CFS Monetary Measures for August 2017

Today we release CFS monetary and financial measures for August 2017. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.1% in August 2017 on a year-over-year basis, maintaining the same growth rate as in July.

For Monetary and Financial Data Release Report:

For more information about the CFS Divisia indices and the data in Excel:

Bloomberg terminal users can access our monetary and financial statistics by any of the four options:

3) {ECST} –> ‘Monetary Sector’ –> ‘Money Supply’ –> Change Source in top right to ‘Center for Financial Stability’
4) {ECST S US MONEY SUPPLY} –> From source list on left, select ‘Center for Financial Stability’


SEC Committee on Small and Emerging Companies Makes Final Recommendations

The SEC Advisory Committee on Small and Emerging Companies (the “Committee”) met to review the Final Report of the Committee. The report included recommendations for future areas of focus including (i) capital raising by “emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization,” (ii) trading securities of these companies, and (iii) public reporting and corporate governance requirements for them. The Committee also reviewed the auditor attestation report under Section 404(b) of the Sarbanes-Oxley Act and the registration exemption under Securities Act Rule 701.

The Committee recommended that the SEC focus on facilitating exempt offerings for privately held small companies, asserting that legal costs and associated risks have made such offerings less attractive to broker-dealers, which in turn makes it difficult for small companies to find investors.

Specifically, the Committee noted that (i) non-registered entities are hesitant to take part in exempt offerings because there is significant uncertainty in the market about what activities require broker-dealer registration under the current definition of “broker” and (ii) companies seeking to comply with the rules find it difficult to determine when they can engage a “finder” or online platform that is not registered as a broker-dealer. As a remedy, the Committee encouraged the SEC to provide regulatory clarity in this area and to create a less burdensome avenue for small businesses to engage potential investors.

The Committee also proposed that the SEC should revisit the definition of “accredited investor” under Rule 506 of Regulation D, and to avoid raising the threshold to qualify as an accredited investor. The Committee supported potential revisions that would take into account the “sophistication” of investors, but cautioned against revisions on the basis of net worth or income.

With respect to reporting and corporate governance requirements, the Committee urged the SEC to finalize a rule that would expand the number of small businesses that qualify for “scaled disclosure requirements.” The Committee explained that, since the implementation of the JOBS Act, 87% of initial public offerings (“IPOs”) have qualified as emerging growth companies (“EGCs”) (companies with less than $1,070,000,0000 in gross revenue during its most recently completed fiscal year), and that IPOs have declined significantly in recent years. This decline was described as being a result of the high costs of compliance and disclosure requirements that impose undue burdens on small companies. The Committee expressed support for the rule that would allow smaller reporting companies to qualify for the same disclosure and reporting requirements as EGCs. Furthermore, the Committee suggested amendments to the “accelerated filer” definition to exempt certain smaller companies from Section 404(b) auditor attestation requirements.

The meeting also included a presentation by executives from Orrick and Warby Parker regarding amendments to Securities Act Rule 701. The executives recommended (i) removal of the “hard cap limit” that restricts the value of securities sold in reliance on Rule 701, (ii) increase of the “soft cap limit” from $5 million to at least $10 million, and (iii) exclusion of material amendments from calculation of either limit. The executives asserted that equity compensation is a crucial aspect of facilitating success for small businesses, and said that it can be “critical to recruit talent” for companies that are not able to offer competitive cash compensation.

Finally, the Committee made recommendations for facilitating secondary market liquidity through preemption of certain state registration requirements, continued monitoring of the tick-size pilot program and less strict listing requirements for smaller companies.

This was the final meeting of the current Committee, as the two-year term expires on September 24, 2017.

Lofchie Comment: New SEC Chair Clayton has pledged to focus on improving the ability of companies to raise money in the public markets at a reasonable cost. This is an important change to the persistent governmental mindset of “ever more regulation.” After almost a decade of regulatory explosion that has shaped the norms and expectations of government behavior, any real reduction in regulation seems extraordinary.

One aspect of the recommendations was odd: the notion that it is not clear who must register as a “broker.” Under the law, it’s actually pretty clear: just about anyone who touches a securities transaction must register as a broker. Legal clarity isn’t really the issue; the issue is whether there should be a real exemption from registration for private placement brokers or else a form of much lighter registration/regulation that looks more like the regulatory scheme that applies to investment advisers (which may not be light, but it is much lighter than the broker-dealer scheme).

Sargen: The Fed Begins to Shrink Its Balance Sheet


  • The Federal Reserve is expected to announce it will begin to shrink its balance sheet over the next few years at this month’s FOMC meeting.  Investors are pondering how smoothly the process will go.
  • Opinions on this matter are divided.  Some observers are concerned it could disrupt financial markets, but the prevailing view is it will not.
  • Another issue is whether monetary policy will ever be as it was before the 2008 Global Financial Crisis (GFC).  Our take is it has been permanently altered, because the transmission mechanism increasingly works through capital markets.
  • We believe the Fed will aim for the funds rate to reach 2% and will then pause.  The changing composition of the Board of Governors, however, adds an element of uncertainty in 2018.

The Controversy Surrounding Quantitative Easing

During the GFC the Federal Reserve engaged in unorthodox policies that were intended to stabilize the financial system and to encourage investors to add to holdings of risk assets.  The Fed did so by purchasing massive amounts of government securities and residential mortgage-backed securities (RMBS) that increased its balance sheet four-fold (Figure 1).  The initial round of quantitative easing (QE) is widely credited by economists as having stabilized the financial system and thereby averted an even worse outcome.  However, subsequent rounds were viewed more skeptically, as they occurred when the economy and markets had stabilized.

Figure 1:  Assets of the Federal Reserve ($ billions)

Source: Bloomberg and Federal Reserve.

The Fed’s intent was to encourage investors to add to risk assets such as corporate stocks and bonds, which would bolster the economy by creating a positive wealth effect and ease borrowing conditions for consumers and corporations.  From the Fed’s perspective, it was worth doing so in order to reduce the unemployment rate, which fell from a peak of 10% to below 4.5% recently.  One of the main criticisms, however, is that its actions also distorted capital market prices and thereby may contribute to another asset bubble.  Previously, the Fed primarily influenced short-term interest rates rather than the entire term structure and risk assets, so it would not distort capital markets.

Normalizing Monetary Policy

The ultimate test of the QE experiment is the Fed’s ability to develop a successful exit strategy.  The Fed’s staff has been working on a game-plan since the early part of this decade.  One of the first actions was the decision to pay interest on bank reserves.  By doing so, the Fed created an additional means to control bank reserves and thereby lessen the risk that the money supply would expand unduly once bank lending expanded materially.  Officials were also cognizant of mistakes their predecessors made during the Great Depression, when the Fed doubled reserve requirements and banks responded by reducing loans outstanding considerably.

One of the key differences today is that monetary policy works through capital markets, as well as through the banking system.  Therefore, the Fed ultimately must influence investors’ expectations by communicating its intentions clearly.  Policymakers learned this lesson all too well during the so-called “taper tantrum” in mid-2013, when Ben Bernanke mentioned in Congressional testimony that the Fed was considering winding down its purchases of securities in 2014.  Much to the Fed’s chagrin, bond yield surged by a full percentage point during the remainder of 2013 as investors believed the Fed was about to tighten monetary policy.

In light of this experience, some observers are concerned that a similar outcome could occur as the Fed pares its holdings of securities.  The prevailing view, however, is that this news already is priced into markets, and a spike in rates is only likely if there are surprise developments. Recognizing this, Fed officials have gone out of their way to reassure investors that it will shrink its balance sheet very gradually: It has stated that it will not sell securities outright, but will allow a portion to roll off its books as bonds mature.

The Fed also indicated at the June FOMC meeting that its balance sheet would eventually decline by $50 billion on a monthly basis ($600 billion annually) until it chooses to halt or reverse the process.  At this pace, the monetary base would revert to its pre-crisis growth trend by 2021. However, Fed watchers do not expect it to get there: Estimates vary, but the general consensus is the terminal size of the balance sheet the Fed range is around $2.5 trillion, or roughly one half of the current level.  The Fed has indicated that the balance sheet will be no larger than necessary to manage monetary policy in the current framework, which requires more reserves than pre-crisis policy.

Challenges Confronting Policymakers

It remains to be seen how well the transition to policy normalization will go.  Although the initial process has been smooth, the Fed nonetheless faces formidable challenges ahead.  One is to ascertain the natural rate of unemployment, commonly referred to as NAIRU, below which inflation rises.  This is important because the Fed utilizes econometric models that assume the Phillips curve relationship between wage increases and unemployment holds.  The relationship, however, is far from stable: Previously, wage pressures would typically be evident when the unemployment rate is below 5%, but this has not happened currently.  The reason is unclear to policymakers and market participants, but one reason may be is that there is a large pool of workers who are currently working part time that are seeking full time jobs.

Meanwhile, the core rate of inflation has drifted below the Fed’s 2% target.  This has increased uncertainty about whether it will raise the funds rate at the end of this year, as it did in 2015 and 2016.  Nonetheless, while the timing of rate increases is uncertain, we believe the Fed is aiming for a funds rate of 2.0% and will then pause.  This is well below the average rate of 4%, which is typical for an economy growing at 2% and inflation close to that pace.

Will Monetary Policy Ever Return to Normal?

This begs the question of whether monetary policy will eventually revert to the way it was conducted before the GFC, when it mainly influenced the volume of bank reserves by purchasing or selling treasuries to influence the funds rate.

Our assessment is that the conduct of monetary policy has been altered permanently, as the transmission mechanism increasingly occurs through capital markets.  If so, investors need a guide to assess whether policy conditions are becoming easier or tighter.  The standard procedure today is to look at a variety of financial market indicators — such as short term and long term treasury yields, credit spreads, the stock market, and the trade weighted dollar – to compute a financial conditions index.  Thus, based on the latest readings, financial conditions have actually eased despite the increases in the funds rate, because equities have risen while credit spreads and the trade-weighted dollar have declined (Figure 2).

Figure 2: Financial Conditions Have Eased Recently

Source: Bloomberg and Goldman Sachs.

Finally, it remains to be seen how monetary policy may shift as the composition of the Board of Governors changes.  By next year, for example, there could be a new Fed Chair, along with a new Vice Chair and three new governors.  It is too early to speculate about what is in store. Nonetheless, investors will be keen to assess whether monetary policy will remain highly discretionary and consensual, as it was during the Bernanke-Yellen era, or whether it will become more rules based, as some Fed critics have argued.  In this respect, the changing of the guard will become a focus for market participants in the coming year.

CFTC Chair Giancarlo Warns European Officials against Unilateral Changes to CCP Regulation

CFTC Chair J. Christopher Giancarlo raised significant concerns related to European CCP regulation in the wake of the UK’s Brexit referendum, and encouraged global regulatory cooperation to enhance the vitality, liquidity and durability of the global financial markets. His remarks were delivered at the Global Forum for Derivatives Markets Bürgenstock Conference in Lucerne, Switzerland.

Mr. Giancarlo highlighted the importance of the collective G-20 commitment, made at the Pittsburgh summit, to work together to support economic recovery through implementing global standards contained in the “Framework for Strong, Sustainable and Balanced Growth.” Mr. Giancarlo restated a desire to show deference to home-country regulation rather than “regulatory uniformity,” particularly in matters of market practices, transparency and price formation. He praised prior cooperation between the CFTC and the European Commission (“EC”) on derivatives reform, specifically in reaching an agreement on CCP equivalence (see previous coverage).

Commenting on a recent EC proposal to amend European Market Infrastructure Regulation to introduce a CCP location policy, Mr. Giancarlo acknowledged that Brexit has spurred various regulatory challenges, but cautioned that any unilateral change to the CFTC-EC Equivalence Agreement would be viewed as a violation of trust between the U.S. and Europe:

“If Brexit is indeed the trigger for a new approach in Europe regarding the supervision of cross-border CCPs, then it must be an approach developed with the cooperation and support of the CFTC – cooperation and support the CFTC is prepared to offer. If the EU must reconsider its approach to cross-border supervision of systemically important CCPs, then we cannot have piecemeal and contradictory rulemaking. Instead, we should together strive for a comprehensive and universal solution that supports strong cross-border markets, recognizes and builds upon the strengths of our respective supervisory programs, and preserves as much as possible the basic tenets of the CFTC-EC Equivalence Agreement.”

Mr. Giancarlo committed to pursue swaps reforms, and promised that a CFTC Swaps Reform Version 2.0 framework will improve on earlier efforts and remedy some of the deficiencies presented by the previous framework. He underscored LabCFTC as a demonstration of CFTC commitment to keeping pace with financial innovations and corresponding challenges in monitoring and overseeing financial markets, and said that he remains dedicated to working with other regulators to “foster safe, sound and vibrant” global markets.

Lofchie Comment: In a somewhat more assertive tone than he struck in yesterday’s remarks, Chair Giancarlo demonstrates awareness that he can best advance U.S. economic interests neither by bullying Europeans nor by acquiescing to European regulations that disadvantage U.S. firms.

CFTC Chair Giancarlo Advocates for Increased Cross-Border Deference

CFTC Chair J. Christopher Giancarlo reviewed the implementation of swap reforms over the past eight years and advocated for increased cross-border regulatory deference. In an op-ed published by French newspaper Les Échos, Mr. Giancarlo said that many of the reforms in the derivatives markets undertaken after the 2008 financial crisis have been implemented successfully, but added that cross-border supervision is an area in need of regulatory attention in light of the increased globalization of markets.

Mr. Giancarlo focused on the regulation of central clearing. He said that “diverging regulatory views” on the effective supervision of global central counterparty clearinghouses (“CCPs”) can cause “regulatory redundancies” and “legal uncertainty.” He expressed concern that these unwelcome effects may lead to increased costs and discourage market participants from centrally clearing trades. He advocated for cross-border deference as the most effective regulatory strategy for futures and swaps regulation. The CFTC, Mr. Giancarlo stated, “has a long history of regulatory deference to overseas regulatory counterparts in the futures and swaps markets.” He noted that this approach gives foreign firms access to U.S. customers. In addition, Mr. Giancarlo described how regulatory cooperation between jurisdictions allows parties to operate in accordance with the rules of their home jurisdictions. This contributes to the resiliency of global markets and, with proper coordination, ensures that CCPs operating across multiple jurisdictions are “held to the same high standards.” Mr. Giancarlo detailed the various benefits of deference arrangements, but explained that the CFTC wants to build stronger relationships with regulators from other jurisdictions and will continue to develop the deference-based framework. He also said that certain circumstances call for an alternative approach, such as when a CCP is systemically important in multiple jurisdictions.

In addition to focusing on clearing, Mr. Giancarlo noted, CFTC staff members are in the process of considering ways in which the Commission can incorporate deference into “other parts” of its regulatory framework.

Lofchie Comment: Under former CFTC Chair Gary Gensler, the CFTC essentially tried to bully the rest of the world into adopting the same rules that the United States had adopted under Dodd-Frank. This simply resulted in the rest of the world pushing back. Seee.g.Joint Cautionary Letter from the EU, France, Japan and the UK to the CFTC on U.S. Cross-Border Swaps Regulation (with Lofchie Comment)European Commissioner Barnier on U.S.-EU Cooperation [or the Lack Thereof] (with Lofchie Comment). The CFTC eventually conceded that this was not a workable strategy. The CFTC and the European Commission on Common “Path Forward” for Regulating Derivatives (with Lofchie Comment).

Chair Giancarlo has to figure out a workable strategy that affirms both U.S. regulatory interests and U.S. economic interests. U.S. financial intermediaries have a very strong interest in the results of this strategy. Too loose, and it puts U.S. firms at a competitive disadvantage in competing for business. Too restrictive, and no one wants to trade with U.S. firms.

SEC Commissioner Encourages Dialogue on Exchange-Traded Products

SEC Commissioner Michael Piwowar opened an SEC-NYU conference by describing different types of ETPs: exchange-traded funds (“ETFs”), exchange-traded notes (“ETNs”), and exchange-traded commodity funds (“commodity ETFs”) and by distinguishing between ETPs and other financial products. ETPs “allow investors to invest in a portfolio of assets or in the performance of a benchmark.” Unlike mutual funds, he said, investors can trade ETP shares throughout the day which “allows investors, both retail and institutional, to tailor their portfolios to take advantage of changing market conditions that occur throughout the day.”

The conference, co-sponsored by the SEC Division of Economic and Risk Analysis and the New York University Salomon Center for the Study of Financial Institutions, addressed (i) the effect of ETPs on the efficiency and quality of the financial markets, (ii) implications for investors in a developing market, and (iii) the future of the ETP market, including potential new products and associated “cost-benefit tradeoffs.”

Mr. Piwowar underscored that ETPs are a rapidly expanding asset class, and that significant growth stems from a variety of factors including (i) ease of access, as any investor with a brokerage account can make transactions, and (ii) low trading costs, since ETPs are passive investments that closely track indexes. As such, they are particularly attractive to retail investors. He also said that ETPs are useful for institutional investors due to the ability to lend ETP shares, short sell, and trade on margin. These features are conducive to implementing sophisticated trading strategies.

Mr. Piwowar stated that ETPs also afford investors an opportunity to pursue “unique economic exposures” that are often dependent upon arbitrage trading by institutional investors. Arbitrage trading helps to ensure that ETPs accurately reflect the value of the underlying assets of an ETP, or the benchmark it tracks. Mr. Piwowar explained that certain ETPs, such as those with reference assets which are illiquid or are not traded concurrently with the ETP, are more susceptible to price deviation. Even a brief deviation can result in significant effects to the value of a security. Consequently, ETPs may affect the value of an underlying asset and, in turn, the “overall quality of financial markets.” Mr. Piwowar said that there is some concern that ETPs have negatively impacted capital market efficiency, noting that academic studies of this issue have produced mixed results.

Mr. Piwowar asserted that, as a result of the constantly evolving structure of the ETP market and the relatively recent emergence of ETPs as a prominent asset class, academic study and industry observations are an important tool that can contribute to effective SEC oversight and regulation.

Senate Banking Committee Votes on Key Administration Nominees

The U.S. Senate Banking committee voted to advance the nominees for two prominent banking regulatory positions. The two nominations will now proceed to the Senate floor for a confirmation vote.

Joseph Otting was approved to serve as Comptroller of the Currency. Mr. Otting most recently was managing partner of Ocean Blvd LLC and Lake Blvd LLC. He previously held positions as President and CEO of OneWest Bank and Vice Chair of U.S. Bancorp. Keith Noreika has served as Acting Comptroller of the Currency since Thomas J. Curry stepped down in May 2017 (see previous coverage).

Randal Quarles was approved to serve as Vice Chair of the Board of Governors of the Federal Reserve System (“FRB”). Mr. Quarles had served as Under Secretary for Domestic Finance under President George W. Bush, Assistant Secretary of the Treasury for International Affairs and U.S. Executive Director of the International Monetary Fund. He is the founder and managing director of Cynosure, a private investment firm, and also was a partner at Davis Polk & Wardwell. Current FRB Vice Chair Stanley Fischer recently announced his intention to step down from his position in October 2017 (see previous coverage).

Stanley Fischer to Resign from Federal Reserve Board

Board of Governors of the Federal Reserve System (“FRB”) Vice Chair Stanley Fischer will resign from the FRB on or around October 13, 2017. Dr. Fischer announced his plans in a letter to President Donald J. Trump.

Dr. Fischer was appointed to the FRB by President Barack Obama in 2014 for an unexpired term set to end in 2020. Dr. Fischer’s term as Vice Chair was set to expire on June 12, 2018. During his tenure, Dr. Fischer served as chair of FRB Committees on (i) Financial Stability and (ii) Financial Monitoring and Research. He also represented the FRB internationally in various capacities.

SEC Names New Directors of Two Divisions

The SEC named Dr. Jeffrey H. Harris as Director of the Division of Economic and Risk Analysis. Currently, Dr. Harris is a professor, and the Gary D. Cohn Goldman Sachs Chair in Finance, at the Kogod School of Business at American University. Previously, he served as Chief Economist of the CFTC, worked with the SEC and the Nasdaq Stock Market, and held a variety of other academic positions.

The SEC named Dalia Blass as Director of the Division of Investment Management. Most recently, Ms. Blass was a partner at Ropes & Gray LLP. She held various roles at the SEC for over ten years, including as Assistant Chief Counsel for Investment Management.

House Financial Services Committee Democrats Criticize SEC “Non-Enforcement” of Conflict Minerals Rule

House Financial Services Committee members Maxine Waters (D-MO) and Gwen Moore (D-WI) (collectively, the “representatives”) criticized the treatment of the Conflict Minerals Rule (the “Rule”) (Exchange Act Rule 13p-1) by SEC Commissioner Michael Piwowar and the SEC Division of Corporation Finance (the “Division”).

In a letter to SEC Chair Jay Clayton, the representatives argued that Commissioner Piwowar’s position on the Rule is inconsistent with court rulings and could expose companies to “reputational risk” by leading them to believe they are not subject to the Rule’s disclosure requirements. The representatives contend that the Division’s non-enforcement position on companies that fail to “comply with the disclosure requirements regarding due diligence on the source and chain of custody of conflict minerals or file a conflict minerals report” is “misguided and irresponsible.” The representatives complained that Commissioner Piwowar and the Division are using the ruling of the U.S. Court of Appeals for the District of Columbia Circuit – that the SEC cannot enforce the “descriptor” requirement of the rule – to improperly inform their non-enforcement position on the due diligence reporting requirement.

In the letter, the representatives stated that the Rule allows companies to understand how their business practices “directly or indirectly financ[e] conflict and human rights abuses.” The representatives cited the “positive” effects of the Rule, including increased efforts to validate conflict-free mines, the implementation of monitoring systems, and improvements in supply-chain management. The representatives argued that contrary to the position taken by the Commissioner and the Division, the Rule (i) does not impose excessive compliance burdens on companies, (ii) has not created a “de facto embargo” on minerals from the eastern Congo, and (iii) does not have an adverse effect on U.S. national security interests.

Lofchie Comment: The representatives make the strongest argument they can that the “conflict mineral” disclosure requirement is providing material benefits. While they do a solid job of letter-writing in this regard, certain of the arguments in the letter are fairly far-fetched (e.g., that companies somehow are exposing themselves to reputational risk by relying on SEC guidance). The representatives also ignore, and do not attempt to refute, the finding of the U.S. Government Accountability Office that the disclosure rules have been a near-total failure. See GAO Director Updates Senate Subcommittee on Conflict Mineral Rule Disclosure. Even if one believes that the Rule does some good notwithstanding the GAO report, it’s simply hard to imagine that it is an economically efficient way of doing good.