The SEC as Financial Stability Regulator

By Allen, Hilary J. | Journal of Corporation Law, Summer 2018 | Go to article overview

The SEC as Financial Stability Regulator


Allen, Hilary J., Journal of Corporation Law


I.Introduction

After the financial crisis of 2007-2008 (the Crisis), regulators around the world adopted the pursuit of "financial stability" as one of the foremost goals of financial regulation.1 However, the ubiquity of the goal belied a lack of consensus about how regulators should approach financial stability, and that lack of consensus persists today. This Article takes an expansive view of financial stability regulation, arguing that such regulation should seek to prevent disruptions to both financial institutions and markets, if such disruptions would have negative consequences for the broader economy. Because the Securities and Exchange Commission (SEC) has much more experience with the securities markets than other US financial regulators, the SEC is the agency best positioned to ensure the robustness of those markets. The SEC can therefore make a significant contribution as a market-oriented financial stability regulator-even if other forms of financial stability regulation might be best left to prudential regulators like the Federal Reserve.

Private participants in the securities markets have neither the incentives nor the ability to promote financial stability (a collective good),2 and so only a government body can work to ensure that the securities markets are robust to shocks, and minimize the likelihood of shocks occurring in the first place. If the SEC fails to take on this role, we cannot expect any other government agency to fill the lacuna. While the Financial Stability oversight Council (FSOC) was created to address threats to the stability of the financial system, it is, at its core, a committee that is designed to leverage the expertise of its member agencies rather than performing extensive regulatory functions itself. Other than the SEC, there is no regulatory agency represented on the FSOC that has extensive experience with the securities markets.3 And there are certainly developments in the securities markets that raise financial stability concerns-this Article will focus in particular on the increasing prevalence of high frequency trading (HFT) in the equity markets.

HFT is an umbrella term for a variety of different automated trading strategies; their common characteristic is that the computer algorithms that make the trading decisions are designed to hold assets for only a very short period of time. HFT now accounts for more than half of all trading in the U.S. equity markets,4 and while the practice certainly affords benefits in terms of reducing the time and cost of executing trades, it also increases the complexity, interconnectedness and opacity of the equities markets.5 Events such as the "Flash Crash" in May 2010 have alerted regulators to HFT's potential to both generate and transmit shocks through the financial system: the potential threats that HFT poses to financial stability (as well as to investors and capital formation) will be explored in detail in this Article. Of course, high frequency traders do not trade exclusively in the equity markets (i.e. the secondary trading markets for listed stocks);6 there is an almost limitless list of assets that HFT firms will trade, including a multitude of derivatives instruments. However, this Article will focus on the equity markets.

The SEC is currently considering how to reform its regulation of the equity markets in light of the rise of HFT and other developments, a project that began in earnest with the issuance of a "Concept Release on Equity Market Structure" on January 14, 2010 (the Concept Release).7 Although some reforms have been implemented since that time, the project of market structure reform is nowhere near complete. To the extent that the SEC is planning to promulgate further rules addressing HFT and the equity market structure more generally, such rules can be said to be in the "preproposal period" (i.e. the time prior to the proposal of any rule in the Federal Register). As Krawiec notes, the preproposal period is "a time period about which little is known, despite its importance to policy outcomes . …

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