For Regulators, It’s All About Timing

Regulators have a hard job. Novel financial products are developed and launched all the time. At first, regulators have very little information about these products; it makes sense to let the market develop a bit before taking action. But waiting too long can be perilous. As time passes and the product becomes established, its proponents can become an entrenched constituency. This constituency can then mount a formidable opposition against attempts at regulatory intervention, even if that regulation is socially valuable.

In short, regulators have an unenviable task in balancing the risk of moving too soon against the risk of being too late. While this is a generic problem, in a new book chapter, I explore this issue in the context of new products in the securities market using three examples: cryptoassets, money market mutual funds, and exchange traded funds.

This dynamic is front and center in the battle over the regulation of cryptoassets. For the past few years, issuers, the SEC, courts, and others have engaged in a prolonged back-and-forth about whether, and which, cryptoassets are securities under the federal securities laws and, to the extent that they are, how they should be regulated. One substantial challenge that the SEC faces in taking regulatory action now against participants in the crypto ecosystem is that the market has been allowed to operate in a gray area—largely outside the securities regulatory system—for 15 years. In that time, it has gone from nonexistent to a trillion-dollar asset class.

Crypto defenders seem to take the view, sometimes explicitly, that, having let the industry operate this long in a gray area, it is unfair for the SEC to now adopt a hardline approach. Instead, they suggest, the SEC should have engaged in rulemaking specific to the crypto industry. The SEC’s unsympathetic response is that there is no need for special rulemaking because the agency is simply applying the flexible, fact-intensive test that the Supreme Court laid down in SEC v W J Howey Co 77 years ago. As a legal matter, the SEC seems to have the better argument: One need not like the Howey test to recognize that it is the controlling precedent. But time seems to be on the crypto industry’s side. Presumably, if the SEC had decided to pursue enforcement against, say, crypto exchanges when they first emerged, it would have been much harder for the industry to object.

One possible takeaway from the discussion of cryptoassets is that, rather than let the market experiment on its own, a regulator would be wise to allow experimentation within the confines of the regulatory regime. This takes us to money market funds. Unlike cryptoassets, money market funds have long operated with the formal blessing of the SEC via the promulgation of Rule 2a-7. The standard account of money market funds is that they were created in the 1970s in response to the Regulation Q interest-rate caps at banks. While they are formally mutual funds, they function—and are used—more like bank accounts.

Because of this, at least some commentators recognized that money market funds posed potential prudential risks well before the 2008 global financial crisis. Those risks materialized in September 2008, and again in March of 2020. Yet a multi-trillion-dollar market is well positioned to push back against aggressive regulatory action. As I discuss in the chapter, that’s exactly what happened. Notwithstanding its shaky track record, the industry beat back stringent regulation after the 2008 crisis (and indeed, the relatively modest reforms that were implemented may have exacerbated the problems in 2020). While there is some indication that the SEC may take action now, it appears—based on a reading of the regulatory tea leaves—that such action is again likely to be incremental. Simply put, too much time has passed, and the market has grown too large, for it to be otherwise.

Based on this account, one might think that the lesson is to nip these products in the bud. But it would be ridiculous to argue that innovation is uniformly bad for markets or market participants. Even the more modest conclusion, that regulatory permission to deviate from the norm leads to bad outcomes, does not necessarily apply generally. Take, for example, ETFs: Like money market funds, they rely on exemptions from other SEC rules regulating mutual funds. For most of their existence, the only way to operate ETFs was through individual exemption letters—the first of which was granted in the early 1990s—from the SEC.

What started as a bespoke product proved wildly popular. Unlike money market funds, plain- vanilla ETFs, which make up most of the market’s assets under management, appear to have little social downside. The SEC eventually changed the regulatory framework to accommodate these funds: Plain-vanilla ETFs no longer need exemptions and can instead rely on Rule 6c-11, adopted in September 2019.

Returning to the generic regulatory challenge, some themes emerge. All three of these examples are from a single regulatory setting (the securities laws). All three saw important developments over the last five years or so. Alas, even in that narrow setting, there isn’t a simple rule on when something becomes so entrenched that regulators’ hands are tied. All we can say with confidence is that regulatory options diminish as the size of the market grows. As a result, regulators have an extremely difficult job. Scholars and other observers would do well to remember this next time we’re tempted to pile on the criticisms.

Adriana Z Robertson is the Donald N Pritzker Professor of Business Law at the University of Chicago Law School.

This post first appeared on the CLS Blue Sky Blog and can be accessed here.