The Regulatory Outlook


New York – 2009 will bring significant regulatory changes which will impact the investment research industry. The exact shape of the regulatory landscape will emerge in the coming months, but the environment is already set for much more proactive involvement from Washington than the research industry has been accustomed.

The appointment of Mary Schapiro as head of the US Securities and Exchange Commission (SEC) puts an experienced regulator with a strong enforcement background at the helm. She is a good choice on two levels – she is known as a very capable and seasoned regulator, and, even more importantly, she has managed significant mergers of regulatory agencies, namely, the regulatory arms of the NYSE and NASD to form FINRA in 2007. Her merger experience will come in handy in 2009 because the SEC is almost certain to be combined with other agencies.

Future Regulatory Structure

One scenario Washingtonians anticipate is the merger of the SEC and Commodity Futures Trading Commission (CFTC). The logic is compelling: futures markets and securities markets have converged yet the regulatory authorities have not. As noted in the US Treasury Blueprint for a Modernized Regulatory Structure the SEC would need to do some housekeeping to make such a merger more seamless. The primary change recommended by the Treasury is to make the SEC more principles-based, to be consistent with the CFTC’s approach. On a practical level, expectations are that the size of the SEC will grow dramatically, with or without a merger.

There is speculation also on the longer term regulatory landscape. Treasury considered a few different options for the longer term structure: a functionally organized approach similar to the current structure centered on historical industry segments of banking, insurance, securities and futures; a modified functional-based system more focused on financial institutions than industry segments; a single regulatory authority similar to the FSA in the UK; and objectives-based regulatory approach similar to the structures in Australia and the Netherlands.

Treasury recommended an objectives-based approach focusing on three objectives: market stability, prudential financial regulation focused on risk management, and business conduct focused on consumer protection. Under this proposal there would be three regulators, each responsible for executing its regulatory objective. Treasury nominated the Federal Reserve to be the market stability regulator. The prudential regulator would be focused on all institutions that have some form of federal guarantee, such as deposit insurance.

The business conduct regulator would regulate all providers of financial products, including broker-dealers, hedge funds, private equity funds, venture capital funds, and mutual funds. The business conduct regulator would focus on operational ability, professional conduct, testing and training, fraud and manipulation, and duties to customers (e.g., best execution and investor suitability). Under the Treasury proposal, this would be the regulator most concerned with investment research. And the combined SEC/CFTC would be the most likely candidate to assume this role.

It is far from certain that the new administration will adopt the Treasury Blueprint. However, the depth of regulatory change contemplated by the Blueprint is appealing, particularly in light of the significant market and regulatory failures which have come to light since the Blueprint was first proposed in March. What is likely is that there will be a major consolidation in the number of financial regulators – including the SEC and CFTC, that the staffing of the regulators will be increased, and that the mandate will be for more proactive regulatory involvement in financial markets. The SEC, or its successor agency, will not wither but grow larger and more assertive than it has been in the recent past.

Implications for Research

The biggest issue for investment research will be the future of soft dollar regulation. In the short term, it is most likely that the SEC will continue its current regulatory path, which is the adoption of soft dollar guidelines for mutual fund directors (see Integrity’s comments). The comment period closed in October, which under typical circumstances would result in final rules by April 2009. In our opinion, the SEC’s actions on soft dollars have been inadequate in promoting full disclosure and transparency. Although the regulatory climate will be more conducive to greater transparency, it is not clear that soft dollars will be high on a regulatory agenda that encompasses massive structural change.

Client commission agreements (CCAs), the US equivalent of Commission Sharing Arrangements (CSAs), also require regulatory attention. CCAs, unlike CSAs, exclude the proprietary research of investment banks pending clarification of how CCA payments might impact proprietary trading. The effect of this is less transparency on the costs and payments for proprietary research.

NRSROs are another research related topic which will receive regulatory attention in 2009. At a minimum, it is likely that the SEC will reduce the regulatory entitlements afforded NRSROs. Congress may have other goodies in store, such as higher liability for NRSROs.

Longer term, it is likely that the new regulatory regime, however it is structured, will favor greater disclosure and transparency, prompting additional steps to unbundle investment research from execution. This will be bullish third party research (for those that can survive the dramatically reduced commission budgets for 2009, that is).


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