SEC Chief Economist and Director Lewis on Investor Protection through Economic Analysis

SEC Chief Economist and Director, Craig M. Lewis, delivered a speech at the Pennsylvania Association of Public Employee Retirement Systems Annual Spring Forum on the role of economic analysis in furthering the Commission’s mission to protect investors and the ways in which the public can help craft regulations to effectively accomplish this goal.  Lewis specifically discussed what the Commission considers the four basic elements of a robust economic analysis. These elements include: (1) an identification of the justification for the regulatory action; (2) a definition of the baseline against which to measure the economic effects of that regulatory action; (3) an identification of reasonable alternative regulatory approaches; and (4) an evaluation of the economic consequences of the proposed rule and the principal regulatory alternatives.

Lewis notes that analyzing the benefits and costs of a proposed regulation can be complicated and nuanced, especially considering that not all benefits and costs can be quantified. Lewis also discusses how the SEC staff recommends engaging in rulemaking using authority provided in the Dodd-Frank Act to adopt rules with a uniform fiduciary standard of conduct for all broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers.

See:  Investor Protection through Economic Analysis.

Assessing Involvement of Central Banks in Financial Stability

Since the financial crisis we have seen an evolving and deepening role for central banks around the world. No longer are central banks responsible for only monetary policy and inflation but they are now tasked with safeguarding the financial system and maintaining financial stability.

Pawel Smaga conducted a comprehensive survey of the 27 European Union central banks and ranked European central banks using a “Financial Stability Engagement index” to measure involvement in fostering financial stability.

The index measures the extent to which a central bank analyzes and promotes financial stability. The most important factors determining its value are a central bank’s actions, decisions taken by the parliament (e.g. formal division of tasks within the safety net), and actions of other safety net institutions in cooperation with the given central bank. The author identifies 10 criteria, which can describe differences in the behavior of central banks toward fulfilling its role of contributing to financial stability.

The ten criteria are in bold and the complementary survey question is beneath it:

1) Does the central bank have a legal financial stability mandate?
Survey: Is the scope of the current mandate sufficient or should it be widened?

2) Does the central bank have a financial stability definition?
Survey: How does the way the definition is constructed determine the scope of financial stability analysis?

3) Does the central bank publish financial stability indicators?
Survey: Are FSIs based on the methodology by IMF or ECB? Are they useful when analyzing financial stability? In what way can they be expanded?

4) Does the central bank publish its own financial stability index?
Survey: Does the central bank have its own financial stability index? Please explain why yes or no and give its brief description. Is it regularly published or for internal purposes only? Does it have a satisfactory forecasting power?

5) Does the central bank carry out and publish its own stress tests results of the banking/financial sector?
Survey: Is stress testing the most effective tool in financial stability analysis?

6) Does the central bank publish reports on financial stability?
Survey: What are the reasons behind (aims of) publishing FSRs? Are they being achieved?

7) Does the central bank act as payment systems overseer?
Survey: In what way does overseeing payment system developments enhance the financial stability analysis?

8) Does the central bank act as a microprudential supervisor of the banking/financial system?
Survey: What are the benefits for financial stability policy of the current engagement in microprudential supervision and whether the central bank would like to see its mandate widened in this respect?

9) Does the central bank act as a macroprudential supervisor?
Survey: Does the macroprudential oversight have to be within central bank objectives? What would be the benefits? How to formulate the macroprudential mandate?

10) Does the central bank have a separate department responsible for analyzing financial stability?
Survey: What is the best organizational solution for financial stability issues?

To read the full study and see the results of the rankings click here.

AIMA Paper on Deeper International Coordination of OTC Derivatives Regulations

The Alternative Investment Management Association (“AIMA”) released a paper that highlights the key areas where deeper coordination of over-the-counter (“OTC”) derivatives regulation is required to achieve the G20 objective of maintaining global markets.

At one level, this is a general statement that the various national regulators should work together to coordinate their activities.  However, on a more specific level, the paper is directed primarily at the CFTC.  Here are some of the key sentences in this regard:

        “The CFTC Cross Border Guidance has been the subject of substantial comment and concern from non-US institutions and governments.”

         “[S]ignificant questions remain [as to the CFTC’s cross-border policy], including the treatment of funds and similar entities as US persons and the application of CFTC rules to such entities or the transactions into which they enter.”

          “With limited exceptions, the CFTC has not proposed to allow substituted compliance with respect to the clearing obligation in a transaction between a US person and an EU counterparty.”

         “In our submissions to the CFTC on the CFTC Cross Border Guidance as well as the CFTC’s further proposed guidance on cross-border issues, we recommended that the US authorities should, in tandem with other jurisdictions, defer to the mechanism of jurisdiction-level equivalence for resolving situations of conflict or overlap, rather than using either the requirement-by-requirement form of substituted compliance it has proposed or ad hoc no-action relief for individual requirements.  Substituted compliance should apply to all US swap requirements, including Transaction-Level Requirements.  In addition, we would respectfully submit that the CFTC should use broad-based criteria in making any determinations required as part of implementing a substituted compliance framework.  Given that the reform of the OTC derivatives market stems from a G20-level agreement, we believe that substituted compliance should be broadly construed, rather than based on one-to-one correspondence of specific requirements.”

Lofchie Comment:  Nearly three years after the adoption of Dodd-Frank, no one really has any idea what the CFTC’s intended direction is as to the cross-border application of its rules.  Its initial proposals have been met with global resistance from market participants and, much more significantly, from financial regulators around the world, and the CFTC has given some indication that it will modify its position in response to this resistance.  But we do not have any specifics as to what this modification will entail.  From the standpoint of sound regulatory policy, I think it is the responsibility of the CFTC to put out a full rule proposal, as the SEC did, and to allow market participants and other financial regulators to comment on it.  If the CFTC does not do so, but simply proclaims its rules full-blown, then – if the past is a guide – the proclaimed rule will not function as expected; it will go to the brink of effectiveness or beyond and then be postponed, and numerous no-action letters will have to be issued to deal with unanticipated problems.  At some point, it should become clear that regulation by consultation works better than regulation by surprise.

See:  Paper – Addressing Overlaps between EMIR and CFTC OTC Derivatives Regulation.
See also: 
Press Release.

ISS’ Employees Misuse of Confidential Proxy Voting Information

The SEC charged Rockville, Maryland-based proxy adviser Institutional Shareholder Services (“ISS”) for failing to safeguard the confidential proxy voting information of clients participating in a number of significant proxy contests.

The SEC’s order finds that ISS willfully violated Section 204A of the Investment Advisers Act of 1940. The order censures the firm and requires ISS to pay a $300,000 penalty and engage an independent compliance consultant to review its supervisory and compliance policies and procedures. Without admitting or denying the SEC’s findings, ISS agreed to cease and desist from committing or causing any future violations of Section 204A.

Lofchie Comment:  This is an interesting disciplinary action for a few reasons.

First, it is another firm or person who has had compliance problems lately as a result of a failure or mishandling of technology.  The technology failure in this case involved allowing unrestricted access to a broad range of client information to too many employees without good reason, and a failure to monitor that access.  The information in this case happened to be in regard to shareholder voting, but the concern which this case raises extends far beyond information and firms of this type.  That is, every firm must worry that what information it holds or is held by others is vulnerable to improper use by its employees or by the employees of another organization.

Secondly, the case involved a “miss” of a fairly substantial red flag involving a conflict of interest; i.e., that the employee of a proxy solicitor was giving gifts to the employee of a proxy advisory service, even though there was no obvious legitimate business reason for the gift. 

Third, it is the second time in a week that proxy advisory services are in the regulatory news.  Although the stories are wholly unrelated, these are not the kinds of coincidences that any business likes.  Here is the prior story:  SEC Commissioner Gallagher Delivers Remarks on Proxy Advisory Services.

See: Order; Press Release.

Treasury Secretary Lew’s Testimony on FSOC Annual Report

Treasury Secretary Jack Lew delivered testimony on the Financial Stability Oversight Council’s (“FSOC”) 2013 Annual Report at the Senate Committee on Banking, Housing, and Urban Affairs.  In particular, Lew discussed cross-border regulations for swaps and stated that foreign officials, who had previously submitted a letter to Lew criticizing the “lack of progress” in developing workable cross-border rules with the CFTC and the SEC, are being overly critical.  Lew further discussed the following concerns in his testimony:

  • Wholesale funding markets (tri-party repo and money market funds);
  • Housing finance reform (getting private capital into the market);
  • Operational risks (computer failures at the exchanges, Hurricane Sandy, cyberattacks);
  • Reference interest rates (LIBOR);
  • Interest rate risk (rates may go up);
  • Impacts of fiscal policy;
  • Global economic and financial developments.

See: Lew’s testimony.
See also: Foreign Officials’ Cross-Border OTC Derivatives Regulation Letter (April 18, 2013).

Comments on Dudley Interview with Bloomberg’s McKee

Bloomberg’s Mike McKee conducted an interesting interview with FRBNY President Bill Dudley.

When asked about concern surrounding the potential for a spike in interest rates, President Dudley offered two points (at about the 8 1/4 minute mark).  I take issue with each.

(1) President Dudley noted that “people are talking about this [a spike in interest rates] all the time.”  Based on his experience, when events are anticipated, “things don’t happen.”

My sense is that this is an overly simplistic view.  Three illustrative examples immediately spring to mind.

NASDAQ:  Although many market participants were “talking about” a correction in tech stocks for months before the collapse beginning in April 2000, this did not “prevent” the Nasdaq from falling by 78%.

ARGENTINA:  The Argentine peso collapse in 2002 was the most telegraphed crisis in the history of recent financial crises.  Although anticipated, the peso plunged by 73% versus the USD and the economy sunk by 16% in real terms.

CARRY TRADE AND BANK OF JAPAN:  In late 2005 and early 2006, market participants were “talking about” the impact of Bank of Japan’s exit from its Zero Interest Rate Policy (ZIRP) scheduled for March 2006.  It was widely discussed and anticipated.  Nonetheless, the Nikkei peaked at the end of March 2006 and plunged by 19% into June.  Similarly, the exit from ZIRP triggered a correction in emerging market currencies – despite the fact that everyone was talking about it.

The bottom line is that expectations do not preclude events from occurring.  What could be argued is that when events are anticipated, the potential damage is reduced, since economic agents are forewarned and can protect themselves.  This assumes, however, that the agents know the “correct” response to such signals.

(2) President Dudley noted that the risk of a spike in interest rates is diminished as the Fed holds many of the “long duration assets” on its balance sheet, resulting in less risk for the private sector.

This is false for many reasons – as it both focuses on flows versus stocks and misses the linkage between public and private debt markets.

Many interest rates in the private sector are based on their spread to Treasury yields.  So any move higher in Treasury rates will immediately impact private credit markets.  Similarly, the stock of Treasury debt dwarfs flows.  So, if private market participants (either domestic or foreign) get nervous, their resultant selling paper will drive yields sharply higher still.

Going forward, the optimal path for the Fed is to more precisely hone its communication and be less dismissive of realistic risks.

The Fed, Markets, and CFS Money Supply Statistics

CFS Divisia M4, including Treasuries (DM4) – the broadest and most important measure of money grew by 5.1% in April 2013, on a year-over-year basis.

CFS monetary data demonstrates an expanding economy – yet shed light on the potential for a correction in asset markets. For special analysis, please contact LeAnn Yee at

Click here to access the Monetary and Financial Data Release for April 2013.

Chicago Fed Paper Urges Markets to Slow Trading

Chicago Federal Reserve Bank Senior Policy Advisor, John W. McPartland, authored a paper in which he discussed altering the financial markets in order to slow trading and allow market participants more chances to compete with some High-Frequency Trading (“HFT”) strategies.  According to the paper, although HFT may in general be a good thing, HFT strategies run counter to good public policy and inflate transaction costs with limited benefits for liquidity and pricing.  McPartland argues that his proposals would help make security and derivatives markets fairer to mutual funds and individual investors while not restricting high-speed firms’ ability to rapidly quote prices.  The proposal would also scale back pricing information which his research indicated adds millions of dollars per year in data management costs, according to his research. He further makes six recommendations in the paper that, if implemented, would alter competitive advantage in the market.

Lofchie Comment:  Among other things, the article provides very clear definitions of layering, spoofing and quote stuffing. It is somewhat ironic that the CFTC’s definitions (in its final guidance, published yesterday) were ambiguous. They would have benefited from considering and possibly incorporating Mr. McPartland’s definitions.

See:  CFTC Publishes Final Text of Disruptive Trading Guidance (with Explanation from Delta Strategy Group).

As to the substance of Mr. McPartland’s comments, if they in fact ring true to business people, I wonder if some exchange somewhere in the world would not be willing try out his proposal without government mandate. 

“Music to Slow Trading by” (YouTube link).

See:  Recommendations for Equitable Allocation of Trades in High Frequency Trading Environments.

CFTC Publishes Text of Swap Execution Facilities Rules

The CFTC published the text of the three final rules adopted last week. These rules cover the following:

(i) core principles and other requirements for swap execution facilities (“SEFs”);
(ii) the process for a designated contract market or swap execution facility to make a swap “available to trade”; and
(iii) procedures to establish appropriate minimum block sizes for large notional off-facility swaps and block trades.

Core Principles

Section 733 of Dodd-Frank enumerates 15 core principles that all SEFs must fulfill.  These include matters such as the ability to monitor trading, having sufficient financial resources and having a chief compliance officer.  The big-print version of the proposed release runs over 500 pages, much of which is substantive.  Many of the core principles will be fairly expensive to implement, including the development of an audit, compliance and enforcement system.  The rule does allow SEFs to contract with third parties to provide many of these compliance services.

Lofchie Comment:  The requirement that attracted the most comments before the adoption of the SEF “request for quote” provision require, the person seeking the quote to obtain at least three bids (on only two for the first year). It seems odd that the CFTC believes it is helping swap customers by forcing them to obtain more bids than they want to, even when the CFTC acknowledges that this solicitation process could move the market against the customer. This process presumes that the CFTC can establish a rule for all circumstances which is effectively “smarter” than the judgment that a market participant can make at the time that it trades.  See May 10th post of Craig Pirrong’s blog, which does a good job of asking how the CFTC can be confident that it is smarter than swap customers.

Available to Trade

“Available to trade” means, contrary to the implication of the term, that a swap is required to be traded on a CFTC-regulated market – either a fully regulated Derivative Contract Market (“DCM”) or a SEF.   A swap may be found “available to trade” only if the subject is subject to mandatory clearing. 

As a starting matter, the CFTC declared that a swap would not be found available to trade simply on the basis of the fact that it was required to be cleared.  A separate finding had to be made by either the CFTC or by a DCM/SEF that the swap is available to trade based on a consideration of at least one of seven factors, including whether there were willing buyers and sellers, and the frequency or size of transactions.

A DCM/SEF that, on its own initiative, submitted a certification that a swap was available to trade would be required to list the swap for trading before the swap was ultimately deemed available to trade so that market participants were forced to trade on the exchange.  However, the level of trading functionality that the DCM/SEF would be required to provide would only be the minimum amount required by law for any DCM/SEF and, thus, a full range of order types or trading procedures might not be available.

As part of its cost-benefit analysis, the CFTC estimated that it would cost a DCM/SEF no more than $938.40 to prepare a submission that a swap is available to trade.  Interestingly, the CFTC elected not to consider the cost to market participants of an available-to-trade determination, saying that this was not relevant to its required analysis.

See also the related news stories below, including “CFTC Adopts Rules Regarding SEFs” and “Timeline for Implementation of SEF Trade Execution Requirements (Prepared by Delta Strategy Group).”

Lofchie Comment:  Clearly, the rule is structured to encourage DCMs/SEFs to make an available-to-trade finding, or at least to make doing so inexpensive. Presumably, the end result of this procedure is that every swap which is required to be cleared is also found to be available to trade.

Block Trade Rule

The Block Trade Final Rule establishes measures to protect the identities of swap counterparties and to maintain the anonymity of their business transactions and market positions in connection with the public dissemination of publicly reportable swap transactions by amending existing CFTC regulations to establish the “cap sizes” for notional and principal amounts that mask the total size of a swap transaction based upon a 75-percent notional amount calculation for a given swap category. “Cap size” means the maximum limit of the principal or notional amount of a swap that is publicly disseminated.

The Block Trade Final Rule is also intended to protect market participant anonymity by establishing limits on the public dissemination of certain otherwise reportable swap transactions in the other commodity asset class, such as swaps with certain delivery or pricing points.

Core Principles and Other Requirements for Swap Execution Facilities (Pre-Fed. Reg. Version);
Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade under Section 2(h)(8) of the Commodity Exchange Act; Swap Transaction Compliance and Implementation Schedule; Trade Execution Requirement under Section 2(h) of the CEA (Pre-Fed. Reg. Version);
Procedures to Establish Appropriate Minimum Block Sizes for Large Notional Off-Facility Swaps and Block Trades (Pre-Fed. Reg. Version)
See also Related News Items:
CFTC Adopts Rules Regarding SEFs” (May 17, 2013);
Remarks of the CFTC Commissioners with Regard to SEF Trade Execution Rules and Anti-Disruptive Trading Practices Guidance” (May 17, 2013);
Commissioner O’Malia’s Dissenting Statement on the CFTC’s Adoption of the Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade under Section 2(h)(8) of the Commodity Exchange Act” (May 20, 2013);
Timeline for Implementation of SEF Trade Execution Requirements (Prepared by Delta Strategy Group)” (May 16, 2013)