OFR Publishes Brief on U.S. Stock Prices

The Office of Financial Research published a brief titled “Quicksilver Markets” which asserts that U.S. stock prices today are high by historical standards. The brief uses a quantitative threshold to identify potential stock market bubbles.

The brief, which was authored by Ted Berg, found that markets can change “rapidly and unpredictably,” and that these changes are “sharpest and most damaging” when asset valuations are at extreme highs. The brief notes that these high valuations have “important implications for expected investment returns and, potentially, for financial stability.”

The brief also found that the financial stability implications of a market correction could be moderate due to limited liquidity transformation in the equity market. However, it noted, potential financial stability risks deserve further attention and analysis including those arising from leverage, compressed pricing, interconnectedness and complexity.

Lofchie Comment: It is at least mildly ironic that government economists (who of course do not speak for the government) should identify high stock market prices as a source of market instability. At the same time, federal economy policy has been driving interest rates lower, which in turn drives up stock market prices. And now the prudential regulators seem determined to prevent private investment funds from taking on risk, also potentially boosting stock market price. If government economists now identify the consequence of their regulatory action as market instability, it creates an interesting twist. From a regulatory powers perspective, it raises the question of how much power private decision making should in fact surrender to the government, given that the government may (just like private parties) work at cross purposes.

SEC Commissioner Piwowar Criticizes Prudential Regulators’ Attempt to Regulate Non-Bank Participants in Capital Markets

SEC Commissioner Michael Piwowar delivered remarks at the 2015 Mutual Funds and Investment Management Conference. He spoke about the “continuing efforts” of prudential banking regulators and quoted Daniel Tarullo in characterizing their goal: “to ‘broaden the perimeter of prudential regulation’ to regulate the activities of non-bank participants in the capital markets.”

According to Commissioner Piwowar, it is “ironic” that prudential banking regulators are pushing for more oversight of capital markets and non-bank participants, since they themselves are “responsible for creating the dominant position of investment funds in providing liquidity in the fixed income market.”

Commissioner Piwowar explained that prudential regulators, who caused capital market activities to exit the banking sector and move into the non-banking sector through their own regulatory decisions, now believe that it is necessary to regulate the non-banking sector. He stated that recent actions taken by the Financial Stability Oversight Council (“FSOC”) and the Financial Stability Board (“FSB”) “confirm” the targeting of investment companies and their advisers as non-banking entities that are subject to prudential regulation.

According to Commissioner Piwowar, prudential banking regulators, such as FSOC and the FSB, have been “jumping to a conclusion without engaging in a deliberate analysis of available data” – particularly regarding the risks of non-bank, non-insurer global systemically important financial institutions and leveraged inverse exchange traded funds. In Commissioner Piwowar’s words, the risks are “likely exaggerated.”

Commissioner Piwowar stated that three areas of the regulatory regime “might warrant a closer look”:

  • Fund Data Reporting. He stated that he supports Chair White’s initiative to enhance data reporting for both funds and advisers, and noted that the SEC should make the existing quarterly fund portfolio holding information available in an interactive data format that can be analyzed readily;
  • In-Kind Redemptions. According to Commissioner Piwowar, the SEC should revisit and consider eliminating in-kind redemptions, particularly “if that will further clarify the fact that a mutual fund is not a bank, and therefore, a mutual fund shareholder is simply not the equivalent of a bank depositor”; and
  • Temporary Suspension of Redemptions. He explained that if the SEC concluded that the redemption requirements in Section 22(e) could create broader market concerns, then it would be advisable for the SEC to consider which regulatory solutions could be constructed to address such concerns “[r]ather than for prudential regulators to designate funds and/or their advisers and/or their activities as systemically risky.”

Lofchie Comment: “Prudential regulation” of private investment decisions is a step toward an economy in which the prudential (banking) regulators could prohibit or direct the investment decisions of private parties. Such a state-directed economy rests on the rationale that private investment decisions, if left uncontrolled, could create risk that the regulators find unacceptable. It is not surprising that some SEC Commissioners resist such assertions of authority. It is not apparent that Dodd-Frank contemplates such an exercise of power. If Congress intends that the prudential regulators exercise that power, then sufficient public debate and an express legislative grant of authority should be required – assuming that any such grant could be obtained.

Shadow banking / CFS monetary measures for February 2015…

After over 80 months of continuous declines in market finance or shadow banking, some evidence of stabilization exists. In February, market finance – money market funds, repurchase agreements, and commercial paper – reached $4.124 trillion up modestly from a November 2014 floor of $4.111 trillion in real February 2015 terms.

The data reveal that since 2011, the needed correction in reducing the role of market finance in the economy has fallen too far and compromised financial market liquidity.

For more details:

Today we release CFS monetary and financial measures for February 2015. CFS Divisia M4, which is the broadest and most important measure of money, grew by 2.7% in February 2015 on a year-over-year basis versus 2.9% in January.

For today’s monetary and financial data release report:

CFTC Orders ICE to Pay Civil Monetary Penalty for Recurring Data Reporting Violations

The CFTC issued an order to file and settle charges against ICE Futures U.S., Inc. (“ICE”), a designated contract market (“DCM”), for submitting inaccurate and incomplete data and reports to the CFTC.

In addition to imposing a $3 million civil monetary penalty, the CFTC ordered ICE to improve its regulatory reporting. These improvements include (i) the creation and maintenance of the new senior position of Chief Data Officer (the appointee will be directly responsible for systems and procedures relating to regulatory reporting), and (ii) the hiring of at least three additional members of its quality assurance staff to be dedicated to regulatory reporting.

Pursuant to Part 16 of the Rules, a DCM is required to submit certain trading and market-related reports and data to the CFTC. According to the CFTC order, on every reporting day during a 20-month period, ICE submitted reports and data containing errors and omissions, their cumulative inaccuracies totaling in the thousands. Additionally, the order found that even though the CFTC staff notified ICE of the problems repeatedly and requested action to correct the mistakes, ICE continued to submit inaccurate reports and data.

Lofchie Comment: Given the overwhelming recordkeeping and reporting requirements to which firms and not just exchanges have become subject, large firms at the very least might want to create Chief Data Officer positions. The person in such a role would not only develop expertise with a firm’s technology and how/where to find data within it, but also serve as a point of contact for regulators who request information.

SEC Director of Division of Trading and Markets Testifies on Establishment of Venture Exchanges

SEC Director of the Division of Trading and Markets Stephen Luparello testified before the Senate Subcommittee on Securities, Insurance, and Investment, discussing the approaches that could lead to the establishment of venture exchanges.

According to Mr. Luparello, the two most significant challenges facing small and emerging companies are attracting the attention of a wide range of investors and achieving a liquid secondary market. He also presented research evaluating how market structure can be improved to facilitate secondary market liquidity for smaller companies and their investors.

To meet these challenges, he explained that the unique needs of smaller companies and their investors should be addressed by exchanges and regulators, such as the fact that smaller companies generally involve greater investment risk. He also mentioned that the SEC is currently considering the comments on a tick size pilot program to inform the SEC on how to address concerns about improving liquidity in the secondary market.

Mr. Luparello went on to describe the Exchange Act provisions that govern venture exchange proposals, stating that in general the SEC has “considerable flexibility to interpret the Exchange Act in ways that recognize the particular needs of smaller companies and their investors.” Additionally, since maximizing liquidity is “likely to be essential to the success of venture exchanges,” he listed potential initiatives that a venture exchange might explore to promote liquidity, including: (i) limiting all trading to particular times of the day or through particular mechanisms, (ii) attracting dedicated liquidity providers with a package of obligations for making a market in listed companies, and (iii) exploring different minimum tick sizes in ways other than through a tick size pilot.

Mr. Luparello explained that SEC would need to consider a number of things when evaluating the rules protecting the liquidity pool of a venture exchange, such as whether it would serve the needs of small companies, their investors, and the broader markets. He said the SEC would also have to evaluate whether and when any period of liquidity pool protection would need to end if a listed company reaches a significant size and level of liquidity, as well as how efforts to protect a venture exchange liquidity pool would affect competition.

Lofchie Comment: I wish that the SEC would attend more to the restrictions that it has imposed on the production of investment research and ways that writing research could be made profitable. It is well and good to reduce the cost of going public, or try to improve liquidity, but it would be better if investors had access to research on the companies that they trade. Unfortunately, the SEC’s current rules make it hard for firms to make a profit producing research, particularly research on small firms.

SEC Chair White Discusses Disqualifications, Exemptions and Waivers

SEC Chair Mary Jo White spoke at the Corporate Counsel Institute. Her remarks focused on how the SEC has and should exercise its authority over certain kinds of enforcement actions such as disqualifications, exemptions and waivers under the federal securities laws.

Chair White stated that the “ultimate objective” of the SEC’s decisions to grant waivers is to “safeguard the public interest and protect investors.” She explained that in order to achieve this objective, the SEC must scrutinize each waiver decision and apply the applicable legal standards uniformly to determine whether the entity or individual can engage “responsibly and lawfully” in the activity at hand. She noted that waivers are not intended to be used as an additional enforcement tool “designed to address misconduct or as an unjustified mechanism for deterring misconduct.”

Chair White defended the quality of the SEC staff’s analysis when deciding whether to grant a waiver by emphasizing that staff carefully reviews the nature of the violation, the duration of the wrongdoing, the specific employees involved and their seniority, as well as the state of mind of the participants. She noted that the staff also reviews the extent of the remediation implemented by the institution in the wake of the enforcement action and what measures will be used on an ongoing basis in the future.

Chair White stressed that no financial institutions are “too big to indict or otherwise charge, too big to jail, or even too big to bar.” In order to achieve lasting deterrence, Chair White explained, the “cost of doing business” mentality of wrongdoers must be broken. According to Chair White, the most effective deterrent ultimately is strong enforcement against the individuals who are responsible, especially senior executives.

Lofchie Comment: Although it may be viewed as a non-substantive procedural matter, part of the problem with granting waivers is this: the statute elicits the presumption that a firm which has been found guilty of a violation is subject to disqualification unless a waiver is granted by the SEC (which is usually the case). More sensibly, a firm that is convicted of a violation should not be subject to a disqualification automatically; rather, the SEC should be required to seek disqualification affirmatively in those unusual instances where it is necessary. Changing the process (which would require a statutory change) would align it with reality and eliminate the SEC’s need to justify itself in many instances in which it grants a waiver from disqualification appropriately.

State of the International Financial System: House Committee on Financial Services Hearing

The U.S. House Committee on Financial Services announced a full committee hearing titled “The Annual Testimony of the Secretary of the Treasury on the State of the International Financial System.” The hearing is scheduled for March 17, 2015.

It will be informative to see how Secretary Lew assesses backdoor currency wars (see pages 2, 9, and 10 of the New York Society of Security Analysts presentation).

CFTC Chair Massad Discusses Ways to Reduce Clearinghouse Risk

CFTC Chair Timothy Massad spoke at the Future Industry Association Conference in Boca Raton. In his keynote address, Chair Massad focused on ways the CFTC addresses clearinghouse resiliency.

As clearinghouses become integral to the financial system, Chair Massad stated, the risks they pose to the system overall must be acknowledged and considered by regulators. He highlighted certain “increasing” concerns involving clearinghouses, including (i) assessing the adequacy of recovery plans, (ii) ensuring that clearinghouses have enough capitalization, or “skin in the game,” and (iii) addressing whether the potential liability of clearing members is “properly sized or capped.”

Ultimately, Chair Massad explained, the CFTC’s regulatory goal for clearinghouses is to create a framework that is designed to “strengthen the risk management practices” of derivatives clearing organizations (“DCOs”), “promote financial integrity for swaps and futures markets, and enhance legal certainty for DCOs, clearing members, and market participants.” He reported that CFTC regulations for clearinghouses are consistent and current with the Principles for Financial Market Infrastructures (“PFMIs”) published by CPMI-IOSCO in 2012.

Chair Massad explained that creating written standards for clearinghouses is a start, but that the CFTC must engage in “extensive” oversight activities – such as daily risk surveillance, analysis of margin models, stress testing, back testing and in-depth compliance examinations – to supervise clearinghouses properly.

Chair Massad went on to stress that regulators must look at the “full picture” when considering issues pertaining to risk mitigation. He stated that capitalization issues for a clearinghouse should be viewed in the context of its overall financial resources, and reasoned that both initial margin and default fund contributions are not enough to cover losses in certain situations. Additionally, he acknowledged that circumstances might arise in which a clearinghouse faces risks beyond that of a default by a clearing member, and regulators have required that clearinghouses maintain capital or other resources sufficient to cover operating costs for one year.

Chair Massad praised the CFTC’s clearinghouse policies overall, and noted that more can be done with respect to the frequency of examinations.

Lofchie Comment: The risk that needs more attention is a clearinghouse’s demand for more margin in a period of falling prices and declining liquidity – a demand that has the potential to lead to a massive and rapid sell-off of assets. The requirement that clearinghouses maintain sufficient capital to cover one year of operation is trivial in light of the potential cost of the economic risks that flow through a clearinghouse.

SEC Commissioner Gallagher Discusses SEC Supervision of Fixed Income Liquidity, Market Structure and Pension Accounting

SEC Commissioner Daniel Gallagher spoke at the Financial Industry Regulatory Authority conference in New York. He talked about liquidity, market structure and pension accounting risks in the fixed income markets.
According to Commissioner Gallagher, dealer inventory and liquidity in the secondary markets have “dramatically decreased,” despite record issuances of corporate bonds. He explained that, with a record-breaking amount of outstanding corporate debt and dealers unable to commit capital or hold inventories, “there is a real liquidity crisis brewing.”

Commissioner Gallagher explained that the SEC can take steps to address these liquidity concerns, including considering all options for facilitating electronic and on-exchange transitions of these products. Additionally, he stated, the SEC must commit the necessary resources to determine how to incentivize standardized primary offerings in order to facilitate secondary liquidity even more.

Commissioner Gallagher mentioned that a more “discrete and addressable” issue in the fixed income markets is the lack of transparency. He expressed his approval of FINRA and the MSRB’s active engagement with this issue through proposals that require dealers to provide pricing reference information on retail customer confirmations, and applauded the recent SEC approval of the MSRB’s best execution rule.

Commissioner Gallagher also discussed the call to change the bond disclosure regime, particularly in the municipal space. He stated that the SEC has been making better use of its existing authority to improve municipal disclosure practices by testing compliance with Rule 15c2-12 (“Municipal Securities Disclosure”) and actively pursuing municipal issuers and individuals who commit fraud. Additionally, he explained, he is concerned about accounting for municipal pensions and other post-employment benefit liabilities, and recommended a legislative fix to mandate the use of Governmental Accounting Standards Board-approved standards for municipal issuers.

Lofchie Comment: While Commissioner Gallagher and securities market participants warn about liquidity being driven out of the markets, the banking regulators emphasize “safety,” without adequate attention to diminished liquidity. A market without liquidity is extremely fragile (and therefore unsafe) because even the smallest selling pressure will overwhelm the willingness to buy. In other words, push safety too far and you get its opposite.

Acting Director of the SEC Division of Investment Management Talks About Data, RIC’s and Liquidity

Acting Director of the SEC Division of Investment Management (“Division”) Dave Grim delivered remarks at the PLI Investment Management Institute. He discussed the Division’s priorities regarding data reporting, the use of derivatives by registered investment companies (“RICs”) and liquidity requirements.

Mr. Grim stated that the Division currently is reviewing its information-collection strategies in order to “enhance and modernize” data reporting to the SEC. He mentioned that the SEC is considering making updates to the basic census information requirements of Form N-SAR to reflect new market developments, products, and investment practices or risks. The Division staff also is evaluating ways to standardize the information required to be reported regarding certain investments, including swaps, forwards and securities lending.

Additionally, Mr. Grim explained that the SEC plans to assess the use of derivatives, and to take a “more comprehensive and systematic approach to derivatives-related issues under the Investment Company Act,” including considering whether funds should be required to establish broad risk-management programs to address risks related to their derivatives use. He also acknowledged that the Investment Company Act contains no provisions that deal specifically with derivatives, and that the SEC essentially has been crafting a regulatory scheme based on treating derivatives as “senior securities.”

According to Mr. Grim, the SEC has not reviewed the guidelines for liquidity management in “many years.” The current guidelines state that “open-end funds (other than money market funds) generally were not permitted to hold [any] more than fifteen percent of their net assets in illiquid securities and other illiquid assets.” The Division, according to Mr. Grim, is considering recommending a new “comprehensive approach to the management of the liquidity risks associated with fund portfolio composition,” which would address the redemption rights of investors, improve investment companies’ management of liquidity risk, and update the liquidity standards and disclosures of liquidity risks.

Lofchie Comment: Although Mr. Grim indicated a number of prioritized areas for the Division of Investment Management, he gave little indication of why those areas were prioritized. For example, it is not clear that the Division is concerned about funds being insufficiently liquid and, if so, what the basis for that concern might be.