12 June 2014 – The Aleph Blog

Self-Regulation in the Financial Markets: Exchange Issues, Market Structure, and Investor Protections (Part 3)

Posted on 12 June 201413 June 2014 by David Merkel

US System of Self-Regulation through SROs: Strengths and Areas for Reform?

Questions

What are the most substantial/significant contributions of the current SRO system in the United States?
What areas present the greatest need for reform?
How can the private versus ?state actor? functions of non-exchange SROs be reconciled?

David Blass
Chief Counsel, Division of Trading and Markets
US Securities and Exchange Commission

Trading markets division oversees oversees rules, rule changes, etc. ?Promulgate rules, exposes to the public. ?Dodd-Frank gives strict deadlines now, which if exceeded leads to proceedings, which now means further time to evaluate, decide, and additional public exposure.

Lynnette Kelly
Executive Director
Municipal Securities Rulemaking Board (MSRB)

Created in 1975 to deal with egregious conduct. ?Regulates the muni market. ?Writes rules and others enforce. ?SEC regulates on anti-fraud. ?Protect muni issuers since Dodd-Frank. ?Provides data to other regulators.

Daniel J. Roth
President and CEO
National Futures Association

SRO deals with Futures & Swaps — interacts with the CFTC. ?NFA is to CFTC as FINRA is to the SEC regarding crafting of regulations.

Moderated by: Cheryl L. Evans, CFA Institute

DM Note: attendance down to about 50 at this point.

Q to LK: ?How does MSRB “protect issuers?”

LK: Qualified professionals are held to a higher standard. ?[DM: note Poway School District…]

Q: What do you look for in an SRO?

DJR: Mandatory membership is needed, which makes expulsion end the business of the one thrown out.

LK: Collection of data is important. ?Led the way on “pay to play” issues. ?Argues that the muni market is the most transparent bond market after Treasuries. ?[DM: I doubt that.]

DB: Authority, Deep Knowledge, Sanctions help make for a good SRO.

Q: How can SROs aid regulators with data issues?

DB: we are data hungry in order to classify market participants. ?MIDAS — more timely analysis of market trading data.

LK: Aids in collecting analyzing data. ?Analyzes trade data daily. ?Responds to requests from law enforcement and regulators. ?They have allocated a lot more time and money getting analyses together.

DJR:?Drawing together all of the data is tough, but when you do it, you uncover anomalies. ?Constantly developing new systems. ?Have to have human intervention, computers aren’t enough.

Q to DB: How are you increasing your analyses of data at the SEC?

DB: lots of ways, one example is churning.

Q: Conflict challenges, how do you deal with them?

DJR: Create a system of checks and balances. ?34 people on his board, public director are the largest bloc. ?Diverse interest also sometimes checks matters.

LK: We are audited. ?Staff is independent of the board. ?Directors must be competent & ethical.

Q to LK: How do you provide interpretative guidance?

LK: they try to interact quietly with the regulators to resolve differences of opinion.

DB: FINRA is in the same place regarding the SEC. ?FINRA has to enforce SEC securities rules.

Q: What the data sharing rules regarding agencies and SROs?

DJR: CFTC has full access to our data. ?We notify other affiliated regulators/SROs.

LK: Formal rules w/FINRA, IRS, banking regulators, etc., law enforcement via subpoenas.

Q to LK: Additional financial information on new issues?

LK: No authority over financial issuers, more frequent disclosure would be better. ?We make our systems easy for?issuers to upload data. ?FOIA requests can be made as well on issuers. ?Munis are not high quality liquid securities.

Q: Thoughts on principles-based rules and regulations?

DB: perennial issue, we will never be fully one way or another. ?Market participants request rules to guide them when principles are issued.

LK concurs.

DJR says that principles-based rules allow them to be tougher. ?Market participants have a rule: they complain. ?(laughter from audience)

Self-Regulation in the Financial Markets: Exchange Issues, Market Structure, and Investor Protections (Part 2)

Posted on 12 June 2014 by David Merkel

Exchange SROs: Meeting the Needs of Investors and the Financial Marketplace

Questions:

How do exchange SROs contribute to the effective functioning of the securities markets?
How has the role of exchanges changed since they were first designated as SROs, and have these changes affected their ability to function effectively in that role?
Do recent breakdowns in exchange oversight functions indicate a need for an overhaul of structure/functions or point to ?fatal flaws? in the current system?
Are conflicts in the current system of demutualized exchanges resolvable or inherent in the system?
What needs to be done to reinforce the integrity of the system and increase investor protections?
How does increased competition from broker/dealer internalization networks and foreign trading markets affect exchanges under the constraints of the current self-regulatory system?

Panel

Roberta Karmel
Centennial Professor of Law, Brooklyn Law School
Former Commissioner of the US Securities and Exchange Commission

The change from fixed commissions was significant. ?NASD traders had preferential rates trading with one another. ?Existing SROs continued on. ?Expulsion was a threat. ?Exchange listing standards were a significant protection.

Many markets, and profit seeking exchanges have changed matters. ?Sarbox and Dodd-Frank have affected matters ?with listing requirements. ?JOBS act has opened up listing standards, and perhaps not in a good way. ?SEC was happy to see the monopoly of the NYSE broken, but there have been unanticipated secondary effects. ?We need to ask what kind of regulation we need now in the present environment.

Richard G. Ketchum
Chairman and CEO,?Financial Industry Regulatory Authority

Mentions MS was the first Chair of FINRA. ?Merger of NASD and NYSE Reg. ?FINRA has an enhanced majority of public governors. ?No way for industry to capture FINRA. ?Oversees all bond and equity trading. ?Exchange SROs can delegate to FINRA, but they must oversee what FINRA does for them.

Mary Schapiro
Vice Chairman of the Advisory Board, Promontory Financial Group
Former Chairman of the US Securities and Exchange Commission
Former CEO of the Financial Industry Regulatory Authority (FINRA)
Former Chairman of the Commodity Futures Trading Commission

SROs are cost-effective and flexible, with deep expertise. ?Examine participants, Surveill markets, etc. ?New tech, markets, exchanges as profit-seeking entities are new challenges. ?Conflicts of interest have grown along with HFT.

Moderated by: Andrew N. Vollmer, University of Virginia School of Law

Q: Does the current system work well? What areas do we need to change?

MS: It’s working well. ?Vigilence is needed. ?Well-functioning SROs are an aid to regulators. ?Easier for an SRO to address an issue with stakeholders.

RK: Wants the SEC to have a bigger budget, merge the CFTC into the SEC. ?SROs are necessary now because the system won’t work without them. ?Fragmentation of?trading makes self-regulation less effective.

ANV asks RGK to reply.

RGK says FINRA aids regulators. ?FINRA brings knowledge, focus and access. ?Government regulators are more confrontational, FINRA can get more done. ?Exchanges are the only ones enforcing listing?standards.

MS concurs that listing standards are needed.

Q: Have we lost some of the benefits of SROs with the delegation of authority to FINRA?

RGK: has worked with SROs his whole life. ?Comments how things were often worse in the past, not all things are worse today.

MS:?Concurs with RGK.

RK: There has been loss, much of it through the destruction of exchange-based trading. ?2008 meltdown — few firms did anything to stop the crisis. ?Everyone acted in their own interest.

Q: Aside from listing standards, what other?things should the exchange SROs do?

MS: Exchanges will always be responsible for aspects of investor protection.

RK: Exchanges will always have an interest in the integrity of their markets.

RGK: Comments that exchanges should watch over the quality of products traded [DM: think of leveraged and inverse ETFs, ETNs, penny stocks, promoted stocks, etc.]

Q: What about efficiency at the SRO level?

MS: Competition and efficiency don’t always work well together. ?SEC and CFTC should be merged.

RK:?SEC and CFTC should be merged. ?Need more than one regulator, though. ?Did not work in the UK. ?FSOC a disaster, a non-solution.

RGK: We interact with everyone. ?No opinion on whether the?SEC and CFTC should be merged.

Self-Regulation in the Financial Markets: Exchange Issues, Market Structure, and Investor Protections (Part 1)

Posted on 12 June 2014 by David Merkel

I’m at the?Self-Regulation in the Financial Markets: Exchange Issues, Market Structure, and Investor Protections Conference hosted by the CFA Institute and the DC Society. ?I will be making occasional posts on this today, in the form of summary notes.

Jim Allen, CFA
Head, Capital Markets Policy ? Americas

CFA Institute ? already self-regulated.? Aids in flexibility of regulation.? De facto standards of investment performance measurement ? GIPS [Global Investment Performance Standards].

Keynote talk

Has spent much of her life heading self-regulatory organizations [SROs].? She thinks SROs lever the effectiveness of government in regulating finance.? Congress does not appropriate the proper amount of money to regulate finance on its own.? Employee levels in the government regulators have not grown.

Regulating RIAs ? only 9% examined in 2013 managing $55 Trillion of assets.? SROs are not a second choice solution.? There is more expertise, tech knowledge, etc.

The Future of Self-Regulatory Organizations

Cited this article: Top 10 Characteristics of Effective Self-Regulatory Organizations

DM note: There are about 60 people here in this room adequate to hold about 150.

First Panel

Global Overview: Role of Self-Regulation in Increasingly Interconnected and Complex Markets

Topics

What are the benefits of an effective self-regulatory system in the securities markets?
What challenges does the self-regulatory system face in light of the complexity of financial products and trading mechanisms (algorithmic trading, dark pools, etc.), and what resources are needed in response?
How does the use of ?front-line? regulators in certain market sectors contribute to more effective regulation?
What is the future for self-regulation? How do the experiences differ between emerging markets and those that are more established?

Chris Brummer
Professor of Law — Georgetown University Law Center
No intro talk.
Amarilis Sardenberg
Chair of the Board?– BM&FBOVESPA Market Supervision

Government Bond ? Central Bank

OTC Bond, Securities, and Derivatives ? all under one regulator.? Each has its own SRO.? Her securities SRO audits brokers and custodians.? All trades tracked by beneficial owner; makes tracking manipulation easier.
Susan Wolburgh Jenah
President and CEO –Investment Industry Regulatory Organization of Canada [IROC]

Heads a national SRO in Canada.? Provinces have financial regulatory authority.? This is somewhat similar to insurance regulation in the US.? SROs have greater authority in Canada.? Audited regularly, and the results are made public.? Thinks they hold to the Top 10 Characteristics of Effective Self-Regulatory Organizations pretty well.

Moderated by: Jim Allen, CFA, CFA Institute

Q: Challenges of SROs?

CB: 2 ? points: 1) Globalization ? financial trade can go on anywhere ? affects regulation.? Coordination is helpful, the US cannot dictate international rules.? Soft principles have dominated over negotiating hard principles.

2) Disintermediation of financial services firms eliminates gatekeeping functions of financial firms.? Bitcoin, Crowdfunding, Dark pools, etc.? (DM: I would have said derivatives or money market funds?)

SWJ: Changes have been huge ? explosion of exchanges in Canada and the US. ?High frequency trading [HFT] is highly controversial ? and it is a data-intensive task to investigate what is right or wrong.

AS: Coordination of policy is important.? A little surprised at arbitrage trades.

Q: What to do about attacks from hackers?

SWJ: Big issue, the investment banks are big targets.? Smaller firms lag on resources.? We try to educate on the issue, create best practices, policies, etc.? Their SRO hires hackers to test their systems.

AS: Similar answer to SWJ, adds that the exchanges have their own efforts.

CB: Capture the right data, analyze it.

Q: Regulatory arbitrage, how to reduce?

CB: Cites: The Danger of Divergence: Transatlantic Financial Reform & the G20 Agenda

Different regulators move at different speeds, and face local challenges.? Different cultures affect implementation.

SWJ: Businesses move faster than regulators.? Are provincial securities regulators able to adapt more rapidly than a national regulator? [DM: If they cooperate, I think it can work.]

AS: There are so many trades going across borders that it is very difficult to police.? Post-trade settlement is tough ? harmonizing settlement standards has a long way to go.

Q: How do you avoid industry capture?

SWJ: IROC does not advocate, it only regulates.? Purity of purpose is important.? Board is 7 independent, 7 industry and the Chair.? Nominating Committee composed of the independent directors plus Chair.? Everything public and transparent.

AS: Her exchange SRO is established by statute, and has clear authority and goals as a result.? Board of 11, 8 must be independent.

Q: Not many SROs in banking, as finance goes more global, how will SROs fare?

CB: Harmonization of data collection would help.? Difficult to harmonize all regulation under one roof.? Federal Reserve doing some of this. [DM: not really]? Long history of SROs in finance and other areas, like accounting.? Independent majority on SRO boards need with an independent source of revenues.

SWJ: There is an academic paper to be written here.? [DM: Panic of 1907, Great Depression help explain it.]

AS: Not many exchange based SROs: US, Canada, Brazil, Columbia…

Post 2500: What is the Aleph Blog About?

Posted on 12 June 201420 June 2017 by David Merkel

Every hundred or so posts, I take a step back, and try to think about broader issues about blogging about finance. ?Tonight, I want to explain to new readers what the Aleph Blog is about.

There have been many new followers added to my blog recently, ?through e-mail, RSS, and natively. ?This is because of this great article at Marketwatch, which builds off of this great article at Michael Kitces’ blog.

I am humbled to be included among Barry Ritholtz, Josh Brown, and Cullen Roche, and am genuinely surprised to be at number 4 among RIAs in social media influence. ?Soli Deo Gloria.

What Does the Aleph Blog Care About?

I’m writing this primarily for new readers, because I’ve written a lot, and over a lot of areas. ?I write about a broader range of topics than almost all finance bloggers do because:

I’m both a quantitative analyst and a qualitative analyst.
I’m an economist that is skeptical about the current received wisdom.
I like reading books, so I write a lot of book reviews.
I’m also a skeptic regarding Modern Portfolio Theory, and would like to see it discarded from the CFA and SOA syllabuses.
I believe in value investing, in both the quantitative and qualitative varieties.
I believe that risk control is a core concept for making money — you make more money by not losing it.
I believe that good government policy focuses on ethics, not results. ?The bailouts were not fair to average Americans. ?What would have been fair would have been to let the bank/financial holding companies fail, while protecting the interests of depositors. ?The taxpayers would have been spared, and there would have been no systematic crisis had that been done.
I care about people not getting cheated. ?That includes penny stocks, structured notes, private REITs, and many other financial innovations. ?No one on Wall Street wants to do you a favor, so do your own research and buy what you want to own, not what someone wants to sell you.
Again, I don’t want to see people cheated, so I write about ?insurance. ?As a former actuary, and insurance buy-side analyst, I know a lot about insurance. ?I don’t know this for sure, but I think this is the blog that writes the most about insurance on the web for free. ?I write as one that invests in insurance stocks, and generally, I buy the stocks because I like the management teams. ?Ethical, hard working insurance management teams do the best.
Oddly, this is regarded to be a good accounting blog, because as a user of accounting statements, I write about accounting issues.
I am a skeptic on monetary and fiscal policy, and believe both of them tend to sacrifice the future to benefit the present. ?Our grandchildren will hate us. ? That brings up another issue: I write about the effects of demographics on the markets. ?In a world where populations are shrinking in developed nations, and will be shrinking globally by 2040, there are significant economic impacts. ?Economies don’t do well when workers are shrinking in proportion to those who are not working. ?(Note: include stay-at-home moms and dads in those who work. ?They are valuable.)
I care about the bond market. ?There aren’t that many good bond market blogs. ?I won’t write about it every day, but I will write about i when it is important.
I care about pensions. ?Most of the financial media knows things are screwed up there, but they do not grasp how bad the eventual outcome will likely be. ?This is scary stuff — choose the state you live in with care.

Now, if you want my most basic advice, visit my personal finance category.

If you want my view of what my best articles have been, visit my best articles category.

If you want to read about my “rules,” read the rules category.

Maybe you want to read some of my most popular series:

My blog is not for everyone. ?I write about what I feel most strongly about each evening. ?Since I have a wide array of interests, that makes for uneven reading, because not everyone cares about all the things that I do. ?If that makes my readership smaller, so be it. ?My blog expresses my point of view; it is not meant to be the largest website on finance. ?I want to be special, even if that means small, expressing my point ?of view to those who will listen.

I thank all of my readers for reading me. ?I appreciate all of you, and thank you for taking the time to read me.

As one final comment, I need to say this. ?I note people unfollowing my blog at certain times, and I say to myself, “Oh, I haven’t been writing about his pet issue for a while.” ?Lo, and behold, after these people leave, I start writing about it again. ?That is not intentional, but it is very similar to how the market works. ? People buy and sell investments at the wrong times.

To all my readers, thank you for reading me. ?I value all of you, and though I can’t answer all e-mails, I read all e-mails.

In summary: the Aleph Blog is about ethics and competence. ?I want to do what is right, and do what gives the best investment performance, in that order.