Remarks of Chairman Heath P. Tarbert at the 2019 Annual Robert Glauber Lecture at Harvard University’s Institute of Politics

October 24, 2019

Remarks as Prepared for Delivery

Thank you so much. It is really terrific to be here tonight. Before the presentation, I’m supposed to say this disclaimer: the opinions, analyses, and conclusions expressed herein are those of the presenter (that’s me), and do not necessarily reflect those of other Commissioners or the Commission itself.  But, one day, I hope they will! So I’ll just put that out there.

One thing I don’t have to disclaim, however, is the admiration I have for Bob Glauber. Bob is truly a legend in both financial regulation as well as public leadership. I could actually spend two hours going through all of Bob’s career accolades, so I’m not going to do that tonight. But one of the things I will say, is that at least throughout my life and many others with whom I’ve spoken have said apart from family and friends one of the things you cherish in life are mentors. And I am privileged to have had Bob as a mentor. It’s not just me by the way. I know for many of you Bob is a current mentor. His mentees include, the Chairman of the Federal Reserve System, the Vice Chair of the Fed for Supervision, a former SEC chairman, and the list goes on and on.  So I will just say that the United States, Bob, is lucky to have had your leadership in government during those years. And this university is particularly, I think, honored to have had over 50 years of your service. So thank you so much, Bob. It’s an honor to be here.

So, tonight I thought, as Bob mentioned, I would talk about two basic types of regulation: what we call principles-based regulation and what we refer to as rules-based regulation, explain what they are, talk about the advantages and disadvantages of each, and then, for the first time in a forum, talk a little bit about how you would choose each approach—what are the factors. In other words, what are the principles for rules and what are the rules for principles?  And then finally, I wanted to share with you some actual real-world applications—things that at the CFTC we are actually working on—where we have to make decisions about do we think about it in a rules-based way or do we think about it in a more principles-based approach.

So why am I here at Harvard? Well, I am here at Harvard because I’m surrounded by some of the brightest minds in the country and throughout the world. And many of you are in this room. And so my hope is that by introducing some ideas here, I might get some feedback from all of you, you might even think about continuing research and discussion about it, so we can learn from all of you. And I will note that the mission of the Kennedy School, which I think is incredibly articulate and eloquent, the very last line of it says this: “The reason the Kennedy School exists is to have an impact on solving public problems that no other institution can match.” So I figured what better place to come and talk about this than right here at the Kennedy School.

So let me set the scene a little bit before we dive in on explaining to you—Bob did a great job of it, but I’ll just talk about it little bit more—who is the CFTC? What I often say is the CFTC is the most important regulator many people have never heard of. The mission of the agency is to promote the integrity, resilience, and vibrancy of the U.S. derivatives markets through sound regulation. Now, I’ve worked with all of the financial regulators in the United States in one form or another. And what makes the CFTC, I think, really unique is because the derivatives markets touch on all of the underlying markets. We effectively regulate everything from corn to crypto. So we have to know about agriculture, about energy, about financial markets, and now we find ourselves learning more and more about digital assets. So that, I think, makes the CFTC really unique because derivatives essentially touch everything.

The vision of the agency is to be the global standard for sound derivatives regulation. So both the mission statement and our vision statement, which we just created only a few weeks ago with the entire staff of the agency, both of them use that term, sound regulation. So what is sound regulation? Well the best I can explain it is sound regulation is about using the right tools at the right time for the right reasons.  And so one of the ways that we’re focused on using the right tools at the right time for the right reason are first distinguishing between how we regulate. Because how we regulate, in many ways, is just as important as what we regulate.

So the CFTC, as Bob noted, has a unique history and tradition of being a principles-based regulator. And this was codified by Congress—Congress recognized its importance—in something called the Commodity Futures Modernization Act back in 2000 where we took a series of core principles—principles that govern our exchanges as well as govern our clearinghouses—and we essentially codified them into law. At the same time, our fellows in the UK were doing something very similar. The Financial Services and Markets Act of 2000 also created a principles-based regime. And the interesting thing about principles-based regulation is that it’s not really ideological. There are a number of former Chairmen (including Chairman Massad, who is a fellow here at the Harvard Kennedy School and he was President Obama’s second CFTC Chairman) who have said principles-based regulation is a really important tool for our markets. In fact, one of the interesting features is that after the financial crisis, the CFTC was the only regulator not to lose jurisdiction and arguably not to be criticized. Indeed, what happened was Congress said the entire swaps market is largely unregulated and we want you take the approach that you’ve been using for futures and options and essentially apply it to swaps.  In many ways it was a validation of the principles-based approach the CFTC had been taking for a number of years. The whole entire point is to stay ahead of the curve. Now, there’s only one thing that is worse than falling behind the curve and that’s getting wiped out by it. There’s a very real chance that can happen if we don’t keep up and we don’t approach new markets. One of my goals is to reinvigorate a principles approach as it is one of the tools that you can use to stay ahead of the curve when things are rapidly changing.

So what is principles-based regulation? Principles-based regulation has a high level of generality. It’s flexible and can be applied broadly. If focuses on outcomes, not specific conduct. It’s also generally qualitative rather than quantitative. It’s also susceptible to elaboration. So when you have very specific rules, they become ossified. They become frozen in time to some extent, whereas a principles-based approach can be allowed to evolve over time as markets and behaviors change. Later in my presentation, I will provide some examples for when principles make sense and for when rules make sense. The other thing to talk about and make clear to everyone is what principles-based isn’t. Principles-based is not “light-touch.” Light-touch regulation is not really regulation in my opinion, it’s more of a monitoring function. Principles-based regulation is also not a euphemism for deregulation.

I think there’s a general consensus that we’ve had a little bit of an information overload in terms of rules. I think there’s also a consensus among everyone that for risk and other types of features involving our financial system, we shouldn’t treat Main Street institutions the same way we treat Wall Street institutions. So things have gotten a little bit out of hand. Regulation has grown quite enormous—a ten-fold increase since 1950. Winston Churchill of course said, “if you make ten thousand regulations, you destroy all respect for the law.” A principles-based approach sort of dispenses in some ways with the need for detailed rules and regulations that dictate every aspect of a firm’s possible behavior. So again, I’m not saying that rules-based doesn’t necessarily make sense, but what I am going to try to articulate is when it makes sense and when principles makes sense.

So what are the key advantages of a principles-based approach? Well number one, obviously, simplicity. A few principles can cover a lot more ground and reduce complexity. Flexibility – it’s much more adaptable. It avoids over and under inclusion. The moment you write a specific rule you’re excluding things and including things that maybe you didn’t want to include. It promotes innovation because it allows flexibility. And this is an important one: it discourages loophole behavior. We’ve had a number of situations where accounting rules and types of tax laws have been very, very specific and the overarching point of why we have these things is often lost. So people quote unquote “comply,” but they undermine the whole reason the regime is there to begin with. It also creates a better supervisory model. If something is principles-based, it actually creates much more work for the regulator. So you’re constantly working with the regulated firm to understand how they’re complying with your principles. The other thing it does, particularly in a globally interconnected world is it facilitates international cooperation. Higher-level principles can be agreed upon in a much more easier way than detailed, specific rules.

That said, principles-based regulation has some downsides and there are some advantages to rules-based regulation. In fact, many people on both the Libertarian Right and I’d say the far Progressive Left have actually criticized principles-based regulation and said you should go with rules-based regulation and there are some points we need to take into account.

So what are the key advantages of a rules-based approach? Well obviously, greater clarity. Being more specific leads to more consistency because everybody knows what you expect of them. It avoids retrospectivity. So in other words, it’s a lot easier to know when you’re about to violate a specific rule than whether or not you’re going to violate a principle. And you only find out the regulator disagreed with you and you violated the principle later on in time. This is what I call the “dark side of flexibility.” You know in advance whether or not you’re going to violate the regulations. It also protects against some private lawsuits. So you have a situation that if you have private lawsuits for certain financial behavior, and there are no clear regulations, but they are principles-based, you end up with the problem that lawsuits can effectively create the regime for you. So if you actually have a detailed rule book and someone accuses you of wrongdoing you can point to it and say, “no, we did follow the rules.” The other interesting thing, and this is really important, people have said one of the potential issues with principles-based regulation is not a race to the bottom, but rather a race to the top. That if you use principles-based regulation in a certain set of circumstances, it tends to sometimes blur minimum standards with best practices. And so you end up with people saying, “in order to comply with the principle, I need to use the gold standard.” So that’s really interesting. So those are some key advantages of a rules-based approach.

So how do we choose which approach to use? We’ve reviewed some of the academic literature, some of the other literature, and no one has given us a set menu and said, “here’s how you do it, Mr. Regulator.” So what we have done and what I have thought about is to propose to all of you tonight a framework for starting to think about how you choose rules versus principles. The first thing to mention is it’s not a false dichotomy; it’s not mutually exclusive. In many places you’ll see a hybrid approach where you choose some principles, you articulate what those principles mean, and a certain set of circumstances with rules, but you have both.  But I think at the end of the day, a regulator still has to decide are we going to have an emphasis on principles, are we going to have an emphasis on rules?

Well, I’d propose to you there are at least four categories you should look at. The first category are your regulatory objectives. Second, the nature of the market and actually the subject—what you are regulating. Third would be the attributes of market participants—who is in your market? And finally, you’ve got to look at yourself if you’re the regulator. Using these categories, what are the factors that lead us to choose principles-based regulation—where it makes more sense to choose principles?

So let’s take the first, regulatory objectives. Number one, you are more likely to choose a principles-based approach if a chief objective is prudential supervision. So prudential supervision is where you’re looking at the safety and soundness of institutions. You’re looking at things like capital, margin, and risk management where one-size-fits all approaches don’t necessarily work. Second, a situation where you need quick action. Quick action is needed for standards or guidelines for market behavior. You’ve got to get out there with something. Rules take time; specific rules take a lot of time. Principles can be fashioned much more quickly. A third factor would be: do you want the direct involvement of senior management in compliance? No CEO, CFO, or even a general counsel is going to read 13,000 pages of regulation. But I’ll tell you what, for our clearinghouses, we have 17 core principles. They’re pretty easy. You can read them in about five minutes. I’m almost certain that every CEO, every member of the board, as well as senior management of all of our clearinghouses have read these core principles. So it’s important. Also, another factor is if there are several different ways to achieve the desired regulatory outcome. So if we’re talking about something like cybersecurity where there’s various ways where you can set up defenses, if we’re talking about something like value at risk and various calculations and there are a number of scientifically and analytically validated approaches, then you may a apply a principle that at least requires them to do one or more of those.

The second category would be the nature of the market—the subject matter. You want to use principles in a situation where detailed rules could be easily gamed. Remember the accounting example or the tax code. If you have a check-the-box situation and it could lead to disaster, you want some principles in there to guide the overarching behavior. You also want principles where you have specific governing rules or processes would require frequent updates. Think about things that require mathematical models and economic data—if you’re continuing to have to change them. The average regulation probably lasts about 15 years. So once we come out with a detailed rule if it’s going to be useless a year from now, we probably want to go with principles. Similar point: if the area of regulation deals with rapidly changing technology, again we’re more likely to use principles. And finally, if the regulated market and its products are in the nascent phase. So in our area, we look at something like crypto assets versus hard red spring wheat—very different. It’s been around for at least 30 years, the same type of contract; you compare that to some of the new cryptocurrencies. Again, in that instance, principles-based probably makes more sense for rapidly changing nascent industries. We also want to look at the market participants. So if the participants are more sophisticated, you’re dealing with institutional markets. That’s one of the big reasons the CFTC has largely been principles-based. Closely related to that point is information asymmetry between the participants. Again, if people can look out for themselves largely, then you can go more with principles-based. If there’s a natural asymmetry between certain groups in the market, then you may need more detailed rules. Also, consider whether participants have extensive internal compliance functions. If they’re pretty sophisticated, they have internal compliance functions, you can rely more on principles. And then finally, ask if participants are subject to a self-regulatory regime. If there’s an SRO there, like the one Bob Glauber ran, where they are close to the industry participants and everybody agrees that there are certain standards of behavior, then the regulator doesn’t need to necessarily dictate the rules.

Last, we look at ourselves. If there is a high level of trust and frequent interaction between the regulator and the regulated entity, and we’re constantly interacting with them, that’s a place where you’re more likely to use principles. Consider whether there’s information asymmetry between the regulators and the regulated entity. So here what we’re talking about is when the regulator can’t possibly know as much as the people they’re regulating.  We don’t want to have specific rules in that case, we want to have more general principles. The private litigation point—if there’s not a lot of private litigation, then we’re more likely to use a principles-based approach. And then finally, if it’s an area where we’re coordinating—these are cross border markets—and we need to coordinate with our overseas counterparts, we’re more likely to use principles-based because they’re more like international standards.

So those are the instances where I’d say you want to use principles. We would use the same categories in thinking about when you’d use rules. Many of these are simply the reverse, though there are a couple that are unique. So first off, if your objective is market conduct or disclosure, you’re more likely to use rules-based regulation. If clarity is really important, you want to use rules-based. If the regulation targets behavior that is generally malum in se—that’s just Latin for bad in and of itself—you’re more likely to use a rules-based approach. Everybody agrees we don’t want falsifying documents; we don’t want unlicensed people. Well, there, you can write rules. You can clearly write rules to address those situations. And finally, if there’s just one way to comply with it, why not write a rule like a registration requirement, for example?

Looking at the second category, the nature of the market, the subject matter, you’re more likely to use rules if, number one, broad principles would just lead to confusion. There are some areas where it’s just going to be confusing. The market really needs clarity. Secondly, we look to see whether specific rules governing behavior or processes would likely stand the test of time. Okay, so here we’re not worried about things rapidly changing. Anytime you’re dealing with disclosures or standard forms—any kind of standardization—we want to use rules. And then finally, if you’ve got mature markets, they’re more likely a candidate for a rules-based approach.

We next look at the market participants, the third category. Well, if we’ve got a situation where we’ve got consumers, retail investors, and other unsophisticated participants and there’s asymmetry that’s natural, we’re going to use rules. And these two points may be the very reason why we have a difference between the CFTC and the SEC historically. Also again, sometimes participants say, “I don’t want flexibility, I don’t want to have to choose; I just want consistency and I want transparency.” In those instances, when you can, you’d use rules-based regulation. And then finally, you would go with a rules-based approach when there’s no self-regulatory regime.

And then lastly, look at the qualities of the regulator. If we the regulator don’t interact with market participants regularly, we see them once every few years—we’re probably going to rely more on rules because we can’t check up on them and have interactions to determine whether or not they’re complying with our principles. This one’s a bit counterintuitive: if the regulator must coordinate its regime with one or more domestic regulators, you’re more likely to use a rules-based approach. Any idea why that is? Well, number one, our fellow regulators like the SEC are pretty rules-based. So if they have a rules-based regime and we have a principles-based regime, we have the potential for regulatory arbitrage right here in our own country with very similar products. So, generally speaking, we should actually be able to do detailed rules in that case. Finally, the private litigation point—if private litigation is used, we don’t want an odd situation where rather than the expert financial regulator setting the rules, we have a patchwork of courts around the country that are deciding them. It needs to be the regulator themselves making the rules. So the private litigation aspect plays a role. And then finally, rules are more appropriate where the regulated market has little connection with overseas markets—so we’re not worried as much about regulatory arbitrage overseas. With things like consumer finance, where there’s not going to be a lot of spillage overseas; buying houses, mortgages, and things of that domestic nature.  So that in a nutshell, are some principles for rules and rules for principles.

And now, we have the pop quiz: real life situations in the derivatives markets. And so I’ll give you an area, and I’d like you guys to think about whether you’d choose a principles-based approach or a rules-based approach. And I’ll explain to you what the area is if you’re not familiar with it.

So, in closing, I would like to say earlier in the presentation I mentioned that the mission of the CFTC is to promote the integrity, resilience, and vibrancy of the U.S. derivatives markets through sound regulation. And I told you that, at least from my standpoint, I thought sound regulation was about doing the right things, using the right tools, at the right time, for the right reasons. And so I thought I would end with one of my favorite quotes by JFK, after whom the school is named as well as the forum here. And it is this:

“Let us not seek the Republican answer or the Democratic answer, but the right answer. Let us not seek to fix the blame for the past. Let us accept our own responsibility for the future.”

While I hope today that at least articulating some principles for rules and some rules for principles, I’ve at least gone a step in the right direction in focusing on that right answer. And I hope that in so doing, I’ve perhaps shed a little light in making a little sense of financial regulation. Thank you very much.