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Speech by SEC Staff:
A Few Observations Based On International Regulatory Conversations


Ethiopis Tafara

Director, Office of International Affairs, U.S. Securities and Exchange Commission

Before the CESR Conference
"Preparing for the Future: Where to Now for the Regulation in the Field of Securities"
Paris, France
February 23, 2009

I would like to start by thanking Chairman Wymeersch and Carlo Comporti for the invitation to join this very august group. It is an honor to be present. I was asked to offer a US perspective on the current crisis. There was no better way to ensure the truth of the disclaimer I am about to make in saying that the views I express today are strictly mine and do not necessarily reflect those of the Commission or its staff. And as you can imagine, I can't offer a blueprint for regulatory reform in the United States, but I can make a few observations based on a series of international regulatory conversations.

The current crisis is of paramount concern. But in the long run, what may be of more concern, is what it reveals. It is said that this crisis is a once-in-a-century event. If viewed narrowly in terms of the proximate causes, this is true. But closer examination of the crisis reveals a fertile ground for additional crises, albeit with each crisis perhaps displaying unique features. So in devising reforms, we must not only address the most immediate causes of this crisis. We must also address the fertile ground from which they spring.

In essence, the crisis finds its origin in the evolution of markets and financial services. Over the past 15 years, the world's financial system has seen dramatic change to its structure and principal characteristics. The current turmoil likely is the result of the system having failed to adapt to these fundamental changes.

The four characteristics of the modern market are:

  1. its global nature and the resulting mobility of capital;
  2. the significantly increased competition among financial service providers;
  3. the elimination of differences between historically separate financial products, sectors, and actors; and
  4. the development of a large and relatively liquid unregulated institutional financial market paralleling the regulated markets.

I was going to describe the connection of each of these factors to the current crisis, but in the interest of time I will cut to the chase and address the type of reform called for by these characteristics.

First, of course, the new regulatory framework must address the issue of increased systemic risk, while not suppressing risk-taking per se. This is crucial if we are to address problems, yet not undermine economic innovation. To sustain the economic innovation needed to drive the economy, financial capital must be able to take risks.

As a corollary, we need a regulatory framework that provides prudential regulation for those financial intermediaries that are too big too fail. Surely, the essence of our financial system is to let people take chances with their money, and to enjoy most of the benefits and to endure most of the pain associated with taking those risks. However, if we are in a world where financial entities are too big, too indebted and too interconnected to fail, we know that those entities will have an incentive to take on excessive risk at the ultimate expense of the public. From a policy perspective, we want to end up in a world where, in fact, we can afford to let financial entities fail if they make bad decisions. If we cannot afford to have them fail, then they should be regulated so as to prevent imposing systemic risk.

Second, we need the regulatory framework to address the misaligned incentives that lead to taking excessive risk. In a world where one can slice and dice risk any way that is desired by trading highly opaque, difficult-to-value instruments, it is challenging to monitor well the people hired to manage money. Part of the answer will lie in finding different compensation schemes. Part of the answer will also lie in fuller disclosure, so that investors in the market can tell what intermediaries are doing, and the source of returns. Part of the answer will lie in extending the regulatory framework to cover entities not currently covered.

Third, we need a regulatory framework with better disclosure, so that lenders can better determine counterparty risk. Credit markets dried up when this crisis hit, because nobody was able to assess anyone else's exposure. A major step in this could be to introduce clearing houses and exchanges in any market (including derivative markets) above a certain scale and impose basic disclosure requirements with respect to any type of financial product that achieves a certain prevalence.

Fourth, the regulatory framework needs to account for the fungibility of financial products, actors and markets. Many products, actors and markets have the same underlying economic characteristics, motivations or clientele, yet are regulated based on connection to an institution that can be described as having either a securities, banking or insurance function. This leads to market participants searching for the path of least regulatory resistance and pursuing regulatory arbitrage. Although this is often in the interest of the regulated community, it is frequently to the detriment of consumers and investors. By the same token, we need to be vigilant not to pursue uniform regulation for the sake of ease given that there are instances where differences in the regulation of securities, banking and insurance are legitimate and indeed important.

Fifth, the regulatory framework of the future must be responsive to the fact that capital is mobile, markets are interconnected, and technology makes the movement of capital irrepressible. Capital travels in search of investment opportunities, which means companies, intermediaries and markets can choose their preferred location. Preference is frequently a matter of regulatory comfort. As a consequence, we need to ensure that our regulation is optimal in providing the best protection for investors and at the same time comparable across developed markets. Otherwise, we will create opportunities for jurisdictional regulatory arbitrage in contrast to functional arbitrage.

Finally, we need a regulatory framework that is ruthless in pursuing the protection of investors. Securities regulators must remain focused on market confidence. Trust is the lubrication that keeps the wheels of a market from grinding to a halt. It is the faith that a buyer is buying what he or she expects, and the faith that the seller will receive the payment promised at the time promised. And this faith has never been blind. Without this basic trust, no market in the world will succeed. In the diamond markets of New York and Amsterdam, trust is based on ethnicity, religion and the personal interaction of a handful of traders. The markets work because of reputation and the small community that makes up these markets.

With the anonymous trading that characterizes modern capital markets, this personal trust, perforce, has been replaced by a surrogate - clear, useful and timely information about the products bought and sold, rules on fair dealing between buyers and sellers, and vigorous enforcement by securities regulators with the powers and resources necessary to do the job.

As we consider regulatory reform, we should not lose sight of the differences between market regulation and the supervision of institutions.

Thank you for your attention.


Modified: 03/13/2009