Two regulators, two missions

October 8, 2010 07:24 AM

Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler and Securities and Exchange Commission (SEC) Chair Mary Schapiro begin an op ed piece in the USA Today with the following: “The missions of the Securities and Exchange Commission and the Commodity Futures Trading Commission are to protect investors and ensure our derivatives and securities markets are as fair, transparent and efficient as possible.”

That line has past CFTC Chairman Philip McBride Johnson a little worried because it suggests that the two agencies are in the same business when they exist for quite different purposes and could reprise efforts to merge the two.

The piece, “Opposing view on markets: SEC, CFTC weighing safeguards,” explains efforts being undertaken by the two agencies to address what happened with the May 6 “flash crash”  based on a joint report they released last week.

While there have been efforts going back a long time to merge the two agencies, those efforts often ignore the fundamental different mission each regulator has. Here is Johnson’s description of the different purposes of the CFTC and SEC:

SEC - in a capitalist society, the economy relies heavily on the wealth of its citizens to fuel growth. That process is called "investing" where you and I contribute money to an enterprise (over which, in all likelihood, we have no control) in the hope that it will succeed and that such success will translate into a profit for us.  In other words, you and I are encouraged to take a risk that we could easily avoid.  So, to make sure that our risk is limited only to poor management or products, the SEC exists to "watch our backs" against other forms of chicanery that might hurt us - fraud, manipulation, etc.

But the SEC also knows that you and I are unlikely to "invest" (i.e., take on voluntary financial risk) if we expect to lose money in the process. If investing were not more-likely- than-not to be successful, nobody would do it. And the vast majority of us can profit only from rising prices. So, the SEC tilts the table a bit by discouraging behavior that would tend to depress prices (good examples: "short selling" or rapid liquidation of holdings - "dumping"). It could be said - not critically but realistically - that the SEC has a "long bias" because it is expected to.

CFTC - in a capitalist society, enterprises expect to measure their success in terms of how well they excel at what they do. On the road to that outcome, however, are many pitfalls. Some of them cannot be "managed" because they simply cannot be avoided. What to do?

Buy insurance, of course. There is the conventional route of calling one's hazard insurance agent but, in addition, we have derivatives markets capitalized by private funds (just as "investors" fund enterprises) that offer the same protection as conventional insurance (often at lower cost). But the risk that worries our enterprise may need insurance that pays out when prices rise (say, raw materials get more expensive) or when prices fall (say, the end product loses value).

Now, what must you and I know in order confidently to either (i) contribute capital to the derivatives market, or (ii) use it as a hedging tool?  Above all else, it must be price neutral.  We cannot suspect that the CFTC or anyone else is "tilting the table" because, should that happen, speculators will not provide funds and hedgers will not take positions on the side of the market that is disfavored by regulatory policy.  And, because those potential speculators and hedgers have withdrawn due to this discrimination, the favored side cannot find counterparties and disappear as well.

The CFTC exists primarily to assure that these markets provide insurance protection for anyone who needs it.  It cannot view short selling any differently from long positions.  Its role as a policeman is important, of course, but it will quickly have nothing to regulate if it demonstrates the slightest bias.

Summary: the SEC is expected to encourage people to take risks in the hope of future rewards and, as a result, polices the markets but also leans toward policies that increase the chances that those rewards will materialize because, otherwise, the investment markets would disappear. The CFTC is expected to help people avoid risk by using the derivatives markets and, as a result, must be studiously neutral about price direction as neither the providers of capital nor the hedgers will support what they see as a biased environment. The SEC must favor higher prices or else its markets will disappear, while the CFTC cannot favor any price direction or else its markets will disappear.

Philip McBride Johnson

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.