure on newer banks to make them open some branches, to serve older people?

TR – It does seem rather unfair that the whole social burden is being placed on legacy banks, while newer banks like Monzo and Revolut are allowed to gather millions of customers without ever being asked to open branches.

TM – Yes it’s not a level playing field. The new banks have structurally lower costs by virtue of not having any branches, allowing them to undercut legacy banks. When legacy banks try to compete by getting more efficient, the regulator tells them not to.

TR – Perhaps something like a regulatory requirement for a minimum number of branches per 100k customers, applied to the whole industry, might be fairer.

TM – Agreed.

TR – So before we move on to the news, I wanted to highlight a report that we’ve been talking about in the office over the last week, looking into the regulatory burden in the US. The authors, from a think tank called the Institute for Justice, looked at how many regulatory steps are required to open different types of businesses in different states, and their findings were quite amazing really.

TM – Yes this really surprised me

TR – As an example, opening a restaurant in Boston requires 92 different steps involving 9 different agencies, including 17 in-person visits to government offices, and over $5k in fees.

TM – Wow

TR – In San Francisco, opening a restaurant requires paying 17 different fees to government agencies, at a cost of almost $23k.

TM – I mean, I can understand the necessity of things like hygiene inspections, but this is plainly ridiculous, and it must put a lot of people off starting a business.

TR – Yes it’s another example of regulation being very regressive – it’s so much easier for richer people, with professional help, to deal with these hurdles. And it’s not just restaurants – here’s your quiz question for this episode: how many steps do you think it takes to open a bookstore in Newark?

TM – I don’t know – it should be a lot less than for a restaurant as it’s hard to imagine a bookstore endangering anyone. 10?

TR – 74! And opening a barbershop requires 81 steps in Boston and 68 in Atlanta!

TM – Crazy!

TR – … And the same is true for jobs – in the 50s about 5% of employees in the US needed a licence to do their job.  Now it’s nearer 30%.

TM – wow – that’s a stark reminder that when we were calling for more regulation of Crypto earlier, we do have to be mindful that excessive regulation can be a big problem too.

TR – Let’s move onto this episode’s news – and carry on the bitcoin theme. This year, Cryptocurrencies have been cratering.

TM – Yes I saw Bitcoin has fallen from almost $70k in November to less than $18k in June.

TR – yes, down 75% from the peak – and it’s not just Bitcoin.  We’ve seen Terra and Luna collapse towards zero, after investors lost confidence that it would be pegged or matched to the value of the dollar… but the one I wanted to talk about is Celsius

TM – Was it by any chance billed as the next hot thing.

TR – de dum… well it was – effectively it was a savings and lending platform that at one stage had about $24bn of assets. It paid a handsome interest rate of as much as 18%.

TM – That sounds too good to be true.

TR – Well it was, they had a liquidity shortfall and their investors lost most of their money… and of course deposits weren’t protected like in regulated banks. An 18% yield isn’t that attractive when you lose almost 90% of your capital.

TM – It’s terrible - I wonder how many people involved in that really understood the risks. So my first piece of news this episode is a call back to our discussion on food a few months ago. One of our colleagues, Hong Chen, highlighted some analysis from a research house called Thunder Said Energy. They looked at global food production and consumption, and found some interesting things. So global food production is about 7,500 calories per person per day.

TR – That sounds like a lot.

TM – It is. Only around 30% is eaten by people. Another 30% is wasted.

TR – That's terrible!

TM – Yes, and then a further 30% is fed to animals, where it takes 8 calories to produce 1 calorie of meat.

TR – That is so inefficient.

TM – Yes it makes me feel worse about eating meat to be honest. The remaining 10ish percent is used to make biofuels and other consumer products.

TR – Fascinating

TM – Yes and it brings things into stark relief really – we are producing plenty of food for everyone, but we use it so inefficiently that hunger is still a huge global problem. Part of the issue is that food production is not evenly distributed. Brazil for instance produces 4x its own calorific needs, the US produces 3x and Europe produces 1.1x, whereas Asia only produces 0.7x and Africa 0.5x.

TR – Which ties in with some of the things we’ve spoken about previously, like the need for intensive indoor farming.

TM – Exactly

TR – So we talked about cyber-crime a few episodes ago and when you’re encrypting data, one of the things you need is a genuinely random number.

TM – Ok, that makes sense.

TR – Well, it turns out that computers aren’t very good at doing that, and a company called Cloudflare has come up with a cunning way of generating random numbers.

TM – So, this is Cloudflare, the security company that protects websites from denial of service attacks.

TR – Exactly

TM – So – how do they generate these random numbers?

TR – Well they use a camera that’s pointed at an array of about 100 lava lamps and then use the numbers that come from the image to generate encryption keys.

TM – What! I thought you were going to tell me about a quantum computer or something like that. Lava lamps!

TR – Yes!

TM – So falling back on analogue technology from the 1960s to generate cutting edge encryption today! So my last piece of news this episode is a bit frivolous – I saw a post by a software engineer on Medium about using AI to generate stories. He’s used a natural language AI called  GPT3 to generate the start of story, using the prompt ‘Write the beginning to a short, fictional story about a child that is afraid of Artificial Intelligence, but then makes friends with a robot’.

TR – And was it any good?

TM – Yes it was very sweet really. And it was made more interesting because he’d also used the image generation AI, DALL-E 2, that we spoke about in a previous episode, to generate some illustrations.

TR – So this was a story written and illustrated by AI – how cool.

TM – That’s what I thought too. Perhaps in the not too distant future we’ll see much longer works of fiction created in this way.

TR – Indeed! Thank you for listening to Global infusions - a podcast that believes that the best discussions are had over tea and cake. We hope you've enjoyed your cuppa and our thoughts on regulation. Please do subscribe through Apple or Spotify and with that we wish you goodbye!

TM – Goodbye!