Harmony in the Eye of the Beholder

By Lisa Valentine

So how do you get two government regulatory agencies – with differing priorities – to work together for the greater good?

It’s a trick question. You can’t get them to work together, no matter how much you want them to. You simply fold both into a single agency.

Unfortunately it looks like both the SEC and the CFTC will exist as separate entities for the foreseeable future. As part of his plan for financial reform, President Obama has asked the agencies to work together in harmony. The SEC and CFTC have given this task considerable thought (and resources) in the tome “A Joint Report of the SEC and the CFTC on Harmonization of Regulation.”

The SEC, which governs securities, and the CFTC, which governs futures, were created in the 1930s as a result of the Great Depression. At the time, having two separate agencies worked relatively well. Due to financial market innovations, what made sense in the 1930s simply doesn’t make sense in 2009.

The report, at 94 pages in length, doesn’t address important issues such as closing the gap on derivatives legislation between the two agencies. It does, however, focus on the following points. The differences noted between the two agencies is just a small sampling of inherent conflict between the SEC and CFTC. Harmony is a huge task – sort of like spitting in the ocean.

•    Product listing and approval: The SEC relies on high quality disclosure about securities whereas the CFTC does not review products before introduction. This becomes a problem for those products that don’t neatly fall under either jurisdiction (or fall under both).

•    Exchange/clearinghouse rule changes. The CFTC is more limited in its ability to regulate exchange and clearinghouse rules.

•    Risk-based portfolio margining and bankruptcy/insolvency regimens. Both the SEC and CFTC can segregate assets, but how they do so differs. Also, the SEC can regulate customer margins but the CFTC cannot.

•    Linked national market and common clearing versus separate markets and exchange-directed clearing. Securities are traded on multiple markets, part of the national market system in the U.S. (NMS). The SEC uses a common clearing model that serves competing exchanges while futures exchanges select a clearinghouse. The clearinghouse could be in the U.S. or it could be elsewhere in the world.

•    Price manipulation and insider trading. This is an area that has historically been less of a concern for the CFTC (and an area where the SEC could use a bit of a boost).

•    Customer protection standards applicable to financial advisors. Since futures are considered inherently “risky,” the CFTC assumes buyer beware. The SEC imposes many more limits on financial advisors.

•    Regulatory compliance by dual registrants. For instance, the SEC and CFTC have different retention and reporting requirements.

•    Cross-border regulatory matters. The CFTC allows for much greater cross-border access by intermediaries.

Harmony is a tall order, to be sure. In follow up posts, we’ll dive into some of the specific recommendations from the report. But the bottom line remains that the agencies are wasting a lot of time and resources trying to make a pig fly.