1The approaching end of the twentieth century and, indeed, the second millennium after Christ, has brought forth a demand for explanations which give meaning to the past and inspiration for the future. The seekers for meaning to inform United States public policy range from "the first partner" Hillary Rodham Clinton, to Wall Street social satirist Tom Wolfe. What better time to reflect on the past and future of financial services regulation in the United States?

2The concept of financial markets as a public utility is a hallmark of the twentieth century as is the abandonment of the legal doctrine of caveat emptor in favor of the concept of fiduciary responsibility where one person is handling another person's money. These concepts emerged from the collapse of the U.S. economy in the 1930's and have matured over time. The development of trading, investment and risk shifting technologies, such as options pricing theory, portfolio management theory, financial engineering and financial derivatives are relatively recent innovations. The new markets of the 1980's and 1990's, such as electronic auction markets (using ideas developed from experimental economics), the proliferation of proprietary trading by brokers and the recognition that the needs and demands of commercial and institutional market users and public customers may be different, have evolved within (or despite) the existing regulatory framework. These changes are rapidly transforming our expectations as to the market structure of the future.

3To borrow from U.S. Senator Daniel Patrick Moynihan, financial services regulation is in need of both a philosopher and a prophet for this new day and age. Not surprisingly, both the Commodity Futures Trading Commission ("CFTC" or "Commission") and the Securities and Exchange Commission have commenced studies directed at the structure of markets and, more fundamentally, the structure of regulation of the markets of the future. The SEC's "Markets 2000" study specifically asks questions about the regulatory environment of the secondary markets in equities in light of developments in technology and trading trends.2 That Commission requested public comment in July, 1992, as to the proper allocation of regulatory (including self-regulatory) responsibilities and the need for enhanced transparency in view of market decentralization and the fact that markets need no longer have a physical location. The CFTC, in connection with receiving authority in October, 1992.3 to exempt certain over-the-counter activities "to promote responsible economic or financial innovation and fair competition" was directed by Congress to conduct a study in cooperation with the SEC and the Board of Governors of the Federal Reserve System. The CFTC similarly must consider changes in the marketplace, address "the size, scope, activities and potential risks of off-exchange derivative financial products" and the need for additional regulatory Controls and report to Congress in October, 1993.4 These studies by regulators will be based on data collection, industry and public input, and economic and legal analyses. In the spirit of the fin de siècle urge for deductive as well as inductive answers, however, I propose to suggest certain Cartesian principles (to the extent Anglo-Saxons can think in Cartesian terms) of financial services regulation in anticipation of such studies, which the studies may wish to draw on in reaching their conclusions.5 My examples will be taken primarily from the regulatory scheme for exchange-traded futures and other derivatives.

41. The goals of regulation are: customer protection and market (including financial) integrity

5As goals, these are simple enough when markets have physical locations and customers act through intermediaries. To the extent that financial markets become decentralized communication Systems to which users have direct access, however, what these goals imply for regulatory Systems and how they might be achieved may need to be rethought.6 There is a fair amount of certainty about the questions to ask in such event: Who is the customer? Where is the market? There is a lot less certainty about the answers — indeed, different interest groups have different answers.

62. Generally, regulation is event driven; as night follows day, well-intentioned legislation will follow a financial crisis

7The basic legislation under which the Commission operates, to this day, is the Commodity Exchange Act ("CEA" or "Act").7 This legislation has been described as primarily directed to market integrity but it includes core customer protections against fraud and misuse of customer funds.8 The Act, although enacted separately from the securities laws of the same period, was part of President Roosevelt's call to arms for national regulation of financial markets "to eliminate unnecessary, unwise, and destructive speculation."9 The brief, eventful history of futures regulation underscores the crisis/response evolutionary principle.

8In 1968, with memories of the De Angelis salad oil scandal in mind^,10 the Act was amended to make clearer what the law considered theft. The 1968 amendments clarified that the trust imposed on customer funds followed those funds to any custodian or depository with its hands in the till and made clear that customer funds could not be invested in certain instruments.11 The changes also increased the financial protection rules and oversight and enforcement authority12 of the Commodity Exchange Authority, a part of the Department of Agriculture then responsible for commodity regulation and a predecessor of the CFTC, and the Commodity Exchange Commission, composed of the Secretaries of Agriculture and Commerce, and the U.S. Attorney General.13

9In 1974, in response to, among other things, the so-called "Great Grain Robbery,"14 a separate agency was created to administer the Act — with expanded oversight powers over the exchanges and over all "services, rights or interests in which contracts for future delivery are now or in the future dealt in."15 That agency was the CFTC. The Act was then extended to cover the activities of any person, including foreign governments.16

10In 1978, new legislation banned options trading in response to scandals in the option market pending Commission demonstration of its ability to effectively regulate such markets.17

11In 1982, to address cash market and off-exchange fraud in commodities, an "open season" provision was adopted to permit the fifty States to help the CFTC (a federal agency) address fraud using all available regulatory and enforcement tools at its disposal18 Most recently, between 1989 and 1992, in response to a joint CFTC/FBI sting operation which resulted in the indictments of 48 floor traders (46 of which were convicted) in Chicago for customer abuses, a major overhaul of the CFTC’s legislation was adopted. Much of that overhaul codifed the CFTC exchange oversight process and granted additional sanctions (short of actual enforcement action) for failure of self-regulatory organizations to enforce or upgrade self-regulatory programs19

12Professor Louis Loss, in commenting on the securities laws, said that the episodic nature of such legislation, and its origin in crisis, has inevitably led to "a great many inconsistencies, a considerable number of gaps and overlaps and, in general, needless complexity..."20 It is also true, however, that although crisisbased reactions may codify solutions to yesterday's problem which may be unsuited to today's, anticipating innovation with regulatory solutions may be equally problematic if, for example, restrictions on the evolution of a market are imposed which are unnecessary for customer or market protection.21 As Marguerite Yourcenar reflected in her Memoirs of Hadrian22 "our civil laws will never be supple enough to fit the changing diversity of facts. Laws change more slowly than custom, and though dangerous when they fall behind the times are more dangerous still when they presume to anticipate custom." Therefore, both reactive and proactive regulatory approaches benefit from cautious balancing of the interests affected.

133. In the first instance, deregulation tends to reduce protected enclaves and thereby increase market access — eliminating pricing, capacity, and market restrictions increases competition. Ultimately, however, deregulation may lead to consolidation because it eliminates restrictions that may make it possible for interests to compete which could not otherwise do so.23

14In the European sense, major "deregulatory" initiatives occurred in the U.S. securities markets in 1975. On "Mayday" 1975, fixed commission rates were phased out forever and replaced by negotiated rates24. In the same legislation, access to exchange membership was expanded.25 Also, Congress mandated a national market System to address the growing over-the-counter marketplace. These initiatives were intended to increase competition for order flow and to improve execution of public orders.26

15No comparable legislative initiatives relative to futures were introduced, as the practice of fixing commissions was suspended by the futures exchanges voluntarily before entry of a consent decree in a litigation brought by the Justice Department fairly contemporaneously with the securities law changes.27 In the same year, Section 15 was added to the Commodity Exchange Act.28 That section requires the Commission "to take into consideration the public interest to be protected by the antitrust laws and endeavor to take the least anticompetitive means of achieving the objectives... as well as the policies and purposes" of the Act in taking any regulatory decision including review of an exchange rule. This provision is as important for recognizing that there may be a public interest in applying certain restrictions to exchange trading as it is in recognizing the potential applicability of the antitrust laws against anti-competitive policy to exchange action. I believe this change also implicitly recognized that futures were not like equities for purposes of determining what type of public market was in the public interest — that is, the idea of multiply traded futures or a national futures market System may not be consistent with futures supervision.

16The principal restriction on competitive access affecting futures trading has been the exchange trading requirement — that is, the requirement that all "futures" trade on exchange. In lieu of suspension of this requirement, which has only officially been permitted under certain circumstances delineated by rule and for certain specified sophisticated users known as "appropriate persons" since October 1992,29 the assault of the competition on the exchange trading requirement took the form of attempting to design products which mimicked futures economic properties without causing the CFTC to deem it necessary to regulate them as risk shifting futures. As a consequence, the development of a regulatory treatment for such products (a process that has been ongoing since 1986) has been limited to finding theories for placing them outside the CFTC's jurisdiction.30 The CFTC believed that its enabling statute limited its choices in addressing over-the-counter derivatives to applying the exchange trading requirement or finding a product to be beyond its regulatory reach. With this general view, it was not possible to develop or even articulate a rationale based on the purposes of regulation cited by the Act for a different or lesser form of regulation for over-the-counter futures-like products, such as swaps. One had to turn a blind eye to such products or call them something else. In the U.S., "deregulatory" debate thus has focused primarily on what futures are and not on the purposes for regulating their trading. This has raised questions as to what the proper governmental interest should be now that the CFTC's authority is more comprehensive.

17Although the number of intermediaries trading exchange futures declined from 390 in 1982 to 285 in 1992, the number of contracts traded on approved contract markets increased in the same period from 107.6 million contracts to 359 million contracts. No one knows the extent to which unregulated entities traded off-exchange instruments which perform similar functions. Nor is it possible to predict what the eventual consequence will be to either the exchange or the off-exchange marketplace of current product innovations and resulting structural developments. The Commission is studying these issues, but as no study can put the genie back in the bottle, it is more likely that a rationale will be developed for deregulation than that products previously freed from regulation will be re-regulated to require exchange trading.31

184. Deregulation also fosters innovation and tailoring to user needs by substituting general standards of prudence for prescriptive standards of design. Ultimately, this may lead to complexity which the regulatory framework should address by disclosure or, to the extent innovation could have systemic implications, by other measures.

19The best example of this concept is to compare the requirements for commodity pools (commingled funds which invest on exchange-traded commodity interests) regulated under the CEA in 1974 with those for investment companies regulated under the Investment Company Act of 1940. Apart from general fiduciary standards and certain requirements as to the use and segregation of funds received from the sale of participations, commodity pools are principally subject to disclosure requirements.32 By contrast, investment companies are subject to comprehensive design requirements many of which are intended to limit leverage within the offering, to assure ready access to redemption of funds, and to prevent related party transactions. Most of these provisions have their origins in 1940 investment company legislation.33

20Pools, therefore, are more modem and also more flexible products. To the extent pooled offerings are speculative vehicles for trading commodity instruments, they also can be risky and, to the extent various offerings are combined, they can disguise costs. Thus, the demands on pool disclosure may be great. Similarly, the leverage (which is permitted and indeed inevitable) in such vehicles should cause the futures commission merchants or brokers who carry them to be vigilant to assure that such limited risk vehicles (usually designed as limited partnerships) have sufficient liquid assets to meet their obligations to the market. Although the Commission has reduced specified disclosures for certain sophisticated customers of pooled offerings, leaving the disclosure format to the vendor,34 the law continues to require that all material disclosures be made.

215. Regulatory necessity is the mother of financial invention

22Much attention has been directed to the potential for regulatory costs to dampen innovative enthusiasm. It is as true a principle, however, that regulation can spur the development of innovative products. In the U.S., the tax laws are one of the best examples of this type of inspiration. Sales and leaseback arrangements can turn curtailment of principal as well as interest into deductible expenses for tax purposes. Debt augmented with an equity "kicker", as well as straight interest, can convert equity returns to debt returns for tax purposes.

23In the parochial world of futures, financial alchemists have developed ingenious products to attempt to securitize futures returns and thereby to avoid the exchange-trading requirement creating, among other things today's $ 5 trillion swaps industry from nothing. In 1989, Michael Lewis, an industry participant and pundit, in his book Liar's Poker described financial engineering’s relationship to regulation in the 1980's as follows: "To attract new investors and to dodge new regulations, the market became ever more arcane and complex. In some cases, the sole virtue of a new product was its classification as 'off balance sheet'."35 The profits from off balance sheet products were described by marketing departments as "high quality earnings" because they were designed specifically to get around certain regulatory costs.

246. Zero sum derivative markets are susceptible to being the markets of blame (or "why you can't trade onion futures inthe U.S.")

25In zero sum derivative markets, participants make money irrespective of the direction of prices. To the extent related cash markets have a long bias, downward pressure on prices may be blamed on futures. Indeed, producers and consumers over the years have complained, without much empirical support, that futures trading is alternately depressing or elevating prices in the respective cash market. These allegations lead, among other things, to an outright prohibition on trading of onion futures in the U.S. and the attribution of the stock market breaks of 1987 and 1989 to trading in stock index futures.36 Most recently, during the Persian Gulf crisis, President Bush blamed futures markets speculation for the escalating price of oil. A subsequent report of the Department of Energy concluded otherwise, thus exonerating the oil traders.37 Nonetheless, because of the tendency to blame the thermometer when we don't like the temperature, there is a particular need for the thermostats to be perceived to be fair.38

267. Economists prefer efficient markets; market professionals, however, profit from inefficiencies.

27Hence, arbitrageurs. Much also has been written about pricing of exotic products — and, in particular, the difficulty of determining the correct price where the market is limited and opaque. So-called bespoke products are designed partly because they can be sold at a premium. However, illiquid and opaque markets have added risks. Perhaps then, the perfect transaction for a market professional is the creation of a futures contract in the exchange for physical market which is reported for clearing to the exchange — this permits pricing in the less efficient market and offsetting in the more efficient one — that is, it avoids that risk of being unable to trade out of a tailored transaction.

288. Bigger is not necessarily better, safer or smarter.

To name a few:
The Hunt Brothers attempt to corner and manipulate the silver markets in 1979 and 1980.39
The Bank of Credit and Commerce International.40
Drexel Burnham Lambert.41
The Bank of New England.42

29Although it is not the responsibility of regulators to protect market users from their excesses, regulators do have a responsibility to the marketplace itself. At a minimum, some of the losses on proprietary trading are exemplary.43 Indeed in 1989 Merrill Lynch lost a record amount in proprietary trading in a short time. Further, it is indisputable that it is more likely that failure of a large firm will have systemic repercussions than would that of a small firm. Need I say more?

309. Systemic risks must be acknowledged and addressed.

31The stock market breaks of October 19th and 20th, 1987 scared us all. The proposition that systemic risk is a regulatory concern brooks no arguments. There are no dissenters. The debate on systemic risk instead relates to how best to anticipate and to minimize the adverse affects of market disruption and — of course, arguments as to what caused it.44

3210. Self-regulation is a good idea but, by itself, it is not enough.

33Governmental endorsement of self-regulation is an experiment in using market forces to encourage self-policing of the marketplace that dates from the enactment of the securities and commodities acts in the 1930's.45 The idea is that consumers want a fair, not a rigged, marketplace and that market participants generally expect markets to be financially Sound so that the self-interest of market participants favors maintaining fair markets. Self-regulation appears to be a permanent feature of securities and futures regulation in the U.S. To assure that self-policing is sufficiently zealous, the System contemplates consequences for performance failures. For example, the CFTCs ongoing oversight program is intended to encourage fair, diligent, effective self regulation. The CFTC has even brought enforcement cases against exchanges to emphasize that their commitment to their self-regulatory responsibilities is a necessity not an option.46

3411. Is enforcement enough?

35Obviously not. Effective enforcement demonstrates what activities, in particular fraud, conversion, misrepresentation and other abuses will not be tolerated by the financial System. Free marketers generally are thought to favor developing the law through enforcement cases rather than prophylactic rules. This is because such cases are directed to specific wrong doing and wrongdoers and do not necessarily burden the market as a whole or stifle the law abiding with rules designed to address potential malfeasors. Nonetheless, some market participants prefer guidance by rulemaking to the potential reputational harm or potential legislative overreaction to spectacular enforcement cases and guidance and preventive maintenance may deter misconduct in the financial markets where the temptations are great and detection may be difficult. Fraud, for example, may be more difficult and resource intensive to prove than are rule violations.

36The question of the right mix of compliance and enforcement is very au courant. The U. K. Securities and Futures Authority just recently in reviewing its selfregulatory procedures determined to separate the monitoring and enforcement oversight functions.

3712. Like Physicians', the Regulators' Motto should be "First, Do No Harm"

38This motto does not necessarily advocate inaction as opposed to action. Although it has been said that "all human wisdom is summed up in two words - wait and hope" (Alexandre Dumas the Elder, The Count of Monte Cristo), regulators cannot merely rely on hope. What it suggests is that financial markets are stores of public wealth which are — circularly — dependent on public confidence that they will continue to function properly in order to continue to function properly. Because of this, I suggest that the one thing on which we all can agree is that the regulator's responsibility is a heavy one.

39Postscript

40Since the foregoing "deductive reflections on the art of financial regulation" were presented in 1993, experience and practice have reconfirmed their basic thrust. In January, 1994, the SEC published its Market 2000 study which concludes that it is possible to protect customers and promote fair competition consistent with the principles of the existing securities laws. In October, 1993, the CFTC issued its report OTC Derivative Markets and Their Regulation which recommended cross jurisdictional coordination among domestic regulators, increased access to information about opaque OTC markets for market measurement and supervisory purposes, improved disclosure to facilitate pricing and risk management, emphasis on appropriate risk management Controls, and consideration of the potential for OTC clearing arrangements.

41In the wake of losses at Metallgesellschaft, Procter & Gamble, Gibson Greetings, Orange County, and revelations of fraud at Banker’s Trust securities affiliate, resulting in enforcement actions by the CFTC, SEC, and the Federal Reserve Bank of New York, several pieces of legislation addressing the regulation of over-the-counter derivatives have been introduced. The President's Working Group on the Financial Markets (formerly active after the Market Crash of 1987) has been revitalized to look at issues raised by OTC derivatives, and the debate is ongoing as to appropriate regulatory approaches, particularly with respect to accounting, disclosure, risk management, fair pricing, marketing practices and systemic risk.

42It has been demonstrated again that large commercial can make market misjudgments, that market and customer protections are features of market integrity and components of confidence in markets irrespective of the size of the participant, that legislators will worry where public funds are at stake and losses have occurred with political consequences.

43To date the responses have been measured, but all agree that the losses to date will result in a number of regulatory initiatives relative to accounting, reporting, disclosure, sales practices, risk management Controls and capital requirements. Although the regulators have not requested new legislation to date what the future holds will depend on market events.