Wednesday, November 12, 2008

CFTC Chair Urges Regulation by Objective by Three New Regulators; Replacing SEC and CFTC

Acting CFTC Chair Walter Lukken has called for a complete rewrite of the federal securities and commodities laws and the creation of three new regulators under principles-based regimes. The three new regulators would be: the Systemic Risk Regulator, the Market Integrity Regulator, and the Investor Protection Regulator, with all three operating under an objectives–based framework focused on risk. In remarks at a recent FIA seminar in Chicago, he rejected the idea of merging the SEC and CFTC as ineffective and only reinforcing the current outdated regulatory structure. Under his plan, the different functions of the CFTC, the SEC and the various banking regulators, would be dispersed among the three new regulators.

The Systemic Risk Regulator would have the responsibility of policing the entire financial system for risks that could cause a contagion event and take preventive action against such occurrences. Such a regulator does not exist in the current framework, he said, but is absolutely necessary given the global interconnections of the financial markets. The Market Integrity Regulator would oversee the safety and soundness of key financial institutions, including exchanges, investment firms and commercial banks whose failure may jeopardize the integrity of the markets. The Investor Protection Regulator would broadly oversee investor protection and business conduct across all firms in the marketplace.

In Chairman Lukken’s view, this objectives approach would significantly improve financial market transparency across-the-board, but most importantly in the current unregulated OTC markets. Regulation by objective rather than function will ensure that all products and institutions are properly overseen based on identified public risks rather than futile and difficult determinations of whether an instrument is a security, a future, or a swap contract. Under this approach, the Systemic Risk Regulator would have broad access to information from the entire marketplace as it monitors concentrations of risk, while the Market Integrity and Investor Protection Regulators focus more specifically on their respective missions.

The flexibility of a principles-based system also would help to manage the important but different missions of the futures and securities regulators. For example, the CFTC is charged with promoting price discovery and risk management in the markets, he noted, while the SEC upholds the important mission of investor protection and the banking regulators focus on the safety and soundness of depository institutions. As products converge, these differing missions can conflict and agencies are left attempting to balance the competing public interests. In his opinion, a new objectives-based, principles-based system would provide the new regulators with the tools to better coordinate and manage the critical but sometimes competing public missions of these industries while avoiding the rules-based tripwires that bog down the current system.

This new structure would require reporting of exchange and over-the-counter market data to regulators, particularly when such products begin playing a public pricing role or when their size creates the risk of a systemic event. He said that the credit default swaps market would meet this threshold. The resulting enhanced transparency would enable the Market Integrity and Systemic Risk Regulators to police the markets for misconduct and concentration of risk.

In building such a framework, he urged Congress to look to the model adopted in the Farm Bill for the OTC energy swaps market, which triggers additional oversight and transparency when a product begins to serve a significant price discovery function. Such an approach enjoys the advantage of allowing the over-the-counter market to continue to serve as an incubator model for product innovation and tailored risk management, he believes, but would trigger additional oversight when certain public risks arise.

He emphasized that the proposed restructuring must be accompanied by a complete rewrite and modernization of the laws and regulations governing the financial markets, including the securities and futures laws, to adopt a more consistent principles-based regulatory approach.

One of the lessons from the crisis is that the current rules-based regulatory approach was not able to keep up with the speed and innovation of the financial markets. A principles-based structure complements tailored rules by adding needed guidance and flexibility to desired policy objectives. This helps prevent institutions from making end runs around static rules when such actions violate a broader public policy. The CFTC currently utilizes such an approach, coupled with strong enforcement, which has enabled the agency to keep pace with fast moving global markets.