Rules and referees help keep the investment markets fair.

In a perfect world, every player in the capital markets would always deal honestly and fairly with every other player. The field would be perfectly level, giving everyone the same access to information and opportunities.

But in the absence of perfection, there is regulation. The system that has developed in the United States to regulate the capital markets is designed to keep them fair and efficient by setting and enforcing standards and rules, settling disputes among market participants, mandating changes, and preventing fraud.

The ultimate goal of regulation is often described as maintaining investor confidence while encouraging capital formation. But why is that so important? The reason is that investor dollars are the fuel on which the economy runs. If the public distrusts the markets, investors keep their money out of investments — and out of US businesses. But when people trust the markets, they’re willing to put money into investments like stocks and bonds, giving companies money to innovate and expand.

Although individual states began regulating securities trading in the early 20th century, the foundations of federal regulation were laid in the aftermath of the stock market crash of 1929. Construction is still underway.

Meet the referees 

In the current structure, no single regulator oversees all the interlocking elements of the capital markets. Instead, there are a number of regulators with different but sometimes overlapping jurisdictions. And some segments of the markets are only lightly regulated.

There are two types of market regulators: government regulators, at the federal and state levels, and self-regulatory organizations (SROs), through which industry players govern themselves.

At the federal level, the Securities and Exchange Commission (SEC) oversees the nation’s securities industry, enforcing laws passed by Congress as well as its own rules. The SEC also supervises the SROs and has the right to demand changes in their rules.

The Commodities Futures Trading Commission (CFTC) regulates futures markets, as well as certain derivatives and derivative clearing organizations. Its mission is to foster an open, competitive, and financially sound trading environment, and protect investors against abusive practices.

Market Regulation

Each state also has its own securities regulator to supervise business within its borders and regulate activities that fall outside the SEC’s or CFTC’s scope. These regulators belong to the North American Securities Administrators Association (NASAA).

FINRA, the Financial Industry Regulatory Authority, the largest industry SRO, oversees brokers, brokerage firms, and investment companies.

The National Futures Association (NFA) is the self-regulator for the derivatives industry, including exchange-traded futures contracts as well as retail trading in foreign currencies and swaps trading.

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Regulators overview

Regulation is a dynamic, evolving system of guidelines and controls, adapting to changes in the market environment and to events — such as scandals and failures — that reveal vulnerabilities.

When things go wrong, however, not everyone believes that more regulation is necessarily the best solution. Although few people argue for zero government oversight, what’s often debated is exactly how much oversight is the right amount.

Opponents of regulation argue that the markets work best when government lets them alone — what is sometimes referred to as laissez faire. From this perspective, government interference increases the cost or difficulty of doing business, stifles innovation, and prevents ordinary market forces of supply and demand from determining prices and products.

But proponents of government regulation point to the industry’s failure to prevent past problems as the reason to appoint and strengthen third-party watchdogs, especially since the securities markets are so central to the health of the US economy. They argue that outside policing is necessary to protect investors, whose interests may conflict with industry interests. They also maintain that government intervention is needed to calm public concerns, especially in cases where the public doesn’t believe the industry can or will resolve its own problems.

For example, in response to the credit and banking crisis of 2008 that followed a period of deregulation, Congress passed the far-reaching Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act imposed new requirements on financial institutions and products, established an independent Consumer Financial Protection Bureau (CFPB) within the Federal Reserve System, and sought to create a system to identify and defuse systemic risks to economic stability, among other changes. Some provisions are still being put into place.

Acting on regulation 

The landmark federal legislation that governs financial markets — the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodities Exchange Act of 1936, the Investment Company Act of 1940, and the Investment Advisers Act of 1940 — are amended and expanded regularly, often in response to financial market innovations or in reaction to market abuses.

Shared responsibility 

In 1996, the National Securities Markets Improvements Act gave federal regulators sole authority to review and register what the act described as covered securities. This category includes all securities listed on a national securities exchange, mutual funds and other securities issued by a registered investment company, securities sold to accredited purchasers, and securities exempt from registration under Rule 506 of Regulation D of the Securities Act of 1933. Accredited purchasers are those whose net worth or annual income meets the minimum levels the government sets.

States, on the other hand, can require the registration of securities that are not defined as covered, all broker-dealers doing business in the state, and registered investment advisers (RIAs) who manage less than $100 million. States also regulate the insurance companies that operate within their borders and the products those companies issue, with the exception of products that are defined as securities, such as variable annuities.

Both federal and state regulators can investigate and prosecute fraud, deceit, and any illegal actions by any issuer, broker-dealer, or adviser, though in the case of a state the action must have occurred within its borders.

How Are Capital Markets Regulated? by Inna Rosputnia

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