Yesterday, the U.S. Treasury reached out to Fools to hear our community's thoughts about investor protection and financial regulatory reform. October has been a busy month. So far this month, House committees have passed bills to:

And today, the House Financial Services Committee begins to consider a package of legislation that will:

  • Establish a fiduciary duty for brokers, dealers, and investment advisors.
  • Toughen oversight of credit rating agencies like Moody's (NYSE:MCO) and McGraw-Hill's (NYSE:MHP) Standard & Poor's.
  • Strengthen investor protection and disclosure.
  • Require registration of private pools of capital (i.e., hedge funds).
  • Establish a Federal Insurance Office to monitor all aspects of the industry.

You submitted a number of important and timely questions. Neal Wolin, Deputy Secretary of the U.S. Treasury, has provided answers below.

The Motley Fool: What provisions in today's investor protection bill should be of particular interest to the ordinary investor?

Neal Wolin: Thanks so much to the community here for your interest and for giving me a chance to post today. We think the legislation under consideration today, together with the rest of the President's proposed reforms, will go a long way toward making our financial system stronger and safer. Clearly, that's in everyone's interest. And there are two elements of today's investor protection bill that, I think, should be of particular interest to ordinary investors.

First, the Administration has worked with Congress to require that all investment professionals be held to the same high standard when they give investment advice. The old divisions between a broker-dealer who just executed trades and an investment advisor have broken down. The legislation under consideration today would require that both broker-dealers and investment advisors consider the client's best interest when giving advice. This is a simple standard, but it's not the law today.

Second, the Administration is fighting for disclosure of mutual fund fees prior to the purchase of a mutual fund. Some in the mutual fund industry are trying to weaken or strike this provision, but we're standing up for transparency. Mutual funds should not be allowed to hide the fees from investors when they make a purchase.

TMF: The usual rationale for having credit default swaps (CDS) is that despite their danger, they function like insurance. If that's the case, (a) why do we allow naked CDS, and (b) shouldn't CDS be regulated as insurance products?

Wolin: When used properly -- and when regulated properly -- credit default swaps can serve a number of valuable economic functions. For example, CDS allow financial institutions to hedge the credit risks in their loan books -- making the firms safer and enabling them to increase credit availability in the economy.

CDS markets also provide a valuable amount of transparency for the debt markets. CDS markets tend to be substantially more liquid than the corporate bond and ABS markets, and hence provide a much greater amount of more timely information about the credit quality of debt issuers and instruments. Accordingly, CDS are an important source of market discipline for firms.

The Administration's plan will provide a regulatory framework for CDS and other over-the-counter (OTC) derivatives that will enable our financial system to keep the benefits of CDS while significantly reducing the risks that unregulated CDS markets could pose to our financial system. For example, the risks created by CDS stem primarily from dealers and other major financial firms who sell the products but don't hold enough capital or collateral to meet their contractual obligations on the CDS. That's where AIG (NYSE:AIG) went wrong. And that's why we're proposing capital requirements and close supervision of all those firms that deal in CDS or are major participants in the CDS markets. Additionally, our proposals will push a substantial portion of the CDS market onto exchanges and into central clearinghouses. We are requiring unprecedented transparency -- so that regulators, market participants, and the public can follow the transfer of risks across the landscape of complex financial products.

TMF: Will all derivatives contracts be traded on a single, transparent exchange?

Wolin: The Administration has proposed, and two House Committees have now approved, legislation that would comprehensively regulate the over-the-counter derivatives market for the first time. These derivatives reform bills would require central clearing and centralized trading of standardized derivatives between dealers and major market participants, full regulatory transparency and substantial public transparency for all OTC derivatives, strong prudential regulation of all OTC derivative dealers and major market participants, and enhanced tools for the SEC and CFTC to prevent fraud and manipulation in the derivatives markets.

Under this regime, we would expect a significant migration of derivatives to exchanges or other transparent centralized trading systems. The proposed reforms do not, however, require derivatives to be traded on a single exchange. Competition among exchanges and other transparent centralized trading platforms should result in better service and lower prices for users.

TMF: On the issue of resolution, even if the government had the authority, seizing a Citigroup (NYSE:C) or an AIG in itself could cause the system to collapse. The problem isn't just authority. It is size and interconnectedness. Would a systemic regulator be empowered to ban instruments that are (a) unpredictable and (b) dangerous if they go wrong? Are there any financial products you think we should eliminate?

Wolin: The Administration has put forward a comprehensive and robust plan to address the problem of large, complex, and interconnected financial firms. Our plan includes several key elements: ensuring that any financial firm that could pose a threat to financial stability is subject to thorough supervision; imposing extra capital requirements on large firms and firms that engage in risky activities; building larger buffers throughout the financial system and in the critical nodes of the financial market architecture; and giving the government the tools to wind down failing firms in an orderly way -- imposing losses on management, shareholders, and creditors, but preventing the spread of contagion to the rest of the financial markets. Our plan will improve market discipline and reduce moral hazard by making the financial system safe enough and strong enough to withstand the failure of a major firm.

TMF: Many of our readers want to know what the major drawbacks would be to reinstating Glass-Steagall. We often hear that reinstating these historic regulations isn't practical. But why? What harm would it do?

Wolin: First of all, I think it's important to recognize that the recent financial crisis was not caused by the combination of commercial banking, investment banking, merchant banking, and insurance underwriting. In fact, some of the most spectacular collapses of this crisis were those of specialized firms, such as government-sponsored housing enterprises, monoline thrift organizations, monoline insurance companies, and stand-alone investment banks.

In addition, the financial distress at several of the diversified firms was not caused, at the core, by the combination of commercial and investment banking operations. Their problems stemmed more from poor credit underwriting in traditional lending activities.

It's also important to recognize that there are benefits to combining commercial banking and some forms of investment banking and other activities. Diversification can be a real strength. In addition, we should keep in mind that going back to Glass-Steagall would put American banks at a disadvantage internationally, where they have to compete with large universal banks on the European model.

We do, of course, think that it's critical that large, complex financial institutions be subject to strong regulation and supervision. And, by the way, supervisors can require asset sales or require firms to exit a line of business if the activity is determined to threatening to the firm's safety and soundness. We've advocated for higher capital requirements and stronger firewalls between banks and their affiliates. And we've also made clear that these firms must do a far better job of managing risk. They must hold sufficient buffers against the risks they take. If they don't, their shareholders and creditors must bear the losses.

TMF: What's the line between safeguarding consumers and permitting financial innovation? If one has to be sacrificed, which way do you prefer to lean?

Wolin: We shouldn't have to choose between safeguarding consumers and permitting financial innovation. The lack of clear rules in the past has made consumers victims of the wrong kind of innovation. The firm that could make its products look best by doing the best job of hiding the real costs won. For example, we had "teaser" rates on credit cards and mortgages that lured people in and then surprised them with big payment increases.

President Obama's proposal for a Consumer Financial Protection Agency will encourage innovation and restore consumers' control over their own financial decisions by creating and enforcing clear, common-sense rules of the road.

The best way to foster innovation is to set a level playing field for the whole market. The Consumer Financial Protection Agency will set ground rules and make sure that consumers get simple, transparent and accurate information. This will give families confidence that financial firms will play by the rules and treat them fairly. When consumers choose products and services that best suit their needs, based on clear and simple information, providers will compete to meet the real needs of American families.

What do you think? Will these proposals help protect investors and reform markets? Let us know in the comments box below.

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