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Should the SEC and CFTC be consolidated?
That's part of the latest Treasury plan.
The potential gain is that a single agency would be accountable for all the in-between derivative products which are currently overseen by no one. Even if you're a libertarian who hates regulation, a lot of the subsequent oversight (but not all of it) would be enforcement of laws against fraud and false dealing. Some of it would be preventing excess leverage to take advantage of the Fed safety net.
At current margins the gains from regulatory competition are less than before. Arguably the CFTC applies a lower regulatory tax to keep economic activity in one of the sectors it oversees, most notably financial futures, and thus to keep itself in business. This in turn forces the SEC not to regulate stock trading too heavily, otherwise volume will jump into the futures market. All true, but that argument made more sense in the mid-1980s (post Shad-Johnson), when stock index futures were still a novelty with an uncertain future. Furthermore international competition constrains the regulators more today than it did twenty years ago (London would gladly pick up business from the Merc), so that means less need for regulatory competition within the USA.
Ideally a regulatory marriage should focus the resulting agency on its most important roles, namely discovering and penalizing outright fraud and preventing catastrophic meltdowns. Of course that wish might be dreaming. After all, if investors are tricked why will underpaid lawyers see through the underlying problems in the market?
Note also that few regulatory consolidations have gone well, at least not in their first few years. Imagine actually forging the SEC and CFTC into a single culture with a single set of norms and regular communication patterns and employment practices. I'd be surprised if it could be done in less than four years' time and that is usually with some big bumps along the way, all in the service of learning of course. (Google "Homeland Security.")
So ideally the time to consolidate the SEC and CFTC is when the crisis is truly passed, not today. In the meantime we should recognize that the case for separate agencies isn't as strong as it used to be. But given that the SEC already has its hands full (did they catch the Bear Stearns problems? No), do you want to divert its talent to managing the merger? I'm not ready to press the "yes" button on this one, even though the final outcome is probably a better place to be. A simpler alternative is to give the SEC authority over the derivatives and fold in the CFTC five years from now.
Posted by Tyler Cowen on March 31, 2008 at 03:46 PM in Economics | Permalink
Comments
The SEC is run by socialists who believe it is their job to protect the "little guy", or what we jokingly refer to as Chuck Schumer's grandma. The CFTC is run by capitalists because Grandma Schumer isn't trading interest rate futures on the Chicago Merc. To any market participant, it is obvious that there need only be one regulator; unfortunately it is also obvious that the incompetent, markets hating, heavy handed approach of the SEC will prevail, "little guy" needing to be protected and all that...
Posted by: joe at Mar 31, 2008 4:16:10 PM
I would quibble with your case that there is less need for regulatory
competition within the united states because London will serve just as well.
The SEC and CFTC competition would go something like this, a call goes out
by some politicians for increased scrutiny by the SEC. The SEC responds and
some trading moves to the futures market under the watch of the CFTC. The SEC realizes that its power has waned
as trading has moved out of its domain, they then complain back to the
politician, who will have the feedback to get the regulation into some semblance of balance.
With a joint SEC-CFTC, the call goes out for enhanced scrutiny. The SEC-CFTC
responds. Trading moves to London. The SEC-CFTC complains that their
influence is waning as capital is moving abroad. Under this scenario, we are
presented with the frightening prospect that this will cause the politician
to call for capital controls on the denizens of the US, prompting real financial
crisis.
Hence, I would not be as sublime about all this as you are being.
Posted by: scott clark at Mar 31, 2008 4:43:39 PM
Here is what I don't understand:
If the SEC was abolished (or its power reduced to nothing more than an information-gathering role), what would prevent individual stock markets from competing with their own regulations to attract both investors and firms? I understand the need to punish fraud, but it seems like a lot of what the SEC does doesn't punish fraud. We don't have much of any competition in stock markets (I'm guessing because the regulatory hurdle is huge), and it seems like only a market can answer questions such as: "How many reporting requirements do investors demand of public companies?"
If regulations are politically inevitable, why not apply this to other markets? Why not merge the FDA and EMEA? How about the DOT and the European and Canadian equivalents? I'm always surprised environmentalists don't take note of how many fuel-efficient cars America can't get imported partially because of stricter regulations on diesel fuel and safety requirements.
Posted by: Grant at Mar 31, 2008 5:18:47 PM
I have to disagree with Grant. We have lots of competition among stock markets. Because of recent SEC changes to market oversight, stock exchanges are even competing with broker-dealers via electronic trading systems (something, incidentally, the Europeans copied in their new MiFid directive). That, after all, is why Nasdaq was bidding so heavily for the London Stock Exchange -- because it wanted to make sure the NYSE didn't get it and they had a foot in Europe to compete against the NYSE-Euronext merger. The problem is that for exchange to compete on regulation, they need more control over setting their own listing and conduct of business rules, and the SEC has not only the right to veto those rules (like any good regulator), but must actively approve them. And that takes forever.
Posted by: M.D. Fatwa at Mar 31, 2008 6:46:05 PM
It's not relavent to this discussion, but Charles Stross (noted science fiction author) will be in your town drinking beer tomorrow night at The Brickskeller at 1523 22nd St NW from about 7pm.
See his post at: http://www.antipope.org/charlie/blog-static/2008/03/beer_in_dc.html
Have fun ...
From Budapest
Posted by: Peripatetic Entrepreneur at Mar 31, 2008 7:37:56 PM
M.D. Fatwa,
Are there lots of smaller players in the stock market business that don't get much press? I know there are many OTC and private equity markets, but I didn't think they were allowed to list the same sorts of stocks the big exchanges can. I didn't mean to suggest that there isn't much competition, but just that there isn't as much as their might be if there was free-entry into the industry.
Posted by: Grant at Mar 31, 2008 8:05:29 PM
Google Martha Stewart to see how the SEC might do its job.
BlackRock CEO Laurence Fink blames the rating agencies for the collapse of Bear Stearns in his interview in Barron's this week. When they lowered Bear to below investment grade status, this increased the possibility of bankruptcy. He says that the derivative contracts they traded had provisions stating they had to break their contracts if they were downgraded to below investment grade.
My question is, is there some law or regulation that requires these contracts to have such provisions?
On another matter, Krugman is at it again, in his NY Times column today, blaming the lack of regulation (surprise!) for the collapse of the banking system in the Great Depression.
What he doesn't say, as if he knows, is that the banks collapsed because of state anti-branch banking laws, which were designed to protect local mom-and-pop banks, but which had the disastrous consequences of preventing them from growing and gaining access to the capital that would have stemmed bank runs.
Canada, which had no such restrictions, had no bank failures during this period, and didn't get stuck with a central bank until 1935.
Posted by: William Stepp at Mar 31, 2008 11:14:51 PM
On Grant's question, there are 3 big formal exchanges in the U.S. (NYSE, Nasdaq, AMX), several smaller exchanges (ISE, Boston, Chicago, Philadelphia, CBOE), 2 tiny exchanges (Arizona and Tradepoint) and then a large number of alternative trading systems/electronic communication networks that link buyers to sellers directly and are regulated as broker-dealers (about 40 right now, at least based on the SEC's no-action letters). Some of of the ECNs have been bought out by the larger exchanges (Archipelago, for example) and, of course, there used to be a large number of smaller exchanges around the country that have since been bought out as well (i.e., the Pacific Exchange bought by NYSE). The big barrier to competition in the past, of course, wasn't SEC regulation per se, but the fact that these exchanges were all non-profits run by their members (the broker-dealers), with a focus on enhancing profits for these members. Only recently have they become for-profit corporations that compete with each other for issuer listings.
On William's question, there are no laws or regulations that require loan contracts to have "ratings triggers". In fact, SEC rules require issuers to disclose such triggers, since they were the immediate cause of the Enron failure (immediate cause, not the ultimate cause -- Enron was going to collapse, it was just a question of when with the ratings triggers answering the "when"). And these ratings triggers don't "force" someone to break a contract, but they allow a contract's terms to change. Usually this is with a loan -- I lend you money, which you pay back over 10 years. However, if you are downgraded to junk, the loan is due in full immediately. The idea is that I want to get mine (or at least have a superior bankruptcy claim on it) before you formally declare bankruptcy, if the chances of you declaring bankruptcy are pretty high. Of course, all these loans coming due immediately almost guarantees that you will go bankrupt (a "death spiral"). In many cases, lenders realize this and renegotiate the terms so that a troubled but otherwise solvent company doesn't go belly-up as a result of these triggers. These ratings triggers function the same way for derivatives, since if the counterparty goes bankrupt, the trader on the other side of a short, put or other derivative is in real trouble.
Posted by: M.D. Fatwa at Apr 1, 2008 11:36:26 AM
Even if you're a libertarian who hates regulation...
I am amused by how often Prof. Cowen starts sentences like this, only to follow with why the libertarian is "obviously" wrong on this particular issue. I realize there are different ranges of libertarian purity (or extremism if you prefer), but there are plenty who think the federal government has neither the authority nor the competence to do anything right. Just stop and think again about what you are saying. You admit that libertarians are correct in their criticism of much of what government does, but you think when it comes to enforcing financial innovation and keeping people honest with their books, that's an area where politicians will excel? Regulators are notoriously corrupt in other matters, but they will ignore bribes from huge investment banks when contractual integrity is at stake?
Posted by: Bob Murphy at Apr 1, 2008 12:14:55 PM
Perhaps the better solution is not to fold the CFTC into the SEC, but the opposite. Perhaps the marketplace will be better with fewer duties to the public other than disclosure.
chsw
Posted by: chsw at Apr 1, 2008 4:05:59 PM
the futures exchanges do a pretty good job of mandating margin requirements of their member firms and they are pretty picky about collateral and haircuts unless you are posting tbills for account collateral.
most of the current problems seem to be coming from the over the counter markets. if bear gets downgraded it spirals down. same with enron. if their stock dropped below a certain level they would go in the crapper. these firms used themselves as margin. focus should be there if the taxpayer is going to back you up. no calling a turd a chocolte bar and recording it as such on your balalnce sheet.
Posted by: oops at Apr 2, 2008 1:50:43 PM
The DHS is exactly the right cautionary analogy. As the Economist recently observed, "The department is a bureaucratic mess. In May 2007 a quarter of the department’s executive jobs and a third of the jobs in its intelligence department remained unfilled. In a survey of 36 government departments the DHS ranked last in job satisfaction, second to last in leadership and 33rd in talent management." If we can’t get the domestic security alphabet soup right 6+ years after 9/11, how credible is a proposal like Paulson’s?
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