MFA Submits Comments to IOSCO and FSB on Assessment Methodologies for Nonbank Non-Insurer SIFIs

Posted on April 11, 2014 by Steven Lofchie

The Managed Funds Association (“MFA”) submitted a comment letter to the Financial Stability Board (“FSB”) and IOSCO in response to the FSB-IOSCO consultation paper on assessment methodologies for nonbank and non-insurer globally and systemically important financial institutions (“SIFIs”).

In the letter, MFA encouraged the FSB and national systemic risk regulators to analyze hedge fund information using a quantitative-based metric, which MFA believes will demonstrate that hedge funds do not pose systemic risk. Additionally, MFA responded to specific proposals in the consultation paper, encouraging the FSB to adopt final recommendations consistent with the following key points:

systemic risk regulators should conduct analysis at the individual fund level and not at the level of the family of funds, the asset manager, or the asset manager and its funds collectively;
the FSB and IOSCO should use a metric other than gross notional exposure (“GNE”) to measure an investment fund’s gross assets under management, since GNE does not a reflect a fund’s actual market risk or counterparty exposure and ignores material variations among positions by (i) asset class, (ii) tenor, (iii) netting terms, (iv) margining and collateral arrangements and (v) clearing status;
the FSB and IOSCO should only recommend indicators that are consistent with the statement in the consultation paper that investment funds may cause systemic risk via the counterparty channel and the market channel; and
the FSB and IOSCO should only recommend indicators that are well designed to measure systemic risk and not recommend indicators that are likely to measure other types of non-systemic risk.

See: MFA Comment Letter.
Related news: SIFMA AMG Submits Comments to the FSB and SEC in Response to OFR Study and with Regard to Separate Accounts (April 8, 2014); SIFMA AMG Submits Comments to the FSB on Assessment Methodologies for Identifying Non-Bank Non-Insurer G-SIFIs (April 7, 2014); IOSCO and FSB Publish Proposed Assessment Methodologies for Identifying Non-Bank Non-Insurer Global SIFIs (January 9, 2014).

Market Participants Support Challenge to CFTC Cross-Border Guidance

Posted on April 10, 2014 by Steven Lofchie

ISDA, SIFMA and the Institute of International Bankers (“IIB”) (together, the “Associations”) submitted a consolidated reply in support of their motion for summary judgment and in response to the CFTC’s Cross-Motion for Summary Judgment and to Dismiss in Part, in the Associations’ challenge to the CFTC’s Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations (the “Cross-Border Rule”). The consolidated reply asks the Court to grant the Associations’ motion for summary judgment and to deny the CFTC’s cross-motion, arguing that:

Though the CFTC defended the Cross-Border Rule as a policy statement, and contended that the Cross-Border Rule cannot possibly be a rule, as it contains disclaimers of any binding effect, the Cross-Border Rule nevertheless establishes who must register, which transactions must be cleared and other critical aspects of the CFTC’s regulatory regime; therefore, it is a substantive rule.
Because the CFTC did not properly address cross-border application in adopting the Title VII rules, those rules cannot apply overseas and are invalid to the extent to which they purport to do so.
In addition to the procedural issues with the Cross-Border Rule, the Associations outline additional significant errors by the CFTC in the course of fashioning the Rule’s specific provisions.
Notwithstanding the CFTC’s argument that the Associations’ claims are not ripe for decision because the Cross-Border Rule adopted a “case-by-case approach” and “does not purport to express a view on all scenarios,” the Cross-Border Rule is a substantive rule and therefore is reviewable.
Finally, the Associations contend that the Court can and should remedy the CFTC’s violation of basic rulemaking procedures. The Associations state that, contrary to the CFTC’s claim, granting the request relief would “promote the public interest,” foster uniform and transparent regulation, prevent lawless agency action and, ultimately, uphold the rule of law. The Associations quote N. Mariana Islands v. the United States, which found that “The public interest is served when administrative agencies comply with their obligations under the APA.”

Lofchie Comment: The CFTC should lose this suit as a matter of law. In many ways, though, the CFTC would benefit from such a loss, which would allow it to walk away from a material part of the flawed rulemaking and restart with a better approach. As things are progressing, the agency may have no choice. The House of Representatives yesterday passed a bipartisan bill (supported by both the Republican and Democratic leaders of the House Agriculture Committee) that would effectively render the guidance moot (Section 359 of the bill, titled Cross-Border Regulation of Derivatives) and require the CFTC to adopt a formal rule governing cross-border jurisdiction within 180 days (not a long timeframe given the complexity of the issues). The CFTC is now stuck with guidance that it has conceded is not enforceable as an administrative matter, that makes very little sense as a matter of public policy, that has been rejected by both Republicans and Democrats in the House, and that may be rejected in the Senate as well (assuming that the issue continues to be addressed in a bipartisan manner).

House Agriculture Committee Approves Bipartisan Legislation to Reauthorize CFTC

Posted on April 10, 2014 by Steven Lofchie

The House Agriculture Committee approved the Customer Protection and End User Relief Act (H.R. 4413) by voice vote. The Bill, which was introduced on April 7, 2014, would reauthorize and improve the operations of the CFTC and address concerns relating to market certainty and customer protection.

The bill was reported out of Committee on April 9, 2014. Among the most significant aspects of the bill, are (i) the express imposition of cost-benefit requirements on the CFTC and (ii) the required changes that the bill would make in the administration of the CFTC.

The proposed cost-benefit provision would amend the existing one in Sec. 15(a) of the Commodity Exchange Act to make it more comprehensive and robust. In essence, the new language would make the cost-benefit consideration consistent with the cost-benefit analysis requirements of President Obama’s Executive Order 13563 for the entire executive branch to which the CFTC agreed some time ago when flaws in the way it went about cost-benefit analysis relating to Dodd-Frank rules were exposed by the agency’s Inspector General. This will codify such requirements in the statute.

Among the new items that the CFTC would be required to take into account and, presumably, to evaluate in its cost-benefit analyses would be:

considerations of the impact on market liquidity in the futures and swaps markets;
available alternatives to direct regulation;
the degree and nature of the risks posed by various activities within the scope of its jurisdiction;
the costs of complying with the proposed regulation or order by all regulated entities, including a methodology for quantifying the costs (recognizing that some costs are difficult to quantify);
whether a proposed regulation or order is inconsistent, incompatible or duplicative of other Federal regulations or orders; and
whether, in choosing among alternative regulatory approaches, the CFTC selects those which maximize net benefits (including potential economic and other benefits, distributive impacts and equity).

In addition, the legislation would make the Chief Economist and the Division Directors answerable to the Commission, not the Chairman alone as in current practice.

Lofchie Comment: While the proposed cost-benefit provisions of the bill are clearly a reaction to the conduct of former CFTC Chairman Gensler, the same would appear to be true of the statutory provision giving the Commission as a whole (and not merely the Chairman) authority with respect to Chief Economist and the Division Directors. Shared authority with respect to these important posts could go a long way toward reducing the future risk of fostering an imperial head of an agency who is able to exercise authority on a remarkably unchecked basis.

See: H.R. 4413; Summary of Legislation; House Agriculture Committee Press Release.
See also: FIA Statement on Bill.
Related news: House Agriculture Committee Introduces Legislation to Reauthorize CFTC (April 9, 2014).

SEC Deputy Director Grim Discusses Division of Investment Management Initiatives

Posted on April 10, 2014 by Steven Lofchie

At the 5th Annual DCIIA Public Policy Forum, SEC Deputy Director David Grim delivered remarks on the initiatives of the Division of Investment Management (“IM”) regarding target date funds, money market fund reform, the variable annuity summary prospectus, the investment adviser and broker-dealer initiative, and the rollover of retirement plan assets.

Director Grim stated that target date funds are a “prime example of industry innovation developed to meet the incredibly important and shifting challenge of retirement stability to American investors.” In 2010, the SEC proposed rules regarding target date funds to address concerns about investors’ understanding of those funds and, in 2013, the Investor Advisory Committee submitted a set of findings and recommendations relating to target date funds. In response, Director Grim stated that the Division of IM’s staff is currently preparing a request soliciting additional comments on a standardized risk-based glide path illustration for target date funds.

Regarding money market fund reform, Director Grim mentioned that, along with the first set of reforms in 2010, the SEC proposed additional reforms in June 2013 that were designed to “lessen money market funds’ susceptibility to heavy redemptions, improve their ability to manage and mitigate potential contagion from high levels of redemptions, and increase the transparency of their risks” while preserving their benefits. The proposal included two principal alternative reforms: (i) a floating NAV and (ii) allowance of the use of liquidity fees and redemption gates in times of stress. Director Grim stated that the staff is currently reviewing comment letters on the proposal, noting that adopting final rules on money market mutual funds is a critical priority for the SEC in 2014.

Director Grim also mentioned that the Division of IM is working on potential reforms to variable annuity disclosure. Even so, he noted, it is a challenge to boil down long and complex disclosure about variable annuities into the key facts that investors need to know about the limitations, costs and benefits of investments.

Additionally, he explained, Chair White has directed the staff to evaluate potential options available to the SEC regarding the investment adviser and broker-dealer initiative, including a uniform fiduciary standard for broker-dealers and investment advisers when dealing with retail customers, as well as other measures.

Director Grim briefly mentioned that colleagues in the OICE National Exam Program have indicated that, in keeping with their examination priorities for 2014, they will undertake initiatives related to the rollover of retirement plan assets.

See: Director Grim’s Speech.

FRB, FDIC and OCC Adopt Final Rule to Strengthen Leverage Ratio Standards for Large Banks

Posted on April 9, 2014 by Steven Lofchie

The Board of Governors of the Federal Reserve System (“FRB”), the FDIC and the Office of the Comptroller of the Currency (“OCC”) adopted a final rule to strengthen the leverage ratio standards for U.S. top-tier bank holding companies with more than $700 billion in consolidated total assets, or more than $10 trillion in assets under custody (“covered BHCs”), and their insured depository institution (“IDI”) subsidiaries.

Covered BHCs must maintain a leverage buffer greater than two percentage points above the minimum supplementary leverage ratio requirement of three percent, for a total of more than five percent, to avoid restrictions on capital distributions and discretionary bonus payments. IDI subsidiaries of covered BHCs must maintain a supplementary leverage ratio of at least six percent to be considered “well capitalized” under the agencies’ prompt corrective action framework. The final rule currently applies to eight large U.S. banking organizations that meet the size thresholds and their IDI subsidiaries.

The final rule will be effective on January 1, 2018.

The FRB, FDIC and OCC also issued a notice of proposed rulemaking that would modify the denominator calculation for the supplementary leverage ratio in a manner consistent with recent changes agreed to by the Basel Committee on Banking Supervision. The revisions in the proposed rulemaking would apply to all internationally active banking organizations, including those subject to the enhanced supplementary leverage ratio final rule. Comments on the proposed rulemaking will be due by June 13, 2014.

See: FRB Press Release; FDIC Press Release; Final Regulatory Capital Rule; Proposed Revisions to Supplementary Leverage Ratio.
See also: Chair Yellen’s Statement; Governor Tarullo’s Statement.
Related news: FRB, FDIC and OCC Issue Notice of Proposed Rulemaking on the Supplementary Leverage Ratio for G-SIBs (July 10, 2013); SIFMA, ABA and FSR Submit Comments to U.S. Federal Regulators on Proposed Leverage Ratio Rule (October 23, 2013).

NASAA Holds Public Policy Conference, SEC Commissioners Stein and Aguilar Speak

Posted on April 9, 2014 by Steven Lofchie

The North American Securities Administrators Association (“NASAA”) held its annual Public Policy Conference in Washington D.C., featuring speakers such as SEC Commissioners Kara Stein and Luis Aguilar, as well as Senator Joe Manchin (D-WV).

The two panels discussed (i) digital investments, focusing on Bitcoin and other new or emerging types, and (ii) the decrease of stock ownership among Americans and how to encourage main street investors to return to the capital markets.

Commissioner Stein discussed the importance of revisiting the partnership between the SEC and NASAA, especially with the upcoming finalization of the JOBS Act rules, including general solicitation, crowdfunding and Regulation A (“Reg. A”). Additionally, Commissioner Stein briefly noted that she would like to hear from the NASAA regarding disclosure reform and the debate surrounding high-frequency trading. She stated that the SEC should be considering whether there has been illegal conduct, and stressed the “need to revise or create new rules to stop conduct that we think should be illegal.”

Commissioner Aguilar focused his remarks on the States’ role in Reg. A-plus offerings, the SEC’s proposal to improve Regulation D (“Reg. D”), and the importance of taking steps to combat the potential increase in fraud resulting from the JOBS Act rules. He voiced his awareness of NASAA’s concerns with the provision of proposed Reg. A-plus that would effectively preempt state securities law registration and qualification requirements for all Tier 2 offerings. He stated that one key consideration is a concern about the cost of having to file and qualify an offering separately under the state securities laws of each jurisdiction, and the impact that it would have in discouraging market participants from using the new exemption. Commissioner Aguilar mentioned that the Coordinated Review Program, which NASAA members approved last month, could help to address this concern.

Additionally, Commissioner Aguilar spoke about the JOBS Act rule allowing general solicitation and advertising in securities offerings under Rule 506, or Reg. D, stating that there were concerns that mass marketing under Reg. D would make fraud easier. He urged NASAA to encourage the SEC to adopt changes to help ameliorate the risks in Rule 506. Overall, Commissioner Aguilar stated, the JOBS Act and its rules have the effect of blurring the lines between public and private companies. He stated that the SEC and NASAA members must communicate with one another to address the potential problems.

Lofchie Comment: One negative consequence of Dodd-Frank has been the intrusion of regulatory agencies into areas in which they have no particular expertise. By way of example, a number of the SEC Commissioners pointed out the intrusion of bank regulators (partially under the cover of FSOC) into matters that are within the expertise of the securities regulators. In this regard, it is interesting that Commissioner Stein should seek NASAA’s views regarding “high-frequency trading.” Although members of NASAA are experienced in matters of securities regulation, their expertise is focused generally on issues of investor protection and not matters of market structure (which is a fairly specialized regulatory and economic area). On the positive side, various Commissioners are pushing for a comprehensive review of market structure – an effort that seems overdue.

See: NASAA Conference Information; Commissioner Stein’s Remarks; Commissioner Aguilar’s Remarks.

House Agriculture Committee Introduces Legislation to Reauthorize CFTC

Posted on April 9, 2014 by Steven Lofchie

The House Committee on Agriculture introduced bipartisan legislation titled the “Customer Protection and End User Relief Act” (H.R. 4413) to reauthorize and improve the operations of the CFTC and to address concerns relating to market certainty and customer protection.

If passed, the Act would, among other things, amend the CEA to allow many end users who are legitimate “commercial market participants” to avoid being treated as financial entities. It would provide relief for end users who use contracts that result in the actual physical delivery of a commodity that has an embedded option to change the amount of a commodity delivered. It would also require the CFTC to conduct a report on high-frequency trading.

Highlights of the Bill include:

New procedural requirements for no-action letters and similar guidance;
New requirements associated with the use of the CFTC’s subpoena power;
Recordkeeping relief for certain end users;
Clarification for certain contracts with embedded volumetric optionality;
The lock-in of an $8 billion de minimis threshold;
Definition of bona fide hedging;
Relief for utility special entities; and
Cross-border rulemaking requirement with automatic exemptions absent agency action.

Lofchie Comment: This bipartisan measure, which seems consistent with the views and actions of Commissioner O’Malia and acting Chairman Wetjen, is a repudiation of the most egregious substantive and procedural regulatory excesses over the past five years. The new CFTC Chairman will greatly benefit from the passage of this legislation, as it will give him something of a fresh start in adopting reasonable swap regulation (within the limits of rationality afforded by Dodd-Frank).

One can readily imagine further improvements to the bill as well. For example, it is unclear why the “relief for municipal entities” should not be extended to other types of entities that are effectively precluded from entering into swaps with any person that is not a registered swap dealer. The definition of a non-financial entity in Section 351 of the bill is too narrow (it tracks the too-narrow definition in Dodd-Frank) and should be expanded (the 90% test just does not work).

See: H.R. 4413; Summary of Legislation; House Agriculture Committee Press Release.

Forecasting Bank Credit Ratings

Posted on April 9, 2014 by LeAnn Yee

We recently added Forecasting Bank Credit Ratings by Periklis Gogas, Theophilos Papadimitriou and Anna Agrapetidou from the Department of Economics, Democritus University of Thrace, Komotini, Greece to our policy library. The study was recently published in The Journal of Risk Finance (Volume 15, Issue 2, pp 195-209). Below is the abstract:

Purpose – This study aims to present an empirical model designed to forecast bank credit ratings using only quantitative and publicly available information from their financial statements. For this reason, the authors use the long-term ratings provided by Fitch in 2012. The sample consists of 92 US banks and publicly available information in annual frequency from their financial statements from 2008 to 2011.

Design/methodology/approach – First, in the effort to select the most informative regressors from a long list of financial variables and ratios, the authors use stepwise least squares and select several alternative sets of variables. Then, these sets of variables are used in an ordered probit regression setting to forecast the long-term credit ratings.

Findings – Under this scheme, the forecasting accuracy of the best model reaches 83.70 percent when nine explanatory variables are used.

Originality/value – The results indicate that bank credit ratings largely rely on historical data making them respond sluggishly and after any financial problems are already known to the public.

Keynote Address by Commissioner Scott D. O’Malia at New Risk in Energy 2014

Posted on April 8, 2014 by Steven Lofchie

In a keynote address at the New Risk in Energy 2014 Conference, CFTC Commissioner Scott O’Malia discussed how Dodd-Frank rulemakings have impacted the energy sector and its use of financial markets.

Commissioner O’Malia’s speech focused on, among others, the following key areas:

the importance of technological innovation as the CFTC moves to implement and enforce its new rules;
the need to limit the costs imposed on end users; and
the “futurization” of swaps and the negative impact that has on end users’ hedging activity.

Commissioner O’Malia began by discussing the CFTC’s technological shortcomings. He urged the CFTC to adopt a broader and more effective technology footprint and to ensure that CFTC regulations keep up with technology and the evolving market structure.

In his discussion of the implications of Dodd-Frank rulemakings for energy traders and other end users, Commissioner O’Malia observed that the CFTC “rushed to implement” 68 rules, noting that it has since issued over 180 staff no-action letters offering “some relief from our hastily drafted rules.” Considering the implications of this process, the Commissioner stated that the relief issued by the CFTC often “imposed new conditions and arbitrary deadlines” and that, “in more than two dozen cases, these no-action letters provided indefinite relief.” Detailing issues with the bona fide hedging requirements and safe harbor determinations stemming from the swap definition, Commissioner O’Malia further urged the CFTC to confront shortcomings in its rules in a way that is consistent with the Administrative Procedure Act.

Commissioner O’Malia concluded his speech by discussing the futurization of swaps and, in particular, the fact that futures do not provide the same tailored hedging benefits to end users that swaps provide. Noting the expansion of this practice, the development of new products, and growing interest in FX, interest rates, and credit products, O’Malia encouraged the CFTC to hold a hearing on these matters before it makes recommendations, suggesting that a Concept Release may be useful to initiate an open dialogue.

Lofchie Comment: For the remaining post-Gensler CFTC Commissioners, and for the three incoming Commissioners, including the new Chairman, assuming new responsibilities will be a bit like cleaning up the morning after a very wild party: the place is a mess, the neighbors (i.e. the neighboring countries) are angry and no one is sure why there is a sick goat in the bathtub. The temptation is to burn the place down and rebuild, but the Commissioners are stuck with cleaning it up.

See: Commissioner O’Malia’s Keynote Address; Commissioner O’Malia’s Slide Presentation.
Related news: CFTC Acting Chair Wetjen and Commissioner O’Malia Issue Statements Regarding End-User Issues (April 4, 2014); CFTC Commissioner O’Malia Delivers Speech Discussing Technology and the Future of Financial Standards (March 26, 2014); CFTC Commissioner O’Malia Remarks on the Impact of Dodd-Frank on Commodity Futures and Swaps Markets (March 24, 2014); CFTC Commissioner O’Malia: ”It’s Time to Review Our Rules and Make Necessary Changes” (January 28, 2014).

FRB Allows Banking Entities Two Additional One-Year Extensions to Conform CLO Ownerships Covered by Volcker

Posted on April 8, 2014 by Steven Lofchie

The Board of Governors of the Federal Reserve System (“FRB”) announced that it intends to give banking entities two additional one-year extensions to conform their ownership interests in and sponsorship of certain collateralized loan obligations (“CLOs”) covered by the Volcker Rule.

The FRB previously extended the conformance period for all activities and investment by one year, to July 21, 2015. To ensure effective compliance, the FRB stated that it intends to grant banking entities two additional one-year extensions, which together would extend the conformance period until July 21, 2017. Only CLOs in place as of December 31, 2013, that do not qualify for the exclusion in the final rule for loan securitizations would be eligible for the extension. The FRB stated that it intends to act on these extensions in August of 2014 and 2015.

A banking entity would not have to include ownership interests in CLOs to determine its investment limits under the final rule, and a banking entity would not be required to deduct CLO investments from tier 1 capital under the final rule until the end of the relevant conformance period.

According to the press release, the FRB consulted with the staff members of other agencies charged with enforcing the requirements of the Volcker Rule, including the OCC, SEC, FDIC and CFTC. The agencies plan to administer their oversight of banking entities under their respective jurisdictions in accordance with the Board’s conformance rule, including extensions of the conformance period that are applicable to CLOs.

Reactions

Congressman Scott Garrett, Chairman of the Financial Services Subcommittee on Capital Markets and Government-Sponsored Enterprises, issued a statement urging U.S. financial regulators to “go back to the drawing board.” Noting that Congress did not intend for securitizations (including CLOs) to be covered under the Volcker Rule, Congressman Garrett suggested that the banking regulators were “completely unaccountable to Congress” and that they were engaging in a “remarkable” regulatory overreach.

SIFMA issued a statement expressing disappointment, suggesting that regulators should have addressed the problem in a more “coordinated and conclusive manner.”

See: FRB Press Release.
See also: Congressman Garret’s Statement; SIFMA’s Comments.
Related news: House Bill Would Clarify Ownership Interest Definition for CLOs under Volcker Rule (March 10, 2014); Trade Associations Request Further Clarification Regarding Ownership Interests for Debt Securities under New Volcker Rule Regulations (January 8, 2014); Trade Associations Request Clarifications Regarding Holding Debt Securities under New Volcker Rule Regulations (December 26, 2013).