Financial regulators: The market police

Financial regulators provide oversight to make sure markets run fairly, smoothly, and efficiently. They can also act as police to enforce rules and regulations, potentially keeping damage to a minimum when it does occur and punishing those who break the rules. 

Without these regulators, markets would be more like the Wild West, with greater chances of unfair competition and manipulation. Although the markets’ guardians can’t stop every bad actor, the presence of a regulatory structure allows market participants to trade without constantly looking over their shoulders. 

Modern financial markets are so complex that they require different types of regulators for different types of markets and financial industries. Anyone participating in financial markets should have at least a working knowledge of which agencies regulate what, the rules they create, and how they enforce their regulations.

Securities and Exchange Commission

The U.S. Securities and Exchange Commission, or SEC, oversees the U.S. bond and equity markets. It enforces securities laws related to public companies, fund and asset managers, investment professionals, and other market participants. The SEC has three main goals:

• Protect investors. The SEC requires that public companies selling securities must be honest about their businesses, the securities being sold, and the investment risks. Those who trade securities and offer advice must treat investors fairly and honestly. Information must be timely, accurate, and complete.
• Facilitate capital formation. The SEC helps businesses large and small ensure access to U.S. capital markets, in addition to creating financial opportunities for those who invest in these companies.
• Maintain fair, orderly, and efficient markets. The agency monitors market environments as technology and economic conditions change, and it modernizes its rules, regulations, and oversight tools as needed.

Commodity Futures Trading Commission

The Commodity Futures Trading Commission, or CFTC, is in charge of regulating derivatives, which include futures, options, and over-the-counter markets. Entities that want to trade in the derivatives markets must register with the CFTC.

In addition to the two government agencies that oversee equities and derivatives trading, there are self-regulatory organizations (SROs) that provide market oversight. These agencies are needed because they help to regulate certain professions or industries. The benefits of SRO oversight include field expertise and ensuring members follow a certain standard of conduct. These organizations are funded by the industries they oversee.

Financial Industry Regulatory Authority

The Financial Industry Regulatory Authority (FINRA) is a government-authorized, not-for-profit organization that oversees U.S. broker-dealers and was authorized by Congress to make sure the industry remains fair and honest.

FNRA ensures that:

• Brokers are qualified to handle client assets. As part of this responsibility, FINRA administers licensing exams. FINRA also runs the BrokerCheck site, which allows you to look into your broker or financial advisor’s history, background, and experience, including any disciplinary actions taken against them.  
• Security products are suitable for an investor’s needs. Different types of advisors are held to different standards. 
• Securities product ads are truthful. Because each investor is different, ads and content created for general consumption must not be promissory or advisory. Whenever investment returns are mentioned, the investment risks must balance them out.
• Investors receive full disclosure about the investment products they’re buying. If you’ve seen the boilerplate disclaimers about past performance not guaranteeing future returns, or how securities products aren’t FDIC insured, these are among the FINRA requirements. 

National Futures Association

The SRO for the derivatives industry is the National Futures Association (NFA), which was designated by the CFTC. NFA registers any entity wishing to conduct business in the derivatives industry on behalf of the CFTC. The organization determines industry best practices and enforces compliance to those rules among its members. It also:

• Protects investors.
• Creates member education, resources, and outreach programs.
• Offers arbitration for customers and members over futures and foreign-exchange-related disputes.
• Can take disciplinary action against members that break rules.

How market regulators work

The regulators have committees and divisions to help distribute and enforce their regulatory powers.

Five commissioners head the SEC; they are appointed by the U.S. president. The SEC has six divisions tasked with carrying out the regulator’s work, including:

• Corporate finance. This division provides investors with material information to make informed investment decisions and helps companies understand SEC rules.
• Economic and risk analysis. The department was created after the 2008 global financial crisis to integrate financial economics and rigorous data analytics into the core mission of the SEC.
• Enforcement. This staff conducts investigations into possible federal securities laws violations and prosecutes the SEC’s civil suits.
• Examinations. This division conducts the SEC’s national exam program.
• Investment management. The staff oversees the regulatory policy for investment companies and advisers.
• Trading and markets. This division regulates the major securities market participants.

There are also five CFTC commissioners appointed by the president. The CFTC has 13 operating divisions and offices. Some of those are similar to the SEC divisions, but some are different. These offices include:

• Clearing and risk. This department oversees the unique clearing aspect of derivatives markets.
• Enforcement. This division investigates and prosecutes violations of the commission regulations and the Commodity Exchange Act.
• Office of International Affairs. The office advises the agency regarding international regulatory issues and initiatives. 

The SRO regulators have more narrowly defined tasks for their individual industry. FINRA’s board of directors includes 22 members who are industry and public representatives. It also has four main committees that handle FINRA’s functions, including an advisory committee with 13 subcommittees, plus regional committees made up of five subcommittees. These subcommittees provide feedback on rules and regulatory issues.

As the SRO for the derivatives industry, the NFA has a board of directors, including a chair, vice chair, members of the different groups it oversees, and public representatives. It has 14 committees, which oversee the NFA’s several roles.

How market regulators make rules

As market conditions change and become more sophisticated, new types of products are created, so regulators need to stay on top of these changes to adjust or adopt rules as needed.

To create new regulations, the SEC or the CFTC generally propose a rule and ask for public comment. The organization may tweak the proposal based on the feedback. If the regulator seeks to continue with the proposed rule, it will publish a Notice of Proposed Rulemaking to address the issues or concerns with the initial proposed rule. The organization allows another round of public comment, usually 30 to 60 days. After the second comment period, the organization may issue a final rule that may reflect the agency’s thoughts on the public’s feedback. 

Once approved, the final rule is published in the Federal Register with an effective date, and typically a date by which market participants must comply.

Regulatory agencies are in charge of enforcing their rules, which are legally binding. Enforcement may include fines and in some cases jail time for federal enforcement actions from the SEC and CFTC. The FINRA and NFA can ban members for life and levy heavy fines, depending on which rules were broken, and to what degree.

Both the SEC and CFTC have whistleblower programs to help them uncover wrongdoing. These programs provide monetary incentives for people who come forward and anti-retaliation protections for whistleblowers.

Market regulators and crypto 

When cryptocurrencies rose to prominence, they represented a new challenge for government regulators. These decentralized securities are traded globally. Different countries have various laws regarding cryptocurrencies, but there isn’t a unifying regulatory framework.

Both the SEC and CFTC have jockeyed to regulate these digital assets. One key issue is how to define cryptocurrencies and crypto tokens. Are they currencies or commodities (CFTC jurisdiction), or are they securities (SEC jurisdiction)?

The CFTC says it has jurisdiction over a cryptocurrency when digital assets are used in a derivatives contract, such as the bitcoin futures contract, and that it has authority if there is fraud or manipulation involving a virtual currency traded in interstate commerce. Although the CFTC and some courts say the CFTC should regulate digital assets, it cannot oversee spot markets. The agency has asked Congress for authority to regulate spot markets. 

Meanwhile, the SEC, which has rejected several attempts by exchange-traded fund (ETF) issuers to create a bitcoin ETF, says it should oversee these assets. The SEC says it has more expertise to regulate markets that involve individual investors. In addition, SEC Chair Gary Gensler believes most cryptocurrencies to be securities.

The bottom line

Financial market regulators have a heavy task overseeing the wide-ranging financial markets, especially as technology changes quickly. Financial market regulators are urging Congress to put a framework on crypto market regulation to move digital currencies out of the largely unregulated arena to something with more investor protections and rules. That discussion will likely continue for some time. 

Even as the crypto market regulatory debate continues, investors in stocks, commodities, and other financial products have a strong framework of protection under existing SEC and CFTC rules, allowing hundreds of millions of contracts representing billions of dollars to trade freely and fairly each day.