The Securities and Exchange Commission has come under much criticism in the current financial crisis. Many of the problems have indeed arisen in its bailiwick. It was the principal regulator of Bear Stearns and Lehman. It designates and oversees “Nationally Recognized Statistical Rating Organizations,” more commonly known as credit ratings agencies. Though it delegates lot of its authority, it is ultimately in charge of financial reporting for all corporations, and can in principle compel disclosure of terms of swaps and other derivatives on a firm’s balance sheet. The SEC’s mandate prominently features investor protection. Given the large government transfers to private interests, it appears that the investor most in need of protection was the US taxpayer.
These problems, though, should not prevent us from recognizing the accomplishments of the SEC in other areas. The SEC oversees and regulates the trading mechanisms in US stock and bond markets, including the New York Stock Exchange and Nasdaq. In the crash of 1987 these mechanisms failed. NYSE systems were overwhelmed. Orders were submitted, but then it couldn’t be determined whether they had been executed. Investors didn’t know whether a trade price they saw on the tape was one second or one hour old. Many Nasdaq dealers avoided their market-making responsibilities by simply not answering the phone.
Recent days have been marked by unprecedented volume and volatility. The trading mechanisms have nevertheless functioned smoothly. Although many stocks have declined in value, these declines seem to arise directly from the interaction of investor supply and demand. The losses have been attributed to many causes, but nobody has seriously blamed the trading procedures.
Market mechanisms have evolved significantly since 1987. This evolution was not inevitable, and the SEC played a major role in facilitating it. The SEC was an active enforcer during this period, under both Democratic and Republican administrations. It brought a broad array of charges against Nasdaq dealers, and later against NYSE specialists. In both cases the SEC pursued wrong-doing, but it also leveraged its power to compel reform. Most importantly the SEC established a legal and regulatory framework for US equity markets to morph from crowded trading floors to fast and efficient electronic markets. In 1998 the SEC put forth a regulation allowing “Alternative Trading Systems” There followed a great wave of innovation in market design. Later, concerned with the coordination problems that might arise among markets separated by physical or virtual barriers, the SEC adopted “Reg NMS” (National Market System). This rule established a framework requiring markets to share information and provide access.
In bond markets, the SEC fought an uphill battle against entrenched industry interests to establish last-sale reporting in corporate bond markets. The TRACE system (for Trade Reporting and Compliance Engine) now gives investors of all sizes prompt reports of the prices and sizes of recent trades.
Many of these successful initiatives sprang from crises. US stock and bond markets have emerged from this period lean, efficient and internationally competitive. There is no reason why the present crisis cannot serve as a similar starting point. Our recent experience is being cast as the failure of financial markets. The facts, though, are likely to defy such a simple characterization. As we undertake the process of investigation, accusation, recrimination, and (ultimately) reform, we should be guided not just by what went wrong, but also by what went right.
Originally published at Stern on Finance blog and reproduced here with the author’s permission.