Trading Places: Securities Regulation, Market Crisis, and Network Risk

Abstract:     
The rising power of traders has fundamentally transformed financial market networks and risks. Further, the increased complexity of traded securities and trading strategies within financial networks has magnified shortcomings of existing industry risk management practices as well as dominant regulatory regimes. Financial markets are ultimately places where people trade. Broader social and technological changes have altered the nature of trading activities in financial markets. Innovations in technology, financial instruments, and trading strategies have increased financial market efficiency but have also transformed sources of financial market risks. Financial market networks heighten the need for fundamental rethinking of financial market regulation and reassessment of ways both regulators and market participants can better manage risk. This article evaluates the importance of financial networks and related factors such as globalization, complexity, and secrecy for financial markets. This article argues that, as recommended in a recent Department of Treasury Blueprint for future financial market regulation, U.S. adoption of a modified "Twin Peaks" model of regulation may provide for more efficient and effective regulation of financial market activities and risk and help avoid future market crises. This model would move portions of regulatory oversight of existing functional regulators such as the Securities and Exchange Commission into new regulatory bodies that regulate by objective and would establish a separate regulatory function for market risk and market stability oversight. Adoption of this model, combined with the establishment of specific core financial market regulatory principles, should enable regulators and market participants to manage risk more effectively.

Keywords: trading, securities regulation, compensation, credit crisis, risk, financial market regulation, SEC, derivatives, globalization, secrecy, incentives, regulation, financial market reform, financial networks

JEL Classifications: K22

Working Paper Series