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What's Next for the SEC?

At least one form of rampant speculation has been closed down. Mary Schapiro will step down from the Chairmanship of the SEC by the end of the year. One of her fellow Democratic Commissioners, Elise Walter will take over, leaving a vacancy on the five-member Commission and an even split between Democrats and Republicans. Commissioner Walter is extremely close to Schapiro, virtually an alter ego. She will probably lead the SEC much as Schapiro did, but with less authority. Her term has expired and she can serve without reconfirmation only through 2013.

So this is not the end of the story. The President can designate any Commissioner as chairman, and may well fill the vacancy with someone who will slide into the leadership position. Chairman Schapiro’s recent results, both good and bad, provide guidance as to the type of person who can lead the Commission most effectively.

Under Schapiro’s leadership, the Commission weathered the aftermath of the financial crisis and navigated the agency’s missteps regarding Bernie Madoff. The Commission forced Goldman Sachs to a settlement at an opportune time, helping nudge the Dodd-Frank Act across the finish line. And enforcement of insider trading rules against the likes of Rajat Gupta has been moderately successful.

But the Commission under Schapiro has approached the big issues with unfortunate timidity and lugubriousness. Finalizing rules implementing the Dodd-Frank derivatives provisions was painfully slow, in stark contrast with the dynamism of the CFTC under Gary Gensler, which had far broader derivatives jurisdiction to deal with.

And then the conservative leaning DC Circuit Court struck down the SEC’s Proxy Access Rule under Dodd-Frank, ruling that the cost/benefit analysis was inadequate. The decision poses a very real problem as it drags out the agency’s process. But instead of fighting the unjustifiable ruling, the Commission decided to submit and attempt to comply with the Court’s absurd standards. This will slow down regulation from now on, perhaps achieving the DC Circuit’s real objective.

Even more important is the failure of the Commission to address two real threats to the securities markets, High Frequency Trading and Money Market Mutual Funds. HFT disrupts the orderly functioning of the markets. The May 2010 Flash Crash, in which upwards of $1 trillion of share value evaporated in less than a half hour, only to reverse most of the loss before the hour was up, illustrates the absurdity of allowing Trader Bots to control 75% of stock market trading. But the threat is not just another Flash Crash. HFT-triggered dislocations occur each and every day, all day long. Individual investors have fled the stock market to avoid the mayhem, having for the first time in history massively reducing holdings in equity funds in the teeth of a bull market. As Thomas Petterfry, the immensely successful founder of Interactive Brokers observed:

It is not so much anymore that the public does not trust their brokers. They do not trust the markets. And why should they, given our showing in the last few years? To the public the financial markets may increasingly seem like a casino, except that the casino is more transparent and easier to understand.

Chairman Schapiro took a swing at HFT and whiffed. The economy still suffers from the unreliable and distorted markets caused by HFT while the Trader Bots continue to systematically extract value from the American public.

Chairman Schapiro also took a swing at the immense threat posed by $3.4 trillion in underregulated Money Market Mutual Funds. They were invented by Merrill Lynch to grab a share of the vast ocean of deposits controlled by commercial banks, back in the days when investment banks and commercial banks were separated. They are like bank deposit accounts because the “investors” are guaranteed immediate withdrawal of amounts on deposit even if the Funds incur losses. Unlike deposits, the FDIC does not insure the amounts deposited. During the financial crisis, investors started a run on Money Market Mutual Funds that was halted only when the Fed guaranteed them under authority that was eliminated by the Dodd-Frank Act. Schapiro tightened the rules in 2010, but her effort this year to meaningfully rectify the problem withered away as industry lobbyists fought to maintain business as usual.

When a new Chairman is chosen, he or she will face daunting tasks and formidable industry resistance to regulation. HFT and Money Market Mutual Funds desperately need to be addressed. It would be best if the new Chairman had a grasp of these issues and could make the case that regulation will be good for American business. Commitment to reform is essential, but this is not the place for a bomb-thrower. The day will be won by making the case that regulation will promote economic growth, not stifle it.