Regulatory Apparitions: Remarks at the Exchequer Club
Nov. 28, 2018
It is just about a week past Thanksgiving, which means that we are solidly into the home stretch of the year. 2018 has been a busy and exciting year for the SEC under the hardworking, thoughtful direction of Chairman Jay Clayton. Among other things, we have proposed a new regulatory framework for broker-dealers, a rule set for exchange-traded funds, and a long-awaited summary prospectus for variable annuities; we have adopted new disclosure rules for Alternative Trading Systems, municipal securities, and mining registrants; our staff has held roundtables on market data and the proxy system; and we have put ourselves on an aggressive schedule for completing our security-based swaps rulemaking under Dodd-Frank.
In the spirit of looking back over the past year, I wanted to share some concerns and hopes I have for the state of securities regulation, with an emphasis on the latter word: regulation. I realize the danger in giving a speech on regulation a week after Thanksgiving, when we are all still sleepy from big Thanksgiving dinners, but regulation is a fascinating topic with important ramifications for our lives. I will look at several aspects of regulation that make it a particularly interesting and seasonal topic—the Ghost of Regulation Past, the Ghost of Regulation Present, and the Ghost of Regulation Yet to Come. Before I begin, I must give the standard disclaimer. The views I represent are my own and do not necessarily represent those of the Commission or my fellow Commissioners.
I. Regulatory Reexamination
We will start with the Ghost of Regulation Past. As an agency, we are well into our eighties. Many an octogenarian wakes each day to the accumulated aches and pains of a long, complicated life, some of which is shrouded in a fading memory. So too the Commission is constantly facing the consequences of eighty years of regulatory activity, but sometimes forgetting just what it has done in the past or why. In one sense, this forgetfulness is unsurprising. The number of rules that we have put on the books over the past eight decades is staggering. Moreover, we do not have the option of a comfortable retirement. Our regulatory mandate requires—and the American public expects—that we will continue to engage with and respond to a rapidly changing market.
Given these great expectations, once a rule is on the books, we too easily forget about it. It recedes into the regulatory and market landscape and assumes its place in that undifferentiated body of regulations that helps make our securities markets the deepest and most liquid in the world. Even when problems arise in the market, it is tempting to conclude that they reflect a problem not with our existing rules, but a market failure that requires the writing of new rules. As I have already mentioned, the market is constantly changing, so why revisit an old rule when the Commission is working overtime just to keep up with market innovators?
This one-and-done approach to regulation is short-sighted for a number of reasons. First, if a rule is not solving the problem we set out to solve, then we had better figure out another solution to the problem or, if the problem no longer exists, eliminate the rule. Second, if a rule is imposing higher costs than we anticipated, we should work to modify it to make it work more efficiently and effectively. Third, lessons about what worked and what did not in one rulemaking endeavor can inform future approaches to regulation.
Because the market is always changing, we must always keep in mind that a rule that once made sense may have outlived its usefulness. Perhaps it was designed to solve a problem that no longer exists, or maybe it contemplates solutions using obsolete tools. For example, I was recently alerted to fact that one of our rules still envisions the transmission of information to us by telegraph. Needless to say, my dismay of several weeks earlier about rules that require the submission of ten paper copies of documents has been eclipsed. It is past time that we revisit both of these rules.
Outdated rules can impose significant costs on market participants. These costs are why I oppose the mandating of specific technologies in our rules. To the extent that we as a Commission do issue such specific mandates, we have an affirmative obligation to revisit these requirements periodically. Take, for example, the Write Once, Read Many or “WORM” technology that features in our broker-dealer books and records rules. The concept is understandable—we want to make sure that registrants are not going into records after-the-fact and altering them, but there are other, much cheaper ways to ensure that records are not changed. We ought to consider whether it is time to allow firms the flexibility to use some of these more cost-effective approaches—methods that integrate seamlessly with the firm’s operations. Indeed, the Commission considered and rejected a WORM mandate for recordkeeping for investment companies and investment advisers 17 years ago and acknowledged that this rule differed from the rules adopted for broker-dealers, which require brokerage records to be preserved in a WORM format.
Even beyond rules that mandate potentially obsolete technologies, the Commission should, on a regular timetable, reexamine its rules to ensure that they continue to effectively and efficiently advance the regulatory mandate Congress has given us.
One model for this is then-Commissioner Laura Unger’s single-handed retrospective review of Regulation FD, a year after it was adopted in August 2000. The report she issued examined Regulation FD one year after its effective date, identified issues of common concern, and made recommendations for increasing the rule’s effectiveness.
This task, however, should not be left to individual Commissioners who have concerns about specific rules. All rules should be subject to periodic review beginning shortly after they are adopted. In at least one recent rule, we expressly included a commitment to look back at how a rule, or a particular aspect of it, is working. Specifically, in our new institutional order handling disclosure rules, we built in a de minimis threshold and committed ourselves to a re-examination of the threshold within a year.
The wave of post-crisis rulemakings gives us many opportunities for retrospective review. As one example, Form PF—adopted pursuant to a Dodd-Frank mandate—is intended to “help establish a baseline picture of potential systemic risk in the private fund industry.” Now that firms have struggled with Form PF for several years, it is worth asking whether the data it generates actually provide us with a valuable systemic risk picture, particularly given the enormous costs involved. Indeed, the Managed Funds Association (“MFA”) recently sent a letter to Chairman Clayton requesting, among other things, that the Form PF questions be revised “in a manner that would better identify counterparties whose default would likely lead to a significant loss for the reporting fund, and correspondingly, better identify a reporting fund whose default would likely lead to a loss for financing providers.”  The MFA also requested that certain thresholds in Form PF be revised in order to garner information that would be more likely to identify concerns related to investment concentration or market stress. If we are going to ask firms to spend lots of money answering questions in the name of systemic risk, the resulting data had better be useful.
Retrospective review can also help us evaluate how the rules in our enormous rulebooks interact with one another. In this spirit, the Commission is reconsidering rules related to the proxy process, capital formation, and market structure. Market structure, in particular, is one area in which so many of today’s problems are a product of past follies codified in our own rules.
Taking a fresh look at the rules of the past is essential for an agency as long in the tooth as the SEC and with a quantity of rules to show its age. As they say, however, eighty is the new forty, and, even in our old age, we have a youthful spring in our step that enables us to keep generating rules. The longer the rule book grows, the heavier the burden on financial markets and the more important it is not to assume that every feature of the regulatory landscape deserves to remain unchanged.
II. Regulatory Analysis
The Ghost of Regulation Present, like his counterpart in Dickens’ tale, offers a happy picture contingent on our taking appropriate action to maintain the good and prevent looming bad outcomes. Our markets function remarkably well for investors and people in need of capital. Regulation done right protects investors and the markets and facilitates capital formation without imposing undue burdens. Achieving a state of regulatory felicity requires us—in direct contrast to what Scrooge needed to do—to start counting the money. Regulation is expensive, so we have to undertake it with a clear understanding of the problem we are trying to solve and the reason that government regulation is an appropriate and effective solution.
I am reminded here of another seasonally appropriate short story by O’Henry, The Gift of the Magi, in which a husband and wife face the difficult problem of buying one another Christmas presents without any extra money to do so. The wife sells her prized possession—her hair—to buy a chain for her husband’s prized possession—his watch. He, of course, sold the watch to buy a set of fancy combs for her hair. The trade-offs that regulation demands can, if we are not careful, put us in a very similar position, forcing us, or market participants, to give up something very precious to pay for a new regulatory requirement. In the end, the regulatory price may consume the very aspect of the market we sought to safeguard; it may turn our shiny new regulation into nothing more than a pretty trinket.
The reality is that money spent on drafting or complying with a rule cannot be spent on something else. At a very practical level, we at the SEC have to think about our own costs as we set our rulemaking priorities. Our resources are not unlimited, nor should they be. The time a rulemaking team spends on one rulemaking project is time that cannot be spent on another. Moreover, examining for compliance with or enforcing additional rules is necessarily going to divert resources from other examination and enforcement priorities.
The trade-offs for us at the Commission are only the beginning of my worries. Once a rule is on the books, companies and individuals will spend time and resources on complying with the rule that they cannot spend on doing other things. In fact, they may take some of their most precious resources—such as information technology time and talent—and spend them on regulatory compliance. Part of our regulatory analysis needs to be a consideration of what a firm will have to give up to comply with our rules. We then need to ask whether the benefit promised by the rule outweighs this opportunity cost.
Recently, we had the chance to revisit one of our rules prior to its implementation. Rule 22e-4 under the Investment Company Act was adopted in 2016 to address fund liquidity. We subsequently made some changes related to the liquidity disclosures associated with the rule before the rule took effect. The Commission did not take the opportunity to assess whether the bucketing requirement was still warranted. Lots of resources have been and are continuing to be poured into a requirement that might, at best, produce some information that is interesting to economists who study the market and, at worst, might degrade funds’ investment decisions. At least we did pledge to look at how useful the information is after we have started collecting it.
Economic analysis is key to getting regulation right. The Commission, in recent years, has carved out a bigger role for economic analysis in its policymaking process. In March 2012, the Commission’s top economist and top lawyer issued a joint memorandum formalizing the role of economic analysis in rulemaking. Taking this step was important, but there is more work to be done. Ideally, the economic analysis would not be an essentially standalone document appended to the back of an already lengthy rulemaking release, but would instead be an integral part of the analysis that undergirds the rulemaking. The economics should be woven through the release just as the economics should be woven through our thinking when we formulate a rule.
Economic analysis involves forecasting how the world will change as a result of our rulemaking. Ex post analyses suggest, for example, that the Volcker Rule may have fundamentally changed the liquidity picture in the bond markets and that our money market fund rules have shifted assets to government money market funds. In both cases, rulewriters saw changes coming. Yet it is not clear that we did the necessary work to grasp the contours and magnitude of the changes.
Effective economic analysis weighs costs and benefits, but it also takes a broader view. For example, we are required to consider the competitive effects of our rules, and any such analysis should include an examination of whether a particular group views a rule change as a competitive advantage. For example, large firms might view regulation as a barrier to entry that keeps out smaller, potentially more nimble competitors. Firms that already do things a particular way may welcome a rule that forces everyone else to do things the same way.
Evidence that either concern is driving the call for regulation should lead us to be more skeptical about regulatory action. Barriers to entry or a uniform industry standard may result in fewer and more expensive options for investors. For example, investment advisers, who operate under a fiduciary standard, have been among the voices calling for the application of a fiduciary standard to broker-dealers making recommendations to retail investors, while also opposing the application of an oversight regime to advisers that is similar to the one to which broker-dealers are subject. Unsurprisingly, this push toward a uniform fiduciary standard and its attendant bias against commission-based compensation has led to a broader shift of financial professionals away from the transaction-fee based broker-dealer model, a cheaper alternative for many investors, and into the more expensive asset-based-fee investment advisory model.
Setting out metrics for measuring success when we adopt a rule is another important piece of the analysis. Picking our metrics ex ante would force us to assess a rule retroactively against metrics designed to show whether the rule is actually helping to solve the problem we set out to solve. Absent such pre-established metrics, we might be tempted to assess the rule by whatever metrics will make it look most successful ex post.
Another important component of sound analysis is seeking and taking into account the insights of commenters. Recently, we took the relatively unusual step of reopening the comment period for one of the key rules in our security-based swap rule set in a release that asked commenters to clarify our understanding of previously submitted comments. We have since received a number of very substantive comments that undoubtedly took many hours of intense work to prepare. The easiest course would have been for us to move right to adoption without giving commenters another opportunity to weigh in. I would like to see us resoliciting comments whenever doing so would help to answer important, new questions that emerge during the period between proposal and adoption of a rule.
High-quality regulatory analysis will produce better rules. We need to count the cost, think about how our rules will make the world change, set forth metrics for seeing whether it has changed as we expected, and be flexible in soliciting input from the people our rules are designed to benefit or otherwise affect.
III. Regulatory Modernization
Now for the Ghost of Regulation Yet to Come. Scrooge had the opportunity to see what the world would think of him if he did not change course. We, too, should reflect on the habits we have developed over our long life as a Commission and identify those that need changing lest we find ourselves, like Scrooge, increasingly isolated, even from the investors who are at the core of our mission.
For example, we need to reflect on whether we are constructively engaging with, rather than merely reacting to, new market phenomena in both our rulemaking and our enforcement programs. An obvious example for today’s financial regulator is digital assets. Our enforcement docket now routinely features initial coin offerings, blockchain, and crypto trading platforms. I firmly believe that we need to apply our rules consistently, which means that new technologies do not get a free pass from offering and exchange registration requirements.
That said, we ought also to be doing a better job communicating with new participants in the marketplace we regulate rather than acting as though entrepreneurs need to have the resources to hire a thousand-dollar-an-hour Wall Street lawyer to bring innovations to, or even to do business in, our markets. We cite the Howey Test for determining whether something is a security as if we expect every crypto-entrepreneur to know what it is and how courts and the Commission have applied it over the years. Even the securities lawyers many of these entrepreneurs cannot afford are struggling to apply the test.
We ought to do a better job in helping people think through the difficult legal issues. Enforcement actions ought not to be the means by which we tell the marketplace what we are thinking. The SEC’s recent inauguration of FinHub, a portion of the website dedicated to financial technology, is a good step. Speeches are helpful, but Commission-level guidance would be much more meaningful in assisting people in determining whether a particular token is a security. People considering raising money through the sale of tokens and those considering allowing tokens to trade on their platforms need to hear from the Commission about how the Commission is interpreting the rules in this context. Staff guidance is useful too, but its significance must always be tempered by the fact that it reflects the views of the staff, not the Commission.
We also often demonstrate the same attitude in communicating with the very investors Congress has entrusted to our protection. Investors bear the often incomprehensible effects of our inscrutable legal orders. We too frequently announce regulatory actions without due consideration for how the market will understand or misunderstand what we are doing. Granted, retail investors are as free to hire a Wall Street attorney as any investment bank to decipher the effects of our actions, but I hardly think that it advances our investor protection mandate to make that a necessary condition of investing in our markets. An example I have cited before is our recent decision to suspend trading for ten days in two foreign exchange-listed crypto-based products that were being traded in the United States over-the-counter markets. The SEC was concerned that there was confusion about just what the products were because they were not being described consistently, but our action also confused investors. It is not clear to me how many retail investors holding these products understood that “ten days” actually meant, as a practical matter, “indefinitely.”
Working in good faith with people who are trying to use our regulatory framework to raise money can help to change how people think about us. Some crypto issuers want to use Regulation A+, but the SEC has not qualified any such offerings. The Jumpstart Our Business Startups (JOBS) Act built on the then-current, but rarely used Regulation A to turn it into a useful and usable route for capital raising, but, to date, no crypto-company has successfully navigated through the opaque waters of the Commission’s Reg A process. One way to encourage people who are raising money in token offerings to do so legally is to show them that the process works and does not take so long as to be unusable by issuers. Understanding that token offerings present some unique issues, we have to apply the same standards to crypto-issuers as we do for others and resist the temptation to put up special roadblocks for issuers simply because crypto or blockchain is involved.
Securing a good future for the capital markets requires us to take steps now to help entrepreneurs and investors seeking to use those markets in a way that achieves their objectives and complies with the securities laws. We cannot simply continue doing things the way we always have and assume that modernity will neatly conform itself to our octogenarian ways.
Thank you for listening to my seasonal musings about how we can learn by looking into the past, present, and future. Doing so shows us that we have many opportunities to improve the way we regulate, which should, in turn, make our rules work better. A deep commitment to regulatory process and a true concern for regulatory outcomes should help us establish a healthy and even happy relationship with those we regulate. Investors, the capital markets, and the economy that is built upon those markets will be the beneficiaries of that relationship.
 I offer my deepest apologies to Charles Dickens. Charles Dickens, The Christmas Story. My use of this analogy, however, has precedent. See Paul Atkins, Commissioner, Remarks before the Securities Industry Institute (Mar. 6, 2006), https://www.sec.gov/news/speech/spch030606psa.htm (“Sometimes it feels like we at the SEC have been playing the role of old man Scrooge in Dickens's famous tale, but unlike the progression in that story we are stuck with visions of ‘Regulations Past’ instead of being able to move on to ‘Regulations Present’ and ‘Regulations Future.’ . . . . I hope that, as Scrooge did, we have seen the light and will make better decisions going forward.”).
 See rule 17a-11(g) under the Securities Exchange Act of 1934 (‘Exchange Act”) (17 CFR 240.17a‑11(g)).
 For investment companies filing on Form N-1A (§§239.15A and 274.11A) , Form N‑2 (§§239.14 and 274.11a-1) , Form N-3 (§§239.17a and 274.11b), Form N-4 (§§239.17b and 274.11c) , or Form N-6 (§§239.17c and 274.11d), within five days after the effective date of a registration statement or the commencement of a public offering after the effective date of a registration statement, whichever occurs later, 10 copies of each form of prospectus and form of Statement of Additional Information used after the effective date in connection with such offering shall be filed with the Commission in the exact form in which it was used.
 See, e.g., rule 17a-4(f)(2)(ii)(A) under the Exchange Act (17 CFR 240.17a-4(f)(2)(ii)(A)).
 See Electronic Recordkeeping by Investment Companies and Investment Advisers, Investment Company Act Release No. 24991 (May 22, 2001) at n.7 available at https://www.sec.gov/rules/final/ic-24991.htm.
 See, e.g., Disclosure of Order Handling Information, Securities Exchange Act Release No. 84528 (Nov. 2, 2018), available at https://www.sec.gov/rules/final/2018/34-84528.pdf, at text immediately preceding section III.A. (“The staff will review these amendments, including in particular the de minimis exceptions described in Section III.A.1.b.iv below, not later than one year after the compliance date of the amendments, and report to the Commission.“)
 Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Investment Advisers Act Release No. 3308 (Oct. 31, 2011) at text following n.18, available at https://www.sec.gov/rules/final/2011/ia-3308.pdf.
 Letter from Richard H. Baker, President and CEO, and Jennifer W. Hahn, Associate General Counsel, Managed Funds Association, to Jay Clayton, Chairman, Securities and Exchange Commission (Sept. 17, 2018) available at https://www.managedfunds.org/wp-content/uploads/2018/09/MFA.Form-PF-Recommendations.attachment.final_.9.17.18.pdf.
 See Investment Company Liquidity Risk Management Programs, Investment Company Act Release No. 32315, at 180 (Oct. 13, 2016) [81 FR 82142 (Nov. 18, 2016)].
 See Investment Company Liquidity Disclosure, Investment Company Act Release No. 33142 (June 28, 2018) available at https://www.gpo.gov/fdsys/pkg/FR-2018-07-10/pdf/2018-14366.pdf.
 Memorandum to Staff of the Rulewriting Divisions and Offices (Mar. 16, 2012) available at https://www.sec.gov/divisions/riskfin/rsfi_guidance_econ_analy_secrulemaking.pdf.
 Jaewon Choi and Yesol Huh (2017). “Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs,” Finance and Economics Discussion Series 2017-116, Washington: Board of Governors of the Federal Reserve System, at section 6, available at https://www.federalreserve.gov/econres/feds/files/2017116pap.pdf (“We show that substantial amounts of liquidity are provided by the non-dealer sector and that this provision of liquidity by non-dealers causes the average bid-ask spreads to underestimate the cost of immediacy paid by liquidity-demanding customers. Decreases in dealers’ willingness or ability to provide inventories have pushed more liquidity provision to the non-dealer sector, which in turn has made the bias more severe.”); Hendrik Bessembinder, Stacey Jacobsen, William Maxwell, Kumar Venkataraman, Capital Commitment and Illiquidity in Corporate Bonds, (May 14, 2018) available at https://onlinelibrary.wiley.com/doi/full/10.1111/jofi.12694.
 More than $1 trillion dollars flowed from prime and tax-exempt money market funds to government money market funds as a result of the 2016 amendments and government money market funds went from constituting 33.3% of all money market fund assets to 75.4% as a result of the 2014 money market fund reforms. See Marco Cipriani, Gabriele La Spada, and Philip Mulder, Federal Reserve Bank of New York Staff Report No. 816, Investors’ Appetite for Money-Like Assets: The Money Market Fund Industry after the 2014 Regulatory Reform (June 2017) available at https://www.bis.org/bcbs/events/rtf_sep2017/cipriani.pdf.
 See Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers, Exchange Act Release 84409 (Oct. 11, 2018) available at https://www.gpo.gov/fdsys/pkg/FR-2018-10-19/pdf/2018-22531.pdf.
 Bitcoin Tracker One and Ether Tracker One, Exchange Act Release No. 84063 (Sept. 9, 2018), available at https://www.sec.gov/litigation/suspensions/2018/34-84063.pdf. See also Commissioner Hester M. Peirce, Lasting Impressions: Remarks before the CV Summit—Crypto Valley (Nov. 7, 2018) available at https://www.sec.gov/news/speech/peirce-lasting-impressions-crypto-valley-summit.
 Robert Rosenblum, Amy Caiazza, Julie Krosnicki and Aaron Friedman, The SEC Thinks Most Tokens Are Securities, For Now, Law360 (Aug. 10, 2018) available at https://www.law360.com/capitalmarkets/articles/1069514/the-sec-thinks-most-tokens-are-securities-for-now