Financial markets regulation 101

In a very broad sense, securities markets and futures markets bear the similarity that they both address financial demands or needs. The false conclusion has often been reached from that fact that a common, uniform regulatory program should suffice for both. Here is why not.

What is the fundamental purpose of securities markets?

It is to persuade people to take a risk by contributing their capital to public or private enterprises in the hope that, later, this investment vehicle will appreciate in value and they will make a profit.

What is the fundamental purpose of futures markets?

To allow people to avoid a risk they already face by acquiring an insurance vehicle from other market participants.

How do the economics of the two markets differ?

In most securities markets, a security can be bought and sold successively with profit to every owner if a price trend continues (a "win-win" proposition).

In futures markets, a genuine loss is incurred by one party for every gain that is made by the other (a "zero-sum" game).

In most securities markets, investors generally benefit from rising prices and suffer from falling prices.

In futures markets, half of the participants gain from rising prices and half gain from falling prices.

What protections are needed to get people to invest?

  • First, and most important, is creating a reasonable likelihood of making money over time. People who expect to lose money on their investment simply will not make it.

Regulatory response: Since virtually all investors make money only from rising prices, we discourage trading practices that tend to depress those prices like selling short or "dumping" securities into the market. We, like those we are protecting, have what is called a "long bias" as a result.

  • Second, an expectation that their chances of making a profit are as good as any other investor. People who think others have an advantage over them will not invest.

Regulatory response: We try to assure that every investor has the same quality and timeliness of relevant information for investment decisions by eliminating any inherent advantage of some investors over others. For instance, we prohibit anyone with "insider" knowledge about an investment from trading until that information has been made public.

  • Third, fair treatment by their intermediaries.

Regulatory response: We punish those who betray the investor's trust.

What protections are needed to get people to insure?

  • First, we must recognize that there are likely to be as many people needing to insure against falling prices as those needing to insure against rising prices.

Regulatory response: We remain absolutely neutral with respect to market price direction. People will not insure if they think that the rules favor the other side of the market. Neither a "long" nor a "short" bias can exist.

  • Second, people need to be able to acquire insurance as soon as they identify a real or threatened risk.

Regulatory response: We allow them to acquire insurance without making public disclosures about why. If the latter were required (as with investors' insider information), the market would adjust against them before the insurance (even if still available) could be acquired.

  • Third, fair treatment by their intermediaries.

Regulatory response: We use the same tools employed to protect investors – the only common factor – but also common to all forms of consumer protection.

Topics for the course's paper requirement (choose only one):

1. Since a securities market creates risk, why is it called "investment"?

2. Since a futures market reduces risk, why is it called "speculation"?

3. Since securities regulation encourages people to risk their capital, why is it called "investor protection"?

[1] Professor Philip McBride Johnson. Tuesdays and Thursdays at 3:30 p.m. for three (3) credit hours. There is a paper required in lieu of test.

Philip McBride Johnson is a former Chairman of the Commodity Futures Trading Commission. He is of counsel and the leader of exchange-traded derivatives law practice at the law firm Skadden.

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