Derivatives Regulation: Problems and Prospects

Derivatives regulation in the United States is a jumble of legal fields, including banking, securities, commodities, and bankruptcy law. And any time multiple areas of law and regulation come together, complexities and jurisdictional ambiguities arise.

Derivatives, including futures, swaps, put and calls, are regulated in essentially two distinct ways. First, certain institutions that are already subject to regulation (e.g., banks and thrifts) may have their derivatives activities scrutinized by their institutional supervisors. Second, specific types of derivatives¾namely, futures and certain options¾are regulated as financial products.

Derivatives regulation in the United States is essentially a hybrid of "institutional" and "functional" regulation. As a result of this mixture of two essentially distinct regulatory paradigms, many institutions that use derivatives¾both exchange- traded (e.g., futures and options) and privately negotiated (e.g., swaps)¾are regulated both institutionally and functionally. Because privately negotiated derivatives are not themselves subject to any functional regulation¾unlike their exchange-traded cousins that are regulated by the CFTC or SEC¾other participants in derivatives activity may be neither institutionally nor functionally regulated.

This hybrid regulatory scheme causes intense legal and jurisdictional uncertainty and high regulatory compliance costs, both of which discourage financial innovation and encourage firms to ship their creative financial activities off shore. In addition, the unholy marriage of institutional and functional regulation creates serious competitive asymmetries between some market participants. Financial products may be privately offered by swap dealers, for example, with no intervention by a functional regulator like the CFTC. If a nearly identical product is offered by a futures exchange, however, the exchange, the product, and the users of the product all are subject to CFTC regulation¾and to the CFTC’s notorious contract approval process.

One solution to these "problems" of derivatives regulation is to move the financial regulatory paradigm toward one that is either entirely institutional or entirely functional. Such a shift would eliminate at least some of the overlaps, uncertainties, compliance costs, and anti-competitive biases of the current system. Duplicative supervision of firms that are both institutionally and functionally regulated, in particular, would vanish.

Some overlaps and uncertainties would persist, of course. But those overlaps and uncertainties almost surely would be less in a functional-only or institutional-only system than in a regulatory regime where institutions and products are both selectively regulated. Reforming the financial regulatory system in this manner, however, does carry with it the risk that the new system would be worse than the present one. Three fallacies, in particular, must be avoided in reengineering the financial regulatory infrastructure.

Fallacy 1¾All Firms and/or Derivatives Must be Regulated

A frequent criticism of current derivatives regulation is that some firms engaged in derivatives activity are totally unregulated. Separately capitalized broker-dealer and insurance company affiliates, for example, often operate as largely unregulated privately negotiated derivatives dealers. In like fashion, some even argue that the use of privately-negotiated derivatives by corporate end users should be regulated. No case for the regulation of these firms can be made, however, solely on the basis of supposed market failures. No evidence suggests that either type of firm is "systemically important" in any measurable way. These firms, furthermore, are already policed by the strong forces of competition.

Fallacy 2¾A Single Regulator is Better than Multiple Regulators

All discussions of financial regulatory reform must inevitably mention the recurring proposal that financial regulatory agencies all be lumped together in one super-regulator. Although the notion of moving to an all-functional or all-institutional paradigm might seem to be consistent with the idea of a single regulator, nothing could be further from the truth.

Competition between regulators helps reduce the costs of regulation. Competing regulators define a "market" in which "competition amongst regulators" tends to force regulation down to relatively manageable levels of cost. Surprising as it may sound, regulatory competition also benefits regulators by helping ensure that each regulator can develop specialized expertise about the institutions or functions it regulates. Regulatory competition, moreover, need not imply regulatory overlap. Overlap can be avoided by adhering to a simple principle: institutions should have at most one regulator but have a "choice" among several competing agencies to be that one regulator.

Fallacy 3¾Functional Regulation is Inherently Preferable to Institutional Regulation

Heralding functional regulation as greatly superior to institutional regulation has become quite fashionable in the last decade. The main ostensible benefit of functional regulation is that functions of the financial system are more stable than the institutions that provide those functions at any given time. Especially with somewhat arbitrary charter distinctions between institutions (e.g., "banks" vs. "thrifts"), functions would seem to be a much more consistent target for regulation than institutions.

Functional regulation also is heralded for minimizing regulatory overlap. With a set of functions of the financial system that are defined exhaustively and mutually exclusively, no function should be regulated by more than one agency. That presumes, of course, that the functions of the financial system can indeed be defined mutually exclusively for regulatory purposes, which is not obvious.

A third ostensible benefit of functional regulation is that relatively few resources are allocated into regulatory avoidance and regulatory arbitrage. Whereas institutions are run by people that can consciously opt into another institutional category (e.g., bank charter switching), financial functions cannot opt into and out of jurisdictions.

As enticing as it might seem, however, functional regulation also comes with real costs, most significantly the impracticality of the regulation of functions of the financial system directly. Instead, functional regulation must be implemented as financial product and market regulation. The operationalization of functional regulation at the financial product level leads to a number of problems. First, even if functions of the financial system can be defined mutually exclusively, functions provided by particular financial products cannot. This lack of clarity, in turn, engenders regulatory overlaps and legal and jurisdictional uncertainty for users of particular financial products.

A second problem with functional regulation is that it does not promote regulatory competition at the product level. Financial product regulators do not typically have much incentive to minimize the marginal costs of their regulations. Because their regulatory constituents are first financial products and then only second the institutions that design, issue, and use financial products, the primary constituents of the agencies are defined by law. With a captive marketplace of regulated financial products, cost minimization to attract regulatory constituents is not important, and functional regulators thus tend to make more costly and onerous regulatory decisions than institutional regulators.

Third, functional regulation greatly increases compliance costs for institutions by subjecting them to multiple regulators. A bank, for example, is likely to be engaged in activities and products that provide virtually all functions of the financial system.

Finally, perhaps the greatest cost of functional regulation is the stifling effects on financial innovation resulting from uncertainties about particular product definitions. Definitions of institutions, by contrast, are admittedly arbitrary, but at least no such uncertainty exists about them. Whether a product is or is not a futures contract, for example, is often extremely unclear, whereas whether a firm is or is not a "bank" is entirely obvious from its charter.

On the whole, financial reforms designed to mitigate the current problems with a hybrid financial regulatory system will worsen rather than improve the status quo if those reforms lead to a greater emphasis on functional regulation. The normative goal of any major reform, then, should be to begin moving financial regulation in the United States toward an entirely institutional approach.

Dr. Christopher L. Culp is Senior Fellow in Financial Regulation with CEI and Director of Risk Management Services at CP Risk Management LLC in Chicago. This article is based on a presentation made at the Milken Institute for Jobs and Capital Formation on March 16, 1998, in Santa Monica, CA.