Is an SEC and CFTC merger a perfect fit?

Is an SEC and CFTC merger a perfect fit?

From time to time, but repeatedly, a call goes out to combine the Securities and Exchange Commission (SEC) with the Commodity Futures Trading Commission (CFTC).

Efficiency is often cited as a reason for the merger talk; or the SEC is viewed as a larger, more experienced, and far better funded markets regulator. The latter point is undeniable; after all, the SEC is many years older than the CFTC, and its budget dwarfs that of the CFTC. But would a merger really produce more benefits than problems? I suggest not, for various reasons.

First, the agencies exist for different reasons. The SEC was created by the Congress following the 1929 Stock Market Crash and follow-on Depression to restore the public's (read that "investors'") confidence in our securities markets. It exists, basically, to assure that businesses have ready access to private capital, an outcome that requires the public's respect and support.

But the CFTC and its predecessors at the US Department of Agriculture were formed to protect the integrity of a form of insurance that businesses rely on every day to smooth spikes in the cost of what they buy and dips in the price of what they sell. Acquiring securities entails taking an avoidable risk, while futures contracts reduce extant business risks in the hands of so-called "hedgers."

In other words, securities regulation is designed to create and maintain an environment where people are willing to take risks by buying securities of companies whose ultimate success or failure is usually beyond their control, while futures regulation allows those same companies to reduce the impact of rising costs or falling revenues in their daily business operations. One would suspect that, with such divergent mandates, the SEC and the CFTC would see their worlds differently, and they do. Here are a few examples.

Margin. Perhaps it is simply a misuse of the same term, but margin in the securities world describes the minimum down payment that an investor must make before title to the security can be transferred to that buyer. The remaining amount is borrowed and must be paid later. It is similar to the down payment on a home or other property, where the deed passes to the purchaser even though a substantial part of the cost remains unpaid.

In the futures markets, on the other hand, margin is a form of performance bond deposited by BOTH parties (the seller as well as the buyer) to cover changes in price while the transaction remains pending. No title is transferred unless and until the full purchase price is tendered (a relatively rare event since most futures contracts are nullified or offset by a counter-transaction before maturity, leaving one party to pay the other an amount equal to the change in value prior to cancellation).

Thus, margin in the SEC's domain is a limit on the debt that a buyer can incur in order to complete the purchase while margin in CFTC parlance is extra money that both parties must put up before any market gain or loss is incurred.

As a result, not surprisingly, CFTC margin is typically about 5% of the agreed price of the uncompleted transaction, made at the opening of the trade to cover future price changes (and replenished with more fund - maintenance margin - if prices move against that party), while 50% is usually required for outright securities purchases.

What happens when the SEC exercises jurisdiction over securities derivatives rather than the securities themselves, such as stock options or, more rarely, futures on securities where ownership is deferred or, through offset, avoided entirely? One might assume that the CFTC's 5% model would apply because the same performance-bond function is involved, but no, the margin is frequently 20% or four times greater than for CFTC-regulated products. Why? And if the agencies were merged, which margin level would prevail?

Would anyone use the futures markets if they were required to deposit one-fifth of a contract's face value even before any losses accrue?

The experiment with co-regulation by the SEC and the CFTC of futures markets in single stocks and narrow-based stock indices suggests a negative answer. Of the only two such markets ever to open, one quickly folded and the other - a dozen years later - registers the smallest contract volume among US futures markets, especially when non-competitive trades like private block trades done off-exchange are excluded.

Insider trading. It is a basic tenet of SEC policy that all investors should have equal access, in time and content, to corporate information that is relevant to their trading decisions. It is a crime - vigorously enforced - for corporate "insiders" (persons who have access to confidential information - good or bad - about a company) to trade those securities until after the data have been released to the general public. This prohibition aims to make a "level playing field" for all investors as they are deemed to have an equal right to succeed or fail in their investment quest. It is a fair and honourable rule, for that reason.

But the CFTC does not have an equivalent proscription. Why? Because, as noted above, futures markets offer price protection - insurance - to businesses in their daily operations. These hedgers must be able to acquire or adjust their futures positions as their expectations change, often based on internal data or analyses. Were they required to publicize their thinking before making those changes, the market may react immediately by raising or lowering prices, preventing them from obtaining an effective hedge. The insurance system would collapse and, with it, the congressional policy favouring this safeguard.

But is the CFTC model "fair" to those who take the other side of those trades? The short answer is yes, not only because the Congress has blessed this policy for over 90 years but because market participants - principally speculators - fully understand what is happening and decide freely to bet against their counterparties' expectations, often successfully. The meteoric rise in futures volumes over recent decades offers further comfort that the system is perceived to be fair.

Exchange-centrism. From the earliest versions of what became the Commodity Exchange Act, dating back to 1922, a basic premise has been that, with narrow exceptions, futures trading must be conducted through a federally-designated "contract market" and nowhere else. Indeed, subject to those exceptions, it is a criminal felony to trade futures away from a regulated exchange. In addition, the environment within each exchange must be "open" and "competitive" so that all buyers and sellers have an equal opportunity to bid on all transactions.

The SEC operates quite differently. It allows many venues for securities trading; the registered national securities exchanges are only one of them. The same securities may also be bought and sold privately through broker-dealers, on "alternative trading systems," in opaque "dark pools," or directly between two investors

In a merger, would the contract markets lose their near monopoly? Or would the SEC have to shutter off-exchange venues? The latter is unlikely.

Investors vs. speculators. Here, there may be a similarity between at least some users of both markets. The term investor has an honourable ring about it - the backbone of a free and capitalistic society - while "speculator" is someone you would not want your daughters to date. But, really, how different are they? Let's compare definitions.

An investor is a person who voluntarily places funds at risk for an outcome that is typically beyond his or her or its control.

A speculator is a person who voluntarily places funds at risk for an outcome that is typically beyond his or her or its control.

There. So the two agencies at least have that in common! The only difference is that all investors fit the description while only some futures traders do (hedgers do not conform). In a merger, would the SEC start calling its constituents speculators? This is probably unthinkable to it. So, another divide is identified.

And don't forget the Congress. In this era of Capitol Hill gridlock, we might hope that we could do so, but the SEC and the CFTC answer to different congressional oversight committees that generally control their legislation. That either set of committees would yield jurisdiction to the other is remote in the extreme. Instead, the likely outcome would be non-stop hearings for both agencies at all such committees; with agency leaders perpetually attending hearings on the Hill, little would get done at either commission. This might please some folks, but the American people deserve better.

And so, for these (and, no doubt other) reasons, a merger between the SEC and the CFTC would pose many perils. It is not enough simply to say that they both regulate "markets;" that logic would support giving them supermarkets and art auctions. The adage "Be careful what you wish for" comes to mind.

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