Regulators Talk Cooperation, but Little Progress

Regulators from the Securities and Exchange Commission and the Commodity Futures Trading Commission got an earful last week on how they might reconcile some of the differences in their rules and approaches, and it appears they’ve got their work cut out for them.

Now that a merger of the agencies is off the table politically, the two are trying to find ways to harmonize the regulation of securities (overseen by the SEC) and futures (overseen by the CFTC). Those talks come as the Obama Administration pushes ahead with plans to overhaul regulation of the financial markets generally; the White House has told the SEC and CFTC to submit a report by Sept. 30 identifying differences in their statutes and regulations, either explaining why those differences are necessary or recommending changes.

Last week’s talks were held over two days, one at the SEC and the other at the CFTC. Various market participants, investor advocates, self-regulatory organizations, academics, and former regulators offered opinions aimed at helping the agencies figure out how to bridge some of the gaps between their regulatory approaches.

One large issue will be the murky world of over-the-counter derivatives, which caused so much trouble in last year’s Wall Street collapse. OTC derivatives have gone largely unregulated even as their growth exploded, and the Obama Administration wants to bring derivatives under the regulatory umbrella for the first time. But derivatives are hybrid instruments that could be the jurisdiction of either agency, so figuring out precisely how to oversee them is easier said than done.

A White House proposal to regulate derivatives would split oversight authority between the two: derivatives tied to equities would be the purview of the SEC, while other types of derivatives would go to the CFTC.

During last week’s summit meeting, CFTC Chairman Gary Gensler said both agencies are committed to bringing the full OTC derivatives market under regulation. He urged members of both agencies to “check turf at the door and figure out what works best for the American public.” Sometimes, he said, duplicative regulation from both agencies “stifle competition, increase costs, or limit investor protection.”

Still, both he and SEC Chairman Mary Schapiro then said that some differences in regulatory approach are still necessary, despite the extra burden for corporations and other public filers. Schapiro said some differences in the regulation of markets for securities and futures “are necessary to achieve underlying policy objectives.”

Schapiro

“Harmonization must not be an excuse for inadequate regulation.”

—Mark Cooper,

Director of Research,

Consumer Federation of America

Gensler said the SEC and CFTC should foremost focus on closing gaps in existing regulation, and on ensuring that overlap in their regulation exists only where it’s beneficial, such as in joint enforcement. What they don’t want, he said, was the potential for “regulatory arbitrage”—that is, a registrant seeking out the easiest possible regulatory regime. Harmonization, Schapiro said, would help stamp out that threat.

The Details

The summit meeting consisted of five panel discussions covering numerous issues: the regulation of exchanges and markets; trade clearance and settlement; portfolio margining; regulation of intermediaries; and enforcement and remedies.

One major obstacle is the agencies’ differing approaches to regulation. The CFTC uses a principles-based approach, which is viewed as more flexible, while the SEC employs a stricter rules-based approach. Some panelists, including Chicago Board Options Exchange CEO William Brodsky, expressed support for the CFTC approach.

Brodsky

Brodsky said disparities in the approaches of the agencies “imposes severe competitive disadvantages on securities exchanges and inhibit innovation.” He said the SEC’s rules-based approach leads to unnecessary delays in introducing new products and making operational changes.

“We’ve experienced interminable delays in bringing new products to market because of disputes over which agency has jurisdiction,” he said. He cited the introduction of options on gold exchange-traded funds as an example; approval of those instruments was delayed more than three years as regulators dickered over who had jurisdiction. Brodsky suggested that the Treasury Department act as a tie-breaker to resolve jurisdictional disputes, at least until a more definitive mechanism is in place.

CFTC CHAIRMAN SPEAKS

The following excerpt is from CFTC Chairman Gary Gensler’s Opening Statement at the joint meeting with the SEC:

I believe that there are three broad areas where the CFTC and the SEC must work to enhance our regulatory structures. First, we must close the gaps that exist between the two agencies’ financial regulatory authorities, including over-the-counter derivatives. Second, we should ensure that regulatory overlap only exists where it is beneficial, such as in joint enforcement, and not when it can be used for regulatory arbitrage. Third, we must explore where it is appropriate to bring consistency to the two agencies’ regulation over similar products, practices, and markets.

Participant testimony and yesterday’s panelists highlighted at least twelve specific areas where we should consider possible regulatory changes to bring consistency and best protect the American public. As I summarized at the end of yesterday’s meeting, they are:

1. Product listing: self-certification or prior approval;

2. Exchange and Clearinghouse rules: self-certification or prior approval;

3. Risk-based (“portfolio”) margining with cross-margining of futures and securities products;

4. Fungibility and competition among execution platforms;

5. Uniform customer account and bankruptcy/insolvency regime;

6. Market structure: separate versus linked markets;

7. Standards for prosecuting market manipulation;

8. Punishing insider trading in derivatives markets;

9. Customer protection: suitability or disclosure;

10. Customer protection: fiduciary obligations for intermediaries;

11. Mutual recognition of entities regulated by foreign jurisdictions; and

12. Principles-based versus rules-based regulatory oversight.

I hope that each of today’s panelists will give their views on these issues and give us a sense of if they think there are additional matters that we should keep them in mind.

I take very seriously President Obama’s call to “harmonize regulation of futures and securities.” As we discuss these issues today, I would like to reaffirm that there should be no sacred cows. I believe that we should check turf at the door and focus exclusively on what is best for the American people.

We look forward to hearing a wide variety of viewpoints on these very important issues. Written comments on the topic of this hearing also will be accepted from the public until September 14th, 2009, and included in the record. Please visit cftc.gov or sec.gov for a link and instructions to submit written comments for the record.

Source

Full Text of CFTC Chairman Gensler’s Opening Statement (Sept. 3, 2009).

Mark Cooper of the Consumer Federation of America, however, warned that any harmonization between the agencies should be a “harmonization upwards” to provide greater investor protection. “Harmonization must not be an excuse for inadequate regulation,” he said.

Nazareth

Former SEC commissioner Annette Nazareth, now a partner at law firm Davis Polk & Wardwell, observed that, “Until Congress or the administration are willing to make difficult policy choices, the SEC and CFTC will continue to struggle to find common ground under different statutory mandates and regulatory philosophies.”

Another question was whether some sort of ban on insider trading, which is already barred under securities laws, ought to apply in the futures world.

Mark Young, a partner at the law firm Kirkland & Ellis who was representing the Futures Industry Association, said applying insider-trading laws to the futures markets could miscast hedgers as insiders. But during a panel on enforcement on the second day, Columbia University law professor John Coffee said the CFTC needs legislation to prohibit insider trading on commodities and transactions within its jurisdiction.

Coffee

Coffee said the CFTC also needs a better way to deal with market manipulation. Unlike the pump-and-dump cases the SEC usually faces, Coffee said the typical CFTC market manipulation case is “close to being un-prosecutable.” He suggested the agency look at limiting large positions that can’t be shown to be purely hedging positions. Coffee also said the CFTC should have some sort of “suitability rule” that can be enforced in private arbitration or through actions brought by the CFTC.

CFTC Commissioner Bart Chilton repeated a call for both agencies to have criminal authority. Cooper of the Consumer Federation of American agreed. “The sums of money available in these markets have become so huge, the fines aren’t sufficient disincentive,” he said.

Lawrence Harris, a law professor at the University of Southern California, said criminal prosecution power would “bring [the agencies] closer to looking more like the executive branch, rather than independent agencies.”

McLucas

Meanwhile, former SEC enforcement director William McLucas, now a partner at law firm WilmerHale, suggested “working from the bottom up rather than top down,” by having staff members from the two agencies conduct joint investigations into market abuse and risk.

“It’s worth entertaining the idea of taking 10 or 15 SEC staff and the same number of CFTC staff, and putting them under the same roof,” McLucas said. Where there are areas of market abuse and market risk, the group could conduct investigations under the joint authority of both agencies and make recommendations.

“We ought to be worried about greater transparency to people who can assess market risk and the broader issue of systemic risk,” he said.