Smart Regulation: Is It Possible?

In a new research report from Aite Group, Paul Zubulake examines the various key components of financial regulation being considered by the U.S. Senate today and provides Aite Group's view on the likelihood of each being implemented, and in what ultimate form.

As a result of the financial crisis, creating a new regulatory structure has become the number-one priority in the financial markets. The number-one mission has been to create a more transparent OTC marketplace, with processing and central clearing as the centerpiece.

Progress has been made with the establishment of multiple clearinghouse options and almost 100 percent of all credit deals now being processed at the market depository. The marketplace must improve data management; it is the only way regulators can truly see what is happening in an effective way.

On the legislative front, the House of Representatives has already passed the Wall Street Reform and Consumer Protection Act by a vote of 223/202, while the Senate has provided the market a discussion draft for financial reforms. The process has been disrupted by the recent retirement announcement of the chairman of the U.S. Senate Committee on Banking, Housing and Urban Affairs Chris Dodd, Democrat of Connecticut.

The most recent major development had been President Obama’s proposal to impose limits on banks’ activities. Although details of the proposal are not yet available, the overall goal of the proposal would be to prevent commercial banks and institutions that own banks from owning and investing in hedge funds and private equity firms, and limit the trading they do for their own accounts.

The timing of the announcement - which came the same week that Massachusetts Republican candidate Scott Brown defeated the Democratic candidate - is cause for concern. Is the Obama administration trying to change the negative momentum, attempting to make regulatory changes an election issue in November 2010? If so, politicizing the process before making major changes to the regulatory landscape will cause unintended consequences.

The legislative process is now in the hands of the U.S. Senate, and the responsibility to create and pass a regulatory overhaul bill in the hands of the Senate Committee on Banking, Housing and Urban Affairs. A recent proposal by President Obama has complicated the process - new amendments will now need to be added to the House bill. The reality is that the Senate can address new proposals and add them to the bill. That is easier said than done, as the stakes rise, and Congress tries to avoid a full-fledged partisan brawl.

The key components of the legislation are:

-Ending “Too Big to Fail”: The goal is to create a resolution mechanism to break up firms that are deemed a systemic risk to the marketplace.

-The creation of a council of regulators: The council would be a collection of the head of the major regulatory agencies and two independent representatives nominated by the sitting U.S. President. Their job would be to identify and address systemic risk by large, complex companies and products before they become a threat to the stability of the financial system.

-Addressing risks posed by OTC derivatives: The goal is to close the regulatory gap of the OTC market, mandating that standardized OTC products be processed and clear via a depository and clearinghouse.

-Creating a Consumer Financial Protection Agency: The goal of creating an independent watchdog agency would be to ensure American consumers get clear and accurate information when they shop for mortgages, credit cards, and financial products.

-Creating a single federal bank regulator: This would require the merging the office of the Comptroller of the Currency and the Office of Thrift Savings, along with the state bank supervisory functions of the Federal Deposit Insurance Corporation (FDIC) and the bank holding company supervision authority from the Federal Reserve.

-Requiring hedge fund registration: This would require that hedge funds worth more than $100 million disclose financial data and register with the Securities and Exchange Commission (SEC) as investment advisors.

-Establishing credit rating agency regulation: This would establish a new office of credit rating agency at the SEC to strengthen regulation.

-Ruling on executive compensation: The goal here would be to give shareholders a say on executive pay and proxy access. It could require public companies to set claw-back policies to take back executive compensation based on inaccurate financial statements.

The debate on how to provide the most efficient regulatory environment without destroying the financial service industry will continue in the United States. The reality is that the U. S. economy is a service-based one, and that financial engineering and management is the country’s number-one business. This makes the upcoming legislative decisions ever so important — the future of the country’s economy hangs in the balance.

About the Author

Paul Zubulake is a senior analyst at Aite Group specializing in financial, energy and commodities futures and options markets. His expertise includes how the application of technology, such as algorithmic trading and FIX protocol, is playing an ever- increasing role in futures and options trading.