Wednesday, June 17, 2009

Obama Administration Urges Harmonization of Securities and Futures Regulation

The Administration decided not to propose a merger of the SEC and CFTC. Instead, the SEC and CFTC should make recommendations to Congress for changes to their statutes and regulations that would harmonize the regulation of futures and securities. The SEC and CFTC should also blend their rules-based and principles-based approaches to regulation respectively into a blended regulatory approach more precise than the principles-based approach while still allowing flexible innovation.

The Administration pointed out that the broad public policy objectives of futures regulation and securities regulation are the same: protecting investors, ensuring market integrity, and promoting price transparency. While differences exist between securities and futures markets, many differences in regulation between the markets are no longer justified. In particular, the growth of derivatives markets and the introduction of new derivative instruments have highlighted the need for addressing gaps and inconsistencies in the regulation of these products by the CFTC and SEC.

Many of the instruments traded on the commodity and securities exchanges and in the OTC markets have attributes that may place the instrument within the purview of both regulatory agencies. One result of this jurisdictional overlap has been that economically equivalent instruments may be regulated by two agencies operating under different and sometimes conflicting regulatory philosophies and statutes.

For example, many financial options and futures products are similar. Under the current federal regulatory structure, however, options on a security are regulated by the SEC, whereas futures contracts on the same underlying security are regulated jointly by the CFTC and SEC.

In many instances the result of these overlapping yet different regulatory authorities has been numerous and protracted legal disputes about whether particular products should be regulated as futures or securities. These disputes have consumed significant agency resources that otherwise could have been devoted to the furtherance of the agency's mission.

Uncertainty regarding how an instrument will be regulated has impeded and delayed the launch of exchange-traded equity, equity index, and credit event products, as litigation sorted out whether a particular product should be regulated as a futures contract or as a security. Eliminating jurisdictional uncertainties and ensuring that economically equivalent instruments are regulated in the same manner, regardless of which agency has jurisdiction, would remove impediments to product innovation.

Arbitrary jurisdictional distinctions also have unnecessarily limited competition between markets and exchanges. Under existing law, financial instruments with similar characteristics may be forced to trade on different exchanges that are subject to different regulatory regimes. Harmonizing the regulatory regimes would remove such distinctions and permit a broader range of instruments to trade on any regulated exchange.

In the Administration’s view, permitting direct competition between exchanges also would ensure that plans to bring OTC derivatives trading onto regulated exchanges or regulated transparent electronic trading systems would promote rather than retard competition. Greater competition would make these markets more efficient, which would benefit users of the markets, including investors and risk managers.

The bottom line is that there must be greater coordination and harmonization between the SEC and CFTC going forward. The Commodity Exchange Act currently provides that funds trading in the futures markets register as commodity pool operators (CPO) and file annual financials with the CFTC. Over 1300 CPOs, including many of the largest hedge funds, are currently registered with and make annual filings with the CFTC. It will be important that the CFTC be able to maintain its enforcement authority over these entities as the SEC takes on important new responsibilities in this area.

The CFTC currently employs a principles-based approach to regulation, while the SEC employs a rules-based approach. The Administration said that efforts at harmonization should seek to build a common foundation for market regulation through agreement by the two agencies on principles of regulation that are significantly more precise than the CEA's current core principles. The new principles need to be sufficiently precise so that market practices that violate those principles can be readily identified and subjected to enforcement actions by regulators.

At the same time, they should be sufficiently flexible to allow for innovations by market participants that are consistent with the principles. For example, the CFTC has indicated that it is willing to recommend adopting as core principles for clearing organizations key elements of international standards for central counterparty clearing organizations which are considerably more precise than the current CEA core principles for CFTC regulated clearing organizations.

Harmonization of substantive futures and securities regulation for economically equivalent instruments also should require the development of consistent procedures for reviewing and approving proposals for new products and rulemakings by self-regulatory organizations. Here again, the agencies should strike a balance between their existing approaches. The SEC should recommend requirements to respond more expeditiously to proposals for new products and SRO rule changes and should recommend expansion of the types of filings that should be deemed effective upon filing, while the CFTC should recommend requiring prior approval for more types of rules and allowing it appropriate and reasonable time for approving rules that require prior approval.

The harmonization of futures and securities laws for economically equivalent instruments would not require eliminating or modifying provisions relating to futures and options contracts on agricultural, energy, and other physical commodity products. There are important protections related to these markets which must be maintained and in certain circumstances enhanced in applicable law and regulation.

The Administration directs the CFTC and the SEC to file a report with Congress by September 30, 2009 identifying all existing conflicts in statutes and regulations with respect to similar types of financial instruments and either explain why those differences are essential to achieving underlying policy objectives with respect to investor protection, market integrity, and price transparency or make recommendations for changes to statutes and regulations that would eliminate the differences. If the two agencies cannot reach agreement on such explanations and recommendations by September 30, 2009, their differences should be referred to the new Financial Services Oversight Council. The Council should be required to address such differences and report its recommendations to Congress within six months of its formation.