As Treasury Secretary Henry Paulson’s plan to overhaul financial market regulation makes its way through Washington, the question is how could this impact broker dealers, asset managers and hedge funds. Would there be less regulation for the sake of global competitiveness as some opponents contend? And which entity would oversee the opaque world of OTC derivatives?

While there are many aspects to the sweeping blueprint for redesigning financial markets regulation - two of the most critical parts are the proposed merger of the SEC with the CFTC and the move toward principle-based regulation.

If the SEC, which is mainly led by lawyers and the CFTC, which is led by economists, were to merge, says Larry Tabb, founder and CEO of The TABB Group, “The SEC’s authority will be consolidated and the way they regulate will be significantly changed.” Since lawyers like to ”create rules and that’s generally not the way the CFTC works, there will be conflict between the two ways of approaching challenges in the markets and thinking about solutions,” says Tabb. He predicts the SEC will tilt its approach more to the way of the CFTC. If that happens, exchanges could get a break on all the red tape and time-consuming comment periods they endure to get new products and transaction fees approved, say sources.

“The process to change your pricing structure at the exchange level can take nine months, whereas on the CFTC, they work on a policy basis,” explains Tabb. “As long as you are comfortable with the pricing you issue, that’s fine with us,” says Tabb referring to the CFTC. So the futures industry can almost immediately change pricing, add new products and alter their market structure, while the equities and options exchanges cannot.

The Treasury plan is also urging Washington to adopt a principle-based approach to regulation, which is the way the CFTC works. Instead of a rule-based approach, which is what we currently have, a principle-based approach would regulate firms based upon the type of business they are doing. Tabb says, “This is very good in that you’ve got retail banks, commercial banks and to a certain extent hedge funds and investment managers all doing the same thing and all regulated in different ways, and in some cases, not being regulated at all. So trying to put a consistent approach to the activities you are involved in dictates how you get regulated instead of how you are registered,” says Tabb.

Still, the one area that I’m most intrigued with is the rise of the Federal Reserve as the ultimate supercop to police the capital markets firms. “The Fed will wind up basically regulating the broker-dealers which is in exchange for letting them have access to the discount window,” says Tabb. In fact, Paulson is proposing a Market Stability Regulator under the Fed, which would send in swat teams when they detect a problem. (Perhaps this would work well when hedge funds borrow 30 times their assets to bet on sub-prime mortgages and CDOs.)

Everyone says with the Fed giving investment banks the right to borrow funds at the discount window, this has opened up Wall Street firms to more regulatory scrutiny – perhaps in the form of audits or higher capital reserves to cover their positions in risky mortgage securities.

With the Federal Reserve rescuing Bear Stearns from bankruptcy and arranging the firesale to JP Morgan Chase, the Fed has proven it can intervene in a crisis and save the markets from systemic risk — even though it means using taxpayer’s money. But what about all these other regulatory bodies, i.e., the SEC, the Office of the Comptroller of the Currency, state regulators and FINRA, that send in auditors and supposedly scrutinize he balance sheets of what asset managers and brokers are doing? Well, they missed the boat on the credit crisis and didn’t notice that Bear Stearns was in trouble even when there rumors of a liquidity crisis. Is that why we’re sending in the Fed? Is it because we have too many regulators, that they are not seeing warning signs? “That is true as well,” says Tabb. “Depending upon the organization, different organizations are regulated differently and different products are regulated by different regulators,” says Tabb.

“As we move toward more cross-asset class trading or investment schemes it becomes much more difficult to regulate these transactions,” continues Tabb. If we have separate regulators for futures and cash instruments, it becomes much more difficult to regulate the whole transaction, he adds. “One set of regulators monitors the futures side, and one set monitors the cash side and certain OTC transactions are not regulated at all,” he says. “That’s why the Fed is stepping in.”

While no one expects Treasury’s plan for regulatory structural changes to be adopted in the near term — because this is an election year and the Bush Administration is in lame duck mode — many of the proposals such as the role of the Fed in regulating the broker are gaining traction. It will be interesting to monitor this as the debate unfolds.