Trade Associations Submit Joint Comment Letter to FRB Regarding Activities of Financial Holding Companies Related to Physical Commodities

The Securities Industry and Financial Markets Association (“SIFMA”), the American Bankers Association (“ABA”), the Financial Services Forum (“FSF”), the Financial Services Roundtable (“FSR”) and the Institute of International Bankers (“IIB”) (collectively referred to as the “Associations”) submitted a comment letter to the Board of Governors of the Federal Reserve System (“FRB”) on complementary activities, merchant banking activities and other activities of financial holding companies (“FHCs”) related to physical commodities.

In the letter, the Associations stated that the public benefits of continuing to permit FHCs and their nonbank affiliates to engage in physical commodities activities greatly outweigh the potential risks of those activities, whether conducted under the complementary, grandfathering or merchant banking authorities.

See: Comment Letter.


SEC Associate Director Berman on Complexity and Speed of Markets

At the North American Trading Architecture Summit, SEC Associate Director of the Office of Analytics and Research (Division of Trading and Markets) Gregg E. Berman delivered a speech discussing market complexity, market speed, and research that the Division of Trading and Markets has done to inform both of these topics.

Technological advances, Mr. Berman noted, “allow market participants to submit many thousands of quotes in less than a second on our national equity and options exchanges.” With the events of the past year in mind, Mr. Berman said, he asked whether the current market structure is (i) too fast and (ii) too complex. Mr. Berman stated that data-driven analysis can help inform the policy debate.

The research to which Mr. Berman first referred involved measuring the speed at which quotes are canceled, and at which market participants can lift quotes before they are canceled (SeeThe Speed of Equity Markets,” October 9, 2013). The results, according to Mr. Berman, suggest that the speed of systems that take liquidity by accessing displayed quotes seems to be keeping up with the speed at which those quotes can be canceled and, “thus, if you would like to slow the market down, you have to address both liquidity takers as well as liquidity providers.” Mr. Berman stated that these results, along with other data analyses, suggest that there may be a lot more to the debate about market structure than just high-speed cancellations.

Mr. Berman went on to note that the Office of Analytics and Research published additional findings that provided distinct distributions for quotes at or near the beginning of the book, instead of anywhere in the depth of the book (SeeEquity Market Speed Relative to Order Placement,” March 19, 2014). According to Mr. Berman, the results are a straightforward measurement of the way market participants actually trade: “the data show that the majority of all displayed quoting activities occur in the depth-of-book, away from the inside spread.” Mr. Berman said that these results are unsettling because they suggest that liquidity takers focus their trading efforts on nothing more than what’s available at the National Best Bid and Offer (“NBBO”), and that he wondered whether there is “some fundamental mismatch between the nature of liquidity takers and liquidity makers.”

Mr. Berman also mentioned a white paper, published last October, in which SEC economists used FINRA OATS data to review off-exchange trading, the results of which suggested that “the buy-side uses the same algorithms in dark pools that they use on lit exchanges to slice up large orders into much smaller pieces to trade at the NBBO.” (See Alternative Trading Systems: Description of ATS Trading in National Market System Stocks,” October 2013, Revised March, 2014). The results showed that almost half of all off-exchange institutional trades during the time of the research seem to have been executed by broker-dealers as part of smart-order router networks outside of a registered ATS platform. Mr. Berman stated that, based on all of this research, it seems that “a number of the complexities of market structure may, at least in part, be driven by the complex desires of market participants themselves.”

Mr. Berman concluded with a discussion of the products traded on the markets. He noted that “exchange-traded products, including exchange-traded funds, exchange-traded notes, and other similar vehicles” have grown in the past decade, and that keeping all of these products in line “requires a lot of quoting, canceling, and re-quoting.” He said that the Office of Analytics and Research measured a 21-month period and found that there was “a relatively stead cancel-to-trade message ratio of about 20-to-1 for corporate stocks.” (See Market Activity Overview,” December 2013). Additionally, for every 1,000 shares quoted in corporate stocks, about 30 shares are traded; and for every 1,000 shares traded in exchange-traded products, 3 shares are traded. While these are not necessarily problematic or worrisome facts about exchange-traded products, Mr. Berman said, the products by construction require active quoting and canceling if investors want to receive fair prices when buying or selling the products.

As much as technology has driven complexity in the markets overall, Mr. Berman stated, he believes that “the desires of investors and investment managers – how they want to trade, the products they create, what they want to buy – requires an unavoidable increase in the complexity of our markets, and in a very real sense is also driving the need for more and faster technologies.”

Lofchie Comment: Despite all of the attention that Michael Lewis’s recent book Flash Boys has generated, it seems to have missed the real issue. Those who participate in and regulate the financial markets know it’s not about good guys and bad guys, it’s about market structure and the government rules that create that structure.

See: Associate Director Berman’s Speech.


SEC Issues Risk Alert to Announce OCIE Cybersecurity Initiative

The SEC Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert to provide additional information regarding the Cybersecurity Initiative. The alert states that the OCIE will be conducting examinations of more than 50 registered broker-dealers and investment advisers to assess firms’ governance, identification and assessment of cybersecurity risks. Additionally, the OCIE will evaluate the security of networks and information, including risks associated with customer access to fund information, transfer requests, and working with vendors or third parties.

The OCIE’s Risk Alert includes a sample request for information and other documents used in the initiative, explaining that the initiative is designed to assess cybersecurity preparedness in the securities industry and obtain information about recent cybersecurity threats.

See also: Description of March 26, 2014 SEC Roundtable.
Related news: OCC Comptroller Curry Discusses Cybersecurity (April 17, 2014); SEC Commissioner Aguilar Gives FSOC Thumbs-Down on Mutual Funds, Discusses Cybersecurity and Reg. NMS (April 3, 2014).


OCC Comptroller Curry Discusses Cybersecurity

In his remarks before a CES Government meeting, Comptroller of the Currency Thomas J. Curry discussed cybersecurity and the Office of the Comptroller of the Currency’s (“OCC”) recent guidance on managing third-party relationships.

Comptroller Curry stated that, while the financial industry is not the only sector at risk for cyber-attacks, it is one of the most attractive targets for terrorists and criminals alike. Comptroller Curry stressed that he is not trying to discourage the use of third-party vendors, but added that they pose significant risks in the realm of IT systems and information security.

Comptroller Curry mentioned three specific risks related to third-party cybersecurity: (i) the extent to which service providers are consolidating and leaving financial institutions more dependent upon a single vendor, (ii) the increased reliance by banks on outside vendors, including foreign-based subcontractors, to support critical activities, and (iii) the access that third parties have to large amounts of sensitive bank or customer data. He noted that the OCC issued an updated guidance, which will be updated frequently, that focuses on risk-management practices to address these concerns and others.

See: Comptroller Curry’s Speech.
See also: OCC Risk Management Guidance.


SEC Commissioner Gallagher Urges “Regulatory Humility” before International Regulators

In his speech before the Annual International Institute for Market Development, SEC Commissioner Daniel M. Gallagher discussed cooperation among regulators and post-crisis shortcomings in regulatory harmonization.

Stating that “harmonization” has become a euphemism for “forcing nations to accept a unitary set of regulatory standards created by international bodies,” Commissioner Gallagher contended that the approach taken thus far assumes not only that there is a single regulatory solution to a problem, but also that, simply by joining together in international forums, “imperfect regulators can find that perfect solution.” That, he suggested, is the height of regulatory hubris.

(He cites the recent FSB/IOSCO Consultative Document proposing methodologies for designating globally active systemically important investment funds as particularly problematic.)

Commissioner Gallagher concluded by urging “regulatory humility.” Importing U.S. or EU rules, he noted, would not make sense. Reminding the audience that the SEC’s foreign counterparts have regulatory goals similar to its own, the Commissioner stated that he believes the correct alternative is cooperation through the processes of regulatory equivalence and substituted compliance. This, he stated, will avoid complicated cross-border regulatory disputes and “provide greater certainty and predictability to cross-border transactions.”

Lofchie Comment: There was a time when the United States could boast of having such a sensible regulatory system that other nations ought to imitate it. Post Dodd-Frank, it is impossible to argue that other nations should follow the U.S. model, particularly the U.S. model as implemented by the CFTC in the last several years. Assuming the goal is to create sensible and transparent financial regulation that correlates positively with economic growth, other nations should evaluate their own regulatory needs independently and come up with a sensible set of rules. Perhaps their rules may serve as a model for the U.S. The House’s recent passage, with a bipartisan vote, of a measure to reauthorize the CFTC, but subject it to rational restraints is a positive sign that not even the United States Congress believes that U.S. regulators are leading the world on the right path.

See: Commissioner Gallagher’s Speech.
Related news: House Agriculture Committee Approves Bipartisan Legislation to Reauthorize CFTC (April 10, 2014).


European Parliament Adopts Updated Rules for Markets in Financial Instruments (MiFID II)

The European Parliament voted to adopt updated rules for markets in financial instruments (MiFID II). In response to the vote, Internal Market and Services Commissioner Michel Barnier stated that the new rules will establish “a safer, more transparent and more responsible financial system and restore investor confidence in the wake of the financial crisis.” Key elements of the MiFID II include:

  1. a market structure framework that closes loopholes and ensures that trading, wherever appropriate, takes place on regulated platforms;
  2. increased equity market transparency and, for the first time, an established principle of transparency for non-equity instruments such as bonds and derivatives. (This includes rules to enhance the effective consolidation and disclosure of trading data through the obligation of trading venues to make pre- and post-trade data available on a reasonable commercial basis, and through the establishment, for post-trade data, of a consolidated tape mechanism);
  3. strengthened supervisory powers and a harmonized position-limits regime for commodity derivatives in order to improve transparency, support orderly pricing and prevent market abuse;
  4. a new framework to improve conditions for competition in the trading and clearing of financial instruments;
  5. trading controls for algorithmic trading activities that have increased the speed of trading dramatically and can cause systemic risks;
  6. stronger investor protection through better organizational requirements, such as client asset protection and product governance;
  7. a bolstering of the existing regime to ensure effective and harmonized administrative sanctions; and
  8. a harmonized regime, for granting access to EU markets for firms from third countries, which is based on an equivalence assessment of third-country jurisdictions by the Commission.

See: European Commission Press Release; MiFID II: Frequently Asked Questions.


Basel Committee Issues Final Standard for Capital Treatment of Bank Exposures to Central Parties

The Basel Committee on Banking Supervision released revised final standards for capital requirements for bank exposures to central counterparties (“CCPs”). Notable revisions of the framework include:

  • a new approach for determining the capital requirements for bank exposures to qualifying CCPs (“QCCPs”);
  • employing a standardized approach for counterparty credit risk (as opposed to the Current Exposure Method) to measure the hypothetical capital requirement of a CCP;
  • an explicit cap on the capital charges applied to bank exposures to QCCPs (i.e., those charges will not exceed the charges that would be otherwise applicable if the CCP were a non-qualifying CCP);
  • specification of the treatment for multilevel client structures; and
  • the inclusion of text relating to frequently asked questions posed to the Basel Committee in the course of its work on the revised policy framework.

See: Final Requirements; Interim Requirements; Press Release.


FSB Releases Progress Report on OTC Derivatives Reforms

The Financial Stability Board (“FSB”) published the seventh of its semiannual progress reports on the implementation of OTC derivatives market reforms. The seventh report found that substantial progress has been made toward meeting the G20 commitments, through (i) international policy development, (ii) jurisdictions’ adoption of legislation and regulation and (iii) expansion in the use of market infrastructure.

Additionally, the report identified several areas in which further work was needed. In particular, Agencies were urged to:

  1. put in place their remaining legislation and regulation promptly, and in a form flexible enough to respond to issues of cross-border consistency;
  2. provide clarity on their processes for making equivalency or comparability decisions (including whether additional authority may be needed to defer, where appropriate, to other jurisdictions’ regimes); and
  3. continue to coordinate closely and cooperate as needed to seek to resolve cross-border regulatory issues as and when they are identified.

See: OTC Derivatives Reform Report.


SIFMA AMG Releases Survey on Separate Accounts’ Impact on Systemic Risk

SIFMA Asset Management Group (“SIFMA AMG”) released the results of a survey to determine separate accounts’ vulnerability to systemic risk. 

SIFMA AMG surveyed nine asset managers on a number of issues, including investment strategy, use of leverage, investment in illiquid assets, use of securities lending, the regulatory status of the underlying clients, and risk management processes.  The survey found that separate accounts do not typically pose risk to financial stability.  Specifically, the survey found that in separate accounts with greater than $75 million in assets under management (AUM):

  • 99% invested in long-only strategies, with 53% invested in passively managed, diversified index strategies;
  • less than 4% of the large separately managed accounts (SMAs) surveyed employed leverage and the average leverage reported for these accounts is modest;
  • less than 2% of the large SMAs surveyed held illiquid securities and less than 2% engage in securities lending; and
  • 100% of respondents robustly monitor counterparty risk and employ comprehensive risk management procedures.

SIFMA AMG stated that it conducted this survey to “provide data on the assets and investment strategies of separate accounts managed by asset managers, and to clarify important misconceptions.”

See:  SIFMA Survey Results; Press Release.