RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES:

TOOLS FOR CRAFTING SOUND FINANCIAL REGULATION

Heath P. Tarbert†

I. Introduction1

The fundamental objective for any government agency overseeing financial markets and
institutions should be sound regulation. And how we regulate is just as important as what we
regulate. Every major financial regulator in the world employs, to varying degrees, two primary
methods of regulation: principles-based and rules-based. In this article, I discuss the key
advantages of each of these forms of regulation. I also offer some considerations for determining
when a principles-based, a rules-based, or hybrid approach to regulation is the most appropriate.
That is to say, I outline a number of “rules for principles” and “principles for rules” for achieving
sound regulation. Finally, I consider some real-world applications of this framework as applied to
our modern and increasingly digital markets.

As the Chairman of the Commodity Futures Trading Commission (CFTC or Commission),

my focus will be on the CFTC and its agenda.2 Among my goals is reinvigorating the CFTC’s
primarily principles-based approach to regulation where appropriate. Such an approach can
provide enormous flexibility in rulemaking and enable the CFTC—the world’s premier derivatives
regulator—to stay ahead of the curve by reacting more quickly to changes in technology and the

†
Chairman and Chief Executive, Commodity Futures Trading Commission. The opinions, analyses, and conclusions
expressed in this Article are mine and do not necessarily reflect the views of other Commissioners or the
Commission itself.
1
This Article is based on a presentation I gave at the Annual Robert Glauber Lecture, JFK Jr. Forum, Harvard
University, Cambridge, Massachusetts on October 24, 2019. I want to thank all the participants for their helpful
comments, particularly the Honorable Bob Glauber, former Under Secretary of the Treasury for Domestic Finance
and former professor at the Harvard Business School. See
https://www.cftc.gov/PressRoom/SpeechesTestimony/opatarbert3. I also want to thank Matthew Daigler for his
outstanding assistance in the preparation of this Article.
2
The CFTC regulates U.S. derivatives markets—including futures, the vast majority of swaps, and certain types of
options. These markets see over $4 trillion in notional activity in the United States each day. See Heath P. Tarbert,
Why the CFTC is the Most Important Regulator You’ve Never Heard Of, FOX BUS. (Jul. 29, 2019),
https://www.foxbusiness.com/financials/why-the-cftc-is-the-most-important-regulator-youve-never-heard-of.
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES 2020

marketplace.3 At the same time, I consider the circumstances where a more prescriptive, rules-
based approach is preferable. In pursuing this endeavor, I have been able to build on the work and
ideas of a number of former CFTC Commissioners and Chairs of diverse backgrounds and political
affiliations.4

At the outset, I note that in developing this analytic framework and applying it to concrete
regulatory initiatives, I have been guided by Aristotle’s maxim on methodology: “Our discussion
will be adequate if it has as much clearness as the subject-matter admits of, for precision is not to
be sought for alike in all discussions. . . .”5 Evaluating the factors that lead us to a more principles-
based or rules-based regulatory approach is dependent on facts and circumstances that are, by their
nature, complex and subject to change. We should therefore resist the urge to demand more
certainty from this inquiry than it admits.

II. Background

The CFTC has a unique history and tradition of being a principles-based regulator.6
Loosely stated, this means that the CFTC relies more on clearly stated principles to achieve
regulatory objectives than it does on compliance with detailed, prescriptive rules. The CFTC has
generally been more of a principles-based regulator than other U.S. regulators, in particular our
sister agency, the Securities and Exchange Commission (SEC).7

The Commodity Futures Modernization Act of 2000 (CFMA),8 which was signed into law
by President Clinton, solidified the CFTC’s status as a principles-based regulator. Based on a

3
See, e.g., Sam Woods, Deputy Governor for Prudential Regulation and Chief Exec. Officer, Prudential Regulation
Auth., U.K., Stylish Regulation, Speech at the UBS Financial Institutions Conference, Lausanne (May 16, 2019),
https://www.bankofengland.co.uk/-/media/boe/files/speech/2019/stylish-regulation-speech-by-sam-
woods.pdf?la=en&hash=C63CBBE35E4CFEB15133D1B0D836A347757FD19D (noting the need for regulators “to
be sufficiently fleet of foot to respond to . . . shifts [in the financial system] before they create serious problems—in
short, regulation should be future-facing and keep fit for purpose”).
4
See, e.g., Bart Chilton, Comm’r, CFTC, Let’s Not “Dial M for Merger”: CFTC’s Principles-Based Regulation—A
Success Story, Speech at the Futures Industry Association, Law and Compliance Luncheon (Nov. 13, 2007),
https://www.cftc.gov/PressRoom/SpeechesTestimony/opachilton-4 (referring to “the CFTC’s successful (and sole)
exercise of principles-based regulation at the federal level in the United States”); Walter Lukken, Comm’r, CFTC,
Smart Regulation for the Global Marketplace, Remarks to the Federation of European Securities Commissions (Jun.
26, 2007), https://www.cftc.gov/PressRoom/SpeechesTestimony/opalukken-25 (noting that the CFTC “has been
successfully utilizing a principles-based approach for seven years”); J. Christopher Giancarlo, Comm’r, CFTC, 21st
Century Markets Need 21st Century Regulation, Address to the American Enterprise Institute (Sep. 21, 2016),
https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-17 (“If regulators are going to be effective
overseers of 21st century markets, we must repurpose our rules so that they can keep pace with the digital
transformation. It starts with recognizing that most of our legislative authority was written for last century’s human
markets. We must reconsider and repurpose our analog rules for today’s digital markets. At the CFTC, this can only
be done with a return to its traditional approach of principles-based regulation.”).
5
Aristotle, Nicomachean Ethics, trans. by W.D. Ross, Batoche Books, Kitchener (1999), Chapter 3. See John
Braithwaite, Rules and Principles: A Theory of Legal Certainty, 27 AUSTL J. OF LEGAL PHIL., 47–82, 48 (2002)
6
See, e.g., Chilton, supra note 4.
7
See id. Jerry W. Markham, Merging the SEC and CFTC—A Clash of Cultures, 78 U. CIN. L. REV. 537, 544 (2009).
8
Commodity Futures Modernization Act of 2000, Pub. L. No. 106–554, app. E, 114 Stat. 2763.
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES VOLUME 10

regulatory framework recommended by the CFTC staff,9 the CFMA added to the Commodity
Exchange Act (CEA)10—the CFTC’s governing statue—core principles for designated contract
markets (DCMs) and derivatives clearing organizations (DCOs).11 In layman’s terms, DCMs are
exchanges where derivatives are traded, and DCOs are clearinghouses where trades are centrally
cleared.12 While over time the CFTC has adopted a number of regulations to support and elaborate
on these core principles, such core principles continue to provide the overarching—principles-
based—regulatory framework for CFTC-regulated derivatives exchanges and clearinghouses.13

At the time the CFMA was enacted, other major jurisdictions were experimenting with
principles-based approaches. For example, in 2000, the United Kingdom passed the Financial
Services and Markets Act (FSMA).14 The FSMA set out key regulatory objectives that were
embodied in a set of broadly-stated principles rather than in detailed rules.15 Both the United States
and the United Kingdom came to the same conclusion: a principles-based oversight regime is more
effective than a rules-based system for overseeing financial services in this global technological
age.16

That premise was tested in the aftermath of the global financial crisis. In both the United
States and the United Kingdom, policymakers called their respective financial regulatory regimes
into question. Britain saw its Financial Services Authority (FSA) dissolved and replaced with a
“twin peaks” approach comprising the new Financial Conduct Authority and the Prudential

9
In 2000, the CFTC staff recommended a flexible framework for the futures market that would replace a one-size-
fits-all style of regulation with “core principles.” See U.S. COMMODITY FUTURES TRADING COMMISSION STAFF
TASK FORCE, A NEW REGULATORY FRAMEWORK (2000),
https://www.cftc.gov/sites/default/files/files/opa/oparegulatoryframework.pdf. The CFTC issued final rules adopting
this approach later in the same year. See A New Regulatory Framework for Clearing Organizations, 65 Fed. Reg.
78,020 (Dec. 13, 2000); A New Regulatory Framework for Multilateral Transaction Execution Facilities,
Intermediaries and Clearing Organizations, 65 Fed. Reg. 77962 (Dec. 13, 2000) (to be codified at 17 C.F.R. Part 1 et
al.).
10
7 U.S.C. § 1.
11
While the CFMA codified the CFTC’s new regulatory framework without significant changes, it varied in details
from the final rules adopted by the CFTC in 2000 (see supra note 9), which had not yet become effective. The
CFTC engaged in a further notice and comment rulemaking to implement the new statutory scheme established by
the CFMA. See A New Regulatory Framework for Trading Facilities, Intermediaries, and Clearing Organizations,
66 Fed. Reg. 42,256 (Aug. 10, 2001).
12
A clearinghouse is an intermediary between buyers and sellers. As the intermediary, or counterparty, to every
trade, the clearinghouse acts as the buyer for every seller and the seller for every buyer for every trade. By acting as
the counterparty for every trade, the clearinghouse helps mitigate counterparty risk by maintaining a matched book
and risk-neutral position. See, e.g., Annette L. Nazareth & Jeffrey T. Dinwoodie, Clearinghouse Regulatory Basics
for Swap Market Participants, GLOBALCAPITAL (Mar. 14, 2014),
https://www.davispolk.com/files/03.14.14.Clearinghouse.Regulatory.Basics.for_.Swap_.Market.Participants.pdf.
13
See 7 U.S.C. § 7(d) (Core Principles for Contract Markets); 17 C.F.R. Part 38 (Designated Contract Markets); 7
U.S.C. § 7a-1(c)(2) (Core Principles for Derivatives Clearing Organizations); and 17 C.F.R. Pt 39 (Derivatives
Clearing Organizations).
14
Financial Services and Markets Act 2000, c. 8 (Eng.).
15
See Julia Black et al., Making a Success of Principles-Based Regulation, 1 LAW & FIN. MKT. REV. 191 (2007).
16
See Walter Lukken, Comm’r, CFTC, It’s a Matter of Principles, Keynote Address at University of Houston’s
Global Energy Management Institute (Jan. 25, 2007),
https://www.cftc.gov/PressRoom/SpeechesTestimony/opalukken-23; Kern Alexander, Principles v. Rules in
Financial Regulation: Re-assessing the Balance in the Credit Crisis Symposium at Cambridge University, 10–11
April 2008, 10 EUR. BUS. ORG. L. REV. 169, 170–71 (2009).

3
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES 2020

Regulatory Authority. Policies associated with the former FSA—including an emphasis on

principles—fell out of fashion. Yet more than a decade later, it remains far from clear that it was
in fact a principles-based approach that caused vulnerabilities in financial markets. Some have
contended that the detailed, Basel capital rules mispriced and incentivized risk-taking.17 At the
same time, there is the unmistakable fact that for a principles-based approach to work, those
principles must be enforced. No principle, however noble, can be effective if it is ultimately left
toothless. Some scholars and officials have suggested this is what happened in the 2000s,
observing that principles-based regulation too often became synonymous with what they regarded
as a “light-touch approach.”18

The United States also revisited its financial regulatory framework in the wake of the global
financial crisis. There was little in the way of national consensus on what had gone wrong. Some
blamed federal government housing finance policies, which they believed incentivized ill-
conceived risk taking in the mortgage markets.19 Many argued that lax regulations produced moral
hazard at Wall Street institutions.20 Still others pointed the finger at a host of other purported
culprits, including accounting standards, securitization, and the Federal Reserve.21 Across the
pond, British commentators observed that “the USA’s rules-based regulatory framework did not
cope demonstrably better than the UK’s principles inclined system” during the financial crisis.22

17
See, e.g., Aurelio Gurrea-Martínez and Nydia Remolina, The Dark Side of Implementing Basel Capital
Requirements: Theory, Evidence, and Policy, 22 J. INT’L ECON. L. 125, 128 (2019).
18
See, e.g., Jill Treanor, US warns against light touch bank rules that ‘ended tragically’ for UK, GUARDIAN (Jun. 7,
2011), https://www.theguardian.com/business/2011/jun/07/us-warns-light-touch-regulations-banks (quoting
Timothy Geithner, U.S. Treasury Secretary, as saying: “The United Kingdom’s experiment in a strategy of ‘light-
touch’ regulation to attract business to London from New York and Frankfurt ended tragically”); see also Andrew
Bailey, The Future of Financial Conduct Regulation, FIN. CONDUCT AUTH. (Apr. 23, 2019),
https://www.fca.org.uk/news/speeches/future-financial-conduct-regulation (“Prior to the financial crisis, the light
touch era reflected a view that a greater emphasis on the private interests of firms, their owners and managers would
benefit all and thus the public interest. I tend to call this the ‘rising tide lifts all boats’ view of our world. But it
didn’t turn out that way—there were very clear losers, and the scale of that problem has emerged over a long period
of time.”).
19
See, e.g., PETER J. WALLISON, DISSENT FROM THE MAJORITY REPORT OF THE FINANCIAL CRISIS INQUIRY
COMMISSION, Am. Enterprise Inst. for Pub. Pol’y Research, (May 15, 2011), https://www.aei.org/wp-
content/uploads/2014/07/-dissent-from-the-majority-report_154941211677.pdf; and Peter J. Wallison, Three
Narratives About the Financial Crisis, 31 CATO J. 535, 535–36 (2011).
20
See, e.g., James Crotty, Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New
Financial Architecture’, 33 CAMBRIDGE J. OF ECON. 563, 575 (2009) (“The past quarter century of deregulation and
the globalization of financial markets, combined with the rapid pace of financial innovation and the moral hazard
caused by frequent government bailouts helped create conditions that led to this devastating financial crisis”);
SHEILA BAIR, BULL BY THE HORNS: FIGHTING TO SAVE MAIN STREET FROM WALL STREET AND WALL STREET FROM
ITSELF (Simon & Schuster reprint ed. 2013) at 16 (noting that the “deregulatory dogma” had “infected Washington
for a decade” and “[r]egulation had fallen out of fashion” and that “both government and the private sector had
become deluded by the notion that markets and institutions could regulate themselves”).
21
See, e.g., Steve Forbes, The Economic Disaster of 2008: Why It Can Happen Again, FORBES (Oct. 31, 2018),
https://www.forbes.com/sites/steveforbes/2018/10/02/the-economic-disaster-of-2008-why-it-can-happen-
again/#6deb83061996; Scott Hirst, Did Securitization Cause the Mortgage Crisis?, HARV. L. SCH. F. ON CORP.
GOVERNANCE AND FIN. REG. (Oct. 19, 2011), https://corpgov.law.harvard.edu/2011/10/19/did-securitization-cause-
the-mortgage-crisis/; Matthew O'Brien, How the Fed Let the World Blow Up in 2008, ATLANTIC (Feb. 26, 2014),
https://www.theatlantic.com/business/archive/2014/02/how-the-fed-let-the-world-blow-up-in-2008/284054/.
22
THE INST. OF CHARTERED ACCOUNTANTS, IN DEFENCE OF PRINCIPLES, (Mar. 2009), https://www.icaew.com/-
/media/corporate/files/technical/ethics/policy-briefing-ind-defence-of-principles-based-regulation.ashx?la=en.
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES VOLUME 10

Ultimately, Congress enacted the landmark Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (Dodd-Frank Act),23 which was broad in its scope and breadth. Some
federal financial regulators were rewarded, some chided, and others completely dismantled. The
CFTC fell into the first category. The futures markets regulated by the CFTC not only worked, but
worked extremely well during the financial crisis. Unlike the over-the-counter swaps market—
which the CFMA had forbade the CFTC from regulating—the futures markets were subject to full
price transparency, margining, and centralized clearing. Given the success of the futures markets,
it is my view that Congress likely determined that the CFMA was fatally flawed not because of
the principles-based approach that it codified into law but rather because the CFMA failed to apply
that approach to all derivatives across the board.

Instead of gutting the CFTC’s principles-based framework, Congress reinforced it. First,
Sections 725 and 735 of the Dodd-Frank Act updated the CFTC’s existing “core principles” for
derivatives exchanges and clearinghouses. Furthermore, Congress reversed the decision made a
decade earlier and explicitly mandated that the CFTC regulate swaps. The Dodd-Frank Act created
new concepts such as “swap execution facilities” and “swap data repositories” that in some ways
have replicated key features of the exchange-traded futures framework.24 For both of these new
entities, Congress extended many of the CFTC’s existing core principles, confirming the key tenets
of the longstanding flexible, principles-based approach. Indeed, the Dodd-Frank Act makes clear
that a swap execution facility “shall have reasonable discretion in establishing the manner in which
[it] complies with the core principles described in this subsection.”25 As a consequence, the
principles-based approach serves as the foundation for much of the CFTC’s current regulatory
framework for sound derivatives regulation.

III. Principles-Based vs. Rules-Based Regulation

In general terms, principles-based regulation reflects a transition away from detailed,

prescriptive rules toward high-level, broadly-stated principles that create standards by which
regulated firms must operate.26 Under this approach, firms are responsible for finding the most
efficient way of achieving regulatory objectives.27

23
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
24
Section 5h(f) of the CEA, as added by Section 733 of the Dodd-Frank Act, sets forth core principles for swap
execution facilities, 7 U.S.C. § 7b-3(f)(1)(B). Section 21 of the CEA, as added by Section 728 of the Dodd-Frank
Act, sets forth core principles for swap data repositories, 7 U.S.C. § 24(a)(f).
25
Commodity Exchange Act, 5h(f)(1)(B), 7 U.S.C. § 7b-3(f)(1)(B).
26
For good overviews of principles-based regulation, see Julia Black, The Rise, Fall and Fate of Principles Based
Regulation 1–36, (London Sch. Econ. Legal Studies Working Paper no. 17/2010),
https://core.ac.uk/download/pdf/17332.pdf; Dan Awrey, Regulating Financial Innovation: A More Principles-Based
Proposal?, 5 BROOK. J. CORP. FIN. & COM. L. 273, 282 (2011); Christopher Decker, Goals-Based and Rules-Based
Approaches to Regulation, UK DEP’T FOR BUS., ENERGY & INDUS. STRATEGY, Research Paper No. 8 (2018),
https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/714185/regulation
-goals-rules-based-approaches.pdf.
27
See, e.g., Arnold Kling, Why We Need Principles-Based Regulation, AM. ENTER. INST. (May 22, 2012),
https://www.aei.org/articles/why-we-need-principles-based-regulation. Of course, if the desired objective is not
made clear, principles-based regulation will not work. See Bob Zwirb & Steven Lofchie, CFTC Chair Heath Tarbert
Compares Benefits of Principles- and Rules-Based Regulatory Approaches, CADWALADER CABINET (Dec. 10,
2019), https://www.findknowdo.com/news/12/10/2019/cftc-chair-heath-tarbert-compares-benefits-principles-and-
rules-based-regulatory.

5
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES 2020

Principles-based regulation has the following general characteristics:

• Principles are drafted at a high level of generality to maximize flexibility and

breadth of application;
• Principles focus on objectives or outcomes, not specific conduct;
• Principles contain terms that are qualitative rather than quantitative; and
• Principles can be fleshed out by rules or other forms of guidance (both formal and
informal) as appropriate.

A common example of the difference between rules and principles involves speed limits.
A rule might say, “Do not drive faster than 55 mph.” A principle might say, “Drive carefully under
the circumstances” or “Drive prudently.”28

Of course, regulators may supplement principles with rules in cases where greater
granularity and precision are necessary or desired. Such rules may serve as safe harbors for
compliance. In other cases, industry and self-regulatory organizations (SROs) may be permitted
to formulate their own acceptable practices or rules and submit them to their regulator for approval.
A good example of this is the CFTC’s self-certification process for exchanges and clearinghouses
that introduce new products or services.29

Principles-based regulation is not intended to be “light-touch.” In my view, so-called light-

touch regulation is not really regulation at all; rather, it serves more of a monitoring function.30
That may make sense in isolated circumstances but is far from the kind of conduct regulation or
prudential supervision required in financial markets. Nor is principles-based regulation a
euphemism for deregulation. Instead, principles-based regulation is a different vehicle for
achieving the same regulatory objective or outcome as rules-based regulation. 31 It simply does so
in a way that is often more efficient and less burdensome than rules-based regulation, leaving space
for flexibility and innovation.

A. Advantages of Principles-Based Regulation

One of the key advantages of a principles-based approach is that it helps reduce the need
for volumes of regulations that seek to dictate every aspect of the behavior of an individual, firm,

28
A number of articles cite similar examples. See, e.g., Cristie L. Ford, New Governance, Compliance, and
Principles-Based Securities Regulation, 45 AM. BUS. L.J. 1, 6 (2008).
29
See CFTC & SEC, A JOINT REPORT OF THE SEC AND THE CFTC ON HARMONIZATION OF REGULATION, at 3 (Oct.
16, 2009), https://www.sec.gov/news/press/2009/cftcjointreport101609.pdf (“Under the CEA’s principles-based
approach to oversight, applicable to exchanges and clearinghouses as established by the CFMA, in most cases, rule
filings are made under self-certification procedures”).
30
To give one example of light-touch regulation, consider the Bank Service Company Act (BSCA). 12 U.S.C. §§
1861–1867(c). The BSCA governs situations where a bank arranges, by contract or otherwise, for another party to
perform its applicable functions. Many of those functions are nonfinancial and more operational in nature, such as
information systems or data processing. Arguably, the BSCA was too high-level and barely enforced. Regulators
have arguably been slow to issue clarification and guidance regarding the supervision of third-party service
providers. This absence of clear guidance—“light-touch” regulation—has led to supervisory failures at certain firms.
31
See supra note 18.
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES VOLUME 10

or market. As Winston Churchill so aptly put it, “If you make 10,000 regulations, you destroy all
respect for the law.”32 Churchill was arguing against the burdensome regulation of industry by the
post-war Labour Government in 1945–51, which hampered market development in Great Britain
by creating what he saw as an unfriendly regulatory environment. Today, Titles 12 and 17 of the
U.S. Code of Federal Regulations (C.F.R.), which regulate banks as well as SEC and CFTC-
regulated financial exchanges and firms, exceed 13,000 pages. One can only wonder what
Churchill would make of the entire C.F.R.—nearly 200,000 pages in length—were he to see it
today.

The following are some of the more specific advantages of principles-based regulation.

1. Simplicity

A smaller number of principles can reduce regulatory complexity. Complexity can impede
compliance as sometimes only the most well-financed and sophisticated firms can expend the
resources necessary to comprehend all the nuances of the detailed rules promulgated by regulators.
This is a particular challenge for new or smaller entities facing competition from their well-heeled
and long-established counterparts that have deep familiarity with establishing effective compliance
programs. The fact is that the more detailed, complex rules we adopt, the more difficult it is to
comply with them. Regulations should be as simple and concise as possible to achieve their
objectives.33

32
WINSTON S. CHURCHILL, IN THE BALANCE 21 (Randolph S. Churchill ed., 1st ed. 1952).
33
The point of having laws is for people to follow them. But before they can follow them, they first have to be able
to grasp how to comply with them. As Judge Learned Hand put it ninety years ago, “The language of the law must
not be foreign to the ears of those who are to obey it.” The more complex rules or regulations are, the more likely
people are to get mired in details. LEARNED HAND, Is There a Common Will?, in THE SPIRIT OF LIBERTY: PAPERS

7
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES 2020

2. Flexibility

Principles-based regulation generally promotes a more flexible regulatory approach. Very

specific rules can quickly become ossified, frozen in time while our markets continue to change
and digitize. By contrast, a principles-based approach can evolve over time as markets and
behaviors change. Principles-based regulation provides greater flexibility for both regulators and
regulated entities alike to adapt to market developments and changing technology.34

3. Addresses Over/Under-Inclusion Problem

Rules are almost inevitably over- or under-inclusive. As Professor Cass Sunstein has noted:

Conduct that is harmful, and that would be banned in an optimal system, will be allowed
under most imaginable rules, because it is hard to design rules that ban all conduct that
ought to be prohibited. . . . Rules, in short, are under-inclusive as well as over-inclusive if
measured by reference to their background justifications.35

Professor Sunstein’s point is that, when applied to particular sets of circumstances, rules either fail
to capture conduct that a regulator might want to include, or capture conduct that a regulator might
not want to include. Principles-based regulation can help avoid this problem by establishing clear
and objective standards that regulated entities are required to meet without setting forth rules that
may be under- or over-inclusive.

4. Promotes Innovation

By offering flexibility for regulated firms to determine how to comply with core objectives,
principles-based regulation can facilitate the development of new business models, products, and
internal processes. It also can lower compliance costs, which are particularly felt by new market
entrants. Principles-based regulation thus encourages market innovation, which is central to
economic growth and prosperity.

5. Discourages Loophole Behavior

Principles-based regulation also discourages “loophole” behavior and “checklist” style

approaches to compliance with the law. Because clearly articulated principles are hard to
manipulate, creative compliance is more difficult. By contrast, rules may allow actors to comply
with the “letter of the law” but not the “spirit of the law.” This can lead to evasion of regulatory
requirements. As Professor Sunstein has noted, “Because rules have clear edges, they allow people
to ‘evade’ them by engaging in conduct that is technically exempted but that creates the same or
analogous harms.”36

AND ADDRESSES OF LEARNED HAND 56 (Irving Dilliard, 3d ed. 1960) (quoting from address before the American
Law Institute in 1929).
34
See Woods, supra note 3.
35
Cass R. Sunstein, Problems with Rules, 83 CAL. L. REV. 953, 995 (1995).
36
Id.
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES VOLUME 10

6. Creates Better Supervisory Model

Principles-based regulation can help promote dialogue between regulators and regulated
firms. This can create a more collaborative approach to regulation, particularly for firms that mean
well, but simply fail to understand what complicated and highly prescriptive rules may require.37
Dialogue is good not just for regulated entities, but for regulators as well: collaboration makes
regulation more insightful and effective because it gives regulators on-the-ground feedback from
those working to comply with the regulatory regime.

7. Facilitates International Cooperation

Principles-based regulation helps to promote comparability and convergence among

international regulators. While different national regulators rarely agree on specific, granular
rules—in part because of differences in markets and statutory mandates—they nonetheless
frequently can reach consensus on principles. This creates the possibility for regulators to develop
high standards for market behavior that transcend national boundaries.

B. Advantages of Rules-Based Regulation

None of this is to say that a rules-based approach is never desirable. Rules-based regulation
has distinct advantages over principles-based regulation in certain circumstances. The following
are its main advantages:

1. Greater Clarity

Rules-based regulation can provide greater clarity than principles-based regulation in

certain situations. In supplying more details than high-level objectives, rules can provide a clearer
standard of behavior for regulated entities. In various cases, this may make a more rules-based
approach easier to apply consistently, which some have argued can promote competition because
unclear regulation serves as a barrier to entry.38

2. Avoids Retrospectivity

Rules-based regulation may also avoid creating situations where regulators act
retrospectively—that is, treat past conduct as unlawful when it was not clearly known to be
unlawful at the time. This is a potential danger of a principles-based approach to regulation, which
can tempt regulators to treat behavior as unlawful without proper notice and opportunity to
comment.39 Such a situation risks offending due process and undermining regulatory credibility.

37
See Black et al., supra note 15, at 195.
38
See Peter J. Wallison, Fad or Reform: Can Principles-Based Regulation Work in the United States?, AM. ENTER.
INST. (June 2007), http://www.aei.org/wp-content/uploads/2011/10/20070611_21829JuneFSOg.pdf (arguing “[a]
rules-based system . . . is transparent and promotes competition by making market entry easier”).
39
Even a rules-based approach may fall short of the mark in this regard. Professor John Braithwaite argues that
lawmakers are mistaken in the belief that by writing more rules they can always limit the discretion of regulators.
On the contrary, he writes: “The opposite is the truth: the larger the smorgasbord of [specific] standards, the greater
the discretion of regulators to pick and choose an enforcement cocktail tailored to meet their own objective. A

9
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES 2020

3. Provides a Potential Safe Harbor against Private Litigation

The more litigious a jurisdiction, the more market participants may prefer prescriptive
rules.40 Rules often can provide an effective “safe harbor” from private litigation. Where market
participants can clearly demonstrate that they have complied with the law, they have a strong
defense in the event they are subject to civil litigation. This is much harder to do when the market
participant is subject to more basic principles, the application of which is less clear. At the same
time, however, it is more difficult to prove a breach of a principle than it is to prove a rule has not
been complied with.

4. Avoids Inappropriate Race to the Top

Rules-based regulation may help avoid a blurring of the distinction between minimum
standards and best practices. With the unpredictability and potential hindsight-driven enforcement,
market participants subject to a principles-based regime may feel compelled to adhere to best
practices, even when they are not actually “best” for their particular circumstances.41 By having
prescriptive rules, market participants are able to comply without having to exercise greater
judgment about whether their attempt at compliance fulfills a principles-based goal.

C. Practicality of a Hybrid Approach

In practice, it is rare for there to be pure principles-based regulation or pure rules-based

regulation. Pure principles and pure rules are the two points at the ends of the regulatory
spectrum.42 Every principles-based regulatory regime has some rules, and every rules-based
regime has some element of principle. For this reason, we frequently see blended or hybrid
regulatory systems of principles and rules.

Principles-Based Rules-Based
Regulation Hybrid Regulation

proliferation of more specific laws is a resource to expand discretion, not a limitation upon it.” Braithwaite, supra
note 5.
40
See Wallison, supra note 38 (“[A] principles-based system would be precluded by the existence of the private
class action litigation system. A principles-based regime depends for its effectiveness on a government regulator that
is able to exercise discretion in deciding whether to enforce the rules through litigation or to obtain compliance
through less formal means. The characteristic element of a private class action enforcement system, however, is that
it operates outside any form of government control or priority-setting except the rules laid down by courts.”).
41
See Steven L. Schwarcz, The ‘Principles’ Paradox, 10 EUR. BUS. ORG. L. REV. 175, 183 n.48 (2009) (arguing that
“an actor who is, or feels he is, subject to unpredictable liability for varying from a principle is likely, especially if
he would be a ‘deep pocket’ in future potential litigation, to hew to the most conservative interpretation of the
principle, effectively acting as if subject to a rule.”).
42
See, e.g., Awrey, supra note 26, at 275; James Surowiecki, Parsing Paulson: Paulson Plan to Regulate Financial
Markets, THE NEW YORKER, (Apr. 28, 2008). https://www.newyorker.com/magazine/2008/04/28/parsing-paulson.
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES VOLUME 10

In some cases, the emphasis is on core principles, in other cases on detailed rules.43 The
bottom line is that a principles-based approach rarely can eliminate entirely the need for rules.
Rather, as former CFTC Commissioner Walter Lukken has observed: “[A] principles system is a
hybrid of desired public outcomes complemented by specific rules aimed at achieving those ends.
Each regulatory authority—depending on the maturity of its markets—will need to find the optimal
balance between the flexibility of principles and the legal certainty provided by rules.”44 Thus, the
choice is not either/or, but more a question of striking the appropriate regulatory balance.45

IV. Factors for Applying Principles and Rules

There are four main categories of factors that should be considered in determining the
appropriate mix of principles and rules in a regulatory system, namely: (1) regulatory objectives,
(2) nature of the market/subject matter, (3) attributes of market participants, and (4) qualities of
the regulator. I discuss considerations for each category in turn.

A. Regulatory Objectives

The first category to consider is the regulatory objective—i.e., the desired goal or outcome
of the regulatory program. The following factors should inform the decision of whether principles
or rules best advance the regulatory objectives.

1. Prudential Supervision

The first factor is whether the objective of regulation is prudential supervision. Prudential
requirements (e.g., capital, margin, and risk management) are often very complicated. That is so
because businesses are complex—they vary in size, business lines, products, and riskiness.
Formulating detailed rules to address prudential requirements across businesses is thus very
difficult. That is particularly true with respect to macroprudential supervision, which focuses not
on individual institutions but on the safety and soundness of the financial system as a whole, i.e.,
systemic risk mitigation.46 Accordingly, a more principles-based approach to prudential regulation

43
See, e.g., Decker, supra note 26, at 44 (“In short, a prudently designed blend of approaches may, in some contexts,
bring significant benefits by allowing for the limitations of each approach to be compensated by the benefits of the
other approach.”).
44
See Lukken, supra note 4. In a slightly different context, Cristie Ford writes: “An appropriate balance between
rules and principles in securities regulation may look quite different from the appropriate balance in other regulatory
arenas. The nature of the industry being regulated, the roles of the various players in it, and the risks associated with
that area of conduct will inform the regulatory design process.” Cristie L. Ford, Principles-Based Securities
Regulation in the Wake of the Global Financial Crisis, 55 MCGILL L.J. 257, 268 (2010).
45
See ABA Business Law Section, Comment Letter on Commodity Future Trading Commission’s Request for
Public Input on Project KISS (Sep. 29, 2017),
https://comments.cftc.gov/PublicComments/ViewComment.aspx?id=61488&SearchText= (“[R]egulators should not
be confined to choosing between solely prescriptive and solely principles-based in all cases. Rather, the appropriate
choice in any given circumstance may be a balance between the two approaches that will achieve a particular
regulatory objective while also avoiding unnecessary complexity and undue burden on those subject to the rules.”).
46
See, e.g., Paul Tucker, Banking Culture: Regulatory Arbitrage, Values, and Honest Conduct, Address at the
Institute for Law and Finance Conference on Bank Culture and Ethics, (Nov. 23, 2015) (transcript available
athttp://paultucker.me/wp-content/uploads/2019/12/BANKING-CULTURE.pdf) (noting that “[c]onduct regulation
is quite different from stability policy”).

11
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES 2020

may be more appropriate for prudential supervision than trying to develop detailed, prescriptive
rules for varying businesses and risk profiles.

2. Need for Quick Action

The need for quick regulatory responses can dictate the decision to apply principles or
rules. Regulators have a number of tools for providing immediate relief in appropriate
circumstances, such as no-action letters and exemptive relief. However, these solutions are by
nature impermanent. By contrast, principles-based regulation can provide a more durable solution
when quick action is needed to address market behavior. It is normally easier to promulgate higher-
level principles than more voluminous and granular bodies of rules, which require significant time
and resources to create. Principles may develop into detailed rules over time, but can provide an
immediate antidote to situations demanding a quick response.

3. Involvement of Senior Management

Regulators should also consider whether direct involvement of senior management in

regulatory compliance is desired. Principles-based regulation is premised on the idea that, in
certain cases, firms and their management are better placed than regulators to determine what
processes are most desirable within their businesses to achieve a given regulatory objective.47 In
such cases, principles-based regulation encourages the more direct involvement of C-suite or other
senior management rather than relying on lower ranking compliance personnel. This situation can
improve the “tone at the top” while achieving buy-in from company leaders. By contrast, a rules-
centric regime can push compliance planning lower in an organization because it leaves less space
to craft solutions.

4. Multiple Compliance Alternatives

A fourth factor is whether there are multiple ways to achieve the desired regulatory
outcome. Often it is the case that firms can comply with a regulatory objective in more than one
way. Rather than prescribing detailed rules to mandate one approach over others, regulators can
rely on principles-based regulation to give regulated entities flexibility in how best to achieve a
desired objective. Such an approach can make financial markets more efficient by allowing firms
themselves to choose the most cost-effective way of complying with a specific regulatory
objective. However, when there is only one way of complying with a requirement, a rules-based
approach is usually preferable.

5. Market Conduct or Disclosure Regulation

An additional factor in considering principles versus rules is whether a chief objective of

the regulation is market conduct or disclosure. Unlike prudential requirements, market conduct
and disclosure rules are often aimed at protecting retail investors. Unlike institutional investors,
retail investors generally do not have the power and the leverage to negotiate terms of their

47
See Black et al., supra note 15, at 192 (noting that the “regulators, instead of focusing on prescribing the processes
or actions that firms must take, should step back and define the outcomes that they require firms to achieve”).
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES VOLUME 10

arrangements with market intermediaries, and they may lack the resources to protect their own
interests by monitoring intermediaries’ performance. Accordingly, a rules-based approach may be
appropriate when the regulatory objective is to safeguard retail investors through market conduct
rules, disclosure regulation, and related customer-protection efforts.

6. Malum in se Behavior

Clarity is a key regulatory objective in many situations, but is especially important in

matters involving prohibitions on conduct. Regulators should in particular consider whether the
rule targets behavior that is generally malum in se (“evil in itself”). In cases where behavior is
malum in se, a flat prescriptive rule prohibiting the behavior is often preferable to a general
principle. An example is fraudulent activity, which is clearly deleterious conduct that serves no
legitimate market function. Rules-based clarity is especially important when the regulated person
or entity is less sophisticated, as bright-line standards ease compliance burdens and cleanly
separate lawful from unlawful behavior.

B. Nature of the Market/Subject Matter

The second category to consider is the nature of the market or subject matter of regulation.
The following are a number of factors that should be considered under this category.

1. Possibility of “Gaming”

An initial factor is whether detailed rules can be easily “gamed.” Broadly stated principles
require firms to focus on how to comply with the purpose of the rule rather than using a “check-
the-box” approach to conform merely to the letter of the law.48 Thus, principles-based regulation
can lead to a greater degree of compliance by regulated firms where gaming is possible.

Moreover, more specific rules can at times lead to gaps and inconsistencies, which
encourage “creative compliance.”49 As regulators adjust to these situations by creating new rules
to address the gaps, still further gaps are created that can be exploited—or “gamed”—by regulated
entities.50 Principles-based regulation can address this risk by creating broad standards that are not
easily circumvented by efforts designed to comply in form but not function.

2. Need for Frequent Updating

Another factor is whether specific rules governing behavior or processes require frequent
updates. Principles-based regulation enhances the responsiveness of regulation to market
innovation and other developments. This has the effect of increasing the durability of the principles

48
See id. at 195.
49
See Sunstein, supra note 35. See also Doreen McBarnet & Christopher Whelan, The Elusive Spirit of the Law:
Formalism and the Struggle for Legal Control, 54 MODERN L. REV. 848, 849 (1991).
50
See Black, supra note15, at 193; McBarnet & Whelan, supra note 49, at 873 (“New situations arise and new rules
are produced to deal with them. But new rules cannot control creative compliance . . . . [N]ew rules simply mean
new games.”).

13
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES 2020

and reducing the need for constant amendment, which can help “future proof” regulatory
requirements.

A notable example is where compliance involves the use of economic or mathematic

models subject to further refinements and constantly updated and changing data. In such cases, it
is extremely difficult—if not impossible—to enshrine one particular model in regulation. This
makes a principles-based approach more desirable than rules-based regulation where a rule is
subject to frequently changing data inputs.

3. Rapidly Changing Technology

The speed of technological change must also be considered. In rapidly changing markets,
a rules-based approach risks falling behind the curve and becoming quickly outdated. It is often
difficult for regulators to keep up with changes in the marketplace and technological
advancements. 51 Overly prescriptive rules may hamper innovation and impede progress. In
markets regulated by the CFTC, too much prescription can have a detrimental effect, not only on
intermediaries, but also on the end users who rely on the derivatives markets to hedge their
commercial risk.52 Principles are preferable in rapidly changing environments, as they offer the
flexibility to address new and unforeseen situations.

4. Market Maturity

Similar to the prior factor, regulators should consider whether the regulated market and its
products are in a nascent phase. New markets are prone to great change, both in terms of structure
and product offerings, particularly in the early years. Prescribing detailed rules too soon may retard
this development, whereas a principles-based approach may incubate growth while retaining
regulatory oversight. Over time, principles can develop into rules as market dynamics warrant.

5. Durability of Specific Rules

Whether specific rules governing behavior or processes are likely to stand the test of time
is an additional factor to consider. A rules-based approach is most effective when regulators are
able to adopt rules that can endure. As we saw earlier, rapidly changing markets are rarely good
candidates for rules-based regulation because detailed rules can quickly become outdated. But
when regulators can work with interested parties to craft rules that will endure, regulatory

51
See, e.g., Dawn DeBerry Stump, Regulation: Principles Rather than Prescription, FOCUS (Oct. 2019),
https://focus.world-exchanges.org/articles/regulation-principles-rather-prescription (“I believe the markets regulated
by the CFTC have been well served by regulatory principles that are nimble enough to adapt, and that rigid
regulations are simply not well suited to a constantly evolving marketplace. Writing prescriptive regulations simply
renders the rules outdated almost as soon as they are constructed. Core principles that can be applied flexibly yield
better results by encouraging innovation, while also achieving a high standard of integrity through serious
compliance expectations.”).
52
As I have previously noted: “In leading the CFTC, I will not lose sight of the underlying purpose of our
derivatives markets: to serve the needs of everyday Americans. These instruments touch all corners of the real
economy—from farmers and ranchers who need to hedge grain and cattle prices, to manufacturers and exporters
who need to manage exchange-rate fluctuations. In regulating these financial instruments, the CFTC serves as a
guardian of our free-enterprise system.” Tarbert, supra note 2.
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES VOLUME 10

compliance is more effective. The only thing arguably worse than a bad rule is a constantly
changing one.

6. Standard Forms or Disclosures

A final factor is whether the subject matter involves standard forms or disclosures.
Regulators frequently establish reporting or registration forms or otherwise impose specific
disclosure requirements. In such cases, a rules-based approach is preferable to a principles-based
approach. The standardization of forms and disclosure requirements makes it easier for regulators
to analyze information and compare institutions, thereby enhancing oversight. A principles-based
regime is often a poor choice where standard forms and disclosures are heavily used, as principles
do not offer the needed precision.

C. Attributes of Market Participants

The third set of factors to consider relates to the attributes of market participants. The
following are a number of factors that should be considered under this category.

1. Sophistication

Whether participants are generally “sophisticated” is a key factor in selecting a principles-

based or rules-based approach. The appropriate regulatory approach may depend on whether the
participants in the market are retail or institutional.53 Principles-based regulation is often more
appropriate where sophisticated entities or investors are involved, while rules-based regulation has
been typically used for safeguarding retail investors. Sophisticated entities or investors are
generally better able to protect their own self-interest than retail investors. If not, they generally
have the financial wherewithal to hire someone to do so. For this reason, more prescriptive
regulations are often targeted at protecting retail investors more than institutional investors—e.g.,
disclosure requirements, sales practice obligations, and eligible contract participant rules.

2. Information Asymmetry

A second factor is whether information asymmetry exists among market participants.

Principles-based regulation works best when there is not information asymmetry among market
participants.54 In that case, rules are not as necessary to address situations in which one party has
an embedded advantage—structural or otherwise—over another party. For example, as noted
above, institutional markets, where all participants have generally the same information and can
look out after their own interests, generally need fewer rules to function efficiently and properly.

53
See, e.g., Roel C. Campos, Comm’r, SEC, Principles v. Rules, Speech at the Luxembourg Fund Industry
Association and the American Chamber of Commerce (Jun. 14, 2007),
https://www.sec.gov/news/speech/2007/spch061407rcc.htm (with respect to the U.S. securities markets, Campos
noted that if the United States “didn’t have a large retail sector, then we might be in the position to provide basic
principles and do less enforcement. That, however, is not the world we live in.”).
54
See Awrey, supra note 26, at 291.

15
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES 2020

3. Internal Compliance Systems

Whether participants have existing extensive internal compliance systems is a further factor
to consider. The effectiveness of principles-based regulation is often dependent on the level of
experience firms have in regulatory compliance matters. The more experienced a company is, the
more likely it will be able to implement high-level principles effectively because it will have
familiarity with crafting internal compliance systems. By contrast, less experienced firms may
benefit from prescriptive rules that lay out, in a more detailed manner, what their compliance
obligations are.

4. Presence of a Self-Regulatory Regime

An additional factor is whether participants are subject to supervision by an SRO. SROs

are generally closer to market participants than are regulators. As a result, they generally have a
better understanding of the businesses and operations of market participants than governmental
regulators do. In such cases, it may make sense for a regulator to adopt general principles in an
area while directing or encouraging the SRO to impose more specific rules. SRO-based systems
are often good examples of hybrid systems, as a regulatory authority promotes broad-based
principles that SROs subsequently translate into detailed rules.

D. Qualities of the Regulator

The fourth category to consider is the qualities of the regulator. The following are a number
of factors that should be considered under this category.

1. Nature of the Regulatory Relationship

An overarching factor is whether there is a high level of trust and frequent interaction
between the regulator and the regulated entity. Principles-based regulation requires close
collaboration between regulators and regulated parties with respect to their supervisory
relationships. This increases senior management responsibility and engagement in the regulatory
process. In addition, when determining how to implement principles, it is helpful to have people
in key compliance positions who have worked closely with regulators in the past. This generally
leads to better compliance.

2. Information Asymmetry

As markets develop, regulators often lack the knowledge or expertise to regulate them
effectively. This can lead to an “asymmetry of information” between regulators and the regulated.
Adopting core principles that can guide market development, without imposing cumbersome and
detailed rules, may be a preferable approach when the information available to regulators is
significantly less than the information available to regulated entities. This is particularly true in
markets subject to rapid technological change. In CFTC-regulated futures markets, for example,
rules that may work for an open-outcry trading pit may be completely inappropriate for an
electronic market.
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES VOLUME 10

3. Risk of Private Litigation

Another factor is the absence of private litigation as a tool to reinforce the regulator’s
regime. A more principles-based approach may not be desirable when companies are subject to a
significant risk of private litigation. As noted in Section 3 above, rules may provide an effective
“safe harbor” from private litigation. By contrast, a principles-based regime might very well
encourage more lawsuits.

4. Overseas Coordination

A final factor is whether the regulator closely coordinates with its overseas counterparts to
ensure international standards are satisfied. Principles-based regulation helps to promote
comparability and convergence among international regulators. As noted in Section 7 above, while
different national regulators rarely agree on specific rules—in part because of differences in
markets and statutory mandates—they nonetheless can frequently reach a consensus on high-level
principles. For this reason, the CFTC has been a leader in a range of international standard-setting
bodies and workstreams. 55 The CFTC’s engagement with non-U.S. counterparts in multilateral
committees and fora has furthered the development and implementation of a number of key
principles and standards.

E. Visualizing the Factors

The table below provides a visual depiction of the four general categories and the factors
that support them. The table is intended to be a helpful reference point for regulators confronted
with finding the appropriate balance between principles and rules.

Principles Rules
Regulatory Objective
• Prudential Supervision X
• Need for Quick Action X
• Involvement of Senior Management X
• Multiple Compliance Alternatives X
• Market Conduct or Disclosure Regulation X
• Malum in se Behavior X
Nature of the Market/Subject Matter
• Possibility of “Gaming” X
• Need for Frequent Updating X

55
As the overseer of one of the world’s oldest and largest derivatives markets, the CFTC plays a leadership role in
the development of common standards for global derivatives markets. The CFTC is a leading participant in work
streams and committees in the International Organization of Securities Commissions (IOSCO), as well as other
international bodies such as the Financial Stability Board (FSB) and the Committee on Payments and Market
Infrastructures (CPMI). The CFTC currently chairs the following international committees: Chair, IOSCO Cyber
Task Force; Chair, IOSCO Financial Stability Steering Group; Co-Chair, FSB Working Group on UTI and UPI
Governance; and Co-Chair, CPMI-IOSCO Policy Standing Group.

17
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES 2020

Principles Rules
• Rapidly Changing Technology X
• Market Maturity X (if nascent) X (if mature)
• Durability of Specific Rules X
• Standard Forms or Disclosures X
Attributes of Market Participants
• Sophistication X (if yes) X (if no)
• Information Asymmetry (among market
X (if no) X (if yes)
participants)
X (if X (if less
• Internal Compliance Functions
experienced) experienced)
• Presence of a Self-Regulatory Regime X
Qualities of the Regulator
X X (non-
• Nature of the Regulatory Relationship
(collaboration) collaboration)
• Information Asymmetry (between regulators
X (if yes) X (if no)
and regulated)
• Risk of Private Litigation X (if low) X (if high)
• Overseas Coordination X

V. Potential Applications of Principles-Based and Rules-Based Approaches

As noted above, regulators often use a hybrid approach in order to capture benefits offered
by both principles-based and rules-based regulation. Using the framework outlined above, I now
consider regulatory initiatives that the CFTC may undertake and analyze whether they are better
suited to a more principles-based or rules-based approach, or a hybrid of the two.

A. Automated Trading

In 2015, the CFTC proposed rules that were a comprehensive regulatory response to the
evolution of automated trading on U.S. exchanges.56 Historically, U.S. derivatives markets have
relied on manual processes for the origination of orders, transmission of information, and trade
execution for on-exchange transactions. Today, however, derivatives markets have transitioned
from manual processes to highly automated trading and trade matching systems.57 Trading
facilities have reasonable discretion in crafting rules that govern how orders may interact on their
systems.58 This has led to an increase in the complexity of trading systems and markets.

The CFTC’s proposed rules, known collectively as Regulation AT, represent a series of
risk controls, transparency measures, and other safeguards to enhance the U.S. regulatory regime

56
Regulation Automated Trading, 80 Fed. Reg. 78,824 (Dec. 17, 2015) [hereinafter Regulation AT]; Regulation
Automated Trading, 81 Fed. Reg. 85,334 (Nov. 25, 2016) [hereinafter Regulation AT Supplement].
57
See Regulation AT, supra note 56, at 78,825.
58
See, e.g., supra note 24 and accompanying text.
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES VOLUME 10

for automated trading.59 The over-arching objective of the proposed regulation was to guard
against events that might lead to market disruptions or manipulation (e.g., a “flash crash”).60

In its proposal, the CFTC noted a preference expressed by commenters61 for a principles-
based approach rather than prescriptive regulations.62 Commenters pointed out that prescriptive
requirements would become obsolete and stifle innovation because of developments in technology
and market practices. They also maintained that prescriptive requirements may not account for the
unique characteristics of market participants. In their view, the end result of rules-based regulation
would allow for participants to design evasion measures that could undermine the new
regulations.63

Consistent with the comments received, the CFTC subsequently attempted to take what it
believed was a more principles-based approach in this area. In a supplemental proposal, the CFTC
sought to provide greater discretion to regulated persons, particularly with respect to the
development and testing of algorithmic trading systems.64 I believe the CFTC was correct in
moving to a principles-based approach in this area, but it did not go far enough.

Automated trading is an area of rapid technological development. It requires tailoring rules

for implementation in ways that best consider the technical intricacies between firms and
exchanges. For this reason, prescriptive rules are likely to become obsolete very quickly. Also,
because exchanges have flexibility in how they develop trading rules, there may not be one method
of compliance that would adequately address the risks created by automated trading. Finally, I note
that each exchange is itself an SRO and is actively involved in monitoring its participants. For
these reasons, I have directed the CFTC staff to reconsider the 2015 proposal in order to formulate
an even more principles-based approach to regulating automated trading. The goal is to develop
risk principles without impeding technological development and market innovation, while still
preserving the benefits of regulatory oversight in this area.

B. Position Limits

Position limits is another area where the CFTC has struggled to find the appropriate
regulatory balance. Position limits are intended to prevent any person from exerting undue control
over a market in a particular futures contract where there is physical delivery. For example, in a
commodity with 200,000 open contracts, an order to buy 80,000 contracts could impede the ability
of parties to deliver the physical underlying commodity at contract expiration. The main point of

59
See Regulation AT, supra note 56, at 78,824; Regulation AT Supplement, supra note 56, at 85,334.
60
See, e.g., Andrei Kirilenko et al., The Flash Crash: The Impact of High Frequency Trading on an Electronic
Market, 72 J. OF FIN. 967, 968 (May 5, 2014),
https://www.cftc.gov/sites/default/files/idc/groups/public/@economicanalysis/documents/file/oce_flashcrash0314.p
df; Mary J. White, Former Chair, SEC, Enhancing Our Equity Market Structure, Speech at Sandler O’Neill &
Partners, L.P. Global Exchange and Brokerage Conference (Jun. 5, 2014),
http://www.sec.gov/News/Speech/Detail/Speech/1370542004312#.VKP_o6xOlaS.
61
Comments were responding to a prior CFTC concept release. See Concept Release on Risk Controls and System
Safeguards for Automated Trading Environments, 78 Fed. Reg. 56,542 (Sept. 12, 2013).
62
See Regulation AT, supra note 56, at 78,837–78,838.
63
See id. at 78,338.
64
See Regulation AT Supplement, supra note 56, at 85,353, 85,349, n. 119.

19
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES 2020

position limits is to avoid enabling anyone to manipulate prices to their own benefit while hurting
others, most especially through corners or squeezes.65 Furthermore, these markets are mature, are
largely domestic in nature, and have been around for decades.66

In contrast with automated trading, position limits is an area where rules-based regulation
is more appropriate than principles-based regulation. Specifically, market participants need to
know the precise position limits that are established in the various classes of commodities in order
to plan their business operations efficiently—i.e., they need clarity and transparency. A rules-based
approach in this area also helps avoid potential litigation, where market participants might be
subject to uncertain standards of conduct. In addition, establishing precise position limits prevents
the CFTC from retrospectively applying its regulations to market participants, providing certainty
to the markets.

At the same time, some aspects of a position limits rulemaking will warrant a more
principles-based approach. For example, in providing exceptions for bona fide hedging from
application of position limits requirements, it is appropriate to take a more principles-based
approach. This is particularly true because the nature of hedging varies dramatically depending on
the type of company engaged in the activity. For example, an energy company hedging natural gas
futures may use very different techniques and methods than a cereal or banking company that is
exposed to the price of wheat. Overly prescriptive rules might be over-inclusive, inappropriately
subjecting genuine hedgers to position limits.67

C. Cross-Border Regulations

Applying the CFTC’s rules in the cross-border context is an area where it is appropriate to
take a more hybrid approach. For example, the Dodd-Frank Act requires persons engaged in
dealing activity in swaps to register with the CFTC as “swap dealers” and be subject to substantive
regulatory requirements.68 Non-U.S. dealers typically engage in swaps with both U.S. and non-

65
See, e.g., Heath P. Tarbert, Making Derivatives Markets Work for American Agriculture, AM. FARM BUREAU
FED’N (Jan. 22, 2020), https://www.fb.org/viewpoints/making-derivatives-markets-work-for-american-agriculture
(“If correctly calibrated, these limits could prevent corners or squeezes, which are nefarious tactics to manipulate the
market by intentionally driving up or down prices during the last days of a contract. Position limits also could reduce
the likelihood of chaotic price swings created by excessive speculation, or when prices reflect the gamesmanship of
traders rather than real supply and demand.”); Position Limits for Derivatives, 78 Fed. Reg. 75680, 75681 (Dec. 12,
2013) (“With respect to the position limits that the Commission is required to set, CEA section 4a(a)(3) guides the
Commission in setting the level of those limits by providing several criteria for the Commission to address, namely:
(i) To diminish, eliminate, or prevent excessive speculation as described under this section; (ii) to deter and prevent
market manipulation, squeezes, and corners; (iii) to ensure sufficient market liquidity for bona fide hedgers; and (iv)
to ensure that the price discovery function of the underlying market is not disrupted”).
66
For example, Henry Hub is a distribution hub on the natural gas pipeline system in Erath, Louisiana for U.S.
natural gas futures and has been in operation since the 1950s. See Don Briggs, The Center of the Natural Gas
Universe, DAILY ADVERTISER (Jun. 19, 2017),
https://www.theadvertiser.com/story/opinion/columnists/2017/06/19/center-natural-gas-universe/408389001/.
67
At my direction, the CFTC has recently considered—and approved—a revised position limits proposed
rulemaking along these lines. See Position Limits for Derivatives, 85 FR 11596 (Feb. 27, 2020).
68
In brief, a person is required to register with the CFTC as a swap dealer if the swaps connected with its swap
dealing activities exceed an aggregate gross notional amount threshold of $8 billion (measured over the prior 12-
month period). See De Minimis Exception to the Swap Dealer Definition, 83 Fed. Reg. 56,666 (Nov. 13, 2018).
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES VOLUME 10

U.S. persons, which raises the question whether the non-U.S. dealers have to count trades with
non-U.S. persons toward determining whether they must register with the CFTC as swap dealers.69
In applying registration requirements to non-U.S. dealers, the CFTC is committed to establishing
clear rules to enable non-U.S. dealers to know what dealing swaps they have to count toward
determining their registration status.70 A principles-based approach could lead to uncertainty and
confusion, as different firms might take different views regarding which particular swaps need to
be counted toward the swap dealer registration threshold.

By contrast, when it comes to applying substantive requirements (e.g., capital, margin, etc.)
to non-U.S. swap dealers that are already registered with the CFTC, we have proposed a
“deferential” approach to cross-border regulation. I believe the CFTC should rely on other
jurisdictions to supervise activities conducted largely in their jurisdiction so long as they have
implemented a regulatory regime that achieves comparable outcomes to the CFTC’s. This allows
non-U.S. entities to register as swap dealers with the CFTC but comply with home country
regulation for the most part. It thus avoids duplicative and overlapping regulation.

Over the last decade, the Group of 20 Nations (G20) have moved toward harmonizing the
regulation of derivatives.71 There are many opportunities to build on these accomplishments. 72 For
example, the CFTC has made a number of comparability determinations for foreign regulatory
regimes in the areas of clearing, trading, and swap dealer requirements.73 These determinations
have largely been made using an outcomes-based approach, where the CFTC looks at the outcomes
or objectives guiding a foreign regulatory regime rather than making a detailed rule-by-rule
comparison. I have directed the staff to consider whether more substituted compliance
determinations are appropriate.

69
Title VII of the Dodd-Frank Act added Section 2(i) to the CEA (7 U.S.C. § 2(i)). “Section 2(i) provides that the
CEA does not apply to swaps activities outside the United States except in two circumstances: (1) where activities
have a “direct and significant connection with activities in, or effect on, commerce of the United States” or (2)
where they run afoul of the Commission’s rules or regulations that prevent evasion of Title VII. Section 2(i)
evidences Congress’s clear intent for the U.S. swaps regulatory regime to stop at the water’s edge, except where
foreign activities either are closely and meaningfully related to U.S. markets or are vehicles to evade our laws and
regulations.” See Heath P. Tarbert, Chairman, CFTC, Statement of Chairman Heath P. Tarbert in Support of the
Cross-Border Swaps Proposal (Dec. 18, 2019),
https://www.cftc.gov/PressRoom/SpeechesTestimony/tarbertstatement121819.
70
See Cross-Border Application of the Registration Thresholds and Certain Requirements Applicable to Swap
Dealers and Major Swap Participants, 85 Fed. Reg. 952 (Jan. 8, 2020) (proposed rule). See also Interpretive
Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292 (Jul.
26, 2013).
71
See FINANCIAL STABILITY BOARD, IMPLEMENTATION AND EFFECTS OF THE G20 FINANCIAL REGULATORY
REFORMS (2018), https://www.fsb.org/wp-content/uploads/P281118-1.pdf.
72
See generally INT’L SWAPS & DERIVATIVES ASS’N, CROSS-BORDER HARMONIZATION OF DERIVATIVES
REGULATORY REGIMES: A RISK-BASED FRAMEWORK FOR SUBSTITUTED COMPLIANCE VIA CROSS-BORDER
PRINCIPLES (2017), https://www.isda.org/a/DGiDE/isda-cross-border-harmonization-final2.pdf.
73
“The CFTC has approved a series of comparability determinations that would permit substituted compliance with
non-U.S. regulatory regimes as compared to certain swaps provisions of Title VII of the Dodd-Frank Act and the
Commission’s regulations.” CFTC, COMPARABILITY DETERMINATIONS FOR SUBSTITUTED COMPLIANCE PURPOSES
(updated Feb. 4, 2020), https://www.cftc.gov/LawRegulation/DoddFrankAct/CDSCP/DoddFrankCDF5.html.

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RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES 2020

In addition, the CFTC recently proposed an alternative compliance framework for non-
U.S. derivative clearinghouses “that do not pose a substantial risk to the U.S. financial system.”74
Under this framework, those foreign clearinghouses may register with the CFTC but will be
deemed compliant with our core principles for derivative clearing organizations through
compliance with their home country regulatory regime.75 This proposal reflects a pragmatic
approach to oversight of foreign clearinghouses by using core principles instead of specific
regulations.76

Overall, the CFTC’s approach to cross-border matters is a hybrid of rules-based and

principles-based regulation. It is rules-based when regulatory certainty is desirable—i.e., in
determining registration status through clear and uniformly applied criteria. At the same time, it is
principles-based when coordination with foreign regulators is desirable—e.g., in applying
substantive requirements, where overlapping jurisdictions could impose duplicative and
conflicting requirements on market participants.

D. Digital Assets

Another area where principles-based regulation is generally appropriate is with respect to

developments in financial technology (fintech), including blockchain and digital assets.77
Emerging technologies and related market developments are prime areas for taking a more
principles-based approach to regulation to permit a period of development and observation. It is
my view that the United States must lead the world in this technology, and applying overly
prescriptive rules could stunt the development of this important market.78

74
Registration With Alternative Compliance for Non-U.S. Derivatives Clearing Organizations, 84 Fed. Reg. 49,072
(Sep. 18, 2019).
75
See id.
76
For example, the “Principles for Financial Market Infrastructures” (PFMIs) are the international standards for
financial market infrastructures—i.e., payment systems, central securities depositories, securities settlement systems,
central counterparties and trade repositories. Issued by the Committee on Payments and Market Infrastructures
(CPMI) and the International Organization of Securities Commissions (IOSCO), the PFMIs are part of a set of key
standards that the international community considers essential to strengthening and preserving financial stability.
See PRINCIPLES FOR FINANCIAL MARKET INFRASTRUCTURES (Apr. 2012), https://www.bis.org/cpmi/publ/d101a.pdf.
77
See, e.g., J. Christopher Giancarlo, Chairman, CFTC, Derivatives Regulatory Reform: A Principles-based
Software Upgrade, Remarks before the Sims Lecture at Vanderbilt Law School (Apr. 13, 2018),
https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo44 (“I believe the CFTC must reaffirm its
historic character as a principles-based regulator. The relentless advance of technology and evolution of market
structure requires a flexible, principles-based approach to oversight of some of the world’s most dynamic
commodity and financial derivatives markets.”); J. Christopher Giancarlo, Chairman, CFTC, Regulators and the
Blockchain: First, Do No Harm, Special Address Before the Depository Trust & Clearing Corporation 2016
Blockchain Symposium (Mar. 29, 2016), https://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-13
(“Much like the Internet, U.S. and foreign regulators must coordinate to create a principles-based approach for DLT
oversight in order to provide the flexibility, certainty and harmonization necessary for this technology to flourish.”).
78
See Press release, CFTC, Chairman Tarbert Discusses U.S. Leadership in Digital Assets on CNBC (Nov. 20
2019), https://www.cftc.gov/PressRoom/PressReleases/8082-19 (“I want the United States to lead, particularly in the
blockchain technology that underlies digital assets. . . . [U]ltimately I could see it overtaking the internet or being
effectively parallel to the internet in using a variety of different kinds of transactions, not just the financial system,
but in other types of transactions as well. . . . I think whoever ends up leading in this technology will end up writing
the rules of the road for the rest of the world. My emphasis is on making sure that the United States is a leader.”)
RULES FOR PRINCIPLES AND PRINCIPLES FOR RULES VOLUME 10

However, after we fully understand outcomes and potential risks in this developing area,
more tailored and targeted rules may be appropriate. This will be particularly important as retail
participation in the digital assets markets increases. Detailed sales practice and disclosure
obligation rules may be appropriate for these markets, as well as rules regarding the custodying of
customer assets.

While the market develops further, CFTC staff is considering how the core principles
applicable to derivatives exchanges and clearing organizations can be augmented given the rapid
developments in the fintech space. This may result in the CFTC adding core principles for
derivatives exchanges and clearing organizations, or it may necessitate the CFTC providing high-
level guidance regarding the application of existing rules and regulations to cutting-edge
developments.

VI. Conclusion

Historically, the CFTC has had the distinction of being a principles-based regulator. This
has allowed U.S. derivatives markets to evolve to meet the growing demands of our economy. At
the same time, it has enabled the CFTC to respond quickly to fast-moving crises and major market
developments in a way overly proscriptive regulations would not have permitted. Reinvigorating
our historical, principles-based approach, where appropriate, will help our markets remain fair,
innovative, and vibrant.

Based on the analytic framework outlined above, I have focused on areas where the CFTC
could reinvigorate its principles-based approach to regulation, and have identified areas where a
more rules-based approach is preferable. In some cases, this may require the CFTC to adopt
detailed, prescriptive rules (e.g., position limits). In other cases, it may require the CFTC to adopt
more principles-based regulations that set forth broad objectives and outcomes for regulated
parties to strive toward, without necessarily adopting rules that address every particular fact and
circumstance (e.g., digital assets). To be sure, we will focus on the right blend of principles and
rules to achieve the outcome of sound regulation.

I believe the CFTC should not confront this endeavor alone. These examples, and the
analyses upon which they are based, have a broader applicability. It is my hope that the CFTC’s
use of the framework set out in this article will encourage other financial regulators to reflect on
when principles-based regulation may achieve superior results than rules-based regimes, and vice
versa. The goal is not to create light-touch regulation or to engage in de-regulation. Rather, the
goal is sound regulation. And, at bottom, sound financial regulation is about using the right tools,
at the right time, and for the right reasons.79

79
See supra note 1.

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