The Financial Stability Oversight Council (“FSOC”) released a set of frequently asked questions (“FAQs”) on the nonbank financial company designations process. The FAQs address continued inquiries from insurance companies, asset managers, specialty finance companies, industry associations, and other stakeholders.
Dodd-Frank Section 113 (“Authority to require supervision and regulation of certain nonbank financial companies”) granted FSOC the authority to designate nonbank financial companies for heightened supervision – namely, enhanced prudential standards and consolidated oversight by the Federal Reserve – for the purpose of addressing threats that large, complex, interconnected nonbank financial companies could pose to financial stability.
In April 2012, FSOC issued a rule and guidance on its approach to exercising this authority. This FAQ is intended to provide greater clarity on the designations process.
It is unlikely that this FAQ will serve to answer anyone’s substantive questions as to how FSOC operates or will make designations. The fundamental issue is that the underlying law empowering FSOC is open-ended, giving the agency tremendous amounts of discretionary authority to designate financial institutions as financially significant based on ten factors, each of which may be in itself subjective, and all of which may be weighted in a subjective manner.
The FAQs essentially legitimize FSOC’s authority to make decisions in a completely one-off manner. FSOC asserts, in response to question 20: “In light of the nature, size, and complexity of companies under consideration and as directed by the Dodd-Frank Act, the FSOC conducts its analysis on a company-by-company basis in order to take into account the potential risks and mitigating factors that are unique to each company. Given the diversity of nonbank financial companies, applying identical analyses to all firms would not be an effective approach.” (One might note that a non-identical analysis is not the same as a non-consistent one, but this is not a distinction that the FAQ addresses.)
The FAQs response to question 21, whether the primary regulator for any particular type of financial entity had significant input into the determination of whether particular entities of that type would be designated as financially significant, also poses a problem. In response to this question, the FAQ states: “[As to] the two insurance companies that the FSOC has designated [as significant], the FSOC consulted with multiple state insurance regulators of the companies’ insurance subsidiaries.” The FAQ does not, however, discuss the fact that an insurance regulator who is a member of FSOC opposed the first designation of an insurance company as systemically significant, and may have voted “present” for the second. While nothing prevents FSOC as a group from overriding the input of a single member, disclosure of these facts in regard to question 21 would have provided a more complete answer to the relevant question.
According to an MFA blog post, the new SEC Regulation Systems Compliance and Integrity (“Reg. SCI”) could lead to higher trading fees for money managers and curtailing operations or closure for some smaller equity trading venues.
The rule would require all trading venues to submit alternative plans for operations in the event of a system breakdown, and require regular testing by the venues to ensure that those alternative plans would work. In its initial proposal, the SEC said that the estimated initial cost of organizations subject to the regulation would be up to a collective $242 million, with another $191 million in annual costs.
The original story, which was published in Pensions and Investments, quotes Christopher Nagy, founder and CEO of the market structure research firm KOR Group, as saying that “[t]he exchanges will have to pay for the testing, and that will be passed on to execution firms, the brokers.” Nagy explained that this will raise the bar for the cost of entry and will likely reduce the number of automated trading systems and smaller brokerage firms, causing further cost issues.
One of the ironies of the new regulations is that, for all of the chatter about “too big to fail,” substantial new regulations that impose fixed heavy costs drive up the price of doing business and make it impossible for small firms to succeed. This is not to say that new regulations are bad (or good), but rather to point out the obvious: the more heavily regulated the activity, the more likely it is that a small number of very large firms will be able to absorb the relevant regulatory costs. If the regulators are convinced that reducing risk requires the imposition of substantial “safety” regulations and their accompanying substantial costs, then the regulators must acknowledge that the result of those safety regulations is a highly concentrated industry of very large players. Put differently, where regulatory actions are creating a concentrated market, the policy consequence should be recognized and embraced.
In their remarks before the 2014 SRO Outreach Conference, SEC Chair Mary Jo White and Commissioner Daniel M. Gallagher spoke about reevaluating the role and function of SROs.
Chair White highlighted the key concerns for SROs and equity markets, including the risk of instability and disruption. She explained that there should be “zero tolerance for systems issues that undermine the reliability of our markets and erode investor confidence.” Chair White recommended that SROs develop a collaborative approach across landscapes to help reduce the number of disruptions. She also briefly touched on the importance of the SRO rule-filing process and participation in the National Examination Program.
Commissioner Gallagher advocated reexamining the status and structure of SROs, explaining that they are “fundamentally different from what Congress conceived of as self-regulation decades ago,” and that the circumstances under which they were put in place no longer exist.
The fact that the majority of equities exchanges outsource their SRO obligations and market surveillance to FINRA, Commissioner Gallagher said, calls into question the meaning of the SRO concept. He explained that, while there are benefits that arise from the consolidation of oversight into a single entity, regulators must still question whether this is the optimal solution, especially where the possibility of subjecting investment advisers to self-regulation is being considered. He recommended that regulators compare and contrast the two industries to better examine the strengths and weaknesses of self-regulation.
As to technology failures and self-regulatory organizations, the stated policy objective of “zero tolerance” should be reexamined. In complex systems, things go wrong. A regulatory system that accepts the existence of imperfection is better able to develop mechanisms to catch smaller errors and to share information about how to make improvements. A regulatory system that punishes every mistake results either in the concealment of errors or in driving anyone that makes a mistake out of business, leaving an industry with so few players that it is too dangerous to drive out the rest.
Now that virtually all of the exchange SROs have delegated the relevant regulatory tasks to FINRA, it is awfully hard to see why the system should be maintained in its current form. Let’s just acknowledge that, outside of certain self-surveillance obligations, the exchanges are not, and should not be, regulatory organizations.
The U.S. Government Accountability Office (“GAO”) issued a report (the “Report”) examining FSOC’s efforts to address the recommendations from a GAO 2012 report to improve transparency, accountability, collaboration and coordination. The Report found that, while FSOC has undertaken efforts to improve in those areas, additional efforts are needed.
The Report found that FSOC still lacks a comprehensive and systematic approach to identifying emerging threats to financial stability. Although FSOC developed two tools to address the GAO’s concerns, one of them does not focus on risks to the financial system and the other remains in the “prototype phase.”
Additionally, the GAO found that FSOC still needs to improve transparency and accountability. According to the Report, FSOC approved a revised transparency policy in which its staff said they had tried to provide more information in the minutes of meetings; however, FSOC staff said, they did not keep detailed minutes because of the confidential information discussed.
The Report also identified the ways in which FSOC could improve collaboration and coordination among other agencies. For example, FSOC approved bylaws for the Deputies Committee of senior officials from member agencies that describe its role in coordinating FSOC activities, which the GAO identified as a step toward improving collaboration. However, the FSOC staff stated, they do not plan to clarify the roles and responsibilities of FSOC, OFR and member agencies because the overlapping responsibilities for monitoring systemic risk had not been problematic.
The amount of discretionary authority exercised by FSOC, in light of both the judgment-oriented powers granted to it and the opaque nature of its decision-making process, ensures that the FSOC’s way of designating systemically important financial institutions will continue to be controversial.
IOSCO published a consultation report, titled ”Risk Mitigation for Non-Centrally Cleared OTC Derivatives,” which proposes standards across nine different areas aimed at mitigating the risks in the noncentrally cleared OTC derivatives markets.
The areas for the proposed standards include:
- scope of coverage;
- trading relationship documentation;
- trade confirmation;
- valuation with counterparties;
- portfolio compression;
- dispute resolution;
- implementation; and
- cross-border transactions.
The proposed standards were developed by IOSCO in consultations with the Basel Committee on Banking Supervision and the Committee on Payments and Market Infrastructures, and are intended to complement the margin requirements developed by those groups in September 2013.
Comments on the consultation report are due by October 17, 2014.
The Financial Engineering Division at Stevens Institute of Technology published new research on the state of high-frequency trading (“HFT”) and a proposed solution to mitigate key problems, the authors believe may be created by HFT, while “maintaining its benefits.”
The institute’s white paper, titled “On the Impact and Future of HFT,” addresses three major areas:
- HFT, as seen from various market agents’ perspectives;
- the imminent problems and risks of HFT, including potential HFT systemic risk, as seen by various stakeholders; and
- possible solutions to existing issues of HFT, along with recent claims of unfair practices facing HFT.
Additionally, the paper discusses issues raised by transmission distance and systemic latency, and proposes a new solution based on an “information transmission zoning concept” that would require “minimum financial information flow re-architecting and no major changes in regulation NMS.”
Commissioned by the Investor Responsibility Research Center Institute, the research for the paper was conducted by Khaldoun Khashanah, Ph.D., Ionut Florescu, Ph.D. and Steve Yang, Ph.D., all of whom are from the Stevens Institute of Technology’s Financial Engineering Division.
Today we release CFS monetary and financial measures for August 2014. CFS Divisia M4, which is the broadest and most important measure of money, grew by 2.5% in August 2014 on a year-over-year basis versus 2.6% in July.
For monetary and financial data release:
For more on Divisia methodology and past releases for the United States:
According to Professor Pirrong, Swap Execution Facilities (SEFs) are the “solution in search of a non-existent problem.”
According to Professor Pirrong, SEFs are the “solution in search of a non-existent problem.” Professor Pirrong explained that, in crafting SEFs, regulators took a narrow, one-size-fits-all approach by assuming that centralized order-driven markets were the best way to execute all transactions. In doing so, Professor Pirrong stated, regulators focused on pre-trade and post-trade transparency even as they “totally overlooked the importance of counterparty transparency.”
Every financial market, according to Professor Pirrong, has a diversity of trade mechanisms, since various types of trades and traders are more efficiently suited for different levels of transparency and disclosure. Dodd-Frank, or “Frankendodd,” as Professor Pirrong calls it, created SEFs in an attempt to establish “a monoculture and impose a standardized market structure for all participants.”
The notion that increasing SEF volumes indicates that use of SEFs is being welcomed is odd in terms of transactions in which SEF use is mandated. It’s a bit like claiming that people enjoy paying taxes simply because they do pay their taxes. Given the alternative, obviously, many swaps parties would prefer not to use SEFs.
The SEC announced the creation of a new office within the Division of Economic and Risk Analysis (“DERA”) that will coordinate efforts to provide data-driven risk assessment tools and models to support a wide range of SEC activities.
According to the SEC, the Office of Risk Assessment will continue to develop and use predictive analytics to support supervisory, surveillance and investigative programs involving corporate issuers, broker-dealers, investment advisers, exchanges and trading platforms. It will also support the SEC’s ongoing work related to FSOC.
The SEC stated that staffing for the new office will be drawn from across DERA, but that it will seek a new assistant director to head the office.
The Over-the-Counter (“OTC”) Derivatives Regulators Group (“ODRG”) issued a report that provides an update to the G20 on further progress in resolving OTC derivatives’ cross-border implementation issues.
The ODRG is made up of authorities with responsibility for OTC derivatives markets regulation in Australia, Brazil, the European Union, Hong Kong, Japan, Ontario, Quebec, Singapore, Switzerland and the United States. The report described two areas in which the ODRG is working to develop approaches to address cross-border issues: (i) potential gaps and duplications in the treatment of branches and affiliates, and (ii) the treatment of organized trading platforms and the implementation of the G20 trading commitment.
The report also addressed four areas in which the ODRG is implementing understandings reached previously: (i) equivalence and substituted compliance, (ii) clearing determinations, (iii) risk mitigation techniques for noncentrally cleared derivatives transactions (margin), and (iv) data in trade repositories and barriers to reporting to trade repositories.
The ODRG stated that it will submit its next report for the G20 Leaders Summit in November 2014.
The report “welcomed the set of understandings of the ODRG Principals on cross-border issues relating to OTC derivatives reforms as a major constructive step forward for resolving remaining conflicts, inconsistencies, gaps and duplicative requirements,” and was signed by the Chairpersons of both the SEC and the CFTC. It is difficult to gauge the extent to which the CFTC is prepared to resolve its jurisdictional disputes with regulators in the G-20 countries. On the positive side, the report notes that the SEC’s adoption of its cross-border rules is a sign of cross-jurisdictional progress. On the negative side, the report notes that the European Union is proposing determinations of regulatory equivalence with respect to central counterparty requirements in Japan, Australia, Hong Kong, India and Singapore (though no mention is made of progress with the United States).