Streetwise Professor

December 4, 2012

SWP Hugs a Tree

I’m sure you would never peg me as a green type, but I have decided to join the recycling movement!

I am doing so in response to the call by Barney Frank (the Frank of Frankendodd) to merge the SEC and the CFTC.  This idea has itself been recycled many times, dating back to the 1980s and the birth of stock index futures.

One of the recycling efforts was by Hank Paulson, in the spring of 2008, in his proposal to reform the financial markets.  A centerpiece of this proposal was the org chart shuffling.  What I said then holds true today, so I’ll conserve scarce resources (mainly my time), and merely recycle:

The biggest headline was that the recommendation for the merger of the SEC and the CFTC. This puts in me in mind of two quotes. The first is by Churchill: “A fanatic is one who can’t change his mind and won’t change the subject.” Whenever anything happens in the financial markets, the cry immediately goes up to merge the SEC and the CFTC. Many people are apparently fanatical, because they never change about their minds about the desirability of the merger, and the subject always seems to return to it.

The second quote is by somebody slightly–well, a lot actually–less famous; that would be me. In a 2001 Regulation Magazine piece on the Clinton regulatory legacy, I wrote that the SEC-CFTC combination was a solution in search of a problem.

I am always somewhat mystified by the substance of the arguments for the merger. The most commonly mentioned benefit is a harmonization of margins between stocks and stock index futures. What, it’s not possible to harmonize without going merging the two bodies? Moreover, given the myriad other more important issues facing the two agencies, this seems like a very thin reed on which to rest a major reshaping of the regulatory structure.

In reality, there is very little overlap between the regulatory responsibilities of the two agencies. What’s more, there are huge swathes of the trading landscape that fall outside the jurisdiction of either agency. So merger will hardly reduce that much duplicative or contradictory regulation, and will not fill any regulatory gaps. So what’s the point?

Indeed, there are many sources of potential danger in a merger. One, very underappreciated in my view, is that it sacrifices the advantages of specialization. There are issues unique to securities markets and derivatives markets. Specialized agencies can develop the expertise needed for each market space. Of course the staff at a merged agency could specialize, but major policy, rulemaking, and interpretive decisions are made at the commissioner level. Right now SEC commissioners, for example, need to deal with arcane issues of accounting, disclosure, securities intermediation, and securities trading practices in stock, option, and fixed income markets. This is an already daunting task. Adding new areas of responsibility involving different markets and different instruments with different issues will further tax the already limited expertise of the commissioners of the merged agency.

The inevitable outcome of this dilution of expertise and specialization will be to enhance the power of staff, and degrade the quality of commission decision making. Neither outcome is desirable.

Indeed, I would argue that the SEC is already underspecialized. The agency operates subject to three statutes, the Securities Act of 1933, the Exchange Act of 1934, which focus on primary and secondary markets for securities, respectively; and the Investment Company Act of 1940, which focuses on mutual funds and the like. The agency has responsibility over the issuers of securities, and the markets and intermediaries that trade securities. There is little overlap between these areas. Issues of disclosure and accounting can be conceptually and operationally distinguished from issues of market structure and organization.

A second area of concern is that a unified agency will provide a mechanism to reduce and distort competition between different sectors of the financial markets. There are many on Wall Street that would love to throttle the futures exchanges in order to reduce competition for the securities business. (The margin issue is a perfect example of this. The securities firms would love to force an increase in margins on futures to drive some business from the futures exchanges to the stock market.) The regulatory autonomy of the CFTC has largely precluded such an outcome. The SEC has indeed tried in the past to impede the development and introduction of futures products that compete closely with securities markets but has largely failed in these endeavors because it does not have the necessary authority or jurisdiction.

Now, of course, a merger would change agency politics. Under the current framework, the SEC is largely responsive to securities firms and exchanges, and the CFTC is responsive to the futures exchanges and the FCMs. A merged entity would be responsive to the interests of all of these parties. But that is not necessarily a good thing, as one very likely outcome is that the merged entity would implement regulations that would reduce competition between the varying constituencies.

A more sensible, but still problematic, regulatory reorganization would involve (1) stripping out the primary market, accounting, and disclosure responsibilities from the SEC and putting them in a separate agency focusing on these corporate finance issues, and (2) creating a separate agency responsible for trading and market structure issues in securities and derivatives markets. This second agency, call it the “Commission for Financial Trading and Markets” (“CFTM”) would focus on issues relating to manipulation; fraud; the financial adequacy of intermediaries (securities and derivatives brokerages); and facilitating competitive market structures in financial markets. Arguably the manipulation, fraud and competition responsibilities should give the CFTM some authority in the OTC markets.

This approach would be far preferable to mashing together two disparate agencies with very different histories and cultures in the hope that something beneficial will come out of the unnatural coupling. It would permit the development of some specialization, and many issues of fraud, manipulation, and market structure are common across securities and derivatives markets, so the specialization could be applied to a variety of related markets. This alternative is still problematic, however, because the CFTM could easily become a mechanism for stifling competition between different methods of allocating risks and discovering prices.

All that said, there is little likelihood that the merger (or the creation of a CFTM) will come to pass in any event. The idea has been around for decades, and has never even come close to implementation. This is no surprise. There are powerful political forces in the way. Most notably, the futures exchanges, their members, and the FCMs have fought the SEC’s loving embrace vociferously, and found vocal support in Congress. Moreover, whereas the SEC falls under the congressional banking committees (e.g., the Senate Banking Committee and the Securities, Insurance and Investment Subcomittee), the CFTC is under the ag committees. Neither is about to readily cede jurisdiction over a large, well-heeled, and generous industry.

What he, er I, said.

Expecting miracles from mashing together org charts is insane.  At best, it has no effect.  The more likely outcome is to make things worse.  (Want an example?  Look at the effects of the reorganization of the intelligence community post-911.)   The point about specialization is particularly apposite, IMO (naturally, since I brought it up!)  The five commissioners of the CFTC and the five commissioners of the SEC are already overwhelmed by their complex responsibilities, and can devote relatively little time to becoming expert in any one particular area.  Extending the scope of the commissioners’ responsibilities is supposed to make that problem better?

In the end, nothing is likely to happen.  This is a lame duck kerfuffle.  The people who will have skin in the game in the next Congress will want nothing to do with this, as has been the case for about the last 15 Congresses.

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  1. Before any restructuring is effected what is needed is leadership. Neither the SEC nor the CFTC have had effective leadership in decades. Both have become political lapdogs, neutered by campaign donationsdirected to politicians more interested in their political fortunes than the interests of the markets. Without leadership does it matter what the structure is?

    Here is a fun exercise, since the Professor is in Houston, look at the Texas state database of unclaimed property. Enter “Texas Commerce” in the company name. Last I looked, the entries were in the thousands even though TCB hasn’t existed as a legal entity for almost 30 years. The entries are for trust accounts managed by TCB for the benefit of some unknown individual because the reporting info truncates the name of the beneficial owner. Tens of billions are lost because the heirs don’t know the banks breached their fiduciary duty and just let the money fall through the cracks. The states and the SEC know of this but don’t want to force the financial firms to do the right thing and clean the mess up.

    When the regulators know of financial chicanery involving tens of billions of dollars and choose to ignore it is it a problem of structure or a problem of leadeership?

    Comment by Charles — December 4, 2012 @ 6:04 pm

  2. @Charles-The fact that neither has had leadership for decades is a pretty strong indication that pinning hopes on true leadership emerging is wildly optimistic. The incentive structure from the selection process through to actual performance produces what we get. In particular, since it is ruled by politicians, their interests will be served. And we’ll continue to get lapdogs.

    I remember George Stigler describing some Ralph Nader study of some government agency. The report went through all the agency’s many failures, and then concluded that the solution was “better people.” Stigler mocked this. (It may be in one of his books . . . I remember him saying this in class.)

    IOW, the problem is structural, and the problem lay with the architects-the pols Meaning it won’t change.

    The ProfessorComment by The Professor — December 4, 2012 @ 9:01 pm

  3. More often than not a Reorg is an attempt to show leadership and change where none exists.

    Comment by Sotos — December 6, 2012 @ 1:32 pm

  4. @Sotos. Yes. Shuffling boxes in the org chart is visible and makes it look like you’re doing something.

    I’m not saying that organization is irrelevant. It can matter. But how it matters is often complex and subtle. And the org econ literature demonstrates that there are substantial complementarities in organizational form. The pieces have to fit together in a pretty specific way.

    To me though, the most amazing thing is that the markets are becoming more complex, and regulation is much more complex and pervasive in a Frankendodd/EMIR world. That suggests the need for more specialization, not less. Specialization can necessitate some way of coordinating the specialized pieces, but it’s my sense that this is a less pressing need than getting the details of the specialized regulation right.

    I’ll give you an example I just read from Risk. The SEC, which regulates CDS, has proposed a rule which would require FCMs to take a capital charge if a client misses a margin call. The FCMs are freaking, obviously, because they are at risk of being undercapitalized or having to stump up expensive capital at short notice. So many are saying-No effing way are we going to clear CDS for clients.

    This is quite plausibly due to the fact that SEC has virtually zero expertise in derivatives clearing.

    Even the more specialized CFTC has stumbled in implementing regulations more closely related to its core expertise.

    It’s all maddening.

    The ProfessorComment by The Professor — December 6, 2012 @ 3:51 pm

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