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My Crypto Lawyer Sec Speeches Cryptocurrency Meeting the Challenges and Fulfilling The Promise of Global Financial Markets: Remarks before the Institute of International Bankers

My Crypto Lawyer

Washington D.C.

Thank you, Beth [Zorc], for that introduction and thank you to the Institute of International Bankers for this opportunity to provide closing remarks to your 2023 Annual Washington Conference. For the last two days, you have been addressed by top U.S. financial regulators, including the chairman of the Federal Deposit Insurance Corporation, the acting Comptroller of the Currency, and the chairman of the Commodity Futures Trading Commission, on issues ranging from banking regulation, the economy, and financial crimes to cybersecurity, digital assets, and taxes. It is a privilege to close out your conference with thoughts on the capital markets. My remarks reflect solely my individual views as a Commissioner and do not necessarily reflect the views of the full U.S. Securities and Exchange Commission (SEC) or my fellow Commissioners.

The SEC’s current regulatory agenda is ambitious, with such an extensive list of proposals not seen since the 2008 financial crisis and the enactment of the Dodd-Frank Act.[1] Many of these changes will impact portions of your operations that conduct business in the United States or provide services to U.S. citizens. The agenda’s sheer scale raises good questions on what securities regulators should focus on, and why.

I would like to share with you today my regulatory approach to the securities markets, which itself is drawn, of course, from the work of many others.[2] There is a lot at stake here. Efficient capital formation can bring massive benefits to a nation. The promise of more efficiently allocated cross-border flows of capital resources into investment projects can result in superior risk/return tradeoffs and better portfolio diversification. It can also result in higher economic growth and increased prosperity.

In regulating the capital markets, one goal ought to be creating a set of rules and norms that offer investors a reasonable degree of well-founded confidence, not false confidence, that both the material risks and potential returns associated with their investments are disclosed. This goal is at the core of both investor protection and capital formation.

The notion that investor protection and capital formation are symbiotically related dates back to a famous economic paper published in 1970 by George Akerlof, entitled The Market for “Lemons”: Quality Uncertainty and the Market Mechanism.[3] Professor Akerlof won the 2001 Nobel Prize for this seminal work, which highlights the manner in which asymmetries of information can undermine the powers of the market. In his article, he asks a simple question: why do new cars lose so much value the instant you drive them off of the lot? The explanation, he offered, was the asymmetry of information between the potential buyer and seller. If the new car turns out to have a lot of mechanical defects, we colloquially refer to it as a “lemon” in the United States. If someone has purchased a new car, and soon thereafter makes an attempt to sell it, a potential buyer is likely concerned that the car is a “lemon,” and, in light of this expectation, the buyer is likely to reduce how much he or she is willing to pay. Typically, a new car loses a substantial amount of its original market value. From an economic perspective, this is puzzling: it is the same car as it was a few moments before, with the same likelihood of delivering value across time, and yet we have this precipitous drop. As Professor Akerlof noted, this is due to the asymmetry of information—that is, the seller likely knows the quality of the item offered and the buyer does not.

In some instances, the Lemons Problem can result in the destruction of a market. If potential sellers with quality cars decide to refrain from the market—because they do not want to sell their car for less than its perceived worth—then the probability of purchasing a lemon among the remaining cars increases. This, in turn, leads to a higher discount demanded by buyers, which may result in a further removal of quality cars from the market, until this negative feedback loop effectively causes market failure.

The same Lemons Problem can apply to the securities markets. There may be honest firms with new entrepreneurial ideas trying to raise capital, but there are also bad actors who want to take the investors’ money and run. The firms raising capital know whether they are fraudsters, but potential investors do not. If the potential investors cannot discriminate between which firms are honest and which ones are frauds, then they will demand a higher return to compensate them for the risk they may be giving their money to a fraudster. From the entrepreneurs’ perspective, this increases the cost of capital.

As a rational person will not invest in a project unless the cost of capital is lower than the expected rate of return, an increase in cost of capital reduces investment in the economy, which lowers economic growth. If there are too many fraudsters in the securities markets, then the market may no longer be a viable means of raising capital. As the cost of capital increases through the presence of fraudsters, some honest entrepreneurs will withdraw from the market altogether, which will increase the likelihood of encountering a bad actor. As Professor Bernard Black explains: “Discounted share prices mean that an honest issuer can’t receive fair value for its shares, and has an incentive to use other forms of financing. But discounted prices won’t discourage dishonest issuers.”[4]

The key to addressing the Lemons Problem is to remove a sufficient quantum of fraudsters from the market. This will lower the cost of capital, resulting in more investment, greater economic growth, and more prosperity.[5]

Specifically, there are four essential investor fears that securities regulators must address if they are to overcome the Lemons Problem: first is the investor fear of being uninformed about the investment being offered; second is potential abuse by market intermediaries, as investors enter, participate in and exit from securities markets; third is the fear of inefficient market prices, including due to market manipulation and insider trading; and fourth is the fear of intermediary failures that may leave investors unable to access their wealth.

First, how does a jurisdiction ensure that investors can place some degree of confidence in the information from corporate issuers raising capital? There are five basic regulatory tools: (1) mandatory financial reporting, so investors know what to expect; (2) standardized accounting, so financial results can be compared; (3) auditing, so investors can have some assurance; (4) oversight of auditing, to ensure auditors are doing their jobs; and (5) effective enforcement, so the investors know that the bad actors are being filtered out and removed.

Second, regarding abuse by securities markets intermediaries, the list of harms is long, ranging from misleading statements to churning to front running to unauthorized trading and theft. Regulatory tools include: (1) registration requirements; (2) recordkeeping rules; (3) supervisory rules, so an entity can be held accountable for abuses by its agents; (4) disclosure rules; (5) rules prescribing specific types of conduct, such as sales practice, best execution, principal trading, and other obligations; and, finally, (6) regulatory examinations and enforcement.

The third fear is market abuses, including insider trading and market manipulation. Trading by insiders, or their “tipees,” on material non-public information is a “zero-sum game”; for every dollar an insider gains, or avoids losing, that is a dollar that an investor loses. If insiders are allowed to profit by trading on material non-public information, investors will avoid that market and drive up the cost of capital.[6]

The same is true of market manipulation, which is conduct designed to deceive investors by controlling or artificially affecting the price of securities. There are many ways to engage in market manipulation, ranging from the promulgation of misleading statements to purposefully moving prices through the volume of trading, including via matched or so-called wash sales. The classic manipulation is the pump-and-dump. The regulatory toolset to prevent these activities is well known: antifraud rules, market surveillance, and effective enforcement.

The fourth fear is failures by intermediaries. Investors want access to their wealth. If a failure by a broker-dealer or exchange, for example, results in a multi-year bankruptcy process or other legal entanglements, they are not going to want to hold their wealth through that intermediary. If there are serious cyber-threats that might debilitate the market—again, investors will turn away. The regulatory tools in this space include transparency and disclosure, inspections and enforcement, business continuity planning, appropriate cyber safeguards, capital rules, margin requirements, rules governing custody of client assets, clearing-house rules, and circuit breakers.

The final essential ingredient of a healthy capital market is that the regulatory framework itself must be cost effective. If the regulatory burdens designed to address the Four Fears are excessively burdensome, and not justified by the benefits associated with those regulations, then the capital market will fail to live up to its potential in terms of economic growth and prosperity.

How do we assure cost effectiveness? Cost benefit analysis—both on a prospective and retrospective basis—is crucial. While such an analysis is hard to do—and there are many benefits, costs, and unintended consequences that are difficult to gauge accurately—laying out and presenting the costs and benefits, as best we can, results in a more efficient regulatory framework. Another important tool is the public comment process on rulemaking, so regulators can learn from interested persons. Of course, the public comment process only works as intended when industry participants and stakeholders have sufficient time to analyze a proposal. At the same time, regulators must be cognizant of effects on competition as a regulatory framework can unnecessarily increase market power, which may increase transactional costs and damage a market’s potential.

Globally, one needs to ask whether it is possible to effectively address the Lemons Problem across borders. Investors might be interested in diversifying their portfolio of investments beyond their home country, and gaining not only new investment opportunities, but also ones that are less correlated. However, they will not do so unless there is some degree of confidence that their investments will not be siphoned away by fraudsters. Thus, if we are to work across borders, we need agreements and often assistance from foreign regulatory authorities and they need that same assistance from us.

In the international context, there is the added complexity of different rule sets in different jurisdictions. Beyond the market failures induced by the Lemons Problem, this can introduce other elements that interfere with efficient capital formation. There are a number of areas that may benefit from attention and effort among securities regulators.

First, there should be cross-border clarity on regulatory scope as entities that might operate internationally need to know which rules apply to them and which do not. It is vitally important that regulators ensure that the legal perimeter and regulatory scoping are as clear and assessable as possible. Legal ambiguity can be the death of healthy cross-border activity.

Second, conflicts of law across jurisdictions need to be addressed. If the regulation in one jurisdiction says you must do X, and the regulation in a second jurisdiction says you may not do X, then you cannot lawfully operate across those jurisdictions. Some conflicts of law may even be relatively peripheral from a securities regulatory perspective, arising out of trade, competition, or privacy laws that are enforced by non-financial regulators.

Third, duplicative regulation increases the costs of cross-border securities activity without corresponding benefits if they address regulatory issues in an unnecessarily redundant manner. In order to permit a healthy flow of cross-border activities in financial markets, countries do not need to have exactly the same rule book. If one jurisdiction has a different regulatory approach to an issue, then, so long as the regulatory outcome is qualitatively comparable and transparent, a jurisdiction might choose to recognize the compliance of a foreign-based entity with another jurisdiction’s regulations as satisfactory, and thus ease restrictions on cross-border flows of activity associated therewith. This kind of regulatory collaboration goes by a number of different names—ranging from mutual recognition to substituted compliance.[7]

Fourth is identifying gaps in a foreign regulatory framework that the home jurisdiction believes are of key importance. While a jurisdiction might choose to recognize some aspects of a foreign regulatory framework, it does not have to embrace the whole of that framework to facilitate cross-border activity. In other words, an all-or-nothing approach may not make sense in facilitating cross-border activity. Rather, there will be more success in lowering the cost of beneficial cross-border activity, while maintaining appropriate investor protection, if we embrace a more open-ended, evidence-based approach that examines the actual regulatory differences and similarities, as well as the pertinent compliance mechanisms.

One more thought: healthy competition among jurisdictions when crafting regulations is not necessarily a bad thing. Some argue that globalized capital markets run a risk of a regulatory “race to the bottom.” In other words, capital and market activity will flow to the jurisdictions with the lowest regulatory requirements, and, thus, flow to where there may be a higher degree of fraud to the detriment of investors. This line of argument forgets the Lemons Problem. If regulation is inadequate in a jurisdiction, the Lemons Problem suggests that the cost of capital will be higher than it would otherwise be. And who wants to raise capital in a jurisdiction where they have to pay a higher cost of capital? Indeed, the Lemons Problem suggests that healthy jurisdictional competition may result in a “race to optimality”—that is, there is likely to be more capital market activity in jurisdictions where there is cost-effective and high-quality regulation, including examination and enforcement.

The economic benefits to be gained from increased regulatory cooperation across borders that facilitates a more globalized capital market cannot be overstated. This goal becomes even more important among similarly-minded societies during times when the ideas of free enterprise, democracy, and personal liberty are under threat. However, this requires some degree of trust and resource-intensive collaboration among regulators across borders. The international entities represented in this organization are vital to informing such a process, and I look forward to continuing to learn from you.

Thank you.

[1] See SEC Agency Rule List, available at: https://www.reginfo.gov/public/do/eAgendaMain?operation=OPERATION_GET_AGENCY_RULE_LIST&currentPub=true&agencyCode&showStage=active&agencyCd=3235

[2] For an excellent overview of the basic regulatory ingredients to building and maintaining a successful securities market, which I draw on, see, e.g., Ziven Scott Birdwell, The Key Elements for Developing A Securities Market To Drive Economic Growth: A Roadmap for Emerging Markets, Georgia Journal of International and Comparative Law (Spring 2011).

[3] Akerlof, George A., The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, Quarterly Journal of Economics, Vol. 84, No. 3 (Aug. 1970).

[4] Bernard Black, The Core Institutions That Support Strong Securities Markets, 55 Bus. Law, 1567 (2000).

[5] John C. Coffee, Jr., Law and the Market: The Impact of Enforcement, 156 U. Pa. L. Rev. 229, 230 (2007) (“[H]igher enforcement intensity gives the U.S. economy a lower cost of capital and higher securities valuations”).

[6] See, e.g., Utpal Bhattacharya, Hazem Daouk, The World Price of Insider Trading, 57 J. Fin. 75 (2008) (after controlling for risk factors, a liquidity factor and shareholder rights, finds cost of equity is reduced by 5% through enforcement of insider trading laws).

[7] For a discussion of the evolution of this concept, see Howell E. Jackson, Substituted Compliance: The Emergence, Challenges, and Evolution of a New Regulatory Paradigm, Journal of Financial Regulation Vol. 1, Issue 2, pages 169-205 (2015). For an example of the application of the concept, see Rule 3a71-6 under the Securities Exchange Act of 1934 (“Exchange Act”) which permits the SEC to determine that registered non-U.S. major security-based swap participants may satisfy certain requirements promulgated under Exchange Act section 15F by complying with comparable non-U.S. requirements.

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