Reinventing A Markets Watchdog

By Christopher Cox
Tuesday, November 4, 2008

The Securities and Exchange Commission was created in the wake of the stock market collapse of 1929 to help restore investor confidence and stabilize our markets. For three-quarters of a century, the SEC has performed its mission with extraordinary rigor through law enforcement; public company disclosure; and the regulation of exchanges, broker-dealers, investment advisers and other securities market participants. As Congress and the next administration consider the shape of regulatory reform, they should build on those traditional strengths of the SEC.

But the status quo is clearly not sufficient. The regulatory architecture of the early 20th century did not anticipate and could not fully encompass the bewildering patchwork of unregulated financial instruments, exempted entities, competing legal fiefdoms and regulatory holes that has grown since then. The global financial crisis has exposed many of the weaknesses and holes in our regulatory system that are far greater and more consequential than was previously understood. The priority now must be to address those issues and rationalize that system.

In doing so, legislators and policymakers should be guided by four core principles: closing regulatory gaps, providing clear statutory authority, consolidating regulatory agencies and increasing transparency.

The most visible of the gaps in existing regulations is the $55 trillion notional market in credit default swaps, which lacks oversight and transparency. The risk to the market from these instruments would be far less if investors had the benefit of basic disclosures. The lack of transparency around credit default swaps played a role in the collapse of AIG and contributed to the crisis of confidence that has enveloped other financial institutions. Credit default swaps must be brought immediately into the regulatory framework.

As states and municipalities increasingly face challenges in their finances, the lack of transparency in the market for municipal bonds presents growing risks. Municipal securities are specifically exempted from SEC disclosure requirements. Although the SEC has taken steps under its limited authority to increase oversight of this market, it needs more explicit authority. Congress should grant the commission expanded powers to this end.

Other regulatory gaps persist, including a statutory divide at the SEC itself between the supervision of broker-dealers under the Securities Exchange Act of 1934 and that of investment advisers under the Investment Advisers Act of 1940. One significant effort to reconcile the supervision of these overlapping groups was struck down by the courts last year. Congress has an important opportunity to modernize this area in any reform plans.

Congress should back regulation with the full force of statutory authority. In the Gramm-Leach-Bliley Act of 1999, Congress left a gap regarding investment bank holding companies that the SEC attempted to fill with a voluntary regulatory regime shortly before I became chairman. For credit rating agencies, even the industry's voluntary code of conduct lacked support in law until very recently. In particular, recent experiences make clear that voluntary regimes deprive the regulator of a mandate to force change. Reform legislation should steer clear of voluntary regulation and grant explicit authority where it is needed.

We must address the problem of the U.S. financial regulatory system having too many agencies performing parallel functions -- an issue made worse by the fact that the various agencies operate under conflicting legislation advanced by congressional committees with competing jurisdictions. To overcome the persistent jurisdictional conflicts, Congress should create a select committee with a charter to rationalize the system and eliminate institutional gaps and redundancies.

One tangible outcome of such a process would be the consolidation of the SEC and the Commodity Futures Trading Commission into a single agency with a clear mandate to protect investors by regulating the markets in all financial instruments, including securities, futures and derivatives. Similar consolidation is needed in the banking arena, where a half-dozen federal regulators overlap not only with each other but with state agencies.

Just as important as improved regulation in these areas is transparency for investors. Transparent markets require less outside intervention because investors can make rational decisions if they have complete and sound information. One factor that contributed to the recent turmoil was the lack of good information about financial institutions' exposure to troubled and illiquid assets, including subprime securities and credit default swaps.

Also in need of additional transparency are troubled Fannie Mae and Freddie Mac, both of which are now under government control. Although recent legislation required Fannie and Freddie to comply with some of the SEC's rules, it did not subject them to the full disclosure requirements that private companies must follow. As Congress determines how Fannie and Freddie will emerge from government control, this is an omission that lawmakers must correct.

For 74 years, the SEC has helped generations of Americans become participants and stakeholders in the free-market system. Now, as Congress prepares to overhaul the entire financial regulatory system, we should build on the strengths of the world's foremost securities regulator.

By filling critical gaps in its authority and consolidating duplicative regulatory roles, we can ensure that a robust and empowered SEC can continue to protect investors for generations to come.

The writer is chairman of the Securities and Exchange Commission.

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