Oversight fails to keep pace with a changed market

Introduction

As credit-default swaps and derivatives took off in recent years, lack of authorization to oversee such transactions has forced the Securities and Exchange Commission (SEC) to sit largely on the sidelines, allowing waves of risky new financial instruments to proliferate with little oversight. For example, the volume of credit-default swaps exploded to over $45 trillion in 2007 — twice the size of the U.S. stock market. Without regulation or an electronic system to track such trades, the potential for systematic risk grew markedly. In August, before the government bailed out insurance giant American International Group, it was revealed the company had sold $440 billion in shaky credit-default swaps tied to mortgage securities. Meanwhile, despite more than a decade of warnings about fast-growing credit derivatives— including a plea from the head of the SEC’s sister regulatory agency, the Commodity Futures Trading Commission — the government continued to neglect scrutiny of such markets. The resulting toxic mix of risk, little transparency and sparse oversight is frequently cited as a crucial underlying factor in America’s worst financial crisis since the Great Depression. “The regulatory system,” says the Government Accountability Office (GAO), “currently lacks the comprehensive framework needed to regulate today’s highly complex, ever-changing global marketplace.”

Follow-up:
In December, the SEC adopted new rules to stem conflicts of interest and increase accountability for Wall Street’s credit-rating industry. The SEC has also entered into an information-sharing agreement with the Federal Reserve and the Commodity Futures Trading Commission to promote regulation of credit-default swaps. Meanwhile earlier this fall, SEC Chairman Christopher Cox urged Congress to pass legislation that would regulate credit-default swaps and strengthen oversight of derivatives, stating that the market is “ripe for fraud and manipulation.” This year, Cox also launched the 21st Century Disclosure Initiative, an internal inquiry into the Commission’s information-gathering practices. Attempts to strengthen transparency and regulation are likely to remain on the front burner. An SEC spokesman told the Center that enforcement spending is “at a record high.” The GAO recently named oversight of financial institutions and markets as one of 13 urgent issues demanding the attention of President-Elect Obama and the 111th Congress. Obama has called for creation of “21st century standards” for oversight of the financial system. “We need to streamline a framework of overlapping and competing regulatory agencies,” he added.