Regulation of financial markets and the persons and companies involved in financial transactions is pervasive, and the goals of financial regulation are many. Governments and regulators seek to protect consumers and investors from being taken advantage of by those with more expertise or information. To this end, regulation prohibits fraud and manipulation of markets, and imposes affirmative duties to disclose important information to customers or investors and to act in their best interests. Regulation also seeks to preserve and strengthen the stability of banks and other large financial institutions. Financial regulation evolves in response to the changing circumstances brought about by financial innovation and the continual integration of global financial centers.
Perhaps the most fundamental type of financial institution is a commercial bank or other depository institution. Banks provide the essential economic function of matching up individuals and institutions desiring to save funds with those seeking capital to borrow for investment or other purposes. Regulation of commercial banking primarily involves protecting the funds of depositors, ensuring the soundness of banks, and protecting consumers from unfair lending practices. In the United States, banks are regulated by several authorities at the state and federal level.
Bank regulation stems in part from what is thought to be banks’ inherent instability. Banks typically lend more capital than they have in reserves. If a significant portion of bank loans go bad, or if too many depositors withdraw their funds at once, a bank risks insolvency. To prevent collapses and runs by depositors, governments have established safety nets, such as deposit insurance and the ability of central banks to lend in times of distress. In part because the government stands ready to provide capital to banks, it also comprehensively regulates their activities by requiring banks to disclose their practices and balance sheets and to keep a minimum level of capital in their reserves.
To reduce the risks banks take, the law may prohibit the types of activities a bank may engage in. In the United States, commercial banks are prohibited from owning stock in public companies, although bank affiliated financial holding companies may provide insurance services, deal in securities, and underwrite new issues of securities. In countries like Germany, by contrast, banks often have large shareholdings in public companies and exercise control over management. To protect consumers who borrow from banks, regulation may require disclosures of important costs and risks to consumers, place a cap on the rate of interest charged on bank loans, and prohibit excessively risky loans to unqualified borrowers.
Raising Funds With Securities
Selling (or issuing) securities to raise investment funds is an activity widely regulated by financial regulators. Two basic types of securities are stocks and bonds. Stocks give investors an ownership stake in the company and often rights to control the company through voting. Bonds, which are a form of debt and generally safer than stocks, entitle an investor to periodic interest payments and the repayment of their investment principal at a fixed time in the future. Issuing securities to the general public requires a company to register under the Securities Act of 1933 and disclose important financial information about itself. Companies are also subject to criminal and civil liability for making false disclosures. U.S. regulation is unique in the ease with which it permits investors to bring group lawsuits against companies and their executives and the high level of enforcement by federal regulators.
Furthermore, when a company’s securities are traded in secondary markets such as the New York Stock Exchange (NYSE), the Securities and Exchange Act of 1934 requires the company to make continual, periodic disclosures in the form of annual and quarterly reports, and also upon the happening of certain important events such as the announcement of a merger. In connection with purchasing and selling securities in secondary markets, individuals and companies are required to disclose significant shareholdings in other companies and prohibited from trading based upon inside information not known by the public.
Another type of investment product is known as a derivative. A financial derivative is a security whose value is derived from the price of some other asset or metric, such as stocks or stock indices. A common type of derivative is an employee stock option that gives an employee the right to purchase stock in their own company at a predetermined price. Another type of derivative is a futures contract, which obligates one party to deliver an asset to another on a specified date. Two other types of derivatives are swaps and forwards.
In the United States, derivatives are typically regulated by a particular financial regulator based upon what underlying asset they reference. Options on stocks and currencies that trade on exchanges are regulated by the Securities and Exchange Commission (SEC). Futures and options on assets other than stocks are typically regulated by the Commodity Futures Trading Commission (CFTC). Futures on single securities or narrow-based stock are regulated by both the SEC and the CFTC.
Trading On and Off Exchanges
Regulation applies to the trading of securities and derivatives by regulating the venues on which trading takes place and manner of trading on different venues. Organized stock exchanges and derivatives exchanges are regulated in the United States as self-regulatory organizations (SROs) registered with the government. The NYSE and the NASDAQ Stock Market, as well as futures and options exchanges such as the CME Group, are SROs that have a duty to regulate and discipline the companies and brokers-dealers that utilize the exchange. Exchanges must also seek approval from the government for any changes to their internal rules. Trading of securities and derivatives that does not take place on an organized exchange takes place “over-the-counter” (OTC) and is generally subject to less governmental oversight. Derivatives are overwhelmingly traded OTC, with interest rate and foreign currency derivatives constituting most types of OTC derivatives.
When a company pools together money from the public and invests their money in a group of securities, that investment fund is subject to wide-ranging regulations that are designed to protect the public investors. The most widely utilized type of investment fund is a “mutual fund.” Mutual funds must disclose their holdings and investment objectives to investors, daily calculate their net asset value and stand ready to redeem investors’ capital, and have a board of directors to oversee the activities of portfolio managers. Mutual funds are generally restricted in their ability to charge a performance fee to investors, or engage in short selling, derivatives trading, and borrowing money to finance investments. In contrast, the regulatory situation is much different in the case of hedge funds (private investment funds utilized by wealthy individuals and institutions). Regulation does not require hedge funds to disclose information to investors, nor does it prohibit them from charging performance fees or engaging in the aforementioned trading strategies. However, hedge funds are subject to regulations.
Investment Advisers, Brokers, And Dealers
Financial regulation also applies to intermediaries that facilitate securities trades. An investment adviser is someone who gives advice to others, including investment funds, about whether to buy or sell securities. Advisers must be registered with the government if they advise a public investment company (such as a mutual fund), or advise a sufficient number of clients or funds with significant assets under management. Regulation requires advisers to put the interests of their clients above their own. A broker is a person or company that charges a price for buying and selling securities or soliciting or negotiating such trades for others. Brokers are typically subject to more stringent regulation than advisers. Mandatory broker duties include fair dealing with clients, being licensed by the government or a private self-regulatory body, executing trades for clients with a sufficient mix of price, speed, and certainty, and making sure that the securities recommended to customers are suitable for their financial circumstances and goals. A dealer is a person or company in the business of buying and selling securities, typically because the dealer owns enough of a certain security to make a market by fulfilling the buy and sell orders of customers.
- Terry Arthur and Philip Booth, “Financial Regulation, the State and the Market—Is the Financial Services Authority an Unnecessary Evil?” Business Economist (v.38/3, 2007);
- Paul Barnes, Stock Market Efficiency, Insider Dealing, and Market Abuse (Ashgate, 2008);
- Lisa L. Broome and Jerry W. Markham, Regulation of Bank Financial Service Activities: Cases and Materials (Thompson West, 2008);
- Michael Cichello and Robert Kieschnick, “Product Market Competition, Regulation, and Financial Contracts,” Quarterly Review of Economics and Finance (v.45/1, 2005);
- M. Johnson and T. L. Hazen, Derivatives Regulation (Aspen, 2004);
- Hal S. Scott, International Finance: Transactions, Policy, and Regulation (Foundation Press, 2008);
- D. Soderquist and T. A. Gabaldon, Securities Law (Foundation Press, 2007);
- Stephen Weatherill, Better Regulation (Hart Publishing, 2007).
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