United States
Publication of Financial Sector Assessment Program Documentation: Detailed Assessment of Implementation of the IOSCO Objectives and Principles of Securities Regulation
Author:
International Monetary Fund
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Publication Date:
14 May 2010
eISBN:
9781455206667
Language:
English
Keywords:
ISCR; CR; CFTC regulation; insider dealing; SEC staff; material information; net capital; SEC rule; risk management; business model; SEC oversight; enforcement power
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This paper presents Detailed Assessment of the United States’s implementation of the International Organization of Securities Commissions’ Objectives and Principles of Securities Regulation. The general preconditions for effective securities regulation in the United States are present. The legal and accounting system supports the implementation of requirements and effective regulation of market participants. The legislation regarding bankruptcy, insolvency, and winding up in the jurisdiction and the professionals associated with those matters are sophisticated.

Abstract

This paper presents Detailed Assessment of the United States’s implementation of the International Organization of Securities Commissions’ Objectives and Principles of Securities Regulation. The general preconditions for effective securities regulation in the United States are present. The legal and accounting system supports the implementation of requirements and effective regulation of market participants. The legislation regarding bankruptcy, insolvency, and winding up in the jurisdiction and the professionals associated with those matters are sophisticated.

I. Summary, Key Findings, and Recommendations

Introduction

1. An assessment of the United States securities and futures market regulatory system was conducted by Susanne Bergsträsser, Richard Britton, and Tanis MacLaren from October 7 to November 3, 2009 as part of the Financial Sector Assessment Program (FSAP).

Information and methodology used for assessment

2. The assessment was conducted based on the International Organization of Securities Commissions (IOSCO) Objectives and Principles of Securities Regulation and the associated methodology adopted in 2003, as updated in 2008.1 An assessment of the securities settlement systems under the Committee on Payment and Settlement Systems (CPSS)/IOSCO Recommendations was conducted separately; thus Principle 30 was not assessed here.

3. The conclusions below are based on information and findings as of November of 2009. As noted below, important reforms have been introduced in the past year, some of which have already been implemented and are beginning to take effect. However, while these promise to address many of the issues identified in this assessment, it would still be important to establish a consistent track record before their efficacy could be judged.

4. The assessment team relied on number of sources in carrying out this assessment. The assessment was based on a review of the relevant legislation, self-assessment questionnaires prepared by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) prior to the mission, detailed discussions with CFTC and SEC staff, with staff of the various self-regulatory organizations, securities and futures exchanges, law enforcement agencies and representatives of industry, and the law and accounting professions. We also reviewed the Joint Report of the SEC and CFTC on Harmonization of Regulation issued October 16, 2009 (Joint Report) and the Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure (White Paper). Staff of the regulators was generous in making themselves available for discussions which were helpful, frank, and forthcoming. Assistance from market representatives was also extremely helpful.

5. The assessment did not address the securities regulatory regime that is imposed at the state level to any significant degree. State regulation plays a more minor role, mostly aimed at consumer protection. In certain areas, such as new issues of securities, state blue sky laws have largely been preempted by legislative amendments at the federal level. In others, the state regulatory activities run parallel to federal ones, such as in the area of enforcement and registration of intermediaries and their representatives.

6. The assessment has been challenging given the complexity of the U.S. system and the task of the regulators in this jurisdiction. The methodology notes that “markets with a single or a few issuers, that are totally domestic in nature, or that are predominantly institutional, will pose different questions and issues as to the sufficiency of application of the Principles and as to the potential vulnerabilities likely to arise from their non-application, than jurisdictions where there are substantial numbers of retail participants, intermediaries frequently are part of complex groups, issuers are established in other jurisdictions, or the markets have other international or cross-border components.” The methodology was therefore applied taking into account that a higher quality of supervisory and regulatory oversight is needed where financial systems are large and complex, as is the case in this jurisdiction. While the assessment has been done against internationally agreed standards, care is needed in comparing the results with those for other countries because of this level of complexity. Further, the methodology has undergone changes (in 2003 and in 2008) and finally the application of the standards in this and other recent cases has necessarily also taken into account the lessons of the recent financial crisis.

7. The assessment was carried out in a post-crisis environment, which had a clear impact on the findings. The financial crisis of 2008 exposed a number of underlying issues in the U.S. financial markets, some of which were causally related to the crisis—such as the lack of ability of U.S. investment banks to withstand shocks to liquidity—while others arose as a result of secondary effects of the crisis—such as the exposure of a giant fraud because of the precipitous contraction of investment in-flow during the crisis. The system was tested in a way that most systems are not and this testing has revealed weaknesses that might otherwise have gone undetected. The authorities have been under extraordinary pressure; first to respond to the crisis and then to undertake reforms. An assessment is rarely carried out in such circumstances—a reading of the findings must give this due consideration.

8. The uncommon level of transparency in the jurisdiction has also affected the assessment findings. The mission had access to a range of official reports, internal evaluations of the regulatory framework, and regulatory practice. Given the size and importance of the markets, there are many sources of analysis available from the private sphere as well. The information made available through this unusual level of transparency and ‘self-criticism’ was taken into consideration by mission, and this context is also important to understanding the findings.

Institutional and market structure—overview

9. The legislative framework in place in the jurisdiction provides a comprehensive, but complex, framework for the types of activities undertaken in the public markets. The responsibility for regulation of the markets at a federal level is split between two agencies created under separate statutes. The CFTC is responsible for the supervision of commodity futures market—the commodity exchanges, the intermediaries and the futures products offered in the public markets—under the Commodity Exchange Act (CEA) as modified by the Commodity Futures Modernization Act (CFMA). The SEC regulates securities markets, issuers, and participants. Its authority flows from several statutes including the Securities Act of 1933 (Securities Act), Securities Exchange Act of 1934 (Exchange Act), Trust Indenture Act of 1939, Investment Company Act of 1940 (ICA), Investment Advisers Act of 1940 (Advisers Act), and Sarbanes-Oxley Act of 2002 (SOX). All of these federal statutes are supplemented by an extensive body of regulations, rules, guidance, court decisions, and regulatory no-action letters. In addition, there are state securities regulators involved in both licensing and enforcement activities. Further, other law enforcement agencies, such as the Department of Justice (DOJ) and state Attorneys General, participate in enforcement activities.

10. The CFTC and SEC rely to a significant degree on self-regulatory organizations (SROs) for the regulation of the markets and their participants. These entities include exchanges, clearing organizations, and securities or futures associations, each of which has authority over their members’ activities. The Financial Industry Regulatory Authority (FINRA) is the registered securities association with authority over broker-dealers (BDs), and the National Futures Association (NFA) is the registered futures association for commodity futures intermediaries and commodity pool operators.

Market data

11. The number of futures and options contracts, and the volume of trading in these contracts have increased dramatically since the CFMA was passed in 2000 (by 570 percent and 594 percent respectively). Over the same time period, client funds held by futures commission merchants (FCMs)—one measure of risk in the system—rose by 354 percent. The number of exchanges has been roughly stable which reflects both consolidations among existing exchanges and the creation of new exchanges. The four exchanges in the Chicago Mercantile Exchange (CME) group now account for over 90 percent of total volume. There has been substantial growth in exempt marketplaces that are not subject to formal designation or licensing and are subject to more limited ongoing regulation once operational. During this period, the number of full time equivalent staff at the CFTC has declined by 18 percent.

12. In comparison, the equity market showed more modest growth until 2008. Between 2000 and 2007, daily volumes increased by only 62 percent. During the market crisis of 2008, volumes increased by 52 percent over 2007, taking the 10-year growth to 255 percent. This was still only 44 percent of the growth rate of the volume of trading of on-exchange futures markets. Not included in these statistics was the 780 percent increase in the number of shares of “pink sheet” OTC stocks traded on a daily basis between 2001 and 2008. Although compared to the main markets the values are small (US$200 million in 2001 and US$540 million in 2008), pink sheet stocks are a major source of securities fraud. In the securities markets, as of March 2010, there were 11 registered national securities exchanges, 79 registered alternative trading systems (ATS), and 4 electronic communications networks (ECNs).2

Futures Statistics

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Source: CTFC.

Daily Average Volume of Shares Traded

(In millions of shares)

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Source: SIFMA.

13. SEC staff numbers, although 24 percent up in this period peaked in 2005 and fell back subsequently; they increased somewhat in 2008/9.

SEC Staffing

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Source: SEC.

14. The United States has a system of specialized intermediaries with separate categories across the futures and securities regimes. Intermediaries trading as principals or agents are registered as BDs under the Exchange Act or FCMs and introducing brokers (IBs) under the CEA. Advisers are registered as IAs or commodity trading advisers (CTAs) under the securities or futures legislation, respectively. The operators of Collective Investment Schemes (CIS) are registered as IAs under the Advisers Act or commodity pool operators (CPOs) under the CEA.

15. The number of registered intermediaries participating in the market has grown only slightly over the past five years. The number of registered commodity futures firms and BDs has declined, with more marked drops in the number of CFTC registrants. This reflects both consolidation in and departures from the industry. The data for CFTC registrations also reflects a migration of CPOs to providing services that do not require registration. The number of BDs has declined 6 percent over the 5-year period, while the total net capital of these firms has increased nearly 80 percent and the total number of registered persons at FINRA member firms has remained relatively constant. Substantial growth has been seen in the number of registered IAs and the assets these firms have under management (32 percent and 79 percent). If unregistered firms—such as hedge fund and ones that are only registered at the state level—are added in, the growth rate in assets under management over the period likely would be much higher.

16. The U.S. CIS market is the largest in the world with nearly US$10 trillion in assets under management in the funds that are registered with the SEC. There was a sharp drop in assets under management in 2008 (-20 percent) reflecting substantial declines in equity markets. However, by the end of September of this year, the total assets under management had recovered somewhat. During 2008, assets in funds moved from long-term funds (equity and bond funds) to money market funds with portfolios consisting only of short-term government paper and cash. Since the beginning of 2009, that trend has reversed and the growth is in equity and bond funds.

17. In contrast, commodity pools operated by registered CPOs have experienced steady declines over the past five years. The number of commodity pools reporting to the CFTC is down 52 percent with their aggregate assets under management down 77 percent over the 5-year period. This reflects both responses to adverse market conditions (trading losses, decreased new contributions, and ceasing business) and conversions of funds to ones exempt from reporting to the CFTC.

Futures and Securities Intermediaries Year

(As at September 30)

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Sources: CTFC, SEC, and SIFMA.

Only includes firms registered with one of the two agencies, not firms exempt from registration or only registered at a state level.

A firm registered in more than one category is counted in each category.

Mutual Fund Assets

(US$ billions)

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Mutual Fund Net New Cash Flow1

(US$ billions)

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Source: Investment Company Institute.

New sales (excluding reinvested dividends) minus redemptions, combined with net exchanges.

Commodity Pools

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Source: CFTC.

Preconditions for effective securities regulation

18. The general preconditions for effective securities regulation in the United States are present. There are no significant barriers to entry and exit for market participants. Competition is encouraged and foreign participation is welcomed. The legal and accounting system supports the implementation of requirements and effective regulation of market participants. The commercial law is up-to-date and is capable of supporting the demands posed by cross-border trade, modern financial instruments, and current corporate governance standards. The legislation regarding bankruptcy, insolvency, and winding up in the jurisdiction and the professionals associated with those matters are sophisticated. The regulators have legally enforceable powers of decision and action, the limits of which have been tested frequently by the courts. The taxation framework is supportive to the operations of the industry in the jurisdiction.

Main findings

19. Complexity is a key challenge. The U.S. securities and futures markets are very complex. The regulatory framework and system that has developed equally complex. This is evident in the division of responsibility between the agencies and in the way that each is structured. There is a high degree of specialization evident at each agency. Although specialization may have benefits in a complex environment, regulators may be challenged to appropriately assess overall issues that cross specialization lines—both within an agency and between agencies. A greater focus on systemic issues relating to both securities and futures markets would make the overall regulatory system more robust.

20. The chairmen of the CFTC and SEC have both recognized the need for change and have taken steps toward strengthening their institutions. However, institutional culture is not easy to transform. Moreover, the agencies are under strong and continuous pressure, including from industry, and the agencies’ challenge will be to respond to market developments and develop a reform agenda in an independent manner.

21. These issues manifest themselves in some key areas (such as in the enforcement function or in regulation of over-the-counter derivatives markets) but the problems affect the entire system.

22. As a matter of priority, the system should work toward simplification of internal and institutional structures. Within the agencies, better internal management structures and improved communication between departments should be established to facilitate a regulatory culture of continuous learning and response.

23. Principles relating to the regulator (Principles 1-5): The responsibilities of the CFTC and SEC are clearly stated in law. There are gaps in coverage of the wide range of activity in the U.S. markets and in the scope of authority of both agencies. There are also differences between the futures and securities regimes in how similar instruments are regulated. There are also gaps between the authority of the SEC and the Federal Reserve with respect to the regulation and oversight of investment bank holding companies which added to the fragility of the overall system in the recent crisis. These gaps should be reduced as much as possible. The legal system grants the CFTC and SEC sufficient protection for their independence and the agencies operate independently on a day to day basis. There is a strong system of accountability to Congress. Neither agency has sufficient funding nor does the method of funding provide sufficient assurance of continuing funding levels to be able to commit to long-term capital projects, such as building new market surveillance systems, which are necessary to keep pace with changes in the industry. The CFTC and SEC activities and processes are transparent and there is public consultation regarding their regulations. They are active in investor education. CFTC and SEC staff and commissioners are subject to codes of ethics and other requirements to ensure a high standard of conduct.

24. Principles relating to self-regulation (Principles 6-7): SROs play a very significant role in the supervision of markets and their participants. Exchanges and clearing organizations perform important self-regulatory functions, as do registered associations. SROs are subject to an authorization regime based on eligibility criteria that address issues of integrity, financial viability, capacity, governance, and fair access—although the regimes are different for exchanges in the securities and futures markets. The CFTC has insufficient authority regarding exchanges following the coming into force of the CFMA. The CFTC has limited ability to intervene in the introductions of a new product or changes in rules, such as those governing trading. There is also no opportunity for stakeholders whose interests may be negatively affected to have their views taken into account in advance of a new product listing or rule change. These deficiencies have been recognized and are now being addressed via recommendations for legislative change set out in the Joint Report. Unlike securities exchanges, some demutualized futures exchanges have retained full member regulation powers. Some in the industry are concerned this may be used to restrain member dissent in the pursuit of shareholder interests. The CFTC publicly examined this issue from 2003 through 2009, which resulted in the adoption of acceptable practices for exchanges to follow in addressing conflicts of interest.

25. Principles relating to enforcement of securities regulation (Principles 8-10): The anti-fraud provisions under the U.S. federal securities laws, as enforced by the SEC via Rule 10b-53 and supported by the courts, have proved to be a very effective tool for prosecuting offences under the securities laws. Private litigation is also an unusually powerful tool for securing compliance and obtaining redress in case of breach. The CFTC and SEC have broad investigative and surveillance powers over regulated entities, exchanges, and regulated trading systems. They can conduct on-site inspections without prior notice and can obtain information of all types without the need for a court order. The CFTC and SEC have broad enforcement powers, including the power to seek injunctions, bring an application for civil proceedings, and compel information and testimony from third parties. They also can impose administrative sanctions and refer matters to criminal authorities. The CFTC and SEC have implemented a system of supervision of markets and market participants including conducting on-site examinations. Significant shortcomings were identified in the SEC enforcement program. However, the SEC’s extensive and wide-ranging program to implement the IG’s recommendations and other changes is beginning to generate improvements and such efforts should be brought to a conclusion as a matter of high priority. Resources dedicated to the examination of SEC-registered IAs (a program currently conducted solely by the SEC) are insufficient, thus reducing the effectiveness of the program. Therefore, resources should be increased to at least enable the SEC to match the frequency and scope of the periodic examination of BDs where the responsibility is shared between the SEC and FINRA. Resources for criminal prosecution of securities fraud are too limited.

26. Principles for cooperation in regulation (Principles 11-13): The CFTC and SEC have broad authority to share information with both domestic and foreign regulators, even without having memoranda of understanding (MOUs) in place. Both agencies are signatories of the IOSCO MOU and also have many bilateral MOUs in place with other regulators. The CFTC and SEC have the authority to assist foreign regulators in obtaining information that is not in their files, using the powers that are available for their own investigative activities.

27. Principles for issuers (Principles 14-16): Companies that issue securities in the public market must provide extensive financial and other disclosure on initial offerings and most are subject to detailed continuing disclosure obligations in line with IOSCO standards. Liability provisions are in place to ensure that issuers are held responsible for all disclosure provided. This responsibility is enforced by the SEC, the exchanges and by civil suits by investors. However, there is limited authority over municipal government issuers. Holders of voting securities of a public issuer are generally treated fairly.

28. Principles for collective investment schemes (Principles 17-20): Operators and marketers of CIS offered to the public are subject to registration requirements. Initial eligibility criteria for CIS and their operators should be more extensive, and should be demonstrated prior to registration. The initial and ongoing disclosure requirements for CIS are extensive, however, the update requirements under the CEA are not timely. Assets of CIS are valued in accordance with U.S. generally acceptable accounting principles (GAAP) and verified by an independent auditor at least annually. The custodian of CIS assets is not required to be an arm’s length party.

29. Principles for market intermediaries (Principles 21-24): There are minimum entry standards for all market intermediaries that include criteria relating to integrity. Capital and internal control requirements apply to FCMs, IBs that are not fully guaranteed by an FCM, and BDs; these are assessed prior to licensing by the SROs. Advisers are not subject to capital requirements or to operational capacity assessments prior to licensing. The applicable capital requirements vary by the chief risks undertaken by the FCMs, IBs, and BDs (largely market and credit risk). The ability of the prudential requirements (capital formulae and risk management requirements) to address the full range of risks (funding, liquidity, reputational, and affiliate risks) appears to need improvement. The regulators should strive to ensure that both capital and risk management requirements adequately address risks under stress. The crisis brought to light weaknesses in the framework governing investment bank holding companies, but the conversion of the remaining entities into bank holding companies has eliminated the practical need for the securities regulators to address these problems immediately. There are procedures in place at both agencies to address failures of intermediaries, and these have been tested in practice.

30. Principles for the secondary market (Principles 25-30): Securities and futures exchanges are subject to authorization and oversight. ATSs are authorized and regulated as BDs. Under the CEA, there are categories of futures trading systems which are exempt from authorization (exempt commercial markets or ECMs), although recent legislative amendments have enabled the CFTC to strengthen oversight of operational ECMs where appropriate. The SEC should join the CFTC in considering the introduction of explicit and comprehensive financial resources requirements for exchanges. In the securities markets, post trade transparency (details of completed transactions) is comprehensive as is publicly displayed liquidity or pre-trade transparency (best bids and offers). However, 25 percent of liquidity is not publicly displayed (i.e., dark pool ATSs and broker dealer internalization of trading on behalf of clients). The SEC’s concern that a two-tier market may be emerging—that provides valuable order information on the best prices for NMS stocks only to selected market participants—is justified. Its current broad review of and public consultation on equity market structure is therefore timely. It should accurately establish the needs of investors of all classes. It also needs to reach actionable conclusions promptly. Analysing these issues and those related to advanced trading technologies requires the SEC to be better informed. Any proposed rule changes should be supported by independent factual evidence. Market surveillance by the securities and futures exchanges and FINRA is effective and has kept pace with technological developments in markets. A comprehensive surveillance system for securities trading to be used by the exchanges, ATS, and the SEC (such as exists in the futures markets) would be beneficial for the detection of market abuse and also for identifying indicators of developing stress points. The CFTC and the futures exchanges have been able to construct such a system despite the CFTC’s serious budget constraints. Market manipulation is generally well policed in both markets. For insider trading, the legislation should be more comprehensive in futures markets. The approach to insider trading for securities and futures should be different given the differences in the nature of the markets. Implementing the recommendations in the Joint Report for expanding the insider trading provisions of the CEA will be an important step. Whether additional expansion of coverage is warranted, should be studied. While the IOSCO Principles do not require all markets in financial products to be transparent, the opacity of the OTC derivatives market contrasts with the relative transparency of OTC securities markets for equities and bonds.

Table 1.

Summary Implementation of the IOSCO Principles—Detailed Assessments

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Recommended action plan and authorities’ response

Recommended action plan

Table 2.

Recommended Action Plan to Improve Implementation of the IOSCO Principles

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Authorities’ response to the assessment

31. The U.S. authorities appreciate the effort, time, and resources committed by the IMF to prepare the FSAP. The FSAP is intended to promote the soundness of financial systems in member countries and to contribute to improving supervisory practices around the world. The U.S. assessment has presented a challenging and complex task. In light of the financial crisis as well as the maturity, complexity and significance of the U.S. financial system, we understand that the U.S. regulatory system was subject to a more stringent standard than in previous IMF assessments. Nevertheless, it is essential that regulators hear from third parties to gauge their effectiveness. We are grateful for the opportunity to provide the following comments regarding the IMF’s Report, although as discussed below we take exception to a number of the findings.

32. As recognized in this Report, the U.S. FSAP is occurring at a critical and extraordinary time. According to the G20 leaders in April 2009, major failures in the financial system, including in regulation and supervision, were fundamental causes of the crisis. The last 18 months have taught regulators around the world much about the new realities of our financial markets. We have learned the limits of foresight and the need for candor about the risks we face. We were reminded that transparency and accountability are essential. Only through strong, intelligent regulation—coupled with aggressive enforcement mechanisms—can we fully protect the American public and keep our economy strong. Given the global nature of markets, we recognize that U.S. leadership remains critical to the stability of markets worldwide.

33. The financial crisis left regulators with enormous challenges and a heightened interest in strengthening regulation. Perhaps most importantly, as the Report recommends, comprehensive regulatory reform of the OTC derivatives marketplace is essential. The financial crisis highlighted how opaque markets can threaten the financial system and the broader public. The U.S. authorities agree with the Report’s strong recommendation for increased resources for the CFTC and the SEC should the U.S. Congress expand the agencies’ missions to include the regulation of OTC derivatives. The CFTC and SEC additionally need greater resources to keep up with the growth of securities and futures markets in the United States. The U.S. authorities also agree with the assessment that the CFTC and SEC should enhance cooperation and coordination and already have taken steps to do so.

34. While change is needed, the U.S. regulatory system nevertheless helped ensure that the world’s largest and most complex exchange-listed equity, commodity futures, and options markets continued to function properly and withstood the ultimate stress test during the financial crisis. The system has served as a model for regulatory authorities worldwide. Moreover, some of the proposed reforms to address risk in OTC derivatives—for example, requiring standardized products to trade on regulated trading platforms and to be cleared by central counterparties—reflect long-standing elements in the U.S. approach to regulating financial markets.

35. In addition to supporting reform, U.S. regulators have taken action under existing authority to remedy problems and to make improvements. For example, in the area of disclosure, the SEC proposed new rules that would improve the quality and timeliness of disclosure in municipal markets. In the area of investment management, the SEC sought to provide greater protections to investors by adopting new custody control rules that include surprise inspections to verify assets held by money managers. Finally, in the past year, the SEC launched a robust and vigorous review of equity market structure, including issues such as dark pools. The CFTC is continuing to improve and extend its world-class system of risk surveillance by requiring large trader reporting in the cleared OTC markets. This effort will allow the CFTC to conduct financial surveillance in this area consistent with its existing risk program for on-exchange trading.

36. The overall ratings in the Report, however, do not reflect the CFTC’s and SEC’s regulatory successes and, in some cases, suggest a misunderstanding of the U.S. regulatory system. Thus, the Commissions strongly disagree with many of the ratings in the Report. By way of example, while the IOSCO Principles recognize that regulators may use different approaches to accomplish the same objectives, the Report’s rating on market intermediaries is based on the assumption that every intermediary must be regulated the same way. That is, they must undergo an extensive review prior to registration. This requirement, however, cannot be found in the Principles or the assessment Methodology. The Report rejects a legitimate risk-based approach to a registration requirement and oversight of futures and securities intermediaries without evidence that the approach is ineffective. The Report also states that capital requirements for futures and securities firms do not fully address risk, yet provides no evidence that the CFTC’s and SEC’s current requirements do not already exceed recognized international best practice as reflected in the Principles.

37. In particular, the Report suggests that only systems that call for review of the “fitness and properness” of CIS operators are acceptable. The Report finds that the regulatory framework in the United States does not address the adequacy of the CIS operators’ human and technical resources, financial capacity and internal management and controls. However, this finding does not take into account key and unique features of the U.S. system. The U.S. system mandates disclosure by CIS operators and also relies on oversight by a separate entity, a CIS board, which generally consists of a majority of independent directors. The CIS board serves as an initial check on the fitness, resources, and internal controls of the CIS operator. Moreover, both the CIS operators and CIS boards are subject to fiduciary duties, which are enforced by the SEC and by private litigants. This system offers an ongoing review of the fitness, resources, and internal controls of a CIS operator instead of a one-time “fit and proper” check. The Report disregards these important features of U.S. market regulation, and the effects they have on how regulated entities operate.

38. As a related matter, the IOSCO Principles make clear that they apply to futures markets “where the context permits.” For instance, the Principles relating to CIS were written for publicly offered funds, such as mutual funds. The CIS Principles were not intended to cover privately-offered funds, such as the vast majority of CFTC-regulated commodity pools. The pools that are publicly offered represent a small percentage of total pools regulated by the CFTC. The ratings in this area are misplaced given the de minimis number of publicly offered funds.

39. In addition, some of the Report’s adverse conclusions about the U.S. regulatory system are not based on objective criteria. For example, the Report finds that per Principle 10 the U.S. system fails to “ensure an effective and credible use of inspection, investigation, surveillance and enforcement powers.” This conclusion appears to be based solely on an SEC Office of Inspector General (OIG) Report issued in August 2009 that reviewed the failings of a specific high-profile investigation, and then extrapolates those failings to all SEC enforcement activities. In so doing, the Report overlooks the SEC’s overall success in the area of enforcement. In fiscal year 2009, SEC enforcement actions yielded: (1) orders that required wrongdoers to disgorge ill-gotten gains in the amount of approximately US$2.09 billion; (2) orders that imposed money penalties on wrongdoers in the amount of approximately US$345 million, a 35 percent increase over the previous fiscal year; and (3) the filing of 664 cases against 1,787 persons. SEC enforcement actions also have resulted in the return of billions of dollars to injured investors since the agency received “Fair Fund” authority in 2002. During fiscal year 2009 alone, the SEC distributed approximately US$2.1 billion to harmed investors from both disgorgement funds and Fair Funds.

40. These performance measures are a testament to the credibility and effectiveness of the SEC enforcement program in relation to the U.S. securities markets—a level of enforcement activity and investigative aggressiveness that far exceeds that of any other securities regulator in the world. These facts are inconsistent with a conclusion that the SEC enforcement program broadly fails to satisfy Principle 10. Granted, the metrics set forth above may not be the only objective measures by which to judge the effectiveness of the SEC’s enforcement program. But, the Report fails to articulate any objective metrics on which to base the rating.

41. To be sure, the OIG Report highlights a major failure. The SEC, however, has taken action in response. In the past year, the SEC, among other things, restructured the Enforcement Division and streamlined its procedures. The SEC also took steps to improve its inspection program and place greater reliance on risk assessment. The SEC is actively working to improve its technology and modernize the way it handles the massive number of tips and complaints it receives each year. The Report’s rating fails to give full credit for these improvements. In short, the effectiveness of an enforcement program should not be measured by zero tolerance for failure. There are many effective criminal justice systems around the world that are held in high esteem, not because of an absence of crime or a perfect record, but because, among other things, they apply considerable resources and visible effort to prevent, investigate, and prosecute crime.

42. In conclusion, the SEC and CFTC recognize a number of the areas that the IMF identified for improvement. Much is already underway to address these concerns. However, these types of suggestions in the Report are the exception rather than the rule.

43. Further, the SEC believes that the Report’s conclusions are seemingly at odds with those of investors from around the world, both large and small. Capital markets essentially function to allocate capital. In making decisions about capital allocation and the premiums charged for such investments, investors make judgments about the quality of the regulator, the breadth and depth of disclosure, the efficacy of the enforcement regime and the fairness of the marketplace, among other things. Judging by the degree of global investment in the U.S. market and taking into account the cost of capital in the United States, it would appear that those whose money is at stake view the U.S. regulatory system in a different, more positive light—even in light of recent regulatory failings.

44. In sum, the U.S. authorities firmly believe that the overall ratings are not reflective of the U.S. system for the regulated marketplace. Nonetheless, the U.S authorities will continue to evaluate and, as appropriate, enhance their regulatory programs. The CFTC and SEC look forward to a continuing dialogue with the IMF to advance our shared goal of strengthening financial regulation and enhancing supervision of the global financial services sector.

II. Detailed Assessment

Table 3.

Detailed Assessment of Implementation of the IOSCO Principles

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1

The IOSCO methodology was amended in 2008 to update footnotes to reflect recent IOSCO publications. Currently IOSCO is undergoing a substantive review of the Principles, which will be followed by a review of the methodology.

2

One ECN (Direct Edge) is in the process of converting from an ECN into two separate registered exchanges. The SEC has granted exchange status to those two exchanges, though they are not yet operational. The SEC has recently approved the registration of a third new exchange (C2) which also is not yet operational. This will bring the total number of exchanges from 11 to 14.

3

Rule 10b-5 under the Exchange Act makes it unlawful for any person, directly or indirectly, to use any device, scheme or artifice to defraud, to make any untrue statements of material fact or to omit to state a material fact necessary in order to make the statements made not misleading, and to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

4

The SEC and CFTC have formal policy established by rule that does not permit a defendant to settle an action while denying the allegations. However, settlements are permitted if the defendant states it “neither admits nor denies” the allegations.

5

As applied to IAs, the term “custody” is defined in Advisers Act Rule 206-4(2) (“Custody of Funds or Securities by Investment Advisers”). See also, SEC Release IA-2176 (Sept. 25, 2003); 68 Fed. Reg. 56692-01 (Oct. 1, 2003). Among other requirements, Rule 206(4)-2 requires that IAs with custody of client funds or securities maintain those assets with broker-dealers, banks or other qualified custodians. In addition, on December 31, 2009, the SEC adopted amendments to Advisers Act Rule 206(4)-2. The amendments are designed to strengthen controls over the custody of client assets by registered investment advisers and to encourage the use of independent custodians. The SEC also adopted related amendments to Rule 204-2, Form “ADV,” and Form “ADV-E” that will improve the staff’s ability to oversee advisers’ custody practices. For additional discussion regarding these amendments, see SEC Final Rule Release No. IA-2968 available at http://www.sec.gov/rules/final/2009/ia-2968

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Cover IMF Staff Country Reports
United States: Publication of Financial Sector Assessment Program Documentation: Detailed Assessment of Implementation of the IOSCO Objectives and Principles of Securities Regulation
Author:
International Monetary Fund
Volume/Issue:
Volume 2010: Issue 125
Publisher:
International Monetary Fund
ISBN:
9781455206667
ISSN:
1934-7685
Pages:
108
DOI:
https://doi.org/10.5089/9781455206667.002