What a difference a year makes. This year we begin with a new administration about to take over, a new nominee for SEC Chairwoman and repeated calls for reform and more regulation. Bills are pending in Congress that might dramatically reshape the regulatory landscape. There are calls for the merger of the SEC and the CFTC and even of those two agencies with the Federal Reserve. Others have called for new regulation and additional enforcement. Next year, where will all this have taken securities regulation and enforcement? While nobody knows the answer to this question, it is clear that if Congress does not properly address the situation, there is little likelihood of avoiding a future repetition of the current crisis. In this regard, it is essential that three key points be considered.

Merging agencies: Should the SEC be merged with other regulatory agencies? The current Treasury Secretary called for this months ago. Some agree and some do not. The incoming Chairwoman, Mary Schapiro, certainly has the familiarity with both the CFTC and the SEC that would be necessary to run such an agency. In many ways, this seems like a good idea. Both are regulatory agencies. Both have supervision over certain market based financial products. Adding the Federal Reserve to this could complete the marriage of financial market regulators.

At the same time the SEC, CFTC and Federal Reserve have fundamentally different approaches to those they regulate, although there are similarities in some instances. The approach of each regulator evolved from its origins and the markets and institutions they regulate. For example, banking regulation under the Federal Reserve focuses on the financial soundness of the institution and the faith the public had in it. This approach evolved from the bank failures of the 1930s. While the SEC’s approach evolved from the same time period, it is geared to the securities markets, and not depository institutions. The CFTC crafted its approach beginning in a different time period than either the SEC or the Federal Reserve. Like those two agencies however, the CFTC’s approach has been tailored to its historical markets which differ from those of the SEC and the Federal Reserve.

All of this is to say that while there are common overlapping elements of regulation among these agencies, simply putting the SEC and CFTC together and perhaps adding the Federal Reserve is not that simple and may not work. There is no such thing as a “one size fits all” regulatory scheme or approach to regulation. In evaluating the question of merger or continued independence of these entities, it is essential that Congress carefully consider the focus and manner of regulation that each has traditionally used as well as any possible efficiencies which might be achieved through merger. While mergers might result in better regulation, it may just be that an overhaul of each agency in view of current market conditions would be a better choice.

Regulatory reform: The current market crisis and events clearly point to the need for a careful evaluation of the regulatory framework of each financial regulator. Since the creation of the SEC, Federal Reserve and the CFTC, Wall Street has been ever creative, constantly turning out new financial products and inventions. Frequently, those products are designed to take advantage of inefficiencies in the markets or the regulatory system. In some instances, the new products fall in a crack of the regulatory system. The much talked about credit default swaps are just once example. This product, which has become the poster child of the current market debacle, was not known or even thought of when the SEC, Federal Reserve, or even the CFTC was created. No doubt in the future Wall Street will create additional as yet unheard of products.

This suggests that in evaluating the regulatory jurisdiction of each agency — regardless of whether there is a merger — it is critical that Congress look carefully at the historic roots of each agency and at the regulatory landscape today. Perhaps even of more importance, Congress must look beyond today to tomorrow. While it might be tempting to simply extend regulation over CDS and move on, this would be a mistake. Rather, Congress should carefully consider the entire financial products landscape and give financial regulators a mandate not just to monitor the market of today, but also of tomorrow. While regulators may have difficulty keeping pace with the innovation of Wall Street, if a repetition of the current market crisis is to be avoided, it is essential that Congress direct regulators to look be forward looking.

Enforcement: A key to revamping the regulatory landscape is to ensure that there is an effective cop on the beat. Whether this is the securities or commodity markets or financial institutions, everyone should recall the recent testimony of former Fed Chairman Alan Greenspan. In that testimony Mr. Greenspan expressed surprise and regret at the total deregulatory approach he espoused for years. Markets are not self-policing when there are millions and billions of dollars at stake. Current events are a testament to this point. A cop on the beat is essential if markets are to serve the needs of the investing public on Main Street as well as those of Wall Street and the nation.

At the same time, it is essential that any cop and new regulation be balanced. Over regulation or over zealous enforcement can be worse than too little regulation and lax enforcement. It is often tempting in situations like the current market crisis to swing the pendulum to far in the other direction. What is critical here is that Congress carefully considers the markets and regulatory landscape, fully assess the need for additional regulation and enforcement and then institute the appropriate measures. Grabbing at the obvious or at easy answers like merging agencies or regulating credit default swaps or throwing more resources at the enforcement divisions of each agency may feel good today, but it has little chance of preventing a market meltdown in the future.

The market crisis and the Madoff scandal continue to be the dominant events this week, with the SEC publishing its mark-to-market study as required by Congress and Mr. Madoff providing the SEC with a listing of assets. SEC Chairman Cox defended the response of the Commission to the current market crisis. In the interview, Mr. Cox termed the imposition of the short sale ban earlier this year as his biggest mistake, blaming the Treasury Secretary and Fed Chairman for the move. Mr. Cox also reiterated his earlier assertion that the failure to uncover the Madoff matter sooner is not his fault, while insisting that enforcement under his tenure is robust. Ironically, two new academic studies show that the short sale ban by the SEC and other regulators has not had a negative impact on price discovery and that the number of prosecutions for securities fraud have declined significantly.

The market crisis

Mark-to-market accounting study: The SEC published its Report on Mark-to Market Accounting this week. The report was mandated by the Congress in the Emergency Economic Stabilization Act of 2008. In essence the study recommends that fair value accounting continue to be used but with improvements. The Report contains eight key recommendations:

1) SFAS No. 157 should be improved and not suspended;

2) Existing fair value and mark-to-market requirements should not be suspended;

3) Additional measures should be taken to improve the application and practice related to existing fair value requirements;

4) The accounting for financial asset impairments should be readdressed;

5) Further guidance is needed to foster the use of sound judgment in this area;

6) Accounting standards should continue to be established to meet the needs of investors;

7) Additional formal measures to address the operation of existing accounting standards in practice should be established; and

8) There is a need to simplify the accounting for investments in financial assets.

Chairman’s interview: SEC Chairman Christopher Cox defended the actions of the SEC during the current market crisis in comments made during a recent interview (available here, registration required). Mr. Cox stressed that the restrained approach taken by the agency to the financial crisis has been the correct one. Two other key points during the interview:

• His biggest mistake during his tenure, Mr. Cox noted, was imposing the short sale ban earlier this year. He took that action at the request of Treasury Secretary Henry M. Paulson Jr. and Fed Chairman Ben S. Bernanke.

• Mr. Cox reiterated his earlier comments that he is not responsible for the failure to detect the alleged fraudulent scheme of Bernard Madoff.

At the same time, Mr. Cox noted that enforcement has been effective under his tenure claiming that the agency has been a strong cop on the beat.

The Madoff scandal

Investigators continued to focus on trying to unwind the actions surrounding the alleged $50 billion Ponzi scheme of Bernard Madoff. On New Year’s Eve Mr. Madoff filed an accounting in the SEC’s civil action against him. That accounting, produced under the terms of a consent decree entered in the SEC’s case, is supposed to identify all of the assets Mr. Madoff and his entities controlled. Many of those assets are offshore, according to some reports. If the report is complete, it should provide SEC investigators with significant insights into the workings of investment fund managed by Mr. Madoff. Eventually it may aid investors with trying to recover at least part of their losses.

Suits also continued to be filed by investors. Some of these actions are investor suits filed against the so-called “feeder funds.” Those are the investment funds which channeled huge sums of money to Mr. Madoff. One suit, which probably reflects investor frustrations more than legal merit, was brought against the SEC.

Additional investors suffering huge losses also continue to appear. According to some reports, an Australian bank will have to be bailed out by the government of that country as a result of its losses.

Congress is now set to look into the Madoff matter. Next week, a House committee is scheduling hearings and the SEC inspector general is set to testify. The inspector general is currently conducting an internal investigation to determine why the agency did not discover the alleged fraud sooner.

Private actions

A class action fraud suit was filed which names, among others, Mary Schapiro, the nominee to be the next SEC Chairwoman. The suit claims misrepresentations were made by the defendants about payments made to NASD Members to induce them to vote in favor of the transactions between the NASD and the New York Stock Exchange Group, Inc. which created FINRA. Benchmark Financial Services, Inc. v. Financial Industry Regulatory Authority, Inc., Case No. 1:08-cv-11193 (S.D.N.Y. Filed Dec. 23, 2008).

Studies

Securities fraud prosecutions down: A new study by Syracuse University using Department of Justice data shows that there has been a significant decline in the number of securities fraud cases brought during the first eleven months of this fiscal year. According to the study, there were 133 prosecutions for securities fraud during that time period. In contrast in 2000 there were 437 securities fraud cases. The highest number of securities fraud cases was 513 in 2002.

At the SEC prosecutions for securities fraud dropped from 69 in 2000 to just 9 in 2007, a decline of 87% according to the study.

No impact from short sale restrictions: A study of the impact of the emergency short sale rules imposed by the SEC and other regulators around the world has concluded that the restrictions did not change the behavior of stock returns. Specifically, the study concluded that the short selling restraints did not have any detrimental impact in terms of reduced efficiency of pricing. The study was done by professors at London’s Cass Business School.