Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Alphabet soup: ABCs of investment regulation

Financial regulation is a necessary evil. A vibrant economy depends upon free markets and the opportunity to risk capital in pursuit of profit with the least possible degree of encumbrance. On the other hand, investors must have confidence in the honesty and fairness of the capital markets, and that requires regulation. Striking the right balance is a moving target that evolves in response to episodes of financial disruption or fraud.

Whether one believes the current environment is overly restrictive or too lax, the alphabet soup of regulatory agencies is often confusing and may not be well understood by the average investor. Let’s attempt spell it out.

The Securities and Exchange Commission or SEC is the most prominent and powerful regulatory agency overseeing investments in the US. Created in the wake of the 1929 stock market crash, the SEC is charged with preserving the integrity of capital markets, regulating stock exchanges, setting standards for public offerings and financial reporting by public companies, and enforcing securities laws. The SEC also regulates investment companies like mutual funds, ETFs, and Registered Investment Advisors (RIAs) managing over $100 million in client assets. In general, RIAs operate as fiduciaries required to hold the interest of clients above their own and are not compensated through sales commissions. The SEC has enforcement authority and can bring civil charges in federal court against bad actors.

The Financial Industry Regulatory Authority (FINRA) is a nonprofit self-regulatory organization that operates under the authority of the SEC to oversee broker-dealers in the US. Broker-dealers execute securities trades either on behalf of customers (as a broker) or for their own corporate account (as a dealer) and serve as custodian of client securities in a brokerage account. Brokers are held to a somewhat less stringent “best interest” standard and must disclose any potential conflicts of interest. FINRA supervises broker-dealer firms as well as individual employees known as Registered Representatives or brokers, administers requisite examinations, and approves broker registrations. FINRA also has authority to investigate potential violations by brokers or their firms and to supervise the mediation or arbitration of client complaints.

Both the SEC and FINRA maintain central repositories of registrations, examinations, licenses and disclosures of potential infractions or regulatory enforcement actions involving Investment Advisors or brokers. Individual investors can view this information by visiting the FINRA-run website and searching for a particular individual or firm.

Each individual state also maintains regulates securities transactions within its borders. While largely coordinated with federal statutes, states may also have unique rules. States also have oversight of Investment Advisors with under $100 million in client assets. In general, all Advisors and brokers must also register in the states in which they do business.

Due to their unique nature, some securities are subject to separate regulatory oversight. Municipal bonds are securities issued by states and municipalities to raise capital for public services and economic development. The issuance of municipal bonds and the financial reporting for these securities is supervised by the Municipal Securities Rulemaking Board. The MSRB is another SRO authorized by Congress to engage in rulemaking and to establish qualifications for municipal securities professionals. It also provides investors access to all mandatory filings through its Electronic Municipal Market Access or EMMA website.

The very large and liquid market for agricultural futures contracts and financial derivatives like options and swaps is less familiar to individual investors but critical to a well-functioning capital market. In the US, this market is regulated by a government agency analogous to the SEC called the Commodities Futures Trading Commission or CFTC. This regulatory agency was created in 1936 and has authority to promote fair markets, supervise transactions for accuracy and execution, and enforce compliance with rules and regulations.

Two other government agencies are charged with riding herd on retirement plans. The US Department of Labor maintains overall jurisdiction over private pension plans. DOL oversight includes 401(k) plans and has recently adopted additional rules relating to IRA rollovers from employer plans. The Pension Benefit Guaranty Corporation was created as part of the 1974 ERISA act to establish an insurance fund to partially mitigate pension losses by employees of bankrupt companies. The PBGC may take over failed employer plans or supervise the liquidation of closed or terminated plans. The agency can also place liens on companies that fail to meet minimum funding requirements for defined benefit plans.

The Securities Investor Protection Corporation or SIPC is less a regulator and more an insurance company intended to provide some protection to investors against the insolvency of their broker-dealer. SIPC is a nonprofit corporation created by Congress in 1970 following a wave of brokerage firm failures. Member firms pay into the SIPC fund which then protects individual investors’ brokerage account positions up to $500,000 including $250,000 in cash if their custodian fails. SIPC covers the positions but does not insure against loss in value. Note that most broker-dealers puchase significant additional protection as well.

And then there are the CFPB, FASB, FCA, FDIC, FHFA, FIO, FRB, FSOC, FTC, NAIC, NCUA. NFA, OCC, OTS, and PCAOB. For another day.

The US has the largest and most reliable financial markets in the world thanks in part to a regulatory regime that provides unparalleled transparency, liquidity, and investor protections. Are we overregulated? Probably. But given the status of US markets as the global gold standard, it seems our alphabet soup of regulators usually gets it just about right.

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