As we saw as a result of the 2008 Financial Crisis, the government and its regulators play a very significant role as the final line of defense in managing systemic risk. We will look at the role of the key regulators in this chapter: the SEC and CFTC, and the Federal Reserve.

Regulating the Markets: The SEC and the CFTC

The desire to cut off‐market, off‐exchange deals is ever‐present. This was played out in the original battles fought by Washington and the SEC to establish US securities laws in the 1930s.¹ More than 80 years later, the battle is still being fought. Lest we forget, it was, in part, issues in the off‐exchange credit markets that helped to create the conditions that led to the market meltdown of 2008. There were no limits to the demand for credit insurance (credit default swaps) and untold billions were written. There were limits, however, to how much could be paid out in the event of actual default. The subsequent bailout of AIG and the complex chain of counterparties behind it was a prime example.² The proposal to create a central counterparty, overseen by the Commodities and Futures Trading Commission (CFTC), was conceived in order to address this mismatch and its lack of transparency in derivative, and particularly fixed‐income derivative, markets.³ The SEC, meanwhile, has continued to fight the battle for open and transparent markets in equity trading. Today's threats are posed by dark pools, high‐frequency traders, and inside traders.

Second to the SEC in the regulation of US capital markets, and not so well known perhaps, is the CFTC. While the sentencing of the former Peregrine CEO Russell Wasendorf Sr. to 50 years in prison highlighted the importance and challenges of the CFTC's role in protecting customer assets in futures markets, its oversight of the new, centrally cleared derivative market has also been the subject of much critical analysis by market participants. How effectively it can address both issues will be critical in determining its future success.

Opposition to Dodd‐Frank was very strong throughout its debate in Congress and continues to this day.⁴ Parallels can be drawn to the 1930s and the causes of the Great Depression.

A somewhat similar situation prevailed at that time when, after the Wall Street Crash of 1929, plans were made for legislative reform of the stock market. Most notably the Securities Exchange Act of 1934 increased requirements for transparency. Such changes came under fire from critics who argued that while the crash had driven investors out of the market, the tougher securities' registration rules would help to keep them out. Others, however, argued that the nation was experiencing a “capital strike” by industrialists hoping to force a rollback of the new legislation by refusing to market securities. As a sop to the critics, President Franklin D. Roosevelt appointed Joseph Kennedy (father of future president John F. Kennedy) as the first commissioner of the newly created SEC.⁵ The SEC faced the tough job of overseeing the introduction of new regulations while encouraging investors back into the market. Kennedy approached the task on two fronts: He worked with industrialists and financiers to develop more streamlined rules, and he exhorted capital in public venues to return to the market as being in the national interest. Some have argued that, by the spring of 1935, Kennedy succeeded in reviving America's flagging capital markets. Others argue, however, that what brought investors back to the market was the increased transparency and regulatory authority over those, like Kennedy, who had benefited from markets with few rules. The result, nevertheless, ultimately was a golden age of public markets, an uninterrupted expansion of participation and market volume facilitated not by the exhortations of one man but by the consistent application of rules, regulation, and enforcement.

One might well argue that derivative products such as interest rates and credit derivative swaps are at a similar turning point now as equities were in 1935. While there will be some costs borne by some in the short term, all will arguably benefit in the long term from the greater transparency afforded by the planned changes. Over time, the trust in fair and efficient market functioning afforded by greater transparency will ensure increased liquidity and market participation. In addition, a process by which collateral will have to be put up in respect of positions taken and reported will provide an additional cushion to the market and should act to discourage excessive speculative position taking. The additional reporting of positions will ensure that regulators and market participants have a better handle on the levels of risk and liquidity in the market. The question, though, is whether the CFTC will be able to act effectively when they do have that data. There are those who argue, for instance, that regulators knew how much risk was being taken in the London Whale case, but that did not help them to take appropriate action. At what point in the risk does it become truly actionable?

This gets us back to the advantage potentially provided by big data. If the CFTC is able to build capabilities to analyze the data it has—for investigation of growing risk levels in an AIG‐like scenario, for potential fraud in a Peregrine scenario, or a shortfall of customer assets in an MF Global scenario—then it could start to add real value as a risk manager as well as an regulatory enforcer.

One question, however, that has been popularly posed is whether the CFTC has the wherewithal and the leadership in place, like Joe Kennedy in 1934, to oversee such a transition to a transparent market place. It is clear, for example, from the recent MF Global and Peregrine episodes, that the CFTC is challenged even in its ability to execute on its existing responsibilities. There are, however, three lessons to be taken from the experience of 1935 that should provide some crumbs of comfort to such doubters:

1. If one can provide clear, focused, and unwavering leadership, great obstacles can be overcome, like, for example, the opposition of those entrenched in the old ways of doing things.
2. If regulators/the CFTC can provide a set of clear rules and apply them consistently to all key players, the winners will be those able to take advantage of the new economic opportunities afforded by the new ways of doing things.
3. New technologies will be developed to facilitate the new ways of doing things better, faster, and with greater transparency, which will quickly make the old forms of deal sheets and bilateral negotiations seem outdated and inefficient. This can be seen in the rapid development of technologies from the 1930s to the present day to support faster trade execution and better pricing information. The almost daily announcements of new technology solutions to execute on the new rules for swaps appear to support this argument.

While the derivative products subject to the new clearing rules may be more complex than the cash equity products regulated in the 1930s, the leap forward is not one of the imagination, as it once was. Market participants understand how to operate in a transparent marketplace. All that the CFTC has to do is provide unwavering determination, a clear set of rules, and a regulatory environment that encourages technological innovation. Easy, right?

So let's turn to those equity markets where folks have recently grown more concerned about the prospect of unfair and nontransparent markets. To summarize these concerns:

• There are trades disappearing into dark pools.
• Some traders are benefiting from greater speed to execute trades, with an effective price advantage over their slower competitors.
• There is fear that the whole thing is rigged in favor of those with access to insider information.

Addressing these concerns and risks is really the province of that other regulator, the SEC. The SEC, of course, is the perennial punching bag for critics of regulators' incompetence and has been blamed for such events as Enron, Madoff, and the 1990s Internet Bubble. The decision in 2013 to appoint Mary Joe White, an ex‐United States Attorney for the Southern District of Manhattan, as chair of the SEC sent a strong signal to the markets and US investors.

Since White came to the role at the SEC, she signaled a readiness to take on the world of high frequency trading, dark pools, and other financial bad acts. This directive was given further impetus by the press and discussion generated by Michael Lewis's book Flash Boys.⁶ White and the SEC signaled their readiness to address the issue with a raft of proposals. With White's recent departure from the SEC, following the recent presidential election, it is yet to be seen whether this strong hand in regulating the markets will be continued.

Regulating Risk Taking: The Federal Reserve and the Treasury

Much discussion followed the bailout of Bear Stearns as to whether or not the readiness for the federal government to step in to rescue large institutions was encouraging risk taking. What followed was a zigzag course resulting in the decision to allow Lehman Brothers to fail but then to bail out AIG. Whatever the rights and wrongs of these decisions, it is clear that risk taking and traders thinking on a daily basis was significantly impacted. Another decision made by the Treasury to intervene in the secondary debt markets to provide liquidity likely had an even more significant impact on risk taking. Indeed, the most significant impact, the largest negative swings in daily market movement in the years after the 2008 Financial Crisis, followed remarks from Fed Chairman Ben Bernanke indicating a deceleration of the Treasury's debt purchase program. The purchases provided major liquidity and support to the markets. While the objective of maintaining low levels of interest rates was achieved, risk taking in equity markets was encouraged.

A second feature of the Federal Reserve has been increased transparency provided to the markets to its thinking, plans, and forward strategy.⁷ Additional transparency was believed to be a good thing in that it was expected to facilitate greater stability in the markets. Others take the view, however, that by providing greater certainty to traders, the Federal Reserve has actually, on the contrary, helped to destabilize markets.⁸ The thinking goes that, by providing greater certainty, traders are encouraged to take more risks. What is more helpful is actually providing sudden surprises that cannot be anticipated by traders and, hence, more circumspection is required in trading strategies. The research undertaken by of the University of Cambridge identified patterns that indicated that greater volatility followed Fed announcements. Whatever is the case, it is clear that the Federal Reserve has a major impact on risk management in the markets.

Regulatory Reform since the 2008 Financial Crisis

Wall Street hawks hungry for more aggressive reforms following the crisis should avoid letting the perfect be the enemy of the good.

What do I mean? Toward the end of the just‐released movie The Big Short the narrator recites a list of post‐crisis developments—sure to be the wish list of any industry critic—that in fact haven't happened. They include the arrests of multiple leading players involved in the 2008 meltdown, and a breakup of the biggest banks. Indeed outspoken progressives seem to give flunking grades to the industry's post‐crisis response efforts as they push for more drastic reforms. But focusing too heavily on what has not happened ignores the positive changes in industry practices that have taken place since the crisis. It is worthwhile to summarize them.