MFA Letter to SEC on Proposed Capital, Margin, and Segregation Rules

MFA submitted a comment letter to the SEC on its proposed rules on “Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers”.  MFA emphasized the following recommendations to the SEC:

(i) the desirability of an internationally uniform set of margin requirements;

(ii) MFA’s preference for a single compliance date for imposition of margin requirements;

(iii) that the SEC mandate that security-based swap dealers (“dealers”) transfer variation margin to clients;

(iv) that dealers be permitted to use their internal models for determining risk under cross-product master netting agreements;

(v) that dealers be required to provide customers with the “basic functionality” of their internal margining models; 

(vi) that margin be tailored to the risk of specific products; and

(vii) that customers be able to hold their initial margin either at a tri-party custodian without the dealer suffering a capital penalty for permitting that and that customers have access to a segregation regime that permits customer-by-customer segregation of collateral.

Lofchie Comment:  What this letter implicitly makes clear is that many customers were better off in the pre-Dodd-Frank regime than they will be with the “protections” afforded by Dodd-Frank.  For example, the pre-Dodd-Frank regime allowed customers to (i) negotiate margin levels across a broad range of products, (ii) hold their initial margin at a third-party custodian without the swap dealer suffering a penalty, and (iii) negotiate for margin tied to the risk of specific products. 

Among the other problems pointed out by the letter are that the demands of the rules for high quality collateral may lead to a collateral squeeze and the swaps markets may lose their economic viability because of the high demands of the regulatory system. 

The the trigger that will expose many of the major problems in the regulation of swaps under Dodd-Frank is statutory not regulatory.  The “Lincoln Amendment” (Section 716 of Dodd-Frank) involves the push-out of swaps activities from banks.  Dealing in swaps is largely a credit activity, and when Congress requires that credit activity, which logically belongs in banks, to be done outside of banks, major problems follow.  One of these problems is that margin and capital requirements may be set at a level that is too high relative to ordinary risk (damaging customers and the economy) because, as the SEC pointed out in its capital proposals, non-bank dealers are more vulnerable to runs on liquidity.

View letter in full here (links externally to MFA website).

SEC Chairman Walter on “Making the Markets Safe for Informed Risk-Taking”

SEC Chairman Elisse Walter delivered remarks on informed risk-taking for investor protection and confidence. In her speech, the Chairman urged legislators and regulators to maximize stability and minimize risk, enhance capital requirements, minimize moral hazard and increase scrutiny by regulators. Walter states that regulators should protect investors against fraud and ensure that those who invest are sufficiently sophisticated and able to bear the risk. 

Among the specific issues raised by Chairman Walter were (i) that the SEC have sufficient tools to detect fraud and insider trading, (ii) that issuers make appropriate disclosure not only as to financial issues, but also as to the risks created by, for example, dual class voting structures, and (iii) that there not be further breakdowns in the exchange markets such as we have experienced in the last year.

Lofchie Comment:  Although she did not say so explicitly, I took the Chairman’s remarks as reflecting a good degree of anxiety as to the implementation of the JOBS Act, and whether that will prove a benefit to retail investors, or whether they will invest disproportionately in high-risk ventures that they are not prepared to evaluate.

View speech in full here (links externally to SEC website).
See also: Commissioner Aguilar on Addressing Market Instability Through Informed and Smart Regulation; Commissioner Paredes’ Remarks at The SEC Speaks in 2013.

New Bowles-Simpson Proposal

On Tuesday the dynamic bipartisan duo Erskine Bowles and Alan Simpson was at it again –releasing a new/updated set of recommendations for dealing with our debt situation. Although the exact details differ, seven of the 11 principles outlined in the summary closely resemble those given in the original 2010 Fiscal Commission Report (available here). Of interest, therefore, are the looming risks to economic stability highlighted in the four new principles. They are (the exact wording from their proposal is highlighted below in bold):

(1) the threat of sequestration (Replace Dumb Cuts with Smart Reforms),
(2) the increasing debt burden (Protect the Full Faith and Credit of the U.S. Government),
(3) the changing demographic landscape (Get Serious About Population Aging), and
(4) the rising cost of health care (Bend the Health Care Cost Curve).

There is already plenty of discussion out there regarding sequestration since its deadline looms. Here is why I think the other three are so vital for the financial future of the US.

Protect the Full Faith and Credit of the U.S. Government:  In addition to the magnitude of the debt burden, the front-loaded US Treasury maturity structure is worrying (see “Treasury Maturities: The Other Fiscal Problem” by CFS President Lawrence Goodman). With a large proportion of debt maturing in the near-term, coincident timing of a Treasury rollover of that debt and a Fed exit from quantitative easing could result in the perfect storm, raising borrowing costs substantially. Put another way, one wonders whether the threat of substantially ballooning borrowing costs may limit the speed at which the Fed can raise interest rates.

Get Serious About Population Aging / Bend the Health Care Cost Curve:  I’ve been quite vocal with my view that the changing demographic landscape is one of the biggest risks to global financial stability (see “The Market for Long-Term Care Insurance and Systemic Risk“). Anecdotally just consider the number of countries and corporations that have highlighted the necessity of pension and healthcare reforms – and the hostility from current and future beneficiaries that any proposed modifications generated. I’m glad to see this topic garnering greater attention – policies that address financial stability and systemic risk have implications for healthcare and vice versa. Unintended consequences can result when policy debate about one occurs without consideration of the other.

The new Bowles-Simpson proposal also contained an outline of “Four Steps to Deficit Reduction (2014-2023)”. In Step 3 they reiterate their call for adopting a chained CPI for indexing (i.e., of entitlements like social security). I continue to be concerned about how this proposal might be implemented, specifically with respect to its redistributive implications (see “Changing Inflation Won’t Solve Budget Woes“). We must be careful that such a change will still “Protect the Disadvantaged” (one of Bowles-Simpson’s earlier recommendations that was reiterated in their new proposal).

See also:Budget Solutions: Then and Now“, by Susan Hering and Lawrence Goodman.

SIFMA Comments to FINRA on Requiring Hyperlinks to BrokerCheck on the Internet

SIFMA provided comments to FINRA on a proposed change to FINRA Rule 2267 (Investor Education and Protection) that would require FINRA member firms to “include a prominent description of and link to FINRA BrokerCheck, as prescribed by FINRA,” on firm “websites, social media pages and any comparable Internet presence”.  The proposed amendment would require the same descriptions and links to be included on websites, social media pages and any comparable Internet presence “relating to a member’s investment banking or securities business maintained by or on behalf of any person associated with a member.”

SIFMA believes the proposal should not be approved by the SEC.  The objections raised by SIMFA include that:

  1. the member firms do not control all of the websites from which they would be required to assure the presence of links;
  2. implementation of the rule would be expensive; and
  3. the FINRA rule proposal does not contain protections against automated data mining. 

Click here to view letter in full (links externally to SIFMA website).

CFTC and IOSCO to Host Public Roundtable on Financial Benchmarks

The CFTC and IOSCO will hold a public roundtable on Tuesday, February 26, 2013, to discuss the IOSCO Consultation Report, “Financial Benchmarks,” which was published in January 2013.  Along with the written comments and the roundtable discussion held in London on February 20, this rountable is intended to provide input for the IOSCO Final Report containing principles of best practices for benchmark methodologies and governance.

Click here to learn more (links externally to CFTC website).
Related News Item: IOSCO Report on Financial Benchmarks; e.g., LIBOR.

Overstated Hit to Retail Spending

The WSJ this morning published a terrific piece on the hit to retail spending due to the 2% hike in payroll taxes (see Payroll Tax Whacks Spending).

To be sure, higher taxes are problematic.  However, the piece overstates the damage from this one measure to the overall economy.

Prior to posting the CFS monetary aggregates and components earlier this week, we combed the data for key themes such as the impact of the payroll tax hike on the economy.  It is clear that the 2% boost in payroll taxes marginally reduced liquidity in the banking system.  However, the small decline in bank deposits could also reflect the drawing down of funds to invest in strengthening stock markets.

So on balance, the payroll tax hike is an unfortunate drag on growth.  However, the financial system is heeling.  Banks and corporations are flush with liquidity.  So even if retail spending is reduced on the margin (the WSJ notes that a family with an annual income of $65,000 will lose just over $100 per month in spending power), corporations are and will continue to invest.  This too is clear from the CFS monetary and financial data.

European Commissioner Barnier on U.S.-EU Cooperation

European Commissioner Michel Barnier, responsible for Internal Market and Services, delivered a speech at the Transatlantic Finance Initiative in New York.  Commissioner Barnier discussed the progress of  his recent discussions with the Fed, Treasury and the Regulatory Agencies in Washington.

According to Commissioner Barnier, international standards are largely agreed upon in a few areas, including (i) margin on derivatives, (ii) shadow banking and (iii) the regulation of systemically important banks.  However, he was critical of U.S. regulation in a number of areas, including what he described as “the slowness of the U.S. in moving towards internationally agreed accounting standards.”  On the regulatory side, he warned that “Expanding interpretation of home-grown rules to transactions that are already covered by equally solid foreign rules will only lead to legal conflicts.”  He then went on to say that regulatory differences between the U.S. and the EU are “unnecessary, costly and ultimately undermine efficient control and supervision.”  

Lofchie Comment:  I take what Commissioner Barnier says as extremely important, not just to the direction of EU financial regulation, but also to the potential direction of U.S. regulation.  When in 2012, the CFTC proposed that it would aggressively assert jurisdiction over non-U.S. banks entering into swaps, Commissioner Barnier issued a letter in which he threatened a response against U.S. banks and the possibility of a trade war.  (He was, of course, not the only non-U.S. regulator who criticized the CFTC’s position at that time, but he was the most direct.)  Since then, the CFTC has much backed off this expansive view of its jurisdiction, but only  temporarily (pursuant to what the CFTC describes as “time-limited” no-action relief). 

Now Commission Barnier repeats his warning that the U.S. and Europe must cooperate in financial regulation – particularly the regulation of derivatives – or else there will be bad consequences.  It may seem obvious that U.S. and EU co-operation is a good thing, and that the U.S. regulators should cooperate with the EU by, for example, trusting the EU to regulate the conduct of the European banks conducting swaps activities.   However, this obvious solution has an underlying problem, a very big problem.  The U.S. regulation of swaps is extraordinarily onerous, I think irrationally so; and I think that swaps customers (not just swaps dealers) will find it an unattractive form of regulation.  As a result, if U.S. swap dealers operate and compete under U.S. rules, and EU swaps dealers operate and compete under EU rules, then the EU swaps dealers will be competing on favorable terms and the U.S. financial institutions will be damaged, along with the U.S. economy. 

What this means is that, if the U.S. is going to cooperate with the EU in developing financial regulation, then the U.S. is going to have to substantially rework its derivatives regulations so that U.S. firms have some chance of competing for business on even terms.  I am very much hoping that our government – Congress and the regulators – takes up Commissioner Barnier’s offer of cooperation, tied as it is to a warning of a hostile European response, and rethinks the direction of our financial regulations.

View speech in full here (links externally to Europa website).

SEC Report: Accessing the U.S. Capital Markets – a Brief Overview for Foreign Private Issuers

The SEC staff of the Division of Corporation Finance released a report on accessing the U.S. capital markets.  The report provides a general outline of various U.S. federal securities law issues applicable to “foreign private issuers,” as well as additional matters these issuers may wish to take into account when considering having their securities trade in the U.S. capital markets. In addition, it includes links to various statues and rules.

Lofchie Comment:  It’s a very helpful little guide, but it barely mentions Sarbanes Oxley, and for many foreign private issuers that might have an interest in offering their shares in the United States, that is the elephant in the room.

View report in full here (links externally to SEC website).

Managed Funds Association Submits Comment Letter to CFTC on Proposed Rules for Enhancing Customer Protections

The MFA has submitted a comment letter to the CFTC on its proposed rulemaking on “Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations” (see: 77 FR 67865).   The MFA letter begins by stating that the perspective of its member firms is as customers of FCMs who are at risk of losing money as a result of the default of an FCM.  The letter expresses MFA’s concern with the recent MF Global and Peregrine defaults and applauds the CFTC for recognizing the potential weaknesses in the current customer protection regime, as well as proposing additional measures to increase the protection of customers’ assets. 

More specifically, MFA encouraged the CFTC to:

  1. Require each futures commission merchant (“FCM”) to make certain of its financial information and custodial account information publicly available;
  2. Review its proposed rules to confirm that FCMs are not subject to double capital charges in respect of undermargined customer accounts;
  3. Not shorten the time period before FCMs must take a capital charge in respect of an undermargined customer account;
  4. Not require FCMs to calculate and maintain adequate customer margin on a “real time” basis, as opposed to an end-of-day basis;
  5. Reevaluate annually the proposed rules’ efficacy and the need for additional enhancements to the customer protection regime with existing CFTC guidance in that area;
  6. Continue to evaluate the viability of a full physical segregation option for collateral posted by customers on their cleared swaps positions; and
  7. Ensure that the proposed rules facilitate portfolio margining.

Lofchie Comment:  The MFA’s comment letter implicitly highlights a few of the tensions in, and uncertainties of, the Dodd-Frank regulatory regime.  One of these tensions involves the trade-off between the safety of the custodial regime and its expense.  Another of these tensions is the extent to which the requirements of the regime will benefit institutional vs. retail customers.  The great uncertainty is whether the new Dodd-Frank regulatory regime will be safer for customers than the preexisting swaps regime. 

Let’s take the trade-off between safety and expense first.  The MFA letter opposes shortening the time period before FCMs must take a capital charge for maintaining undermargined customer accounts.  While this may seem counter-intuitive from the standpoint of protecting customers’ assets, it reflects the economic reality that FCMs would likely be required to respond to this rule change by (i) raising margin levels, (ii) shortening margin delivery periods and (iii) perhaps declaring defaults more quickly.  In this regard, MFA comes down on the side of accepting somewhat more risk, so that the expenses of the custodial system are not substantially increased.

The letter advocates that FCMs provide greater public disclosure as to their financial situation.  This raises an interesting policy question because (i) any negative disclosure raises the possibility of a run on the FCM and (ii) institutional customers are likely to be able to run before retail customers.  (This issue is also touched upon in the National Futures Association comment letter, also covered in today’s news.)

The MFA letter observes that many investors would have been able to obtain better protection of their collateral in the pre-Dodd-Frank swaps markets than they will now be able to achieve in the post-Dodd-Frank futures market (see Part III of the letter at page 9).  I believe that this observation is not only accurate, it is worrisome, particularly because post-Dodd-Frank collateral levels are likely to be materially higher than pre-Dodd-Frank collateral levels.  In short, investors will be required, post Dodd-Frank, to post more collateral at FCMs than they would have been required, pre-Dodd-Frank, to post at banks.  This means that these investors will have more credit exposure to less creditworthy financial intermediaries.   This credit risk imposed on customers also goes to the question of U.S. competitiveness: will non-U.S. investors prefer to trade offshore where they can keep less collateral at a bank, rather than trade in the United States where they will keep more collateral at an FCM?

Click here to view letter in full (links externally to MFA website).
Related News Items: CFTC Roundtable on Enhancing Protections Afforded Futures Customers (February 6, 2013) and Enhancing Protections Afforded to Customers and Customer Funds Held by FCMs and Derivatives Clearing Organizations; Notice of Proposed Rulemaking (CFTC; Fed. Reg. Version) (November 15, 2012).

National Futures Association Submits Comment Letter to CFTC on Proposed Rules for Enhancing Customer Protections

The NFA has submitted a comment letter to the CFTC regarding the CFTC’s proposal to enhance customer protections afforded customers and customer funds held by futures commission merchants (“FCMs”) and derivatives clearing organizations (“DCOs”) (see: 77 FR 67865).  The focus of the NFA’s letter is on the requirements that the CFTC would impose on the NFA and the other DSROs in respect of their programs to audit FCMs.

Lofchie Comment:  Although somewhat gently phrased, the comment letter is in many respects quite critical of the CFTC’s proposal.  For example, the comment describes an amendment to Rule 30.7 as “unnecessary and unworkable from a practical standpoint.”  The comment letter says that the leverage ratio suggested by the CFTC “may not be the most appropriate measure” and may “[not] provide a meaningful leverage metric.”  Other requirements of the proposed rule are criticized as being insufficiently defined.  The letter closes by suggesting that certain information the CFTC would require to be made public “may simply be too sensitive, and subject to misinterpretation. . . .”  I interpret this last comment as meaning that the disclosure of the information could precipitate a run that would collapse the FCM.

Click here to view letter in full (links externally to NFA website).
Related News Items: CFTC Roundtable on Enhancing Protections Afforded Futures Customers (February 6, 2013) and Enhancing Protections Afforded to Customers and Customer Funds Held by FCMs and Derivatives Clearing Organizations; Notice of Proposed Rulemaking (CFTC; Fed. Reg. Version) (November 15, 2012).