Dissatisfied With Financial Regulation?: Go to the Roots of the Problem, And Fragmentation Ain’t It

The structure of financial market regulation has been a source of dissatisfaction since at least the time of the birth of the SEC in the 1930s, and maybe even dating back to the first regulation of futures markets in 1922. Don Wilson of DRW is only the latest of those to express this dissatisfaction.

Since derivatives markets first emerged from their niche in the commodities, and especially agricultural commodities, a lot of the criticism has focused on the bifurcated nature of US regulation, with separate securities and derivatives regulators, the SEC and the CFTC respectively. Why not just have one regulator given the substantial overlaps between securities and derivatives markets? Whereas previous “reform” proposals have been to merge the agencies, Wilson suggests scrapping them both and creating a new unified regulator.

This idea is a hardy perennial and has always struck me as mere org chart shuffling, or furniture rearranging. And that’s the best case. Worse outcomes are very possible.

For one thing, the relevant laws–the Securities and Exchange Acts, and the Commodity Exchange Act–would remain in place, with one commission in charge of implementing both. Many of the conflicts, tensions, and contradictions involving the SEC and the CFTC are rooted in the underlying laws, and would remain post-merger (or replacement with a super agency). The conflicts would become intramural rather than intermural as it were, but would not go away.

For another, I generally favor functional regulation and given the myriad functions of financial markets and institutions subsuming all regulatory oversight to a single agency may well impede functional specialization.

The SEC already represents a good example. In broad strokes the Securities Act relates to securities issuers (e.g., disclosures) and the Exchange Act relates to the trading of securities. Those are two very different functions and only tangentially related. Yet a single regulator oversees both.

The CFTC also has authority over trading per se on some venues.

Both agencies have authority over intermediaries (e.g., broker-dealers, FCMs) and clearing.

Maybe there would be some reasonable rationale for splitting off regulation of issuers from regulation of trading, trading intermediaries, and clearing, and putting these last three in a single silo. But even that is problematic due to path dependence.

We are not starting with a blank slate. The pre-existing statutory division is one historic fact. Another is that derivatives and securities markets have evolved very differently, and that could very much reflect the longstanding regulatory bifurcation.

Is it desirable to move toward uniformity in how derivatives and securities markets are organized and governed, and in essence ignore the historical process that created the current market structures? That’s not immediately obvious given how wrenching and unpredictable the process of achieving uniformity would be–and how rife the unexpected consequences would be.

Moreover, how would the political economy work? There’s no guarantee that the politics of a unified regulator would lead to a more efficient regulatory structure.

Indeed, to me it’s more likely that that rent seeking would rule, and efficiency would be damned. There’s actually a strong argument to be made that competition between regulatory agencies disciplines the rent seeking to some degree. And it can also discipline the ideological fervor of someone like Gary Gensler.

The ongoing drama over crypto regulation is an example. I’m not a crypto evangelist by any means but overall I favor letting market processes determine the outcome. If GiGi was king, or even merely the sole regulator of crypto, that would never happen. Regulatory competition (with the CFTC) constrained Gensler and the SEC, so the market will have the chance to have the final vote.

Indeed, one of Don Wilson’s beefs is very specifically with Gary Gensler. (And oh boy, do I get that!) A regulatory structure with one regulator would make some future GiGi far more dangerous.

Why should regulatory monopoly be looked upon more favorably than private monopoly? Indeed, regulatory monopoly is more dangerous because it cannot be disciplined or undermined by entry. Only the naive who believe in the public interest theory of regulation (and regulators) could believe that a single regulator would act to enhance efficiency rather than exploit its power for often malign reasons.

I have often written that there is a multitude of ways for executing financial transactions that have some common elements because transactors and transactions are heterogeneous. One size does not fit all. (Gensler was something of a one size fits all fanatic at the CFTC). Even though any division will lead to anomalies, conflicts, and regulatory arbitrage, there is enough distinctiveness between say derivatives markets on the one hand and security markets on the other to make separate regulators a better outcome. The division of labor is limited by the extent of the market. The scope of financial markets is so huge that there is considerable division of labor in them, and a division of regulatory labor makes considerable sense too.

Further, although the term “regulatory arbitrage” is typically used as a pejorative, it is not necessarily a bad thing. Indeed, it can be a good thing when market participants use regulatory fragmentation to introduce beneficial innovations that a particular regulator would prevent.

It should also not be forgotten that the SEC and the CFTC are not the only regulatory players in this game. The banking regulators and the Fed are also quite involved, especially on issues relating to intermediaries (who are banks or deeply enmeshed in the banking system) and clearing. Some regulatory fragmentation is inevitable as a result. Just mashing together the SEC and the CFTC will not make the fragmentation disappear.

I say only slightly facetiously that the best effect of regulatory consolidation is that reduced specialization would increase the cost of regulation, leading to less of it. There are no economies of scale, and are in fact diseconomies of scale, at the commissioner level. The bandwidth of the commissioners who are the final arbiters of rules is limited. As a rough estimate, a single commission responsible for double the statutes will have the capacity to produce half the rules as two commissions would. Sounds good to me!

(And no, doubling the number of commissioners would not help. Each commissioner has to weigh in on each proposed rule).

(Less factiously, doubling the workload would empower staff as commissioners would be more reliant on staff to craft rules, and explain them, so rule “output” might not decline that much as the commissioners just end up spending less time on each proposal).

Proposing agency merger or creation of a super agency is almost always a symptom of overall dissatisfaction with regulatory outcomes. But those bad outcomes are usually the result of bad regulators or bad underlying statutes. As noted above, consolidating regulators would increase the power of the bad regulators who will inevitably come along, so be careful what you ask for. And redrawing the regulatory org chart won’t address the statutory problems.

So if you don’t like current regulatory outcomes, don’t focus on the number of agencies and the names on the buildings they occupy: focus on the laws that determine what regulators can do and how they can do it.

Frankendodd was full of bad things, so start with that. Go to a slimmer legal framework that focuses on force and fraud rather than one that attempts to micromanage market macrostructure. Work towards a framework that disempowers would be Gary Genslers rather than the reverse.

Recent Supreme Court decisions, especially Loper, will help by constraining the ability of regulators to go beyond the authority explicitly delegated to regulators by statute. But many of the delegated powers are already too broad, so that needs to be addressed too.

In sum, to fix regulation it is necessary to get to its roots. Its roots are in legislation. Shuffling around who implements the legislative mandates is a superficial response to a deeper problem that originates in the Capitol.

PS. My friend Jeff Carter has a Substack on the same issue. Check it out.