Saturday, January 27, 2007

U.S. securities markets and the Maginot Line

Check out the latest speech from SEC chairman Christopher Cox at the 34th Annual Securities Regulation Institute in Coronado, California. (See Re-Thinking Regulation in the Era of Global Securities Markets.) The topic is the cross-border integration of stock markets, and Cox warns that if the U.S. isn't careful, it's securities laws risk becoming like the French Maginot Line. (As you probably know, the Maginot Line was a system of static fortifications that ran along the Franco-German border and built during the 1930s to keep the Germans from invading France. It was premised on the idea that the next war would be like the last -- i.e., a defense-dominated situation like WWI. Instead, technological and tactical innovations allowed the Germans to do an end-run around the Maginot Line and move deep into France before the French -- who actually had more troops and more modern equipment -- were able to respond.)

So, basically, Cox is warning that if the SEC fails to adapt, U.S. securities regulations risk becoming as potent, innovative and competent as the French military. Ouch!

Without a doubt, our regulatory defenses proved very effective in maintaining healthy markets in the 20th century. The world-beating success of America's capital markets is a testament to that. For most of the last 74 years, our ability to police our markets and maintain investor confidence in their integrity has been premised on requiring both domestic and foreign market participants that operate in the U.S. to register with the SEC — and for the most part, to follow the same rules. That approach has followed from our concern that the alternative, permitting foreign market participants to operate in the U.S. without direct SEC oversight, would threaten the integrity of our nation's capital markets.

But while this approach served us well in the past, when the world's capital markets were separated not just by oceans but by the preference and habits of most investors, the world is a far different place today. And so we have to ask ourselves: have the basic assumptions on which we've built these regulations changed?
I'm convinced that the way to surmount these new challenges posed by technology is to harness the power of that same technology. We've got to recognize that to catch a global network of market crooks, it will take a global network of securities cops.

That means that our success will be measured not by the degree to which we close off other marketplaces from our own, but rather by the extent to which we more closely integrate our regulatory efforts as our markets themselves become more closely connected.

Every regulator has an obligation to the investors and issuers within its borders to protect them from fraud perpetrated within those borders. For the SEC, therefore, every other like-minded regulator is our natural ally. We've made great strides in recent years in building ways to share enforcement information with our counterparts in other countries, and to cooperate in doing every other part of our jobs. And as the story of this success has spread, we have found new friends and allies sharing the same concerns and devoted to the same cause of protecting investors and promoting capital formation.

This process of discovering our mutual interests has led us to realize that some of the old ways of doing things are obsolete. For example, while our historical justification for having issuers, broker-dealers and exchanges to register with the SEC is sound, it may be that by working with like-minded foreign counterparts we can find ways to lower costs and increase opportunities for investors while still maintaining the highest standards of investor protection. In this regard, the Memorandum of Understanding we recently concluded with the College of Euronext Regulators should be an excellent start.

And this brings us to an interesting question. Just what is "like-mindedness"? Will we know it when we see it? I believe the answer to this question is not wholly subjective. In my discussions with our counterpart regulators in other countries, I have found one touchstone in particular that is of overarching importance. It is an acceptance by the regulator that the genius of the market is that individuals are free to investigate their options and make their own decisions. It is an appreciation for the "wisdom of the crowd" that is ultimately the consensus of that market — representing the solution of many minds working on a common problem.

Working with all of the world's regulators who share this belief in the power of markets, we can tap that same principle, so that a multiplicity of jurisdictions — each seeking to develop the best regulatory framework — can likewise investigate their options and make their own decisions about ways to handle regulatory issues within their borders. This is something from which we all can benefit: observing what works, and how the market responds, and learning from what doesn't work.

To give you just one example of what the "wisdom of the crowd" means for securities regulators, consider the global reaction to the Sarbanes-Oxley Act. There has been loud complaint about its costs, even by some in other jurisdictions to whom it does not apply. But one interesting effect of these reforms has been the degree to which they have been copied, in one form or another, in many other major markets.
A lot of interesting ideas here. My question is, is Cox really signally support for radical change to how the SEC operates internationally? Some of the ideas in this speech (regulatory competition, working with "like-minded" foreign regulators, etc.) clearly echo ideas in a recent Harvard International Law Journal article by SEC staffers proposing a "substituted compliance" approach. (See here.)

My second question is, what effect would such a radical change have for the U.S. market? The FT on Friday led with an article on comments by Lehmean Brothers vice-chairman Thomas Russo at the World Economic Forum in Davos, Switzerland where Russo basically said that despite all the sturm-und-drang over New York's falling position in world finance, it is unlikely to ever recover no matter what policies the U.S. enacts. (See NY unable to regain lost business, says top banker.) Russo, however, doesn't seem to be imagining that truly radical change is possible. To carry the Maginot Line analogy even farther (by the way, the guy who thought up that analogy -- brilliant!), in 1940 even the German Army High Command believed the invasion of France would break down into a static war of attrition. Only a radical change in tactics, envisioned by Heinz Guderian and Erich von Manstein, allowed Germany to march into Paris only 6 weeks after the invasion began. If the SEC were to adopt a radical change -- made all the more relevant by the cross-border consolidation of stock exchanges -- New York may still have its day in the sun.

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