Danielle D’Angelo raises many legitimate concerns in her article, “The Perils of Principle-Based Regulation,” related to the enforcement of principles-based regulations by malicious financial services regulators in unanticipated and nefarious ways.
However, there are equally compelling arguments why rules-based regulations are problematic. First, nothing prevents a malicious financial services regulator from also interpreting specific rules in ways that no one anticipated. Second, the financial services industry has evolved too quickly to develop specific rules that govern every conceivable conduct.
This letter to the editor is a response to commentary by Danielle D’Angelo. For the original commentary, click here.
Where financial products — whether they be called securities, derivatives or insurance products — are effectively fungible, and where brokers or banks are effectively one and the same, the application of too many specific rules allows bad apples to escape effective regulation and prey on innocent victims undetected, as we saw in the Bernie Madoff scandal.
Under a rules-based environment, the governing code becomes the size of a phone book (maybe multiple volumes), and only teams of attorneys seemingly can determine right from wrong and only after lengthy research and consultation with relevant regulators — often well after the opportunity for a potentially profitable trade or new type of deal has long passed.
Moreover, not only are investors increasingly exposed to more risk, but financial services businesses are stifled, too. When there are too many specific rules, particularly rules which are not flexible and do not evolve with the market, innovative ideas often cannot be pursued. That is due to antiquated regulations that principally address an outdated way of doing business. In the United States today, for example, the absence of a single regulator overseeing all financial products and players applying principles-based regulation prevents the implementation of multi-asset portfolio margin techniques across securities and futures products that could help qualified prime brokerage customers, while reducing systemic risk to brokers and the financial system overall.
Given the pros and cons of both schemes, principles-based regulation is superior. It is better for a financial services regulator to set out broad principles of conduct, and leave it to regulated parties to determine how most appropriately to implement these principles. Of course, dialogue between the regulator and regulatees is crucial, and there must be good faith between both parties.
Indeed, in the United States, the Commodity Futures Trading Commission has operated under a principles-based regime for about a decade, particularly in connection with its oversight of exchanges and clearing houses. Most followers of the exchange-traded derivatives industry credit this approach with encouraging the innovation and unprecedented growth of US futures exchanges over the past decade. Meanwhile, the CFTC has coupled this regime with a very strong and effective enforcement program, and has brought far fewer cases that the industry has bemoaned as frivolous or undeserved.
Ms. D’Angelo is correct when she says that a regulatory system will not work if the perception is that the regulator’s intent is on “gotcha behavior” only. But this danger exists in any case — whether the rules are broad or narrow. However, a principles-based system — perhaps because of the ambiguity — encourages more responsible behavior by industry participants, while affording the industry the greatest flexibility to adjust their business models to current market opportunities. If the United States adopts a single financial services regulator model, — which it must to remain globally relevant, — the regulator must be principles-based.
The author is Senior Managing Director and Group General Counsel for Newedge USA, LLC, a global brokerage firm.
