Volcker Lawsuit on TruPS-backed CDO

The American Bankers Association and four individual banks brought a lawsuit seeking injunctive relief against the banking regulators, and asserting that the provision of the Volcker Rule’s final regulations that requires banking entities to divest themselves of a “commonly held debt instrument known as a ‘TruPS-backed CDO'” was in violation of the law in that the instruments constitute debt, rather than equity interests, and are therefore outside the scope of the Volcker Rule. Beyond the substantive legal question, the lawsuit also challenges the procedure by which this particular provision of the regulations implementing the Volcker Rule was adopted.

Newspapers have reported that proceedings on the lawsuit are delayed while the banking regulators reconsider their position.

See: American Bankers Association v FDIC Complaint; Banking Agencies Press Release; Bloomberg News Article.


CFTC Publishes Comparability Determinations (Fed. Reg.)

The CFTC published the following comparability determinations for various foreign countries in the Federal Register:

  • Comparability Determination for Hong Kong: Certain Entity-Level Requirements (78 FR 78852)
  • Comparability Determination for Australia: Certain Entity-Level Requirements (78 FR 78864)
  • Comparability Determination for Japan: Certain Entity-Level Requirements (78 FR 78910)
  • Comparability Determination for Japan: Certain Transaction-Level Requirements (78 FR 78890)
  • Comparability Determination for Canada: Certain Entity-Level Requirements (78 FR 78839)
  • Comparability Determination for the European Union: Certain Transaction-Level Requirements (78 FR 78878)
  • Comparability Determination for Switzerland: Certain Entity-Level Requirements (78 FR 78899)
  • Comparability Determination for the European Union: Certain Entity-Level Requirements (78 FR 78923)

Related News: CFTC Comparability Determinations for Six Jurisdictions and Related No-Action Letter (No-Action Letter 13-75) (December 20, 2013); CFTC Issues No-Action Relief for Dealers in Five Jurisdictions from Certain Entity-Level Internal Business Conduct Requirements (CFTC Letter 13-78) (December 23, 2013); Commissioner O’Malia Criticizes CFTC Rulemaking and Implementation (October 18, 2013); Market Participants File Lawsuit Challenging CFTC Cross-Border Guidance for Being a Rule Adopted in Violation of the APA (December 4, 2013).


Agencies Are Reviewing Treatment of Specified Collateralized Debt Obligations under Volcker Rule

The SEC, the Board of Governors of the Federal Reserve System (“FRB”), the FDIC, and the Office of the Comptroller of the Currency (“OCC”) (the “Agencies”) stated that they are reviewing whether it would be appropriate, and consistent with Dodd-Frank, not to subject collateralized debt obligations backed by trust preferred securities to the investment prohibitions of Dodd-Frank Section 619, or the Volcker Rule. 

According to the SEC release, a number of community banking organizations have expressed concern that the final Volcker Rule conflicts with the Congressional determination under Dodd-Frank , which provides for the permanent grandfathering of Trust Preferred Securities (“TruPS”) issued before May 19, 2010 by certain depository institution holding companies with total consolidated assets of less than $15 billion. The Agencies are therefore evaluating whether it is appropriate not to cover pooling vehicles that invest in TruPS in order to eliminate restrictions that might otherwise have consequences that are inconsistent with the relief Congress intended to provide community banking organizations under Section 171(b)(4)(C) of Dodd-Frank. According to the statement, the Agencies intend to address the question by January 15, 2014.

See: SEC Press Release; Agencies’ Joint Statement
See also:  Trade Associations Request Clarifications Regarding Holding Debt Securities Under New Volcker Rule Regulations


Trade Associations Request Clarifications Regarding Holding Debt Securities Under New Volcker Rule Regulations

The Loan Syndications and Trading Association, SIFMA, the Structured Finance Industry Group, the American Bankers Association, and the Financial Services Roundtable (together, the “Trade Associations”) sent a letter to federal regulators requesting that they clarify how certain provisions of the recently issued “Volcker Rule” regulations would apply to debt securities of collateralized loan obligation (“CLO”) issuers. In particular, with respect to CLO issuers that are considered “covered funds,” the Trade Associations requested that the regulators clarify that holding debt securities issued by such CLOs would not constitute an “ownership interest” under the Volcker Rule regulations so long as the securities conferred a contingent right to remove a manager “for cause” (or to nominate or vote on a nominated replacement upon a manager’s removal for cause or resignation), without any other indicia of ownership interest. While the regulations define “ownership interest” to include “the right to participate in the selection or removal” of an investment manager of a covered fund, the Trade Associations argued that the right to remove a manager for cause should be viewed as an essential creditor’s right designed to protect debt interests, rather than an ownership interest. The Trade Associations cautioned that, in the absence of such a clarifying statement by the regulators, banking entities could begin to dispose of CLO debt securities, disrupting the CLO market and potentially resulting in ripple effects that affect banking entities and non-bank investors alike.

Lofchie Comment:  As part of the regulatory response to the savings and loan association crisis, the government forced S&Ls to sell their high-yield bonds into the market.  With so many forced sellers, market prices for the bonds dropped.  As a result, the forced sales caused damage to the S&Ls and increased losses to taxpayers.  Now bad regulatory policy repeats itself.  Even if regulators were to conclude that banks should not in the future buy certain types of securities, forcing massive divestitures of past investments seems such an obviously flawed policy, it is surprising the government would repeat it.  Massive forced divestitures do not “cut” losses; they increase them.

See: Comment Letter.


CFTC Issues No-Action Relief for Dealers in Five Jurisdictions from Certain Entity-Level Internal Business Conduct Requirements (CFTC Letter 13-78)

The CFTC Division of Swap Dealer and Intermediary Oversight issued a time-limited no-action letter providing relief to non-U.S. swap dealers (“SDs”) and non-U.S. major swap participants (“MSPs”) established in Australia, Canada, the European Union, Japan, and Switzerland from compliance with CFTC Rule 23.600(c)(2) (“Periodic Risk Exposure Reports as Part of a Risk Management Program for SDs and MSPs”) and Rule 23.608 (“Restrictions on Counterparty Clearing Relationships”), and, in the case of a non-U.S. SD or non-U.S. MSP established in Switzerland, Rule 23.609 (“Clearing Member Risk Management”). 

The delay given in the CFTC no-action letter is effective until March 3, 2014.  According to the CFTC, no delay was required for dealers based in Hong Kong (which was the other jurisdiction to receive a determination that its entity level requirements were generally comparable to those in the United States), as the CFTC reported that the exemption was not required for dealers based in Hong Kong.

Lofchie Comment: First, the CFTC issues “guidance” that is not a rule, but with which firms are expected to comply as if it were actually a rule, except that, at the same time that it issues the guidance, it also issues exemptions from that guidance subject to its further interpretation.  In the instant matter, on Friday, December 20, after the close of business, the CFTC issued an interpretation that partially revokes the requirement to comply with its guidance but with which firms are expected to comply (even though it is not a rule).  Then, on Monday, December 23, after the date that firms were required to comply with this non-rule guidance, the CFTC grants a time-limited exemption from it.   

This is not actually the way that the law or the regulatory process is supposed to work.

See: CFTC Letter 13-78.
Related news: CFTC Comparability Determinations for Six Jurisdictions and Related No-Action Letter (No-Action Letter 13-75) (December 20, 2013).

CFTC Comparability Determinations for Six Jurisdictions and Related No-Action Letter (No-Action Letter 13-75)

The CFTC has approved, with Commissioner O’Malia dissenting, a series of determinations that would permit “substituted compliance” with the CFTC swaps regulatory regime (i) by dealers located in Australia, Canada, the European Union, Hong Kong, Japan and Switzerland (as to entity-level requirements) and (ii) by dealers located in the European Union and Japan  (as to certain transaction-level requirements).  “Substituted compliance” describes the circumstances where the CFTC would permit non-U.S. swap dealers to comply with regulations in their home jurisdictions as a substitute for compliance with the relevant CFTC rules. The comparability determinations are part of substituted compliance with respect to CFTC rules applicable to swaps activities outside the U.S., which is part of the framework the CFTC described in its Cross-Border Guidance (published July 26, 2013).

As to each of the six jurisdictions, the CFTC found that the following entity-level rules were “identical in intent” or “generally identical in intent” with the similar CFTC rules such that compliance with home-country rules would constitute compliance with the CFTC’s rules:  CFTC Rule 3.3 (Chief Compliance Officer); CFTC Rules 23.600-609 (Risk Management); CFTC Rule 23.601 (Monitoring of Position Limits); CFTC Rule 23.602 (Diligent Supervision); CFTC Rule 23.603 (Business Continuity); CFTC Rule 23.605 (Conflicts of Interest); CFTC Rule 23.606 (Availability of Information for Disclosure and Inspection); CFTC Rule 23.609 (Clearing Member Risk Management); and CFTC Rule 23.201 and 203 (Swap Data Recordkeeping); provided, however, in a number of jurisdictions, the CFTC required that additional reports be made regarding substituted compliance.

The CFTC stated that this approval reflects a collaborative effort with cross-border market stakeholders. Working with authorities in Australia, Canada, the European Union (“EU”), Hong Kong, Japan, and Switzerland, the CFTC was able to issue comparability determinations for a broad range of entity-level requirements (see related attached summary chart). In two jurisdictions, the EU and Japan, the CFTC also approved substituted compliance for a number of key transaction-level requirements. 

For the EU, the CFTC issued cmparability determinations for the following transaction-level requirements:  CFTC Rules 23.501 (“Swap Confirmation”), 23.502 (“Portfolio Reconciliation”), 23.503 (“Portfolio Compression”), and certain provisions of 23.202 and 23.504 (“Swap Trading Relationship Documentation”). For Japan, the CFTC issued comparability determinations for transaction-level requirements under certain provisions of CFTC rules 23.202 and 23.504.  No transaction-level comparability determinations were issued for the other four jurisdictions.

In addition to the comparability determinations for certain countries, the CFTC issued a no-action letter providing relief from certain registration and reporting requirements for registered SDs and MSPs that are non-U.S. persons that are established under the laws of Australia, Canada, EU, Japan, or Switzerland, as long as the entity is not a party of an affiliated group or ultimate parent company established in the U.S.  The letter extends relief from certain swap data reporting rules to set forth in CFTC Rule 45 (“Swap Data Recordkeeping and Reporting Requirements”) and Rule 46 (“Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps”).

Lofchie Comment:  These remarkable CFTC findings that every financial regulator everywhere in the world has swap regulations that are “[generally] identical in intent” to CFTC swap regulation seem to constitute a complete retreat by the CFTC from its starting point that the CFTC was going to dictate to financial regulators around the world how their home-country swap dealers should be regulated.  Save for requiring the various swap dealers to provide reports (“generally” in English) to the CFTC, the CFTC completely surrendered on the notion that it would become the world’s chief regulator as to swaps. 

It is not clear what caused the CFTC, or more particularly its outgoing Chairman, to give up on global regulation at the entity-level so completely.  However, one might speculate that with CFTC Chairman Gensler on the verge of departure, and given that he will  be leaving behind for his successor a lot of baggage including: (i) litigation over the cross-border guidance, (ii) potential litigation over the position limits, and (iii) a set of rules that is largely written but is generally believed to need a good rewrite, he felt obligated to resolve at least one mess.   

The dissent to the findings of substituted compliance by Commissioner O’Malia is interesting in a number of respects.  First, he makes that point that the CFTC’s cross-border guidance, which is the predicate for these findings, was itself arguably adopted in violation of the Administrative Procedures Act, which makes the whole exercise of determining the need for substituted compliance  arguably moot.  (This will be ultimately determined in litigation.)  The even more interesting, in some ways, policy point Commissioner O’Malia makes is that the CFTC would be better off working with non-U.S. regulators on developing harmonized rules rather than asserting that the CFTC’s rules were the model and other names must follow as closely as they can.  While it seemed during the debate over the cross-border rules that O’Malia’s approach was more conciliatory than the hard-line U.S.-dominated approach taken by Chairman Gensler, one may now argue the opposite is in fact the case.  By being forced to concede that every country around the world has swap regulations that are substantively identical to those in the United States, the CFTC has effectively put itself in the position where it has no basis whatsoever to criticize non-U.S. regulations going forward.  On the other hand, Commissioner O’Malia’s approach, which would have emphasized global conversations rather than global domination, would have afforded the CFTC an ongoing role in a global dialogue as to appropriate regulation.  

As a closing matter, we observe that U.S. swap dealers subject to the full burden of (we think often ill-conceived) CFTC regulations will now, in many cases, be at a meaningful competitive disadvantage as compared to non-U.S. swap dealers who are subject to home-country regulations.

See:   Home Page for Substited Compliance Determinations with links to all Related Materials; Entity-Level ComparabilityTable; CFTC No-Action Letter 13-75.
See also: Joint Statement of Chairman Gensler and Commissioners Chilton and Wetjen; Commissioner O’Malia’s Statement of Dissent.
Related news: Commissioner O’Malia Criticizes CFTC Rulemaking and Implementation (October 18, 2013); Market Participants File Lawsuit Challenging CFTC Cross-Border Guidance for Being a Rule Adopted in Violation of the APA (December 4, 2013).
See also: YouTube Musical Selection.

Don’t Regulate Asset Managers As If They Were Banks

CFS Advisory Board Member Randal Quarles co-authored a letter with past SEC Chairmen, FDIC Chairmen, CFTC Commissioners, and SEC Commissioners encouraging thoughtful discussion and consideration of alternatives with regards to regulating asset managers. The letter was printed in The Wall Street Journal and is a response to a recent report titled “Asset Management and Financial Stability” that was put forth by the Office of Financial Research.

See: Randal Quarles’ Letter to the WSJ Titled “Don’t Regulate Asset Managers as If They Were Banks”

Studies Referenced in the Letter
See: Office of Financial Research Study
See: General Accountability Office Report

CFS Comments
See: Steven Lofchie’s Assessment of the OFR Study

SEC Commissioner Gallagher Discusses Concerns with Global Financial Regulatory Harmonization

At the Federal Republic of Germany in Berlin, SEC Commissioner Daniel M. Gallagher delivered a speech regarding the impact of post-global regulatory reforms on financial markets, with a specific focus on what he referred to as “the trend towards so-called ‘regulatory harmonization.'” 

According to Commissioner Gallagher, the legislative response to the 2008 global financial crisis, the Dodd-Frank Act, really had nothing to do with the crisis at all. The fact that Dodd-Frank was enacted before the completion of the Commission’s investigation of the causes of the crisis, Gallagher stated, is the most telling indication that Dodd-Frank was really just “a vehicle for ramming through the long-held ambitions of policymakers, bureaucrats, and special interest groups.”

According to Gallagher, prior to the global financial crisis, many U.S. and EU financial institutions were subject to national regulatory standards that were often duplicative and overlapping, and sometimes inconsistent.  To find common ground, regulators worked toward regulatory harmonization, focusing on regulatory equivalence and substituted compliance.  Gallagher noted that there have been some advances toward this sort of regulatory harmonization, such as the regulation of credit rating agencies and the SEC’s more recent implementation of Title VII of Dodd-Frank, which mandated regulation of the over-the-counter (“OTC”) derivatives market.  However, Dodd-Frank greatly complicated the task of arriving at regulatory harmonization through its misprioritizations, such as the conflicts minerals and other “social disclosure” provisions.

Gallagher further stated that the post-crisis form of regulatory harmonization “has become a euphemism for forcing nations to accept a unitary set of regulatory standards created by international bodies that exist outside of the formal constitutional structures of nations.” He cited bodies such as the G20, the Financial Stability Board (“FSB”), and the International Organization of Securities Commissions (“IOSCO”) as organizations that have taken on an “opaque” character, attempting to claim regulatory powers that should reside in sovereign governments.

Commissioner Gallagher specifically noted the Financial Stability Oversight Council (“FSOC”) as an example of this sort of entity on a domestic level, stating that FSOC was given unintended regulatory powers, particularly “the authority to make a ‘recommendation’ to a member agency to engage in a particular rulemaking.”  According to Gallagher, an example of this was the FSOC’s recommendation to the SEC with respect to money market mutual funds.  He said that group like FSOC is particularly troubling, since it is a distinctly partisan body and its members are individuals handpicked by the President “who are under no obligation to represent their agency as a whole.”  As a consequence, Gallagher stated, voices in the FSOC drown out those of the CFTC and the SEC, citing the FSOC banking regulator’s influence in the various Basel Accords as an example.  Gallagher stated that he worries the current approaches to regulatory harmonization will result in capital markets and economies that are inefficient and that operate at less than their full potential. 

Lofchie Comment:  Commissioner Gallagher makes a number of arguments, all of them worthy of discussion. 

As to the notion that Dodd-Frank has essentially nothing to do with the financial crisis, the recent “successes” of the CFTC demonstrate how little benefit Dodd-Frank provides. For example, the CFTC has now forced much of the plain vanilla interest rate swaps market through regulated clearing houses, with the result that the market now has somewhat greater transparency as to the pricing of interest rate swaps. But a lack of transparency with regard to interest rate swaps had nothing to do with the recent crisis. The problem was not that the market remained unaware of what interest rates were; the problem was that interest rates were, in retrospect, too low. Now that we know with some precision what swap interest rates are, how does that make the economy safer? Yesterday’s report by the Office of Financial Research said (at page iii):  “The current financial environment, marked by low interest rates and low volatility, has spurred risk-taking, making markets and institutions more vulnerable to a sharp increase in interest rates, volatility, or both.”  In short, knowing with added precision that swap interest rates are very low is not making the markets any safer. In fact, it is not clear what exactly has changed because of this new bit of knowledge.

A second observation that Commissioner Gallagher makes – that the Office of Financial Research established by Title II of Dodd-Frank is essentially a partisan agency – was not so obvious when the law was passed.  OFR is largely made up of members of one party, unlike most other financial commissions that are made up of three members from one party and two from the other.   As we commented in yesterday’s news report, it did seem that the report on U.S. financial regulation just issued by the OFR was disappointing with regard to the absence of any self-reflection.  (Here is a link to the report and our comment on it.)  By way of example, Form PF (which we understand was largely developed by OFR and is intended to provide information about hedge funds to OFR) has questions that, on their very face, are so badly written that it is obvious they cannot provide useful information to anyone, and certainly not information worth the cost of collection. But rather than focusing on ways that it might reexamine what it is doing, and on whether the information it is gathering is worth the cost, the OFR’s report is heavy with implicit self-praise that seems consistent with the production of a partisan agency. This is too bad, because political balance increases the likelihood of reasonable regulatory policy and oversight. The General Accounting Office is one example of that.

A third observation by Commissioner Gallagher – that there has been an overemphasis in the efforts to harmonize the global regulatory system – is problematic from a practitioner’s perspective. Current government regulation seems so arbitrary that it is impossible to expect companies to operate across borders when they are forced to comply with diverse sets of cumbersome rules. But it is hard to understand why we are forcing other countries to race alongside us. If the United States is convinced that its’ banks are made safer by complying with the Volcker Rule – a belief that (at least as the Volcker Rule was adopted by Congress) seems not to be shared by the banking regulators of any other country – then why exactly is it necessary that we force non-U.S. banks to operate according to a U.S. prescription?

See: Commissioner Gallagher’s Speech


CFS Monetary Measures for November 2013

Today we release CFS monetary and financial measures for November 2013. CFS Divisia M4, which is the broadest and most important measure of money, grew by 2.7% in November 2013 on a year-over-year basis versus 3.7% in October.

The unusually low number was likely influenced by diminished repurchase agreements over the Thanksgiving holiday. Excluding the holiday effect, we estimate that CFS Dvisia M4 would have increased by 3.4% on a year-over-year basis in November.

For Monetary and Financial Data Release:

Office of Financial Research Issues 2013 Annual Report to Congress

Dodd-Frank requires that the Office of Financial Research (“OFR”) annually report the state of the U.S. financial system, the status efforts of the OFR, and key findings from research regarding a robust analysis of the financial system. 

The report found that threats to financial stability have “generally abated” since the previous 2012 report.  However, it also found that the greatest threats that remain are the vulnerabilities in markets for securities financing transactions and credit, increases in interest rates, and uncertainty about the U.S. fiscal policy outlook.  The OFR stated that there could be mispriced credit risk amid weakening standards for loan underwriting, which is reflected in looser covenants and bank lending conditions.

The report also noted that improvement must be made in the scope of data available for financial stability monitoring. It announced a new comprehensive tool to track threats, and the interplay among aggregated activities, called the Financial Stability Monitor.  The monitor addresses five components of financial stability risk: macroeconomic, market, credit, funding and liquidity, and contagion.

Finally, the report outlined the top analytical and data priorities for 2014, which included:

  • further developing the capacity of OFR tools to identify, assess and monitor threats to financial stability;
  • improving and implementing the framework to evaluate stress tests and the macroprudential toolkit; 
  • following up on work on asset management to analyze new data collected from private fund advisers by the SEC;
  • creating reference databases for financial entities and financial instruments;
  • filling the data gaps identified for separate accounts and securities lending;
  • promoting the incorporation of the LEI in market practice and regulations; and
  • assisting and advising market regulators and OFR global counterparts in improving the standards needed to collect and share data measuring derivatives transactions and positions collected in trade and swap data repositories.

Lofchie Comment:  Before the OFR imposes massive new data collection costs on the economy, it ought to revisit (or perhaps the GAO should assess) the burdens of its current information collection efforts and whether it is actually collecting data in useful forms.

See: OFR 2013 Annual Report to Congress.