Commissioner Daniel M. Gallagher
U.S. Securities and Exchange Commission
Feb. 26, 2013
Thank you very much for inviting me to speak to you today. It is a great pleasure to be here in Qatar.
Before I begin, I must, as always, advise you that my remarks here today are my own and do not necessarily represent the views of the SEC or my fellow Commissioners.
We in America often remark that we are blessed by our geography. And there is no doubt that Qataris feel the same about this incredibly unique and beautiful country. In the United States during the post World War II era, our geographical position and natural resources helped our economy develop while others experienced severe disruptions, particularly in Europe. That promoted the development of our capital markets to the great benefit of our citizens, as well as investors foreign and domestic and our partners-in-trade around the world.
It is certainly true that we have suffered our share of economic and financial crises, most recently the crisis that erupted in 2008. Even so, our free market economy and robust capital markets have conferred an enviable prosperity on our people over many years. Indeed, notwithstanding financial crises large and small, it is fair to point out that few in America can remember a time when the United States did not have strong and competitive capital markets.
The risk, however, is that the very resilience of our capital markets has, over time, fostered a latent complacency — a tendency to think strong and competitive markets are, somehow, ours by right — that we are entitled to them when, in reality, we must constantly act — and sometimes decide 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 and competitive. That’s not just good for U.S. investors, I submit, but equally good for others — for all of you. And, of course, rising global markets are good for the United States.
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The SEC’s threefold mission is to protect investors, maintain fair and efficient markets, and promote capital formation. These three mandates are closely intertwined. Too often, though, we hear them discussed as distinct, even competing, priorities. And sometimes, the latter two mandates are simply ignored. The fact is, promoting capital formation and maintaining fair and efficient capital markets must be at the core of any effort to protect investors. Promoting capital formation leads to broader and deeper markets that provide more opportunities to more investors, while ensuring that those markets are fair and efficient allows investors the confidence to enter and remain in those markets. Put another way, stagnant, unfair, or inefficient capital markets would drive away investors, leaving no one for us to protect. Our congressionally established institutional priorities as a capital markets regulator are, in sum, intertwined and interdependent. We cannot protect investors unless we promote capital formation in fair and efficient capital markets.
It follows, therefore, that a capital markets regulator cannot “protect investors” by eliminating risk altogether, for eliminating risk would be impossible without eliminating the very opportunities that cause people to invest in the first place. Instead, what we can and must do is focus on protecting investors from certain categories of risk — not the market risk of investments falling in value, but instead risks posed by unscrupulous market participants who mislead, deceive, and steal. In sum, our regulatory efforts must strike an appropriate balance between protection from the unknown or unexpected risks investors should not have to bear and the risks they knowingly and willingly take in hopes of maximizing their returns — a balancing act that I’m sure all of the regulatory authorities represented here this morning can understand.
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Every financial regulator is likely to believe its own way of striking that balance is best. It is only natural to prefer the familiar, in part to avoid unknown and unnecessary risks in favor of what is known and certain. This principle applies to investors as well, and where financial services are concerned, the tendency to prefer the known has usually resulted in the decision to invest in familiar markets subject to a known legal regime. This is often the case when it comes to regulatory regimes applicable to listing and trading of securities.
Today, however, similar or identical investment opportunities are available in a variety of markets worldwide. Sophisticated financial services firms and investors are able to transact their business in markets around the world. They need not, and increasingly do not, select the traditional venues in New York or London. This is particularly true with respect to IPOs. Of course, not all capital markets operate according to the same laws or regulatory structure, and it’s a safe bet that they never will — and a sure bet that they never should.
Throughout the SEC’s almost eight decades of existence, we have strived to maintain fair and efficient capital markets and foster capital formation, all to the immense good of investors in those markets. But while a sense of pride is justified, it shouldn’t lead to the conclusion that we should commend our entire rulebook to the world at large.
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Today financial products and markets are truly global. This is obvious to the point of being cliché, but it is nonetheless important to remind ourselves. You can trade essentially any financial product almost anywhere, without leaving wherever you happen to be. Capital markets and their participants are, in other words, well on their way to becoming fully de-localized. As they do, jurisdictional questions assume new prominence. What legal regime applies to a given product or trade — why, to what extent, and for how long? Should more than one country’s regulators be able to assert a jurisdictional claim on a transaction and those who enter into it? When more than one authority claims jurisdiction over an entity, product, or trade, whose regulations should prevail— and with what effect?
I could continue with such questions, one after another, each of them with enormous economic implications but without easy answers. These jurisdictional issues often seem metaphysical and are fun cocktail chatter, but they have massive implications on our very real policymaking decisions.
In promulgating new rules, regulators nearly always have a choice among different means of achieving a given end. In our case, the SEC adopts rules to implement the securities laws — that’s the obvious part — but we generally have considerable discretion as to how we do that. When Congress issues us a rulemaking mandate it is very rare that the mandate is so rigidly prescriptive and exhaustive as to deny us any scope to decide how best to achieve the congressional objective. Accordingly, we can choose to adopt rules that entail more or less cost — and in doing so, we can risk acting in a manner that increases the incentives for entities to relocate or for investors to take their capital elsewhere. We can, on the other hand, minimize the costs of our regulatory interventions in the hopes of achieving a more positive result. The point is, there is rarely, if ever, only one way to get the job done; generally, we have a choice between several viable approaches to fulfilling the legislative mandates we are given while remaining faithful to our three-fold mission.
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Faced with such choices, I am strongly in favor of minimizing the costs of our regulations, as ultimately these costs are borne by investors. I am also aware, however, that for any reason or none at all, market participants may choose to conduct their business in non-U.S. markets, and that regulatory costs alone are not always the determining factor. As I’ve noted, regulators generally have more than one way to achieve a single, shared regulatory objective, and it’s not always clear which way is “best.”
In a world where new and complex financial products are traded 24 hours a day across capital markets around the globe, those same products and the entities that trade them may — and probably will — be regulated in different ways in different countries. As products cross international borders and move from one jurisdiction to another, satisfying the regulatory requirements of multiple jurisdictions can be costly, cumbersome, and confusing. In the past, the standard response to such situations has been to begin negotiations directed at adopting a single norm to be implemented by all — sort of a “one-world” government approach to securities regulation. I tend to think that such efforts had limited utility even in their time; I certainly believe that they are now obsolete. To the extent we, as regulators, haven’t fully grasped that fact, the industries and market participants we regulate certainly have.
This should not be a revelation to anyone. Over the past several years, both academics and regulators have devoted considerable attention to concepts such as “substantial equivalence” and “mutual recognition,” in which one country’s securities regulation regime or a portion thereof is deemed to be “equivalent” to another’s. The goal under such an approach is not to fully harmonize the rules across jurisdictions but instead to allow one regulator to accept as sufficient the regulatory actions of a different regulator in the context of a financial services activity that spans multiple jurisdictions.
The SEC began to explore such concepts seriously, under the rubric of “mutual recognition,” about five years ago. In retrospect, we must concede that those efforts, however well intended, yielded only limited success: an arrangement between the SEC and the Australian Securities and Investments Commission to consider applications for exemption from certain market participants1 as well as a joint press release with Canadian regulators stating the intention to begin discussions aimed at reaching a similar arrangement.2 Close on their heels, the financial crisis of 2008 erupted in all its fury and forced the agency to shelve this initiative.
The most dramatic governmental response in the wake of the crisis was over two thousand pages of new legislation affecting the securities industry: the Dodd-Frank Act. Putting aside the wisdom of any particular aspect of that legislation or the question of the utility of the massive amount of rulemaking it entails, that legislative explosion meant that “mutual recognition” in the classic sense, always difficult and controversial, had become, from a practical standpoint, impossible. The regulatory landscape in the United States — our regulatory bodies as well as our “rulebook” — was, like those in other countries, changing so fast that it had become nonsensical to attempt a freeze-frame evaluation of the entirety of U.S. securities regulations against those of any other country. It simply couldn’t be done, and even if we had been foolhardy enough to attempt it, I doubt that any other jurisdiction’s regulators would ever have been willing to expend the resources necessary even to begin the effort.
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All of this brings us to the situation we face today. Financial services products and financial firms are global; capital markets have proliferated worldwide. Regulation, however, remains local — and is changing at an unprecedented rate. Adopting some global code of norms is unrealistic and, in any event, not something I would want to see the United States pursue. Those are, in practical terms, non-starters. And yet the impediments to global trading posed by dual — or even multiple — regulation of the same transaction or activity continue to add cost without demonstrable benefit.
The answer, it seems to me, is for each of us as regulators to accept the reality that, as to any given financial product or activity, there may be, and will increasingly be, high quality regulatory treatments other than our own. And the only way to ensure high quality, but not unduly burdensome, regulation of those products and activities will, ultimately, be for one state to defer to another’s regulatory approach as to that product, service, or transaction. This deference would have to run both ways; its mutuality would be the key. And, of course, seemingly innumerable complex details would need to be resolved as to each set of activities or market participants subject to regulation.
Frankly, exploring this concept amounts to common sense, especially given the alternatives. Our financial services world is comprised of a few older markets and a host of flourishing newer markets competing for capital. Investment products evolve before regulations can be written to cover them. Under these circumstances, a policy of targeted mutual deference seems the wisest solution — and perhaps the only viable one.
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We can, in fact, see some initial moves in this direction.
A first example is application of the Title VII, OTC Derivatives, provisions of the Dodd-Frank Act to activities that cross national borders. As you probably know, the U.S. Congress has directed the SEC and the CFTC to create a new regulatory regime for OTC Derivatives. Derivatives may well be the most global financial products that exist, with dealers and other intermediaries spread across the world trading products for widely dispersed clients that can have impacts in various jurisdictions. Commission staff is, of necessity, discussing this matter with foreign regulators, as well as with our domestic colleagues at the Commodities Futures Trading Commission, who were given responsibility for swaps that are not security-based. Especially given the complexity of the overall regulatory scheme for derivatives set forth in Title VII of the Dodd-Frank Act, the problem of applying the regime to cross-border transactions is significant. For these reasons, it is critical to incorporate some form of regulatory deference into the scheme as it applies to cross-border transactions in security-based swaps.
In a joint statement issued after a November 2012 meeting, the leaders of twelve national and supranational entities responsible for the regulation of OTC derivatives endorsed exploring approaches that included voluntary regulatory deference. The statement described, in broad strokes, potential means of doing so, including recognizing the sufficiency of another jurisdiction’s regulation of cross-border OTC derivatives-related entities and cross-border activities and exempting OTC derivatives-related entities and activities from otherwise applicable national regulations in view of the affected entities’ obligations to other regulators with respect to the same activities. Regardless of the means of doing so, this group of regulators from diverse jurisdictions 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.”3
The European Union also has begun the implementation of a form of legal deference in considering various aspects of the legal regimes of non-EU nations in various areas. The Commission has had first-hand experience with this approach in connection to its regulation of credit rating agencies. The Credit Rating Agency Reform Act of 2006 and the Commission’s rules implementing that legislation established a registration and oversight regime for CRAs that register with the SEC. Following the eruption of the global financial crisis the next year, the EU adopted a directive establishing its own regulatory scheme applicable to CRAs, including a proviso allowing for non-duplicative regulation where the CRA is subject to a regulatory regime the EU has found “equivalent” to its own.4
I should add, by way of caveat, that the forms of voluntary regulatory deference I have cited are not, on their own, a panacea for the problem of overlapping jurisdictions. Our experience with the EU’s regulatory regime applicable to credit rating agencies, appealing as it may be in theory, serves as a case in point. The EU’s equivalency finding as to U.S. regulation of CRAs came after several years of protracted bureaucratic processes. These included an initial European Securities Market Authority (ESMA) opinion, issued in 2010, that U.S. regulation of CRAs should not be deemed equivalent to that of the EU in certain significant respects.5 In 2012, however, citing the enactment — two years earlier — of the Dodd-Frank Act as justification, ESMA revised its earlier opinion to conclude that U.S. regulation of CRAs was, in fact, equivalent to that applicable under EU regulations. The EU followed with its equivalency determination several months later.6 In considering the practical expedient of some form of voluntary deference to other regulators’ equivalent regimes, I submit that common sense and the need for certainty dictate that we do better than what I have just described. I look forward to a smoother road ahead.
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We cannot, however, travel much farther down that road this morning. I want, instead, to return to a point I noted at the outset, that notwithstanding the recent financial crisis, the United States has enjoyed a long period of relative prosperity since World War II, and that much of that prosperity has been driven by our free market economy and vibrant capital markets. We must not, in the United States or elsewhere, take the vitality of our capital markets for granted. We must instead foster them, and in the process protect investors both large and small, domestic and foreign. We must regulate in a balanced manner — smartly. And we must increasingly recognize that the complexity and international character of financial institutions and transactions in capital markets across national borders.
It is incumbent upon us to keep pace without adding unnecessary costs through permitting layers of complex, overlapping regulation. We must, in sum, look not only at the benefits of sound regulation, but also in each instance at whether they are sufficient to justify the costs we have learned that they can 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, where possible, to our peer regulators in appropriate situations.
Thank you very much for your kind attention.
1 Mutual Recognition Arrangement, SEC-ASIC-Australian Minister for Superannuation and Corporate Law (25 Aug. 2008).
2 SEC Press Rel. No. 2008-98 (29 May 2008).
3 See “Joint Press Statement of Leaders on Operating Principles and Areas of Exploration in the Regulation of the Cross-Border OTC Derivatives Market” (4 Dec. 2012), relating to 28 Nov. 2012 meeting, SEC Press Rel. No. 2012-251, at item 4.
4 Regulation (EC) No 1060/2009 (16 Sept. 2009), Art. 5(6), OJ L 302 (17 Nov. 2009), at 1.
5 ESMA technical advice to European Commission, 21 May 2010.
6 European Commission Implementing Decision 2012/628/EU, 5 October 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.