Three coins in the fountain. Through the ripples how they shine.
-- Jule Styne, Sammy Cohn
The Dumbest Idea of the First Quarter of 2017 - and a candidate for my annual Dumbest Idea of the Year Award - is to combine the SEC with the CFTC. As Reuters' Gina Chon reports here:
What will be the top financial merger of 2017? Will it be UniCredit buying Deutsche Bank, or Bank of China swooping on JPMorgan? Think again. It will be America's two markets watchdogs - the Securities and Exchange Commission and the Commodity Futures Trading Commission - crunching into one über-regulator.
With a new Presidential administration always come proposals to fix the various financial regulatory agencies. And God knows the agencies need it. Nobody in her right mind thinks either regulation of the banking system or of the financial market regulatory structure, as it stands now, makes any sense. Easy to see why proposed changes abound.
Dodd Frank added a new layer to the financial market and institution regulatory structure. At the top of the regulatory pyramid now sits the uber-regulator, the Financial Stability Oversight Council (F-sock). Is it possible to hope that the new administration will do away with F-sock, or at least neuter it? Let us live this dream, to get on to more important matters.
We need to reform the duplicative and anachronistic banking regulators: state bank regulators, the FDIC, the Comptroller of the Currency, and the Fed. Normally a new administration floats proposals to eliminate one or more of these agencies. But for some reason, nobody wants to fool around with this multi-agency mess this time around.
The bank regulatory focus has been solely on modification of the Fed. But there have been bad ideas about changing the Fed. The two most notable dumb ideas are:
- Determine monetary policy by rule.
- Audit the Fed.
More about this in a later article. Perhaps, one of these will win the Dumbest Idea of the Second Quarter competition. So many choices.
The American financial market regulatory structure is also deeply flawed. In the United States, the primary regulatory agencies are the SEC and the CFTC, with various related "helpers" such as FINRA, British and Continental European regulators, and F-sock.
Which markets do the agencies regulate? The CFTC regulates "derivatives" markets. The SEC regulates securities markets. Another perennial new-administration reform is to combine the two agencies. And this proposal fits the Trump regulatory position like a glove. It's even better than the Trump regulation proposal, eliminating two old regulations for every new one. It's eliminating two agencies for a single agency. But this reform is just another beginning-of-administration dream.
The merger plan proceeds from the assumption that the performance of the two agencies has not been important. It does not pass out prizes to the successful; nor does it condemn the failures. It also assumes the regulated markets aren't different. And the merger plan also sees no need to involve other federal agencies in regulation of the agencies' purviews.
The SEC: The SEC is an abject failure. Let me count the ways.
- The SEC has failed to promote competition among exchanges. With the SEC's introduction of the National Market System (NMS), the SEC has spawned a brood of unnecessary parasite exchanges.
- The SEC has interpreted its responsibility to assure accurate corporate reporting too broadly.
Competition among exchanges has been actively discouraged by the SEC. On the contrary, the stock exchanges are a growing collection of SEC-spawned parasites, drinking the blood of stock market traders.
How did this disaster develop? It is the result of misplaced trust of regulators and markets; and exaggerated distrust of brokers, dealers and bankers.
There is a habit of the popular mind that stems from distrust of financial institutions rooted in the origins of history. Who invented the written word? Who invented accounting and finance? Those ever-popular professions, tax collectors and money lenders.
And banks had their beginnings in renaissance gold depositories, the first creators of paper money - the gold depository receipt. Who wants to walk around with gold in their pockets? But when gold depositories began to issue more receipts than gold on deposit, modern finance was born. And distrust of financial institutions deepened.
Financial markets, on the other hand, have more benign origins. The bazaars, and more recently, the coffee houses of Amsterdam, London, and New York. But from the beginning, with the "tulip bubble," things went wrong. And regulation of markets began. We have learned only one thing from centuries of market regulation. The regulator that regulates least, regulates best.
The SEC is the proverbial exception that proves the rule. Originally, the SEC protected exchanges, since the stock exchanges were trade associations that, it was hoped, would be self-regulators and self-regulatory organizations (SROs).
The CFTC: But the SEC and the securities trading broker-dealers have watched with envy the success of futures exchanges and their regulator, the CFTC. And they have imitated the successes of these exchanges without considering the effect of grafting the competitive attitude of the futures exchanges (and the laissez faire attitude of the CFTC) onto SROs (the exchanges) and a historically protective regulator.
But there were mistakes made by Congress with the regulatory treatment of derivatives.
- OTC derivatives were thought to present similar regulatory issues to those of futures.
- The facts that OTC derivatives were associated with different broker-dealers, different customers, and different accounting treatments; were ignored.
The CFTC is an agency purpose-built to regulate futures. It is ill-prepared to regulate OTC derivatives.
The Fed: OTC derivatives belong in the broader OTC orbit, with Eurodollars, foreign exchange, and precious metals. The CFTC is in no way prepared to regulate the credit risk issues that drive these OTC instruments to be offered by a few large banking institutions. In the United States, there are five: Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), JP Morgan Chase (NYSE:JPM), and Morgan Stanley (NYSE:MS).
The multiple smaller futures trading firms of the futures industry are consistent with the futures regulatory model. The futures industry is appropriately dominated by a single exchange with a corporate identity, the CME Group (NASDAQ:CME); and by the laissez faire CFTC.
But OTC derivatives, like the other OTC instruments, should be regulated by the Fed. The Fed, unlike the SEC, is able to duke it out with the Bank of England, the other regulator that seeks to regulate OTC market participants. Central banks are appropriate for the regulation of the credit risky, systemically risky, OTC instruments.
The SEC and the CFTC regulate different industries with different corporate structures, different market structures, and different levels of success. They are separated by these differences and by competence. Both agencies overreach. The Intercontinental Exchange (NYSE:ICE) should not have been permitted to purchase the New York Stock Exchange. The acquisition further blurred the regulatory mission of the SEC and the CFTC.
Nor should ICE or the CME operate clearing counterparties (CCPs) for OTC derivatives. These CCPs, like the OTC markets they clear, belong under the roof of the Fed. The CCPs are also sources of super-sized credit and systemic risks.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.