SEC Proposes Cross-Border Regulatory Framework for Security-Based Swaps

The U.S. Securities and Exchange Commission (the “SEC”) reproposed rules addressing the application of certain requirements under Title VII of the Dodd-Frank Act (the “Reproposal”) to non-U.S. persons dealing in security-based swaps (“SBSs”).[1]


I. Amendments to De Minimis Counting Requirements

Under the Reproposal and in addition to the circumstances set forth in the Cross-Border Final Rules,[2] an SBS-dealing transaction that is entered into by a non-U.S. person and is “arranged, negotiated or executed” (“ANE”) through personnel located in a U.S. branch or office, or through an (affiliated or unaffiliated) agent of such non-U.S. person located in the United States (such transaction, an “ANE Transaction”), will count toward that non-U.S. person’s de minimis threshold for registration as a security-based swap dealer (“SBSD”).[3]

II. What Is an ANE Transaction?

The Reproposal does not define what an “ANE Transaction” is in the rule text; rather, the Reproposal provides extensive guidance on the meaning of this term.[4] A transaction generally is considered to be an ANE Transaction if it involves (1) “market-facing” activity (i.e., the activity of sales and trading personnel, including communications with potential counterparties) that is (2) conducted through a permanent location in the territorial United States, (3) whether by personnel of the non-U.S. person or an (affiliated or unaffiliated) agent of such person.

Notably, only activities conducted by personnel or agents of the non-U.S. person that involve material, trade-specific terms would be considered to be “market-facing” under the proposed rules. Thus, certain activities may be conducted in the U.S. without rendering such a transaction an ANE Transaction, including the following:

  • collateral management activities (e.g., the exchange of margin payments);
  • the preparation of master agreement documentation and/or collateral terms;
  • the submission of SBS transactions for clearing;
  • reporting SBS transactions to swap execution facilities; and
  • the negotiation of trade-specific terms by U.S. counsel.

The ANE Transaction requirement replaces an aspect of the Original Proposal that would have required a dealing party to consider the location of its counterparty’s trading personnel (as well as whether the counterparty or its guarantor was a U.S. person) in determining whether a given transaction was required to be counted against its de minimis threshold. Under the Reproposal, a non-U.S. person need only look to the location of its own SBS dealing activity in making this determination. However, ANE Transactions must be counted against the threshold even if executed anonymously on a security-based swap execution facility, since the identity of the counterparty is irrelevant for purposes of the de minimis determination.

With regard to ANE Transactions executed through an agent (instead of an employee of the SBSD), the SEC rejected a proposal provisionally by commenters on the Original Proposal to regulate the agent solely as a “broker” under the existing Exchange Act scheme. The SEC did so because it reasoned that (1) banks acting as agents would be outside the scope of SEC jurisdiction (pursuant to various exemptions from the definition of “broker” in the Exchange Act) and (2) the SEC enforcement of the Exchange Act’s antifraud provisions could be frustrated by difficulties in obtaining the books and records of the principal.[5] The SEC specifically requested comment on the treatment of this issue – i.e., how it should regulate agents of SBSDs, since SBSs are also “securities” under the securities laws and acting as a “broker” of such products could subject a person to broker-dealer registration.

III. External Business Conduct Requirements; Additional Aspects of the Reproposal

  • In line with the CFTC Staff Advisory discussed in footnote 4 below, the Reproposal would apply the (yet-to-be-adopted) external business conduct requirements applicable to SBSDs[6] to ANE Transactions of non-U.S. SBSDs.
  • The Reproposal dropped an aspect of the Original Proposal that would have required an SBS between a registered non-U.S. SBSD and a non-U.S. counterparty to be subject to mandatory clearing and trading requirements. This exclusion would extend to ANE Transactions of non-U.S. SBSDs.
  • The scope of the SBS trade reporting requirements under recently adopted Reg. SBSR[7] would be amended by:
  • requiring subsequent ANE Transactions (including ANE Transactions of non-U.S. “de minimis” dealers) to be reported and publicly disseminated;
  • amending the reporting hierarchy so that when a non-U.S. de minimis dealer faces a U.S. person, the parties may choose who reports (rather than putting the burden on the U.S. person); and
  • subject to certain proposed modifications in the reporting rule, requiring reporting when two non-U.S. persons trade through a U.S. platform or broker-dealer.

Lofchie Comment: The CFTC also uses the phrase “ANE” to describe trades that are entered into by non-U.S. swap dealers but which have a connection with the United States that brings them within the scope of U.S. jurisdiction. However, the CFTC provides far less guidance than the SEC on how the phrase should be interpreted. If the CFTC were to formally (or even informally) adopt the interpretation provided by the SEC, the result would be two material benefits: the market’s uncertainty about how the CFTC interprets the term would be reduced and non-U.S. swap dealers could conduct their SEC and CFTC-regulated swaps activities under fairly consistent guidance on the extent of U.S. jurisdiction (and, in the intermediate run, perhaps the CFTC would abandon its guidance on cross-border jurisdiction and instead adopt the SEC’s rule).

Separately, we note that the SEC’s approach to the application of the cross-border rules assumes that an agent, which is a different legal entity than the swaps dealer, could be responsible for complying with the relevant requirements as to sales practices. In fact, the SEC asks specifically for comment on the legal structure through which sales practice duties may be imposed on such an entity. The absence of that structure is a material gap in the CFTC rules, which do not provide any clear method for an entity acting as a swaps broker to use to comply with sales practice requirements for swaps. Such a structure would be particularly useful in situations in which a U.S. entity is acting as sales agent for a non-U.S. swaps dealer.

SEC Awards Whistleblower in First Retaliation Case

After winning its first retaliation case, the SEC announced that it awarded a whistleblower with the maximum payment of 30 percent of the amount collected.

In the SEC enforcement action In the Matter of Paradigm Capital Management, Inc. and Candace King Weir, File No. 3-15930 (June 16, 2014), the SEC charged Paradigm with retaliating against the whistleblower after learning that he reported potential misconduct to the SEC. According to the SEC, Paradigm immediately engaged in a series of retaliatory actions against the whistleblower that included removing him from his then-current position, tasking him with investigating the very conduct that he reported to the SEC, changing his job function and otherwise marginalizing him.

The whistleblower was awarded over $600,000 for providing the information that led to the successful enforcement action.

Lofchie Comment: This is a case in which the law and human nature may not meet. It is unrealistic, particularly in the context of a small business, to require coworkers to trust someone who has turned in that business to the government and collected a bounty. Practically speaking, would it ever be possible for a firm to discipline a known whistleblower for doing a poor job without potentially being subject to the counteraccusation that the firm has retaliated?

Of course, the real world and human nature have little to do with regulatory requirements. To address these requirements, firms that employ a known whistleblower must develop a meticulous policy for dealing with such an individual. Specifically, as this case makes clear, there should not be any change in the whistleblower’s job or role within the firm, either formally or informally, unless the reasons for that change can be documented fully.

SEC Announces Meeting Regarding Foreign Security-Based Swap Dealers and Executive Compensation Disclosure

The SEC issued a notice in the Federal Register announcing that it will hold an open meeting on April 29, 2015 to discuss (i) foreign security-based swap dealers and (ii) executive compensation rulemaking.

Specifically, meeting attendees will consider:

  • whether to propose amendments and repropose a rule under the Exchange Act concerning the requirements for a security-based swap transaction connected with a non-U.S. person’s dealing activity that is arranged, negotiated or executed by personnel located in a U.S. branch or office or in the U.S. branch or office of an agent; and
  • whether to propose amendments under Exchange Act Section 14(i) that would require registrants to clearly disclose the relationship between executive compensation actually paid and the financial performance of the registrant.

”Streetwise Professor” Craig Pirrong Provides Further Analysis on the Nav Sarao Charges

In a Streetwise Professor blog post titled, “A Matter of Magnitudes: Making Matterhorn Out of a Molehill,” University of Houston finance professor Craig Pirrong discussed the CFTC civil complaint in the Nav Sarao case, along with the affidavit by Cal-Berkeley’s Terrence Hendershott.

According to Dr. Pirrong, instead of supporting the CFTC’s claims that Sarao’s actions had a large impact on contributing to the Flash Crash, Hendershott’s report “undermines” the CFTC’s claims. Rather, Hendershott’s two analyses estimate small price impacts from Sarao’s activity that are minuscule compared to the price effects that the CFTC asserts. Dr. Pirrong goes on to say that he is “deeply disturbed” by the complaint’s and Hendershott’s “sample days” concept which Dr. Pirrong likened to “cherry picking.”

Furthermore, Dr. Pirrong pointed out that the DOJ, the CFTC, and Hendershott all state that Sarao turned the layering algorithm on and off, which caused prices to “rebound by approximately the same amount as turning it on caused prices to fall.” Dr. Pirrong argued that this is “directly contrary” to the consistent insinuation that Sarao was driving down prices. Instead, Dr. Pirrong reasoned that Sarao caused price “oscillations.” Additionally, Dr. Pirrong asserted that the CFTC complaint lacks “actual evidence” in the section labeled “Example of the Layering Algorithm Causing an Artificial Price” that contains no analysis of market price.

Dr. Pirrong contended that if the CFTC tries to prove that Sarao caused or even contributed to the recent “Flash Crash,” “it will face huge obstacles.” He explained that there were many actors in the markets on the day of the Flash Crash, and attributing the huge change in the system to the behavior of any one individual is “metaphysically impossible to prove.” Dr. Pirrong acknowledged that Navinder Sarao’s conduct was “dodgy” and noted there is “a colorable case” that he did engage in illegal spoofing and layering, but concluded that the CFTC’s assertion as to the alleged impact of his conduct and the legal consequences that could arise from his prosecution are “outrageous.”

Lofchie Comment: In light of the writings of Cabinet contributors, including Dr. Pirrong of the University of Houston and Chris Clearfield of System Logic, as well as my own review of the expert testimony filed by the CFTC, it seems unlikely that the CFTC will be able to demonstrate any link, let alone causation, between Nav Sarao’s trading (even if illegal) and the Flash Crash. In fact, based on the material presented by the CFTC to date, the assertion that the CFTC will be able to demonstrate a meaningful link between the two events seems not merely implausible, it seems unserious. At best, the CFTC’s assertions seems an argument of the “butterfly effect“; that because Mr. Sarao’s flapping of his wings (or flipping of his orders) caused a flood of ensuing events. In some philosophical sense it may be true that Mr. Sarao “caused” the Flash Crash, in the sense that every event in the world contributes to every other, but it is not readily demonstrable in any mathematically meaningful way. To take this rhetorical point even further, if Mr. Sarao’s trading in this single instance “contributed” to the Flash Crash, one could reasonably argue that his trading in another 100,000 instances prevented some other Flash Crash that never happened: how could one possibly know?

The extravagance of the CFTC’s assertions in regard to Mr. Sarao’s trading are troubling in at least two ways, one small and one big. The small way (though perhaps not small to Mr. Sarao unless he is of a very Socratic bent) is that it diminishes his right to obtain a fair hearing as to the actual crimes with which he is charged, especially in light of the way that the popular press has highlighted this accusation.

The big way is that it diminishes confidence in the intellectual authority of the government in investigating the reasons why things go wrong. This is, in a nutshell, the problem with Dodd-Frank. On the one hand, no one can doubt the existence of a particular mishap (whether it is in the 2008 market crash or the Flash Crash). But on the other hand, one can very much doubt the causes that the government points to are in the fact the real causes, as opposed to being the politically convenient villains. And if the causes are misidentified, then inevitably the correctives will be wrong, and perhaps even further damaging going forward.

See: Streetwise Professor: “A Matter of Magnitudes: Making Matterhorn Out of a Molehill.”

Streetwise Professor Wonders Who’s to Blame for Flash Crash

Craig Pirrong shared his doubts about the CFTC’s ability to demonstrate that accused spoofer Navinder Sarao caused or even contributed to the Flash Crash. In his popular “Streetwise Professor” series, he states: “it is difficult to see how his [Sarao’s] activities would have caused prices to move systematically in one direction or the other as the government alleges… Attributing the Flash Crash to his activity is also highly problematic. It smacks of post hoc, ergo propter hoc reasoning” he stated.

Lofchie Comment: The CFTC’s assertions against Mr. Sarao overreach when they attempt to hold him responsible for the Flash Crash. Finding a scapegoat – even a scapegoat who happened to commit a crime – won’t fix the problems inherent in a flawed market structure.

See: “Did Spoofing Cause the Flash Crash? Not So Fast!”; “Spoofing: Scalping Steroids?”

Unintended Consequences of LOLR Facilities: The Case of Illiquid Leverage

Although the direct effect of lender-of-last-resort (LOLR) facilities is to forestall the default of financial firms that lose funding liquidity, an indirect effect is to allow these firms to minimize deleveraging sales of illiquid assets. This unintended consequence of LOLR facilities manifests itself as excess illiquid leverage in the financial sector, can make future liquidity shortfalls more likely, and can lead to an increase in default risks. Furthermore, this increase in default risk can occur despite the fact that the combination of LOLR facilities and reduced asset sales raises the prices of illiquid assets.

The behavior of U.S. broker-dealers during the crisis of 2007–09 is consistent with this unintended consequence. In particular, given the Federal Reserve’s LOLR facilities, broker-dealers could afford to try to wait out the crisis. Although they did reduce traditional measures of leverage to varying degrees, they failed to reduce sufficiently their illiquid leverage, which contributed to their failures or near failures.

Several mechanisms to address this unintended consequence of LOLR facilities are proposed in the attached article that appeared in the IMF Economic Review.


Volcker Alliance Releases Report on the Structure of Financial Regulation

The Volcker Alliance, a trade association founded by Paul A. Volcker, released a report titled “Reshaping the Financial Regulatory System.” The report calls for “long delayed” reforms and outlines recommendations for a “stronger” financial regulatory framework.

According to the report, the system for oversight of the financial system is a framework that is riddled with “regulatory gaps, loopholes, and inefficiencies” and developed in a “piecemeal fashion.” The report notes that developments in financial markets have outpaced those of the current regulatory framework, causing it to be under “significant strain.” The report also identified structural “deficiencies” highlighted by the financial crisis, including the following:

  • parts of the financial system remain insufficiently regulated or unregulated, and not well understood;
  • significant forms of risk have migrated to less-regulated or unregulated parts of the financial system;
  • the effectiveness of prudential supervision for certain large market participants, such as broker-dealers and derivatives clearing organizations (“DCOs”), remains uncertain;
  • certain agencies remain under-resourced even as their responsibilities have grown exponentially; and
  • the multiagency framework fuels interagency tension, causing communication and coordination problems at home and abroad, and fostering a lack of accountability.

The report recommends reorganizing the current regulatory system to create a “simpler, clearer, more adaptive, and more resilient regime.” The report’s recommendations are guided by three broad objectives: (i) oversight and surveillance, (ii) supervision and regulation, and (iii) investor protection and capital market conduct. Other recommendations from the report include the following:

  • establishing a Systemic Issues Committee of FSOC that could designate systemically important financial institutions and would be composed of the chairs of the Federal Reserve, the Federal Deposit Insurance Corporation and a newly created Investor Protection-Capital Market Conduct Regulator; the directors of the Federal Housing Finance Agency, the Consumer Financial Protection Bureau and the Office of Financial Research; and a state insurance commissioner designated by the state insurance commissioners;
  • removing the Office of Financial Research from the Department of Treasury to create an independent entity that would be required to collect, compile and standardize data;
  • eliminating the Office of the Comptroller of the Currency; and
  • merging the SEC and CFTC to create an investor protection and capital market conduct regulator.

Lofchie Comment: The Volcker Alliance’s criticism of financial regulatory structure provides an excellent excuse to initiate a much needed discussion and debate about our regulatory framework.* In the interests of fostering that debate, here are a few areas of disagreement regarding what Mr. Volcker has to say about the cause of the problems as well as their proposed solutions:

Were I but King and Master of the Universe. Mr. Volcker’s thesis is that the U.S. government failed to anticipate and head off the financial crisis because it just didn’t have enough power, and even when it did, that power was not sufficiently concentrated in a single agency or person (see page 17). Given the nature of human frailty and imperfection, the argument that the solution to governmental failure is to provide the government with more power, and to make that power more concentrated, is unsound. Mr. Volcker’s argument would have more force if he were able to show, for example, that the Board of Governors of the Federal Reserve was trying desperately to shut down the housing bubble before the financial crisis. Sadly, it was not. Here, for example, is a link to a speech by former Federal Reserve Board Chairman Greenspan, in which he acknowledged that while the rate of increase in housing prices may have slowed, he was not especially concerned. The purpose of linking to this speech is not to point a finger at Mr. Greenspan, but rather to take issue with the notion that the answer to ignorance about the future is to create a single mighty regulator.

Let’s All Agree, but Not Indulge in Groupthink. Apparently, Mr. Volcker would place the Financial Stability Oversight Council at the top of his new regulatory pyramid. Even so, he does not like certain aspects of FSOC. For example, he thinks that FSOC is “too divided” to provide a “comprehensive, forward-looking view” or to “take decisive and timely action.” Additionally, he regrets FSOC’s ability to “require” other regulators to adopt rules that it would prefer to mandate. However, in what seems to be an utterly contradictory statement, he says that “the regulatory system must contain effective safeguards to ensure the independence of the responsible agencies; reduce the risk of group think; and guarantee a broad perspective in governance and decision-making” (at page 4).

We Are All Banks (and Should Be So Regulated). Mr. Volcker observes that non-banks now “hold two-thirds of all credit-market assets” (at page 1). The corollary of this observation is that these “shadow banks” are “potentially unstable” and “create a risk of contagion,” and so presumably should be regulated as if they were banks. Contrary views are possible: Isn’t it a good thing that credit is held outside of banks? Doesn’t that allow greater diversification of risk than if all credit assets were held inside of banks? Isn’t part of the reason that so much credit is held outside of banks because banking regulators have made offering loans much more expensive for banks? Since they’ve effectively pushed so much lending activity outside of banks, should the bank regulators really be given regulatory authority over all other lenders?

The Supremacy of the Banking Regulators at FSOC.
The slightly reorganized version of FSOC at the top of Mr. Volcker’s regulatory pyramid would be dominated by banking regulators. At least five of the six members, and potentially all, would come from a single political party (although FSOC would be, according to Mr. Volcker, “non-partisan”). It is not that the banking regulators are unwise; the bank regulators have the most intellectual culture among all U.S. regulators. The problem is that they see the world through a bank regulator’s lens. They want to dictate not just what banks can own, but what non-banks can own; they want to control the risks taken not just by banks, but also by non-banks; and they want to control borrowing and leverage by banks and non-banks as well. But we are not all banks. Other imperatives exist besides freedom from risks, including the freedom to take risks.

The Volcker Alliance Report challenges us to have a real and important debate about fundamental structural issues. Congress should take up this challenge. As to his solutions, the above commentary identifies two principal points of disagreement. First, Mr. Volker’s advocacy for “safety” above opportunity presents great dangers. His structural solution, to give a concentrated dominant role to the bank regulators should be subject to significant scrutiny. Second, implicit in Mr. Volcker’s position is his advocacy for greater control and discretion for the government regulators of private entities. That solution ought not to be accepted even if proposed by a wise man. It is possible to revisit our system of financial regulation and improve it without the expansion of governmental power that Mr. Volcker envisions.

*One may want to begin the discussion by linking to two articles (humbly submitted) by a different author: “The Future of Financial Regulation” and “Some Concerns with the Derivatives Legislation.” These two pieces anticipate some of the Volcker Alliance’s observations (by seven years) and offer a private citizen’s view of the workings of government regulation.

See: Reshaping the Financial Regulatory System.

CFS Monetary Measures for March 2015

Today we release CFS monetary and financial measures for March 2015. CFS Divisia M4, which is the broadest and most important measure of money, grew by 2.8% in March 2015 on a year-over-year basis versus 2.8% in February.
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:

U.S. and EU Trade Associations Issue Statement in Support of TTIP Negotiations

Trade associations from the United States and the European Union, including SIFMA, the Financial Services Roundtable and the Institute of International Bankers, issued a joint statement voicing their “strong support” for a Transatlantic Trade and Investment Partnership (“TTIP”) that would include financial services regulatory coordination. The statement comes in advance of the ninth round of negotiations to be held in New York City beginning on April 20, 2015.

According to the trade associations, a TTIP will provide an “incredible opportunity” to strengthen ties between the United States and the European Union. To maximize this benefit, the trade associations stated, the TTIP must include “both a framework for financial services regulatory cooperation as well as solutions to market access issues.”

Lofchie Comment: The TTIP process provides an opportunity to clean the slate and bring a fresh set of negotiators to the swaps cross-border disputes between the CFTC and global regulators.

See: SIFMA Press Release/Joint Statement.