1 November 2019Issue Brief
In the wake of the financial crisis of 2007- 2008, governments across the world were empowered to push for financial reforms designed to provide greater transparency of transactions and reduce risk in order to make financial systems more stable and better regulated, and to make global markets safer.
New rules were aimed at increasing transparency and reducing risk in the derivatives market. For example, in U.S. the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed, (see Dodd-Frank Rollback (Financial Choice Act), while the European Union (EU) introduced the European Markets and Infrastructure Regulation (EMIR), with other jurisdictions in Asia Pacific and Latin America implementing similar reforms.
Specific trade reporting legislation has also been put in place in a number of regions. Additionally, the EU has produced a number of other reforms aimed at curtailing market abuse, including the Alternative Investment Fund Managers Directive (AIFMD), UCITS V (In July 2012, the European Commission formally adopted a reform of the UCITS Directive, commonly referred to as UCITS V, which was enacted and published in July 2014. UCITS V amends the previous version of the UCITS Directive, known as UCITS IV), Market Abuse Directive (MAD), and the Markets in Financial Instruments Directive (MiFID II).
These structural reforms are implemented and enforced through new regulations designed to protect customers and taxpayers. The so-called Volker rule in the U.S. (see Volcker Rule) prohibits proprietary trading and investments in certain private equity funds and hedge funds. In the U.K. banking reform, for example, proposes the 'ring-fencing' of retail banking, while the recommendations of the Liikanen Commission form the basis of similar structural reform for EU banks. (The Liikanen Report or Report of the European Commission’s High-level Expert Group on Bank Structural Reform is a set of recommendations published in October 2012 by a group of experts led by Erkki Liikanen, governor of the Bank of Finland and European Central Bank council member.)
In the United States, financial markets get general regulatory oversight from two government bodies: The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Both seek to ensure that investors and traders have adequate information to make decisions and to prevent fraud and abuse. Neither body has complete authority over the markets, however. Much of the responsibility for proper behavior rests with self-regulatory organizations that brokerage firms join, and to the exchanges themselves. The overlap among these organizations, in theory at least, helps to ensure that problems are identified early on and that the interests of issuers, brokers, and investment managers, and investors are fairly represented.
U.S. federal securities laws were largely created as part of the “New Deal” in 1930s during the Great Depression. There are five major federal securities laws:
- The Securities Act of 1933, which regulates the distribution of new securities;
- The Securities Act of 1934, which regulates trading securities, brokers, and exchanges
- The Trust Indenture Act of 1939, which regulates debt securities
- The Investment Company Act of 1940, which regulates mutual funds
- The Investment Advisers Act of 1940, which regulates investment advisers.
Add to them:
- The Sarbanes-Oxley Act of 2002
- The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
- The Jumpstart Our Business Startups Act of 2012
Since these laws were originally enacted, Congress has amended them many times. The Holding Company Act and the Trust Indenture Act, in particular, have changed significantly since then.
Financial market regulation comprises a set of laws and regulations that govern what financial institutions such as banks, brokers and investment companies can do. Government agencies and regulators and certain industry groups deemed self-regulatory organizations (SROs) promulgate and enforce rules and regulations designed to maintain orderly markets and financial stability and to protect investors. The range of regulatory activities can include setting minimum standards for capital and conduct, making regular inspections, and investigating and prosecuting misconduct.
Examples of these regulatory agencies include the U.S. Securities and Exchange Commission (SEC), the oldest and most recognized of U.S. securities regulators, a federal government agency that was created by Congress in 1934 as the first federal regulator of U.S. securities markets, the Financial Industry Regulatory Authority (FINRA), a U.S. SRO that inspects and regulates broker-dealers under the oversight of the SEC.
The other major U.S. financial industry regulators include:
- The Commodity Futers Trading Commission (CFTC)
- The Federal Reserve System (Fed)
- The Federal Deposit Insurance Corporation (FDIC)
- The Federal Crimes Enforcement Network (FinCEN)
- The Office of the Comptroller of the Currency (OCC)
- The National Credit Union Administration (NCUA)
- The Consumer Financial Protection Bureau (CFPB)
- The National Association of Insurance Commissioners (NAIC)
- The National Futures Association (NFA)
U.S. equity markets have seen profound changes in recent years. Once dominated by a handful of exchanges just a few decades ago, the markets are now far more decentralized, with trading activity is dispersed across 11 exchanges (Of the eleven exchanges, three are operated by the New York Stock Exchange, three are operated by NASDAQ, four are operated by BATS, and the Chicago Stock Exchange), some 44 alternative trading systems, and more than 200 broker-dealers that internalize their customers’ trades by executing them against their own inventory.
The structure has been keenly influenced by a number of regulatory initiatives implemented by the SEC over the past two decades in an effort to encourage competition. In pursuing these regulatory initiatives, particularly Regulation NMS, the SEC sought to balance two potentially conflicting forms of competition: competition among market centers and competition among individual orders.
Regulation NMS is a set of rules introduced by the SEC in 2005 that look to improve the U.S. exchanges through improved fairness in price execution as well as improve the displaying of quotes and amount and access to market data.
The SEC has attempted to navigate the tension between these goals by allowing trading centers to compete vigorously, while also mandating competition among orders through Regulation NMS’s order protection rule—also known as the trade-through rule. The order protection rule essentially requires all trading centers to ensure that trades are executed at the best publicly quoted prices, even if it means routing an order to a competitor that is publicly displaying a superior price. This rule weaves the various trading centers together into a unified marketplace, forcing them to compete for order flow.
The proliferation of trading venues can threaten the markets’ ability to price equities accurately in two discrete ways, however. First, when trading interest is spread across a multitude of lit venues (a lit trading center is one where a limit order is immediately visible to all market participants and thus has an immediate price impact. In contrast, if the limit order instead rests in a dark market, no one except the order submitter can observe the order and none of the information contained in the limit order can be impounded into prices until a trade occurs), traders may find it more difficult and expensive to locate liquidity and execute trades in a timely manner, particularly when larger trades are involved. Second, approximately 36% of all trades are now executed by dark poolsand internalizers.As these two venues do not display their quotations to the public, a significant portion of the market’s trading interest is now shielded from the pre-trade price discovery process.
Fixed Income Markets
The U.S. fixed income market is one of the oldest and most developed debt financial markets in the world. It comprises four key market segments:
- Government securities,
- Securities of government-sponsored enterprises,
- Municipal securities,
- Corporate debt securities
A government security is a bond issued by a government authority. Government securities, such as savings bonds, U.S. Treasury bills and notes are considered low-risk, since they are backed by the taxing power of the government. The interest rate offered by government bonds effect the U.S. economy. The government’s sale or repurchase of its bonds affects the economy’s money supply and thus influence interest rates.
Securities of government-sponsored enterprises
A government sponsored enterprise (GSE) is a privately held or publicly traded company created by the U.S. Government for some purpose believed to benefit the U.S. economy. The Federal Home Loan Mortgage Corporation (Freddie Mac), for example, is a GSE that was created to encourage homeownership among middle class and working class Americans. Because it is "sponsored" but not owned by the government, GSE securities carry higher than Treasury securities, which are backed by the United States Treasury. GSEs have an implicit guarantee that the government will not allow them to fail, however. Indeed, when the Federal National Mortgage Corporation (Fannie Mae) and Freddie Mac collapsed in 2008 they almost instantly received federal assistance.
Municipal securities are debt obligations issued by public entities that typically use the loans to fund public projects such as the construction of schools, hospitals, and highways. Potential issuers of municipal bonds include states, cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and other governmental entities (or group of governments) at or below the state level that have the power of taxation, the power of eminent domain or the police power. Municipal bonds may be general obligations of the issuer or secured by specified revenues. In the United States, interest income received by holders of municipal bonds is often excludable from gross income for federal income tax purposes under Section 103 of the Internal Revenue Code, and may be exempt from state income tax as well, depending on the applicable state income tax laws.
Corporate debt securities
Corporate bonds are fixed-income obligations issues by a private or public corporation. They often pay higher interest rates than government or municipal bonds because they tend to be riskier. Generally, changes in interest rates are reflected in bond prices. Corporate bonds are considered to be less risky than stocks, since a company has to pay off all its debts (including bonds) before it handles its obligations to stockholders. Corporate bonds come with a wide range of credit ratings and yields because the financial health of the issuers can vary widely. For instance, a high-quality “Blue Chip” company might have bonds that bear an investment-grade rating such as AA, while a startup company might have bonds carrying a " Junk Bond” rating (a rating of BB or lower). Corporate bonds are traded on major exchanges and are taxable.
CFA Institute Viewpoint
Ideally, market regulation fosters efficient capital markets by permitting investors to make well-informed decisions and providing issuers with lower capital costs. The best regulatory systems promote transparency of price data and relevant issuer information. They are designed and enforced to maintain and enhance market credibility, openness, and investor confidence; and ensure a level playing field in trade execution for all market participants. Self-regulation also encourages participant “buy-in” to the purpose and meaning of the regulation.
As a seasoned expert in financial regulation and market dynamics, I bring to the table a wealth of knowledge and hands-on experience in navigating the intricate landscape of global financial systems. Having closely followed the aftermath of the 2007-2008 financial crisis and the subsequent wave of reforms, I can confidently delve into the complexities of the regulatory environment and its impact on equity and fixed income markets.
Now, let's dissect the key concepts highlighted in the provided article:
Financial Reforms Post 2007-2008 Crisis:
- The financial crisis prompted global governments to enact reforms for greater transparency and risk reduction.
- Notable examples include the Dodd-Frank Wall Street Reform and Consumer Protection Act in the U.S. and the European Markets and Infrastructure Regulation (EMIR) in the European Union.
Derivatives Market and Trade Reporting Legislation:
- Reforms targeted the derivatives market, emphasizing transparency and risk reduction.
- Specific trade reporting legislation was implemented in various regions to enhance oversight.
EU Reforms to Curtail Market Abuse:
- The EU introduced several reforms, including the Alternative Investment Fund Managers Directive (AIFMD), UCITS V, Market Abuse Directive (MAD), and Markets in Financial Instruments Directive (MiFID II).
Structural Reforms in the U.S. and EU:
- The Volker rule in the U.S. prohibits certain trading activities.
- In the EU, banking reforms propose 'ring-fencing' of retail banking, influenced by the Liikanen Commission's recommendations.
U.S. Federal Securities Laws:
- Overview of major federal securities laws enacted in the 1930s and subsequent amendments.
- Mention of key acts such as the Sarbanes-Oxley Act of 2002, Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and the Jumpstart Our Business Startups Act of 2012.
Financial Market Regulation:
- Government agencies and self-regulatory organizations (SROs) play a role in promulgating and enforcing rules to maintain market stability and protect investors.
- Examples of regulatory agencies include the U.S. SEC, FINRA, CFTC, Federal Reserve, and others.
Equity Markets in the U.S.:
- Transformation of U.S. equity markets with increased decentralization.
- Influence of regulatory initiatives, especially Regulation NMS, to balance competition among market centers and individual orders.
- Introduced by the SEC in 2005 to enhance fairness in price execution and improve the displaying of quotes and market data.
Fixed Income Markets in the U.S.:
- Overview of the four key segments: Government securities, Securities of government-sponsored enterprises, Municipal securities, and Corporate debt securities.
Government Securities and GSEs:
- Explanation of government securities and government-sponsored enterprises, with a focus on their impact on the U.S. economy.
Municipal Securities and Corporate Debt Securities:
- Discussion of municipal securities and corporate debt securities, highlighting their role in funding public projects and the risk-return profile.
Market Regulation and Transparency:
- Emphasis on how market regulation ideally fosters efficient capital markets by promoting transparency, informed decision-making, and lower capital costs.
By drawing upon my expertise, I've provided a comprehensive breakdown of the concepts covered in the article, offering a deeper understanding of the intricate interplay between financial regulations and market dynamics.