Key Note: Symposium on Building the Financial System of the 21st Century: An Agenda for Europe and the United States
Commissioner Daniel M. Gallagher
U.S. Securities and Exchange Commission
March 21, 2013
March 21, 2013
Thank you very much, Hal [Scott] for that kind introduction and for inviting me to speak here today. It is a great pleasure to be here at a conference devoted to promoting trans-Atlantic dialogue between the U.S. and Europe.
Before I start, let me keep my chief ethics officer happy and advise you that my remarks here today are my own and do not necessarily represent the views of the SEC or my fellow Commissioners.
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We in America have been blessed with a wonderful combination of geography, natural resources, and free market principles. These and other factors have allowed our economy and our financial system, including our capital markets, to thrive in the post-World War II era.
Although the United States has suffered its share of financial crises, most recently the one that erupted in 2008, our free market economy and robust capital markets have conferred an enviable prosperity on our people over a period of many years, and few in America can remember a time when the United States did not have strong and competitive capital markets.
However, the very strength and resilience of our capital markets could lead us to fall into the trap of believing that we are somehow entitled to such prosperity. Indeed, such a sense of complacency may well have taken root in our government and may threaten to jeopardize that prosperity. The reality is that we live in a world in which we must be constantly vigilant — sometimes taking affirmative action, but more often choosing not to act — in order to preserve the vitality of our markets.
An important part of my job, and that of my colleagues on the Commission, is to ensure that America’s capital markets remain strong, vibrant, and competitive. That’s not just good for U.S. investors, but also for other investors around the world. And, conversely, the rise of robust capital markets in other parts of the world has the potential to benefit the United States and the American people as well.
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Today, financial services firms and investors are able to transact their business in markets around the world without leaving the confines of their homes or offices, much less their home jurisdictions. Companies are increasingly eschewing traditional venues like London or New York and instead turning to rising markets in Asia, Latin America, the middle east, and elsewhere for their capital needs.
Indeed, policymakers, business and financial industry representatives, and other market participants in the United States have been concerned about these developments for some time. In a November 2006 opinion piece in the Wall Street Journal, U.S. Senator Charles Schumer of New York and New York City Mayor Michael Bloomberg sounded the alarm about challenges to New York City’s status as the financial capital of the world.1 In the preface to a consulting report commissioned by New York on this issue, Senator Schumer and Mayor Bloomberg acknowledged other international financial centers’ challenges to New York’s status, warning that “we can no longer take our preeminence in the financial services industry for granted.”2
In March 2007, a report issued by a bipartisan commission established by the U.S. Chamber of Commerce identified and analyzed a number of these emerging challenges for U.S. capital markets.3 The report cited more than 70 years of capital markets excellence enjoyed by the United States and the “unmatched prosperity” that came with it, but also noted that the United States was steadily losing market share to other international financial centers.4 The report drew a distinction between two types of causes for this shift in market share. On the one hand, the report explained, this shift was “a reflection of natural economic and market forces that cannot, and should not, be reversed” and that indeed the development of European and Asian markets was a “positive development for the United States.”5 However, the report also cited internal, self-inflicted factors — such as an increasingly costly regulatory environment and the burdensome level of civil litigation — as negatives that should be corrected.6 Later, in March 2008, the Chamber’s Center for Capital Markets Competitiveness issued a report calling for a modern, coherent regulatory structure and fair legal, regulatory, and enforcement processes.7 In this report, they cited “robust global competition from overseas markets” and noted that “[t]he reality is that America is no longer the sole capital markets superpower.”8
In November 2006 and December 2007, the Committee on Capital Markets Regulation, an independent and nonpartisan research organization led by Hal Scott, issued a pair of reports calling attention to the declining competitiveness of the U.S. public equity markets.9 Among other things, the Committee cited a significant decline in the U.S. share of equity raised in global public markets, a precipitous decline in the U.S. share of the twenty largest global IPOs, and a legion of statistics indicating that foreign and domestic issuers were taking steps to raise capital either privately or in overseas markets rather than in the U.S. public equity markets.10
In November 2007, the non-partisan Financial Services Roundtable added its voice to this growing chorus, issuing a detailed blueprint for maintaining U.S. financial competitiveness.11 This blueprint noted the decades-long prosperity enjoyed by U.S. financial markets and firms, but concluded that this landscape was changing dramatically.12 The report went on to cite the relentless growth of foreign capital markets and the development of modern regulatory regimes in foreign jurisdictions. The report concluded that the United States should make changes to its regulatory system that would enable it to adapt and respond to “growing global competition,” “innovative market developments,” and “the dynamic financial needs of all consumers.”13
In March 2008, then-U.S. Treasury Secretary Hank Paulson neatly summed up these concerns in the Treasury Department’s blueprint for reshaping the U.S. financial regulatory system:
Due to its sheer dominance in the global capital markets, the U.S. financial services industry for decades has been able to manage the inefficiencies in its regulatory structure and still maintain its leadership position. Now, however, maturing foreign financial markets and their ability to provide alternate sources of capital and financial innovation in a more efficient and modern regulatory system are pressuring the U.S. financial services industry and its regulatory structure. The United States can no longer rely on the strength of its historical position to retain its preeminence in the global markets.14
That same month, the financial crisis in the U.S. began in earnest with the bailout of Bear Stearns, followed by the bankruptcy of Lehman Brothers in September 2008 and the low point of the U.S. equities markets in March 2009. In July 2010, well before the complex causes of the financial crisis were sorted out and understood by policymakers, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act as its reaction to the meltdown.
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Unfortunately, this legislative response to the financial crisis bore little resemblance to the competitiveness-enhancing regulatory reform contemplated by pre-crisis regulators and market participants. The Dodd-Frank Act was not a carefully crafted product of bipartisan compromise, as opposed to the Congressional response to the stock market crash of 1929. Rather, Congress — having been exhorted not to let a crisis go to waste — allowed the urgent need for regulatory reform to be overwhelmed by a grab bag of disparate wish-list items, many of which had nothing to do with the financial crisis but were derived instead from long-held ambitions of policymakers, bureaucrats, and special interest groups.
What continues to amaze me about Dodd-Frank is not only what it covers in its 2319 pages, but also the crucial regulatory issues that it failed to address. For example, the act mandates that the SEC create unprecedented new disclosure rules relating to conflict minerals from the Congo — but it omits any mention of money market mutual funds, which Dodd-Frank’s own FSOC tells us are ticking time bombs of systemic risk. The Act requires disclosure of extractive resource payments made by U.S.-listed oil, gas, and mining companies — but it leaves the reform of Fannie Mae and Freddie Mac for another day. The Act was intended to end “too big to fail,” but in reality it enshrined that concept by creating an entire system of special regulation for financial institutions that are “systemically important.” This system threatens to aggravate the problem by conferring a competitive advantage on these already “too big to fail” institutions.
Rather than responding appropriately to the crisis, which would include developing a modern regulatory system with the flexibility to adapt to changes in the global financial system, we instead have been saddled with an increasingly prescriptive and inflexible regulatory environment that is characterized far more by more regulation than by smart regulation. Put another way, Congress, in fact, did let a crisis go to waste. The calls for proactive reform contained in the various reports I mentioned were ignored when the patient was on the operating table. Far from cured, things have, indeed, gotten even worse. To extend the analogy, under the surgeons’ care, the patient’s infection turned into sepsis.
Rather than addressing the competitive concerns raised before the crisis by policymakers and business leaders, the Dodd-Frank Act represents a vast increase in precisely the type of regulation that raised those concerns in the first place. Indeed, Dodd-Frank marked a tremendous expansion of prescriptive financial regulation, with much of the law’s rulemaking burden, including about 100 of its 400 rulemaking mandates, falling on the SEC. The very volume of Dodd-Frank’s prescriptive mandates to the SEC has had the unintended effect of significantly limiting the agency’s ability to bring its traditional expertise and judgment fully to bear in the rulemaking process. In that sense, it has had a negative impact on the Commission’s ability to develop sound, sensible regulation and to adapt quickly and flexibly to the continuing transformation of global capital markets.
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Given these limitations, how can the Commission and other capital markets regulators best approach the challenges of this brave new world? Recognizing that capital markets and their participants are becoming increasingly de-localized in a world where new and complex financial products are traded around the clock and across the globe, it is certain that financial products and the entities that trade them will be regulated in different ways in different countries. As products cross international borders and move from one jurisdiction to another, simultaneously satisfying each of the overlapping regulatory requirements of multiple jurisdictions can be costly to investors, not to mention confusing — and the only ones smiling are the lawyers.
In the past, the standard response to cross-border jurisdictional conflicts was to seek to negotiate one-size-fits-all norms for all to implement. That approach is increasingly seen as impractical and obsolete. Certainly, it cannot hope to keep pace with product development, trading techniques, and even national regulation. Still, we must recognize the significant impediment to global trading posed by duplicative regulation of the same transaction or activity.
The key, it seems to me, is for regulators to accept the reality that, as to any given financial product or activity, there are likely to be high quality regulatory regimes other than ours — or, for that matter, yours. With that in mind, it seems that the best way to ensure high quality, but not layered and oppressive, regulation of those products and activities will be for one jurisdiction to defer to another’s regulatory approach, at least in certain situations.
This is not a new idea — but implementing it effectively will require new approaches. Academics as well as regulators have developed formulations like “substantial equivalence” and “mutual recognition” to describe a situation in which one country’s securities regulators would defer to another’s when their securities regulations were, in substance, largely the same. The goal under such an approach is to allow one regulator to accept as sufficient the regulatory actions of a different regulator with respect to financial services activities and participants that span multiple jurisdictions. Accordingly, this deference would have to be mutual, not unilateral, to have any hope of achieving its objective.
Notwithstanding the complexities involved, exploring this concept strikes me as a matter of common sense, given the pace of change in our financial services world, with investment products evolving before regulations can be written to cover them.
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The SEC began to explore concepts of regulatory equivalence about five years ago, an effort that yielded limited success. The financial crisis of 2008 forced the agency to shelve this initiative. Two years later, the extraordinary expansion of financial regulation stemming from the Dodd-Frank Act further clouded the regulatory landscape, even as it made conspicuous the point that a one-size-fits-all approach had become utterly impractical.
The issue of extraterritorial application of laws and rules is best illustrated by the current debate over how U.S. regulators will apply the OTC derivatives provisions of the Dodd-Frank Act to activities that cross national borders. Given the complexity of the overall regulatory scheme for derivatives set forth in Title VII of the Act, the question of how to apply that regime to cross-border transactions is significant. Because derivatives are perhaps the most global and mobile financial products that exist, with dealers and other intermediaries spread across the world trading products for widely dispersed clients, the SEC staff is, of necessity, discussing this matter with foreign regulators. We must, in addition, coordinate our efforts with our domestic colleagues at the CFTC, who were given responsibility for swaps that are not security-based — the vast majority of the market.
As most of you know, this has not been an easy exercise. As has been widely reported, the CFTC has taken a very aggressive approach, attempting to extend the reach of its OTC derivatives rules deeply into foreign jurisdictions. Not surprisingly, key foreign regulators have expressed serious reservations at the CFTC’s approach. You may recall that leading policymakers from the European Commission, the United Kingdom, France, and Japan wrote a joint letter to the CFTC requesting that it refrain from taking action that would risk fragmenting and damaging the derivatives market, arguing instead for an approach grounded in principles of regulatory equivalence and substituted compliance.15
Subsequently, in a joint statement issued after their November 2012 meeting, the leaders of twelve national and supranational entities responsible for regulating OTC derivatives expressed interest in regulatory approaches that included voluntary regulatory deference. In their statement, this diverse group of regulators agreed that some form of limited regulatory “recognition,” acceptance of “substituted compliance,” or specific “exemptions” “should be considered” in crafting regulatory regimes applicable to OTC derivatives, given the “need to prevent the application of conflicting rules and the desire to minimize … the application of inconsistent and duplicative rules.”16 I, too, believe it will be critical to incorporate some sort of regulatory deference into any cross-border approach to regulating security-based swaps.
Reaching beyond derivatives, you will also know that the European Union has adopted an “equivalence”-based approach to enable deference to non-EU regulators in various areas, including the regulation of credit rating agencies. In the United States, the SEC’s rules implementing the Credit Rating Agency Reform Act of 2006 established a registration and oversight regime for CRAs that register with the SEC. Three years later, in the wake of the global financial crisis, the EU adopted a directive establishing its own regulatory scheme applicable to CRAs. The EU directive included a provision allowing for non-duplicative regulation where the CRA is subject to a regulatory regime the EU has found “equivalent” to its own.17 After some serious bumps and bruises during the early stages of the equivalency determination process, the European Securities and Markets Authority concluded that U.S. regulation of CRAs was, in fact, equivalent to that under the applicable EU regulations. This prompted the European Commission to follow with its own equivalency determination several months later.18
While this experience was not, from a U.S. standpoint, a shining endorsement of the equivalency experiment, I do not think the problem lies in the concept of “substituted compliance,” so much as in the manner of its implementation. To succeed as it surely must, all involved will have to proceed without preconceptions, with clarity of vision, and perhaps with unaccustomed levels of restraint.
In other words, because the equivalency determination is the precondition to one jurisdiction’s acceptance of the regulatory actions of any other jurisdiction, it is inherently subject to misuse of a sort that would fly in the face of the very purpose of substituted compliance. It could, for example, be used as a chokepoint to force the other jurisdiction to regulate in the same way or to the same degree as the determining jurisdiction; it could be used as a protectionist tool, wielded for parochial and anti-competitive reasons.
So I want to stress: If “equivalency” and “substituted compliance” are to have a future — if international commerce in derivatives are not to be dragged down in regulatory confusion and cost — equivalency determinations must be made in good faith and with openness to approaches other than those of the evaluating entity or its political organs. Speaking on this topic, my colleague, CFTC Commissioner Jill Sommers, stressed the key point: “It is important that assessments of comparability be made at a high level, keeping in mind the core policy objectives … rather than a line-by-line comparison of rulebooks.”19
And, I am very happy to report, a bipartisan bill introduced in the House of Representatives just two days ago strikes precisely the appropriate balance, requiring that the SEC and CFTC jointly issue rules on OTC derivatives that show deference to broadly equivalent foreign regulatory regimes. The House bill provides, in pertinent part, that the joint SEC-CFTC rules “shall provide that a non-U.S. person in compliance with the swaps regulatory requirements of a G20 member nation, or other foreign jurisdiction as jointly determined by the Commissions, shall be exempt from United States swaps requirements … unless the Commissions jointly determine that the regulatory requirements of the G20 member nation or other foreign jurisdiction are not broadly equivalent to United States swaps requirements.”20
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Returning to my larger point: Much of America’s post-war prosperity has been driven by our free market economy and vibrant capital markets. More recent experience in other parts of the world, Europe included, underscores that connection. We must not take the vitality of our capital markets for granted. We must instead foster them, and in the process protect investors, whether large or small, domestic or foreign. We must all regulate in a balanced manner — smartly.
Smart regulation today requires, at a minimum, that we keep pace with the evolution of global markets, but that we do so without adding unnecessary costs — that we avoid imposing layers of complex, overlapping, and, to that extent, incoherent regulation. We must not look in isolation at the potential benefits of regulation, but also in each instance at whether they are sufficient to justify the costs that they entail. And we can, I submit, increasingly keep pace with developments in the industries and markets we regulate, while reducing the burdens we impose on those we regulate, by deferring to our peer regulators in appropriate situations.
Thank you very much for your kind attention, and I wish you a productive and successful conference.
1 Hon. Charles E. Schumer & Hon. Michael R. Bloomberg, Op-Ed., To Save New York, Learn From London Wall St. J., Nov. 1, 2006, http://online.wsj.com/article/SB116234404428809623.html.
2 Hon. Michael R. Bloomberg & Hon. Charles E. Schumer, Sustaining New York’s and the US’ Global Financial Services Leadership, at i (2007).
3 Commission on the Regulation of U.S. Capital Markets in the 21st Century, Report and Recommendations (2007) [hereinafter 21st Century Report].
4 21st Century Report, at 11, 15.
5 21st Century Report, at 11 and 17.
6 21st Century Report, at 16.
7 Center for Capital Markets Competitiveness, Strengthening U.S. Capital Markets: A Challenge for All Americans, at 4, 23-26 (2008) [hereinafter Strengthening U.S. Capital Markets].
8 Strengthening U.S. Capital Markets, at 3.
9 Committee on Capital Markets Regulation, Interim Report of the Committee on Capital Markets Regulation (2006); Committee on Capital Markets Regulation, The Competitive Position of the U.S. Public Equity Market (2007).
10 See, e.g., The Competitive Position of the U.S. Public Equity Market, at 1-5.
11 The Financial Services Roundtable, The Blueprint for U.S. Financial Competitiveness (2007).
12 See The Blueprint for U.S. Financial Competitiveness, at 7.
13 The Blueprint for U.S. Financial Competitiveness, at 8.
14 The Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure, at 2 (2008).
15 See Letter from Hon. George Osborne, Hon. Michel Barnier, Hon. Ikko Nakatsuka, and Hon. Pierre Moscovici to Hon. Gary S. Gensler (Oct. 17, 2012), available at http://www.fsa.go.jp/en/news/2012/20121018-1.html.
16 See “Joint Press Statement of Leaders on Operating Principles and Areas of Exploration in the Regulation of the Cross-Border OTC Derivatives Market” (Dec. 4, 2012) (relating to Nov. 28, 2012 meeting), SEC Press Release No. 2012-251, at item 4.
17 Regulation (EC) No 1060/2009 (Sept. 16, 2009), Art. 5(6), OJ L 302 (Nov. 17, 2009), at 1.
18 European Commission Implementing Decision 2012/628/EU, October 5, 2012, OJ L 274/32 (9 Oct. 2012). In separate decisions on the same day, the EU also found the CRA regulations of Australia and Canada equivalent to those of the EU.
19 Statement of Commissioner Jill E. Sommers at a hearing of the Subcommittee on General Farm Commodities and Risk Management, Committee on Agriculture, U.S. House of Representatives, Dec. 12, 2012.
20 House Financial Services Committee H.R. 1256, Swap Jurisdiction Certainty Act, 113th Cong., 1st Sess. (Rep. Garrett et al., introduced March 19, 2013 and referred to Committees on Agriculture and Financial Services) (emph. added).