Market Regulation & Consumer Protection

The regulation of Financial Markets in

the United States
Home Assignment

Zsolt Szabó
D1QHR5
BA IB year 2
07/05/2010
Zsolt Szabó Market Regulation & Consumer Protection
(D1QHR5) The Regulation of Financial Markets in the U.S.

Table of content

1. Introduction to financial markets................................................................................................. 3

2. Regulators of financial markets in the U.S. .................................................................................. 4
The Federal Reserve System ......................................................................................................... 4
The Securities and Exchange Commission.................................................................................... 6
Other regulators ........................................................................................................................... 7
3. The way to the crisis ..................................................................................................................... 7
4. CDOs and CDSs ............................................................................................................................. 8
5. Rating Agencies .......................................................................................................................... 10
6. Conclusion .................................................................................................................................. 11
7. Bibliography and references ...................................................................................................... 13
Zsolt Szabó Market Regulation & Consumer Protection
(D1QHR5) The Regulation of Financial Markets in the U.S.

1. Introduction to financial markets

In capitalist economic systems a financial market is a mechanism where participants are

able to buy and sell securities, commodities and other fungible items of value. The market
works by gathering the many interested sellers and buyers into one place. This is however not
necessarily a given physical location, it can be an electronic system as well. Markets also ensure
trading at low transaction costs and at prices that reflect the efficient market hypothesis. [1]

There are different types of financial markets, which are all connected to each other in many
ways and form a global system. Types of financial markets are the following: capital markets,
commodities markets, derivatives markets, foreign exchange markets. These markets facilitate
the raising of capital, the transfer of risk and international trade. A good example for financial
market is the stock exchange (e.g. NYSE, BÉT), where shares, bonds, derivatives, commodities
and other assets can be traded at a strictly regulated place. At stock exchanges prices are the
same for all participants and only members are allowed to trade. Only listed company’s shares
are traded and listing has strict requirements towards the company (e.g. minimum number of
shares outstanding, minimum annual income etc.). Currencies are traded at the foreign
[2]
exchange market, which is a “worldwide decentralized over-the-counter financial market” . The
term over-the-counter (OTC) means that trading takes place directly between two parties and as
opposed to exchanges the OTC market is not strictly regulated.

There are also different motives to participate in the market. Among these are capital
accumulation, investing, hedging risk and speculation. A hedge is a position taken in one market
to prevent or minimize unwanted risk in another market and/or position. It is most popularly
done by future contracts. For example when a European retailer sells its product to a US
customer he receives US dollars instead of Euros. If the payment takes place at a future date the
retailer takes the risk of changes in the EUR/USD exchange rate (perhaps he will receive less
Euros for the same amount of dollars in 6 months, than he would receive now). This risk can be
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eliminated by buying Euros for dollars in the futures market. Financial speculation means the
buying, selling or short selling of stocks, bonds, commodities, real estate, derivatives or other
assets to profit from the fluctuation in its price. As opposed to speculators investors rather earn
money from dividends or interest payments than from price changes.

2. Regulators of financial markets in the U.S.

As it (hopefully) turned out from the introduction there are all kinds of financial markets
which form a complex system. Players in these markets also have different reasons for
participating. The free-market theory suggests that intervention and regulation should be as
little as possible, since the efficient market will always tend towards equilibrium and thus
market anomalies will always be eliminated. Despite this is a very popular among economist and
a strong argument against strict regulations, George Soros says that the market moves between
euphoria and desperation and thus it needs to be controlled [Soros Gy., 2008]. He also introduced the
idea of reflexivity, in which he argues that market prices can also affect the value and the fundaments of
the underlying.

In case of the United States there are many authorities that regulate financial markets. Perhaps
the most well-known are the Federal Reserve System (FED) and the Securities and Exchange
Commission (SEC). In this part of the essay I will write about the regulators themselves.

The Federal Reserve System

As the nation’s central bank the Federal Reserve (FED) controls the money supply and
credit conditions in the United States. It has two major tools, one is the discount rate the other
is open market operation. The structure of the FED is composed by 5 parts: the board of
governors, the Federal Open Market Committee (FOMC), Federal Reserve Banks, Member Banks,
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advisory councils. From the regulations point of view the FOMC is the most important part as it
is the principle tool for the nation’s monetary policy since open market operations are done by
the FOMC. By managing the money supply the FED tries to achieve maximum employment,
stable prices (preventing both inflation and deflation) and to moderate long-term interest rates.
Besides controlling the money supply itself the FED also sets reserve requirements for banks.
This also ensures the stability of financial markets. With the help of private bankers the FED
tries to solve problems could not be solved by supply and demand side interactions. The FED
provides financial services to depository institutions, the US government and plays a major role
in the nations paying system.

The primary motivation for creating the FED in 1913 was to address banking panics and to
establish a more effective supervision of the banking system. The Federal Reserve’s current
function besides the earlier mentioned control of money supply includes balancing
responsibility of federal government and private banking interests. As far as the bank panics are
concerned there is one thing that has to be understood. Bank runs occur because banking
institutions are only required to hold a fraction of depositor’s money in reserves. Most of the
deposits is being invested to earn profits for the bank, and to be able to pay interest to
depositors. When a rumor starts to spread among depositors about a possible bankruptcy, they
run to the bank to take out there money. This causes the reserve ratio to decline and the bank
might become insolvent. The FED can act as a last resort for lending money, when a possible
bank run occurs.

In its role of the central bank the Federal Reserve serves as the bank of the banks and the
government’s bank. As the bankers bank the FED helps to assure safety and efficiency in the
payment system by providing liquidity for banks for short-term need stemming from
fluctuations in deposits or in unexpected withdrawals. Long term liquidity may also be provided,
but only in special cases. For these loans the FED charges interest, which is called the discount
[11]
rate (officially the primary credit rate). On September 16, 2008 the Federal Reserve Board
authorized an $85 billion loan for saving AIG from bankruptcy. Critics say that by this move the
responsibility of lenders and borrowers has been placed on tax payers.
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The Securities and Exchange Commission

As stated on its website: “The mission of the U.S. Securities and Exchange Commission is
to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital
formation.”[3] To achieve this, the SEC requires public companies to disclose meaningful
information to the public. This provides a common pool of knowledge for all investors who then
can judge by themselves to buy, sell or hold a particular security. This information flow makes
capital markets more transparent, secure, efficient and active. To prevent frauds in financial
markets the SEC consults with market participants continually. Each year the SEC brings
hundreds of civil cases. Most typical frauds are insider trading, accounting fraud and providing
false or misleading information about the securities or the companies issuing them.

The SEC was established in 1934 as an independent, quasi-judicial regulatory agency. It was give
the authority to license and supervise exchanges, the listed companies and the brokers trading
on them. The SEC requires quarterly and annual report from companies and in addition to the
financial reports company executives have to provide a narrative account as well. Investors can
access information about companies via Internet through the EDGAR database. These
information are crucial for making wise investment decisions, since unlike banking, investment
and capital markets are not guaranteed by the federal government.

One of today’s hottest topics is the lawsuit between the SEC and Goldman Sachs Group Inc. The
SEC sewed Goldman for providing misleading information for investors about one of the
investment possibilities it offered. It sold a portfolio of CDOs pretending that it was selected by
an independent third party. In fact it was selected by hedge fund manager John Paulson who
was convinced about the bad performance of these securities and used Goldman as an
intermediary to short-sell the portfolio. Being on the seller side Paulson made a fortune, while
investors lost about $1 billion. [12]
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Other regulators

The Commodity Futures Trading Commission (CFTC) is pretty much the same as the SEC,
but it operates in the commodity futures market as an independent agency. In the commodity
market raw materials, precious metals and primary products are traded. The CFTC regulates the
derivatives (futures and options) of these products.

The Federal Deposit Insurance Corporation (FDIC) provides deposit insurance. It

guarantees deposits in member banks up to $250,000 per depositor per bank. By protecting
depositors it preserves and promotes public confidence in the U.S. financial system. It was
created in 1933 as an independent agency of the federal government in response to the
thousands of bank failures that occurred between 1929 and the early 30s. The FDIC does not
insure stocks, bonds, mutual funds, securities backed by the U.S. government, losses due to
theft of fraud and accounting errors. Its existence provides to be very useful from time to time,
for example in 2008-2009 when many banks became insolvent.

The Office of the Comptroller of the Currency (OCC) regulates and supervises all national
banks and the federal agencies of foreign banks in the United States. Its main objectives are to
ensure the safety and soundness of the banking system. It ensures fair and equal access to
financial services to all Americans and enforces anti-money laundering laws. It also fosters
competition among banks by allowing them to offer new financial products and services to
customers. [13]

3. The way to the crisis

After the burst of the IT bubble and the panic of September 11, 2001 the FED started to
cut discount rates to stimulate growth in the economy. In 2003 the FED rate reached 1%. This in
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fact meant a negative real discount rate, since the rate of inflation was about 3-5%. Whoever
studied macroeconomics knows that when discount rate shifts, the whole yield curve shifts as
well. The low FED discount rate made long-term loans, including mortgages cheaper. The cheap
credit let many people to buy or build houses and this increased demand led to a significant
increase in real estate prices, which tempted speculators to appear on the housing market as
well. As the willingness of banks to give loans increased, access to credit became easier and
even those could get a loan who did not qualify for one before. Many times no own capital was
needed for buying a house as it was 100% financed by the bank. The hazardous thing about
buying real estate with such a high leverage is that it can only be profitable while prices increase
with a higher rate than the interest rates are, and even a smaller decrease in the value of the
asset can wash one’s equity away. Moreover as the value of the real estate decreases, the
amount of monthly payments increase to cover the debt. After the recession seemed to be over
the FED started to increase rates in 2004 to control economic growth. Interestingly long term
rates did not follow, instead they declined further. This let the housing bubble to evolve. Some
experts say that the FED and the US Treasury made a fatal mistake not trying to increase long-
term interest rates by open market operations and/or issuing new long-term government
bonds. [10]

In the meantime banks started to issue more and more synthetic securities backed by loans and
mortgages to maintain liquidity. As George Soros stated during a hearing of hedge fund
managers CDOs, CDSs, and other asset-backed securities make risk less apparent and hardly
[4]
measurable, they involve systemic risk and thus they should be strictly regulated. Now let’s
take a look at what these 3 letter abbreviations mean.

4. CDOs and CDSs

Investopedia defines asset-backed securities (ABS) as “financial securities backed by a
loan, lease or receivables against assets other than real estate and mortgage-backed
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securities.”[5] Others say that real estate and mortgage-backed securities are also types of ABSs.
The process of pooling assets into financial instruments is called securitization.

A collateralized debt obligation (CDO) is a specific type of asset-backed security whose value
and payments are derived from a portfolio fixed-income underlying assets. Common underlying
assets held include mortgage-backed securities, commercial real estate bonds and corporate
loans. The securities of CDOs are split into different categories, called tranches, whereby
"senior" tranches are considered the safest securities. Interest and principal payments are made
in order of seniority, so that junior tranches offer higher coupon payments (and interest rates)
or lower prices to compensate for additional default risk. Losses are first borne by the equity
securities, next by the junior securities, and finally by the senior securities. The risk and return
for a CDO investor depends directly on how the CDOs and their tranches are defined, and only
indirectly on the underlying assets. In particular, the investment depends on the assumptions
and methods used to define the risk and return of the tranches. CDOs, like all asset-backed
securities, enable the originators of the underlying assets to pass credit risk to another
institution or to individual investors. Thus investors must understand how the risk for CDOs is
calculated. [6]

A credit default swap (CDS) is a type of security where the buyer makes a series of payments to
the seller and in exchange receives a payoff if the credit instrument (a loan or a bond) goes into
default. Credit default swaps are not traded on exchanges and there is no required reporting of
transactions to government agencies. CDSs are usually traded between banks. During the 2007-
2010 financial crisis the lack of transparency became a concern to regulators, as was the trillion
dollar size of the market, which could pose a systemic risk to the economy. [7] As a lesson from
the past few years it can be concluded that there must be much more strict regulation in the
markets of these kinds of securities than before. These financial vehicles are very complex, so as
their markets and they involve lot of money. According the George Soros the nominal value of
CDSs outstanding is more than $42 trillion.
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5. Rating Agencies

A credit rating agency is a company that estimates and assigns security ratings for
individual, companies or even countries as well as for financial instruments themselves. The
most well-known companies among them are Moody’s Investors Service and Standard & Poor’s.
A common form of rating uses letters of the alphabet, for example S&P rating scale follows as
AAA, AA+, AA, AA-, A+….CC, C, D. AAA is the highest level of security and anything with a lower
rating than BBB- is considered a speculative or junk-bond. Typically the credit rating tells the
investor the probability of the loan to be paid back. A poor credit rating indicates high risk,
therefore triggers higher interest rate or the refusal of the loan. The value of such ratings has
been questioned after the 2008 financial crises. As John Paulson, CEO of Paulson and Co. said:
“We’ve found Moody’s and S&P rating various securities’ investment grade including as high as
[4]
AAA, that we thought would become worthless.” Within the same panel discussion another
top investor James Simons argued that rating agency’s are nowadays paid by issuers not
investors, therefore they rated junk bonds with AAA secure level. He suggested the creation of a
[4]
non-profit CRA, which also analyzes risk properly. In 2003 the SEC has already submitted a
report to the Congress about the anti-competitive practices of credit rating agencies and issues
including conflicts of interest. Rating agencies argued that their advices constitute only a point
in time analysis and they also made clear the changes in circumstances regarding risk factors
may invalidate their analysis and result in a different credit rating.

Credit ratings are used by individual investors, investment banks, issuers and broker-dealers as
well as governments. It is a useful tool for measuring relative risk and generally increases the
efficiency of financial markets. It also opens up capital markets for those who otherwise would
be shut out altogether (small governments, startup firms, etc.). Bond issuers use credit ratings
to verify their own credit-worthiness and to ensure investors about the value of the instruments
they issue. In most cases, a significant bond issuance must have at least one rating from a
respected CRA for the issuance to be successful (without such a rating, the issuance may be
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undersubscribed or the price offered by investors too low for the issuer's purposes). Studies by
the Bond Market Association note that many institutional investors now prefer that a debt
issuance have at least three ratings. [8]

Government regulators also use ratings of rating agencies. For example according to the Basel II
agreement banks can use their ratings from approved CRAs to calculate their capital reserve
requirements. In the video George Soros argued that this concept is false, and there’s a need for
a Basel III, which will be based on another paradigm. [4] Banks can hide their carried risk through
[9]
complex transactions and the above mentioned CDOs and CDSs. Risks then can be hardly
measured and thus the received credit ratings are not reflecting reality. This can further
increase risk of insolvency as minimum capital requirement can fall under rational limits.
Leverage ratios can rise and even financial giants, like Lehman Brothers, can go bankrupt. If a
financial institution is interested in using the rating of a specific rating agency, to prevent similar
cases, the SEC has to right to research the market and determine whether ratings from a
particular CRA can be considered as reliable and credible.

Credit rating agencies have been the subject of many criticisms regarding their job. For example,
when large losses occurred in the CDO market, despite being assigned to top ratings of CRAs.
For instance, losses on $340.7 million worth of collateralized debt obligations (CDO) issued by
Credit Suisse Group added up to about $125 million, despite being rated AAA or Aaa by
Standard & Poor's, Moody's Investors Service and Fitch Group. Other criticisms say that CRAs
don’t downgrade companies promptly enough, for having to familiar relationship with company
management.

6. Conclusion

It can be stated that the regulation of financial markets is such a complex task as the
markets themselves. Regulators need to understand the moves of the markets very much and
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must keep up with the newest trends in habits of both investors and institutions. They must also
be familiar with the different financial instruments, how they work, which of them has more risk
to it and how they should be regulated. They also need be able to think ahead in the future for
short and long term as well. In my opinion financial markets are needed to be regulated in a way
that first of all ensures the safety of capital. In some areas and in some specific instruments
higher transparency should be reached in order to make transactions clear to regulators, who
then are able to make right decisions.
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7. References

1. Wikipedia Article: Financial Market

http://en.wikipedia.org/wiki/Financial_market

2. Wikipedia Article: Foreign Exchange Market

http://en.wikipedia.org/wiki/Foreign_exchange_market

3. Website of the U.S. Security and Exchange Commission

http://www.sec.gov/

4. Hedge Fund Regulation, Fund Managers Panel (Washington D.C., November 13, 2008)
http://www.c-spanvideo.org/program/282391-2

5. Investopedia Article: Asset-Backed Security – ABS

http://www.investopedia.com/terms/a/asset-backedsecurity.asp

6. Wikipedia Article: Colleteralized Debt Obligation

http://en.wikipedia.org/wiki/Collateralized_debt_obligation

7. Investopedia Article: Credit Default Swap (CDS)

http://www.investopedia.com/terms/c/creditdefaultswap.asp

8. Wikipedia Article: Credit Rating Agency

http://en.wikipedia.org/wiki/Credit_rating_agency

9. Basel II Guidelines: Calculation of Minimum Capital Requirement

http://www.bis.org/publ/bcbs118b.pdf

10. Nyilasi Attila: Conundrum – avagy Greenspan és a nagy kérdés (2005)

http://www.tozsdeforum.hu/index2.phtml?menu=21&submenu=onearticle&news_id=35
1421

11. Website of the U.S. Federal Reserve System

http://www.federalreserve.gov/

12. Bloomberg Article: Goldman Sachs sued by SEC for fraud tied to CDOs (April 16, 2009)
http://www.bloomberg.com/apps/news?pid=20601087&sid=aUpzxecxkNUU
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13. Website of the Office of the Comptroller of the Currency

http://www.occ.treas.gov/aboutocc.htm

Soros György: A 2008-as hitelválság és következményei (2008, Scolar Kiadó)