Speech by SEC Staff:
Investors' Choice in the Regulation of Global Capital Markets?
Director, Office of International Affairs
U.S. Securities and Exchange Commission
2008 International Corporate Governance Network Annual Conference
Globalization of Capital Markets
June 19, 2008
Thank you, Chris (Ailman), for the kind introduction.
Before I begin, however, I should start with the already familiar SEC disclaimer: As a matter of policy, the SEC disclaims responsibility for any private publications or statements made by any of its employees. This speech expresses my own views only and does not necessarily reflect those of the Commission, the Commissioners, or other members of the Commission's staff.
Today I thought I would engage you with regard to not just the globalization of capital markets, but also with respect to what investors want from such a global market. Globalization is not limited to companies seeking capital across borders, but, more importantly, it involves investors investing beyond their own shores.
I think it is particularly appropriate that this panel is meeting in Seoul. Over the past several decades, Korea has proven itself to be one of the most global societies, exporting ideas as readily as products, and importing concepts from around the world that fuse into something uniquely Korean. Whenever I see Seoul's skyscrapers or read of the latest Korean semiconductor innovation, I'm reminded of the first time I heard of budae jigae — American hotdogs and ham, Chinese noodles and Korean kimchi fused into a soul-warming stew that is both far more delicious than the sum of its ingredients and proof positive that Korea knows the secret to engaging the world while never losing the essence of what makes Korea so special.
This secret — adapting while retaining the unique and essential — is something financial regulators must learn. But it also asks a question of you, the investors, as the beneficiaries of financial regulation.
The challenge of globalization is familiar to us all. At its core the challenge derives from the fact that although the capital market is global, its constituent parts are still regulated at the national level and, in light of national sovereignty, this approach is bound to endure for some time.
The Mobility of Issuers, Intermediaries, Exchanges and Capital
We can credit technology for the global quilt of markets that now allows issuers to seek capital on a global basis. The major market intermediaries today operate in multiple jurisdictions. The scale and the nature of these operations vary widely. Many firms are content to operate as niche or monoline players, offering a limited range of products and services internationally. Others organize themselves as financial conglomerates. Whatever the business model, national boundaries themselves are no longer a determining factor in how firms organize themselves. Businesses prefer for the sake of efficiency to organize themselves on the basis of global or regional product lines with management and controls cutting across national boundaries.
And by virtue of technology, it possible for even a novice to execute a cross-border trade via a computer terminal. In fact, from a purely technological perspective, there often is no difference today between conducting a transaction on a domestic market or a foreign market. Where exchanges have gone entirely electronic, market intermediaries — whether foreign or domestic — effectively are just nodes in a very large, relatively seamless, network. An electronic network can allow an order to be executed from a computer terminal placed pretty much anywhere in the world.
But, perhaps most importantly, today capital is both widely dispersed and mobile. More Americans than ever before invest in our capital markets and, increasingly, these investors also trade on foreign markets and invest in foreign securities. Just between 2001 and 2005, US investor holdings of foreign securities of all types nearly doubled, from $2.3 trillion to $4.6 trillion. US investor ownership of foreign equities during this same period increased from $1.6 trillion to $3.3 trillion. Nearly two-thirds of American equity investors are now invested in non-US companies, a 30 percent increase from just five years ago.
In short all factors of securities trading — investors, issuers, brokers, trading facilities and investors are entirely mobile.
This mobility presents both promises and challenges to regulators' mandate to protect investors, ensure fair, orderly and efficient markets, and facilitate capital formation. The promises include greater competition in the market for financial service providers; an opportunity for investors to diversify their portfolio risk across borders more effectively and at less cost; and the ability of issuers to seek the lowest cost of capital wherever it might be.
The Mobility of Fraud and Risk and Opportunities for Regulatory Arbitrage
But mobility also presents opportunities for fraud, risk contagion and regulatory arbitrage.
Fraudsters use both technology and global markets to seek out victims and hide from regulators and law enforcement agents. This is possible because technology today knows no borders, but the investigative powers of regulators and law enforcement agencies stop at national borders. Fraudsters use both technology and global markets to seek out victims and hide from regulators and law enforcement. The same technology that makes it possible for investors to look around the world for investment opportunities also makes it possible for fraudsters to look around the world for opportunities to lie, cheat and steal money from the wary and unwary alike. I would cite as prime examples the recent intrusion cases and the proliferation of boiler rooms that disaggregate the fraud, with the mastermind in one country, cold callers in a second, using voice over internet protocols in a third country, routed through a server in a fourth, to victims in a fifth with the proceeds of the fraud secreted to a sixth. In other words, fraud is now also mobile.
As national markets become integrated, risk becomes mobile and global risks become domestic risks. Recent events have demonstrated how systemic problems in a financial system — whether caused by fraud, negligence, or simple "irrational exuberance" — can spread across borders, potentially causing even more chaos than isolated cases of fraud likely ever could.
But fraud and systemic financial risks are not caused by globalization. Indeed, financial regulation in most countries is the result of fraud or systemic shocks that happened at the national level. Over the past seven and a half decades, the SEC, like other financial regulators, has spent its time not just deterring financial fraud and creating mechanisms to prevent systemic risks from occurring, but also devising firewalls throughout the financial system to prevent the inevitable failure — whether fraud or mistake — from undermining the integrity of the system as a whole.
It is for this reason that regulators fight regulatory arbitrage. Governments have expended considerable effort to buttress the integrity of the major markets and the resulting regulation has a cost. However, where market participants are able to avoid our regulatory efforts by slipping across borders, these costs get called into question. And under these circumstances, failure of a firewall in a single market sector in a single country can allow the fire to spread not just across market sectors, but across borders. Keep in mind that this arbitrage is made possible not only because of advances in technology that allow issuers, brokers and trading facilities to locate anywhere in the world, but also because of the mobility of capital — your capital.
We regulators are now at a crossroads in addressing the globalization of our markets, and there are three alternatives to deal with the concomitant risk of cross-border fraud, contagion of problems and regulatory arbitrage.
One approach is isolation. We can try to seal our borders. The problem with closing the borders is that it is apt to lead to less competition, and, more importantly, less information flowing to investors about investment opportunities abroad. If, in turn, this leads to less diversified portfolios, it may well result in an inferior risk/return tradeoff for the investors. Thus, closing the borders in the name of protecting investors may well lead them into a riskier position overall. Also, since today's technology makes borders porous, isolation may not even protect the integrity of our markets as we might hope.
A second approach is to declare caveat emptor, let in everyone who wishes to do business with investors in your market, no matter the provenance of the securities, the broker or the trading facility, and no matter the regulatory environment under which they operate. This may be an option for investors of sophistication and means.
International collaboration among a coalition of like-minded regulators with comparable regulation is a third alternative. For the past two decades, the SEC has been at the forefront of building relationships throughout the world to better protect investors. These relationships have developed to the point where the next step may be possible — forging an alliance of peers. While countries vary in their approaches to securities regulation, there are other jurisdictions that share the SEC's passion for investor protection and market integrity. The protections these markets offer investors mirror our own and could be recognized as such. Mutual recognition arrangements predicated upon shared regulatory philosophies and outcomes and put into effect through strong supervisory and enforcement cooperative arrangements could create the kind of international regulatory infrastructure that will support current trends and strengthen the global market rather than undermining it.
But all of you, as investors, are also at a crossroads. The question to be asked, as you allocate capital abroad, is what are your expectations of the marketplace of the 21st century? Should we as regulators look to reduce the cost of bringing financial services from abroad to your doorstep or do you already have all the access you need? What kind of regulatory infrastructure should accompany cross—border services? Are you as institutional investors content to abide by caveat emptor or should we regulators devise a system of market access that draws distinctions among regulatory environments supporting financial services from abroad.
In the coming weeks and months, you will have the opportunity to state your preference as some regulators, including the SEC, put forward proposals for addressing the globalization of markets that vacillate between caveat emptor and collaborative oversight. Your stated preference is bound to have a permanent impact on the shape of the international regulatory infrastructure for many years to come.
As with every renovation project, as we tear down the barriers that separate our markets, we must be careful to avoid knocking down any load-bearing walls. I think eliminating barriers to cross-border transactions, without doing more, could be a mistake. But doing nothing is a mistake as well. Rather than just tearing down obstructions to cross-border investment without regard to the systemic regulatory effect, we have the opportunity to make sure that the systemic and anti-fraud protections we want to retain work seamlessly across borders though a network of regulators sharing the same regulatory objectives, even if varying on the mechanics of how those objectives are achieved in practice.
Tearing down the walls that separate markets is a laudable goal. But tearing down the foundations upon which our markets are built is something we should to avoid at all costs.
Fortunately, one does not preclude the other. But it does require us to change the way we think about regulatory cooperation. In the United States, I believe this means we have to change two things about the way we have traditionally looked at markets abroad: first, we have to stop thinking of our regulatory regime as inherently unique and forever qualitatively superior to the rest of the world. Quality market regulation is not a trade secret that no other market can ever discover.
Second, we must have the courage to recognize that not only do some markets share our regulatory philosophies and achieve similar regulatory outcomes, but, just as significantly, some markets do not. To build a new international regulatory infrastructure for a truly global market, securities regulators, not just in the United States but throughout the world, can no longer pretend that market oversight everywhere is either equally good or equally bad. Drawing distinctions may not be easy and indeed will be very difficult and unpopular — but it is crucial if we are going to create a global regulatory network that will protect investors and prevent systemic risks from undermining our markets.
These are my views on the state of cross-border regulation. Regulators around the world await yours.