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Speech by SEC Staff:
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This was prepared for presentation as the opening address for the afternoon of the Conference of the Autorite des Marche Financiers on "Structure and Regulation of the Financial Markets" in Paris on May 14, 2007. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff. |
1. Introduction
It's a great pleasure to be in Paris for the conference organized by the AMF, the French securities regulator, on "Structure and Regulation of the Financial Markets." This is a bit of a homecoming for me since most of my own research in market microstructure has been undertaken in collaboration with the well-known Toulouse researcher Bruno Biais. Indeed, two of our major studies were directly based upon data from the Paris Bourse.1 A prominent member of the Scientific Advisory Committee for the conference is Thierry Foucault, whom I first met fifteen years ago when he visited Carnegie Mellon as a doctoral student accompanying Biais's visit as a young faculty member. I appreciate the invitation to address some of the current challenges in the regulation of our capital markets and will focus upon some aspects of regulatory competition and coordination. This is a broad ranging and important issue for securities regulation given the evolution of technology and the greater integration of the financial marketplace in our global economy. At the onset of my remarks I should emphasize, that of course, the views and perspectives that I am expressing today are my own and not those of the Commission or my colleagues on the staff of the United States Securities and Exchange Commission.
2. The Current Marketplace
The nature of our marketplace has changed substantially in recent years. As a result of both technological innovations and increasing scalability of specialized skills the financial markets have become much more integrated, as illustrated by a number of recent exchange mergers and merger proposals. Recent regulatory implications of these trends have manifested themselves in such diverse forms as the interest in cross-border security exchange mergers and related regulatory consequences, the demutualization of a number of securities markets, the competition among self-regulatory organizations (SROs) and platforms, the importance of derivatives and the Internet and the recent SEC rule change broadening the conditions under which foreign issuers can deregister their securities from the United States regulatory environment. But these contexts also raise fundamental issues about regulatory goals and the interaction among government regulators. After all, in the global environment policy determinations may reflect the actions of multiple regulators and decision-makers and the decisions of individual regulators may lead to "external" effects on investors in other countries.
Regulatory coordination and competition raises important current challenges for regulators and the financial community.2 Both derivatives and the Internet point to a variety of inherent difficulties for regulation in the current era. We now often observe situations in which transactions of differing forms need not have the same regulation, despite the substance of the transactions being similar. There are even new technical challenges to the regulatory environment. For example, to ensure that the specialist on the NYSE does not trade ahead of other traders and investors the NYSE has attempted to delay the specialist's trades by a fraction of a second to compensate for the shorter electronic path required for the specialist's execution. The appropriate offset is a difficult issue to scale appropriately and points to a new technical challenge in the current era.
3. Regulatory Goals and Regulator Interactions
Within the United States the focus of regulation by the Securities and Exchange Commission is motivated by the goals of investor protection and promoting capital formation. However, even with a well-articulated objective there may be various approaches to the appropriate policy as different policymakers operationalize the objective in different manners. But the goals of all securities regulators around the world do not coincide for both cultural reasons and because of the diverse legal mandates and political settings in different countries.3
While the most basic textbook analysis of regulation in economics focuses upon situations associated with a single regulator, for many issues competition or interaction among regulators is important.4 A classic example of government policy with multiple jurisdictions is the competition among political jurisdictions in tax and spending policies. For example, in settings in which there are diverse preferences for public goods and services economists have addressed the competitive aspects of provision of goods in models in which different jurisdictions compete by offering different levels of public goods and taxation with the size of the political jurisdictions adjusting to clear the market in what economists often term the "Tiebout equilibrium" (e.g., see Tiebout (1956)). One of the benefits of decentralized policy-making and allowing for local provision of public goods is that this facilitates accommodating the diverse or heterogeneous preferences in the broader society. For example, different societies may have different perspectives on the costs to be incurred to protect unsophisticated investors.
Regulatory competition can make it difficult to sustain a high regulation level and manifest itself as a "race to the bottom," to attract activity from firms seeking to minimize regulatory costs, making it difficult to address some contexts that would benefit from strong regulatory intervention. Consequently, there may be difficulties in sustaining high regulatory standards, even when appropriate to do so. An illustration in a tax and spending context is the willingness of many United States localities to subsidize the building of sports arenas because of the competition from other jurisdictions. It is hard to articulate a plausible case for public provision of sports arenas absent the pressure from rival localities, which do not currently possess a franchise in the sport.
However, in other situations regulation may be perceived as beneficial, which would reflected in higher asset value in settings in which the asset is bundled with greater regulation, leading to a "race to the top". An example where strong regulation has broad support is the desirability of strong rules and actions against securities fraud. When regulation is desired by the market there can be a "race to the top;" Tafara (2006) highlights some features of Sarbanes--Oxley that have been mimicked abroad.
Inherently, regulatory competition can lead to "regulatory arbitrage." The introduction of new regulations is often oriented to specific types of markets or investment agents. For example, suppose that cash markets are more heavily regulated than over-the-counter derivatives markets and that some types of market participants, such as mutual funds and broker/dealers, are more heavily regulated than others, such as hedge funds. The introduction of new regulations, if they are perceived as burdensome, can lead to the unintended consequence of transactions substituting towards the less regulated markets and toward investors who themselves are less heavily regulated. The form of transactions potentially responds to the system of regulation in place.
To some degree this is an important challenge to the prior models of regulation and highlights the importance of regulatory competition. Does it matter to investors or financial intermediaries where they trade a particular instrument or where an instrument trades? Arguably, the answer may be no unless the location of trading affects the liquidity available to the investor, his information or potential legal protections and remedies. Yet at the same time, where the trades take place is of considerable interest to the rival locations. For example, much of the economic success of New York City since the 1970s is largely attributable to the boom in its financial services industry.
4. Several Examples
One facet of interaction among regulators is that some U.S. firms have argued in recent years that aspects of the current regulatory environment place them at a competitive disadvantage. For example, some U.S. financial institutions have strongly criticized the Patriot Act, whose "know your customer" rules require financial institutions to proactively investigate the source and legitimacy of customers and their funding rather than simply identifying for the government the specific transaction or party. Critics of these rules from the financial services industry suggest that they place U.S.-based financial institutions at a competitive disadvantage, even relative to its many allies in the "war on terror." Part of the difficulty is that the ability to pass along the resulting costs to customers would be limited for customers in the global arena because the financial institution's global competitors do not face similar costs. Indeed, that suggests the importance of trying to define and negotiate these rules and obligations on a more global basis. For example, to the extent that these types of rules are useful they should be promoted to a country's allies and the unwillingness of other nations to adopt such standards could be relevant to their domestic evaluation.5 One way to summarize the overall point is that the relevant domestic policy margins are impacted by the global economy.
An interesting issue for which multiple regulators are central is the appropriate form of accounting standards. There are obvious advantages to greater commonality and standardization to avoid duplication of cost, but yet there still may be some heterogeneity of regulatory objectives. For example, there are different perspectives as to whether U.S. GAAP or IFRS is a preferred accounting approach and some degree of convergence in these standards. The SEC has announced that it plans to consider proposing for public comment allowing foreign issuers to not reconcile IFRS accounting to U.S. GAAP. But this raises the question of whether U.S. domestic firms also should be allowed to file in IFRS, which the SEC is expressing interest in obtaining feedback about. More broadly, should firms be allowed to choose their accounting system? How much discretion in accounting standards is too much and to what degree would discretion lead to adverse selection?6
There also has been extensive discussion recently about the Sarbanes-Oxley framework, especially the certification of material weaknesses required under its Section 404, including whether that places the U.S. at a competitive disadvantage. Critics of Sarbanes-Oxley have noted in recent months the movement of initial offerings to other parts of the world and have suggested that the costs of the U.S. regulatory structure are at the core. Of course, it's plausible that if the United States regulatory framework placed the U.S. at a disadvantage that global firms would respond by instead listing in other markets. The issue is not simply one of comparable cost, but of net benefits; which regulatory arrangement do investors value the most net of the costs? The listing decision is a crucial margin for firms to respond to the differences in regulatory regimes across jurisdictions. Of course, changes in listing behavior can relate to other causes as well-such as the high IPO fees in the United States, greater integration and liquidity of the European markets in recent years and cultural causes related to the origin of the firm. Consequently, changes in listing decisions by European and global companies can reflect a number of considerations, besides the regulatory costs of the U.S. structure.
The foreign issuer deregistration context indirectly raises the issue of the goals and objectives of the regulator. This is especially germane in situations when multiple regulators are potentially relevant, as in the case of foreign issuers. It seems reasonable to suspect that the goals of different regulators could diverge because of differences in objective and philosophy. The recent SEC action to broaden the test by which foreign firms could deregister from the United States and its regulatory regime reflects some of the related tensions. The motivation for this action is in terms of the interests of United States investors as the mission of the Securities and Exchange Commission is defined in relevant part in terms of the best interests of these investors. Easing the conditions for departures from the United States regulatory system in the long-run may increase the ex ante willingness of firms to subject themselves to these regulations, which may lead to benefits in terms of protection of U.S. investors and reductions in net costs by the firms' that choose to exit. Cross-listing in the United States affects foreign investors due to spillovers of both benefits and costs from the U.S. investor protection regime.
5. Exchanges
Portions of the Sarbanes-Oxley framework appear to be unfavorably regarded overseas. At the heart of the issue could be differential assessment among countries of the benefits and costs and the underlying goals of regulation. In recent months there even has been considerable public discussion of the merger of the New York Stock Exchange and Euronext in the context of the Sarbanes-Oxley framework. European regulators and European--listed firms publicly sought assurance that the merger would not by definition scope European firms within the United States regulatory framework. From an exchange perspective, the trans-Atlantic merger also highlights the nature of the impediments to international access to securities trading, such as the ban on general solicitation of non-registered securities and foreign trading screens in the United States, the lack of developed clearance and settlement mechanisms in at least some markets and differences in the regulatory environment for security trading. The international barriers to investment are arguably declining faster than the regulatory barriers. For example, intermediaries may wish to trade international products to compete-which would limit the degree of regulatory competition.
In economic theory regulation often is motivated by attempts to internalize the effects of externalities or to limit the exercise of monopoly power. As an example consider the case of specialists on the floor of the New York Stock Exchange, who historically have had both special rights and responsibilities in the trading process. In the hybrid design that the New York Stock Exchange now is beginning to implement there are major changes to the role of the specialist and the fundamental character of the platform as there is an effort to integrate a fully electronic system with the trading floor. The design changes have emerged as a byproduct of regulatory obligations, the exchange customer's demands, the exchange's demutualization and the dramatic changes to its ownership structure and governance and the evolution of technology. Historically, the motivation for regulation of the behavior of the specialist reflects an attempt to limit the scope of the residual market power that they possess. As a result of demutualization, exchanges are more oriented toward enhancing the value of their platforms rather than the profitability of individual trading market professionals. There is at least some advantage to differentiating the platform's products. The optimal regulation would be tailored to the precise form of the trading mechanism, the nature of the market power possessed by the market professionals and the goals of the platforms. More broadly, while regulation can be very useful to ensure that market power is not excessively exploited, the appropriate regulatory approach should be guided by the specific context.
The exchange merger context raises broad issues about what does an exchange merger mean? What types of synergies can be exploited under various regulatory structures? Ultimately, scale economies play a key role in fueling exchange mergers. Are these confined to technology and know-how? Could these extend to the clearance mechanism or even to reciprocal access? How do the markets plan to evolve? Should (and if so, how should) regulators innovate in response?
6. Concluding Comments
By way of conclusion I should emphasize that the globalization and integration of our markets and new ownership and market structures pose important challenges to regulators about the objectives and underpinnings of regulation and the constraints that individual regulators face. Reflection about the nature of our regulatory framework and its application to new contexts suggest important issues facing both regulators and academics. For example, from an academic perspective models of local public goods may help shed new light on the nature of regulatory competition and regulatory arbitrage. Focusing upon the specific underlying frictions and constraints also may help identify ways to enhance regulatory coordination and strengthen regulatory practice.
References
Biais, B., C. Bisiere and C. Spatt, 2003, "Imperfect Competition in Financial Markets: An Empirical Study of Island and NASDAQ," unpublished working paper.
Biais, B., L. Glosten and C. Spatt, 2005, "Market Microstructure: A Survey of Microfoundations, Empirical Results and Policy Implications," Journal of Financial Markets 8, 217-364.
Biais, B., P. Hillion and C. Spatt, 1995, "An Empirical Analysis of the Limit Order Book and the Order Flow in the Paris Bourse," Journal of Finance 55, 1655-1689.
Biais, B., P. Hillion and C. Spatt, 1999, "Price Discovery and Learning during the Preopening Period in the Paris Bourse," Journal of Political Economy 107, 1218-1248.
Dell'Ariccia, G. and R. Marquez, 2006, "Competition Among Regulators and Credit Market Integration," Journal of Financial Economics, 79, 401-430.
Spatt, C., 2006, "Speech by SEC Staff: Regulatory Competition, Integration and Capital Markets," presented at the University of Calgary, October 23, 2006.
Statman, M., 2006, "Local Ethics in a Global World," unpublished working paper, Santa Clara University.
Tafara, E., 2006, "A Race to the Top: International Regulatory Reform Post Sarbanes-Oxley," International Financial Law Review.
Tiebout, C., 1956, "A Pure Theory of Local Expenditures," Journal of Political Economy, 64, 416-424.
http://www.sec.gov/news/speech/2007/spch051407css.htm
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