Cautions against Macroprudential Regulation

Mercatus Scholar and former Congressional and SEC staff attorney Hester Peirce posted a commentary titled “No, Mr. Tarullo, We’re Not All Macroprudentialists Now.” The commentary examines the effects of a macroprudential approach to financial regulation, particularly in the asset management industry.  According to Ms. Peirce, a macroprudential approach, which would pinpoint the financial system as a whole and not just the well being of individual firms, “could undermine financial stability.” In particular, she explained, adding a macroprudential regulatory layer to asset management would create new risks by narrowing differences in the ways that assets are managed.

Ms. Peirce stated that using tools such as stress tests and liquidity requirements would “corral asset managers into similar strategies, assets, and risk management techniques.” Additionally, she warned that bank regulators will play an “increasingly central role” in regulating asset managers, causing the differences that distinguish the banking industry from the asset management industry to begin to disappear.

Ms. Peirce recommended that regulators emphasize “microprudential responsibility” over macroprudential regulation, since the need for asset managers to plan for bad events cannot be “outsourced to government regulators.”

Lofchie Comment: Governor Tarullo’s belief (see key quote below) that the government should protect the financial system by regulating the investment purchase and sale decisions made by individual investors, funds and advisers is worrisome. Ms. Peirce’s argument that any such regulation would be ineffective is less significant than the fact that allowing the government to regulate investment decisions is fundamentally inconsistent with the continued existence of a “private” market. If the government can dictate, for example, how much “private” investment in the aggregate is to be put into housing, energy or technology, then it follows that the government also must have the authority to allocate investment opportunities (otherwise, how could the government’s decisions about aggregate investments be enforced?). When it is given that much power, the government becomes everyone’s investment “adviser” and failing to take its investment “advice” becomes a violation of law.


Key Quotation: Here is the paragraph from Governor Tarullo’s speech in which he asserts that the government should have the authority to prevent investors from divesting themselves of assets (i.e., from selling), lest they encourage others to do the same:

“Asset management activities have commanded considerable attention lately, both internationally at the FSB and domestically at the Financial Stability Oversight Council (FSOC). The asset management industry has grown rapidly since the financial crisis, both in terms of the dollar amount of assets under management and in the concentration of assets managed by the largest firms. These trends may well continue as stricter prudential regulation makes investment in certain forms of assets more costly for banks. To the extent that asset management vehicles hold relatively less liquid assets but provide investors the right to redeem their interests on short notice, there is a risk that in periods of stress, investor redemptions could exhaust available liquidity. Under some circumstances, a fund might respond by rapidly selling assets, with resulting contagion effects on other holders of similar assets and, to the degree they had not already been subject to redemption pressures, other asset management vehicles holding those assets. The use of leverage by investment funds, including through derivatives transactions, could create interconnectedness risks between funds and key market intermediaries and amplify the risk of such fire sales.”

NASAA Offers Legislative Agenda for 114th Congress

The North American Securities Administrators Association (“NASAA”) issued a legislative agenda highlighting the policy priorities of state securities regulators for the 114th Congress.
NASAA’s legislative agenda includes four overarching principles:

Expand and Strengthen Protections for Senior Investors:
o Establish Senior Investor Protection Partnership Grant Program
o Reduce Reliance on Payment Systems Most Conducive to Fraud
o Adopt Diminished Capacity Legislation
Promote Investor Confidence through Effective Regulation:
o SEC Examination of Federally Registered Investment Advisers
o Sustained Federal-State Coordination Regarding Cybersecurity Challenges
o Law Enforcement Access to Information Stored on ISPs
o Deterring Fraud with Effective Civil Penalties
Promote a Fair and Transparent Marketplace for Retail Investors:
o Uniform Fiduciary Standard for Financial Professionals
o Information Disparities and Conflicts-of-Interest That Harm Ordinary Investors
o Equitable Recourse and Mandatory Arbitration Contracts
o Standardized Disclosure of Broker-Dealer Fees
Facilitate Capital Formation through Federal-State Partnerships:
o State Leadership in Innovation to Promote Capital Formation
o Implementation of the JOBS Act Consistent with Congressional Intent
o Review the Accredited Investor Definition
The NASAA report provides more detail about each of these issues.

Lofchie Comment: Two of NASAA’s proposals seem to have caught the public’s attention. They are not well justified. First, a “uniform fiduciary standard” for broker-dealers and investment advisers only makes sense if both types of entities are holding themselves out as providing the same services. If broker-dealers do not present themselves as providing investment advice that takes account of an investor’s overall financial situation, and do not charge fees that are as high as those of investment advisers, then it does not make sense to hold them to the same level of substantive requirements. Moving to a regulatory scheme in which a broker-dealer who charges a few cents a share for execution is expected to provide the same level of investment advice as an advisor who charges 1% of assets under management is a mistake, and compromises the economics behind being a full-service broker-dealer to retail investors. Under a “uniform fiduciary standard” retail investors will have to either do without talking to a broker or pay a substantial amount to an investment adviser (the economics of which may not really work for a small investor).

Second, the notion that high-frequency traders injure retail investors seems a matter of unsupported popular belief. If high-frequency traders benefit against any type of investor, then it is more likely that institutional investors trading large volumes of stock will be outrun by high-frequency traders.

SIFMA Submits Comments to SEC Relating to OCC’s Proposed Capital Plan

SIFMA submitted comments to the SEC on the proposed capital plan sought in a Notice of Filing of a Proposed Rule Change and in a Notice of Filing of an Advance Notice, both of which were filed by the Options Clearing Corporation (“OCC”).

SIFMA stated that it supports the appropriate capitalization of the OCC and other systemically important financial market utilities. However, SIFMA explained, it is “vital” that the enhancements to the OCC’s capital structure not “detract from or destroy the OCC’s successful history of operating as an industry utility for the benefit of market participants.” According to SIFMA, the proposed capital plan risks that very thing, and turns the OCC into a profit-making venture for selected securities exchanges.

SIFMA stated that the OCC should be encouraged to engage in a “public and transparent process” to ensure that it is able to obtain and maintain additional capital on terms and at prices that are “fair, reasonable, and efficient.”

FRB Powell on Financial Stability Reform and Credit Markets

Federal Reserve Board (“FRB”) Governor Jerome H. Powell discussed financial stability reforms and cautioned against supervisory interventions that “lean against” the credit cycle. The Governor delivered his remarks at the Stern School of Business of New York University.

According to Mr. Powell, the agenda for financial stability reform that relates to global systemically important banks (“G-SIBs”), financial market infrastructure and money markets is well developed. With regard to G-SIBs, Mr. Powell discussed higher capital requirements, liquidity regulation and stress testing, and noted that regulators have yet to work through resolution procedures and address cross-border issues regarding the failure of G-SIBs. Concerning market infrastructure, Mr. Powell explored possible reforms to the tri-party repo market, including the elimination of reliance on discretionary intraday credit to facilitate settlements, as well as central clearing for standardized derivatives and margin requirements for uncleared derivatives. Mr. Powell noted, however, that regulators have yet to adopt liquidity, margin and other regulations applicable to central counterparty clearinghouses. Finally, with regard to money markets, Mr. Powell cited the Securities and Exchange Commission’s 2014 rule on money market fund reform, and discussed the ongoing development by the Financial Stability Board of global margin rules for securities financing transactions involving nongovernmental securities.

In contrast to the reform agenda for G-SIBs, financial market infrastructure and money markets, the basic agenda for financial stability reform relating to credit markets is less advanced, the Governor stated. He argued that the standard for regulatory intervention in credit markets should be higher than in other areas. In particular, he talked about the leveraged loan market, noting that because such loans generally were not held in investment structures that utilized short-term, confidence-sensitive funding, leveraged loans were not a principal source of runs during the financial crisis.

Mr. Powell argued that supervisors should remain alert to the emergence of run-prone financing structures in credit markets that could lead to fire sales, as well as to conditions that could pose risks to the safety and soundness of G-SIBs. However, Mr. Powell cautioned strongly against using supervisory interventions to “lean against” the credit cycle and expressed his skepticism concerning the ability of supervisors to accurately identify “dangerous” conditions. False positives, he noted, would have the effect of limiting the availability of credit unnecessarily by interfering with market forces.

For full remarks:

Proposals Concerning High-Frequency Trading by FIA

The Futures Industry Association (“FIA”) and FIA Europe published a report on MiFID II technical advice issued by the European Securities Markets Authorities (“ESMA”). The report focused on high-frequency and algorithmic trading and provided proposed definitions of those terms.

According to the report, MiFID II aims to develop “considerably stronger rules” concerning high-frequency trading and algorithmic trading to ensure that firms conducting these activities are subject to appropriate controls and oversight. The report also obligates firms to follow a consistent set of rules regarding software and risk management.

Fourth Special Report: Algorithmic and High Frequency Trading:

CFS Monetary Measures for January 2015

Today we release CFS monetary and financial measures for January 2015. CFS Divisia M4, which is the broadest and most important measure of money, grew by 2.9% in January 2015 on a year-over-year basis versus 2.1% in December.

Bloomberg terminal users can access our monetary and financial statistics by any of the four options:

1)  {ALLX DIVM <GO>}
3)  {ECST<GO>} –> ‘Monetary Sector’ –> ‘Money Supply’ –> Change Source in top right to ‘Center for Financial Stability’
4)  {ECST S US MONEY SUPPLY<GO>} –> From source list on left, select ‘Center for Financial Stability’

CFS Divisia indices can also be found on our website at  Broad aggregates are available in spreadsheet, tabular and chart form.  Narrow aggregates can be found in spreadsheet form.

For Monetary and Financial Data Release Report:

OFR Publishes Working Paper on Process Systems as a Modeling Paradigm for Analyzing Systemic Risk

The Office of Financial Research (“OFR”) published a working paper titled “Process Systems Engineering as a Modeling Paradigm for Analyzing Systemic Risk in Financial Networks.” The paper proposes a methodology to quantify systemic risk. More specifically, it proposes that signed directed graphs (“SDGs”), modeling methodologies that are used extensively in process systems engineering, can be used to create frameworks that (i) address the cause and effect of financial instability feedback loops and (ii) can automate the identification and monitoring of potential vulnerabilities. More generally, the paper asserts that a process systems engineering framework is a “useful model” with which to analyze potential hazards and instabilities in the financial system that may not be apparent from a “network-based perspective” on large financial systems.

Lofchie Comment: It has never seemed apparent that the central clearing of swaps makes the financial system safer. Much of what clearinghouses do to improve safety comes at the expense of clearing members and their customers. Because the pricing “signals” that clearing members send have more power than those of individual market participants, any change in valuation declared by a clearinghouse may affect the market and market participant behavior generally and quickly in ways that could be negative. As a result, the actions taken by individual market participants in order to protect themselves may in fact do damage to the safety of the larger financial system.

To put this into more concrete terms, under the logic set out in the paper, if a clearinghouse determines that the value of a commodity has declined, and that the volatility of the commodity has increased, then market participants will come under immediate pressure to sell the commodity in order to pay for losses on the decline and because the cost of financing the required margin has risen. Additionally, clearing members and their customers cannot protect themselves by contract against the margin demands of the clearinghouse (as they could against other private parties).

The paper confirms the concern that clearinghouses are at least a potential source of systemic risk. Query: under what circumstances/assumptions does the model show that clearinghouses increase or decrease systemic risk?

See: OFR Working Paper: Process Systems Engineering as a Modeling Paradigm for Analyzing Systemic Risk in Financial Networks.


U.S. House Committee on Agriculture Holds Hearing to Examine the CFTC’s 2015 Agenda

The U.S. House Committee on Agriculture held a hearing to review the futures, options and swaps markets overseen by the CFTC. CFTC Chair Timothy Massad was the sole witness.

Chair Massad focused his testimony on the CFTC’s key priorities for 2015 and on reviewing what it has accomplished since his time as Chair began.  Chair Massad stated that the CFTC intends to make markets work for commercial end users and has undertaken actions to achieve this goal. The actions include, among other things: (i) proposing a rule on margin for uncleared swaps; (ii) amending its rules for transactions with special entities to allow local utility companies to hedge risks in the energy swaps market; (iii) proposing rules to exempt end users and commodity trading advisors from certain recordkeeping requirements; (iv) clarifying the CFTC’s position on when forward contracts with embedded volumetric optionality may be excluded from being considered swaps; (v) harmonizing rules (such as those for certain commodity pools) with those of the SEC; and (vi) adjusting the settlement deadline for FCMs to post “residual interest” so as not to burden the margin collection process. 

Chair Massad also outlined areas on which the CFTC will focus in 2015, including:

  • the new regulatory framework for swaps;
  • a harmonized cross-border framework;
  • robust enforcement and compliance efforts;
  • cybersecurity, information security and business continuity challenges; and
  • retrospective regulatory reviews of CFTC rules.

Chair Massad also advocated for the CFTC FY 2016 budget increase, stating that the new budget is necessary in order to fulfill the CFTC’s goals and responsibilities.

Lofchie Comment: Quite a bit in Dodd-Frank and in the rules thereunder genuinely needs fixing. No doubt the process will continue for many years to come. Accordingly, it is good to see that “retrospective regulatory review” is high on Chair Massad’s agenda. In a reasonable world (if that is not a contradiction in terms), “retrospective statutory review” would be high on the Congressional agenda as well, since it is a review that could be accomplished more easily if every attempt at a correction were not painted as an attack on The Night Watch.

See: Hearing Notice; Webcast of Hearing; Chair Massad’s Testimony.


SEC Holds First Investor Advisory Committee Meeting of 2015

The SEC held its first Investor Advisory Committee meeting of 2015.  SEC Chair Mary Jo White delivered the opening remarks on developments undertaken by the SEC and issues on which it intends to focus in 2015.

Chair White stated that the staff of the Division of Investment Management is analyzing the asset management industry currently and developing recommendations that target three core initiatives:

  • enhanced data reporting for funds and investment advisers;
  • controls that identify and manage risks related to the composition of registered funds’ portfolios; and
  • transition plans in the event of major disruptions that prevent investment advisers from serving clients.

Additionally, Chair White explained that the staff will continue to consider whether broker-dealers should be subject to a fiduciary standard when providing investment advice and will review the “accredited investor” definition.  She also noted that the SEC currently is reviewing over 50 comments on FINRA’s Tick Size Pilot Program.

Chair White announced that on February 19, 2015, the SEC will hold a roundtable to discuss the proxy voting process, including universal proxy ballots and retail participation in the proxy process.

Lofchie Comment:  The government should not impose further information requirements concerning advisers and funds without being more forthcoming about the failure of Form PF. The financial industry spends huge amounts of money providing the government with “data” that is utterly worthless. Before the SEC demands more information from advisers and funds, it ought to examine and disclose what went wrong with the creation of Form PF so that the same regulatory sinkhole can be avoided on the second try.

See: SEC Chair White’s Opening Remarks.


Sustainable Investing and Environmental Markets by Dr. Richard Sandor

CFS Advisory Board member Richard Sandor and his co-authors Murali Kanakasabai, Rafael Marques, and Nathan Clark, recently released Sustainable Investing and Environmental Markets: Opportunities in a New Asset Class.

With a combination of over 50 years of practical experience in the field of environmental finance, the authors provide a solid preliminary understanding of the promising and transformational new investment category of environmental assets. There is currently no equivalent book in the market that covers environment-financial issues from a practitioner’s standpoint. Bringing together economic theory and practical experience, the twelve chapters cover three broad asset classes: air and water; catastrophic and weather risk; and sustainability. It demonstrates how these environmental asset classes are being incorporated into commodities, fixed income, and equity instruments. The book concludes with some insights into the current state of this emerging asset class, some “food for thought” and an analysis of future trends.

The book’s foreword is by world-renowned energy and sustainability expert Amory Lovins, co-founder and chief scientist of the Rocky Mountain Institute.

The foreword and chapter 1 of Sustainable Investing and Environmental Markets can be read here.