Professors Submit Brief Supporting FSOC’s Authority

In MetLife, Inc. v. FSOC, MetLife Inc. v. FSOC, 15-cv-00045, U.S. District Court, District of Columbia, “fifteen law and finance professors from leading universities whose research focuses on financial regulation and administrative law, including [Dodd-Frank],” submitted an Amici curiae brief on behalf of the FSOC containing “analysis and academic research” in support of FSOC’s determination that MetLife should be regulated as systemically significant. The professor’s argue that a court has the authority to overturn the determination of FSOC only if such determination was “arbitrary and capricious.” The brief emphasized the “great deference” that courts should be required to show to “the nation’s sole regulatory body with a view of the full sweep of financial markets.”

Lofchie Comment: From a legal standpoint, the principal argument that the learnéd professors make is that the courts do not have the authority to overturn FSOC’s designation of MetLife because (i) the standards by which FSOC’s decisions are judged remain quite low and (ii) the “complex and dynamic nature of systemic-risk analysis often renders quantitative measures [i.e., objective standards] unduly narrow or even misleading. . . .” According to the professors, FSOC is in the business of making “predictive judgments,” and for the courts to “second-guess predictive judgments of this type would do more than improperly interfere with agency prerogatives.” The courts cannot even examine the process by which FSOC made the MetLife decision, since it is a “very basic tenet of administrative law that agencies should be free to fashion their own rules of procedure.”

Much of the substance of the professors’ argument is sound. In Dodd-Frank, Congress gave FSOC authority that is too open-ended to allow any “legal” basis for challenging any of its decisions. There is no basis for any court to overturn a decision that is not subject to any objective standard, is based entirely on predictions of the future, and is not subject to any procedural standard.

Notwithstanding the difficulty of the plaintiff in this case to find a legal basis for challenging the FSOC’s decision, a free society is not based on the eternal truth that “administrative agencies should be free to fashion their own rules of procedure.” A free society should be based on the existence of objective rules that can be understood and interpreted by both the persons to whom the rules apply and by the courts. These rules are supposed to serve as a constraint on the power of the government – even on the freedom of administrative agencies.

In support of the freedom that should be granted to administrative agencies, the professors compare the power of FSOC to that of the National Security Council, another “administrative entit[y having] . . . similarly weighty responsibilities.” However, this comparison misses a fundamental difference between FSOC and the National Security Council. The National Security Council deals with the enemies of our country, while FSOC deals with American citizens and businesses. The fact that the National Security Council operates with a certain freedom from procedural or substantive restraints does not mean that it should serve as model for domestic regulation.

As for the “analysis and academic research” that powered the professors’ brief, it is not outwardly apparent that “Congress carefully designed the FSOC’s structure and procedures,” “[a]nticipating that [FSOC’s] work would demand deep expertise and probabilistic judgments.” Turning out a 2,000 page statute in a couple of months with no previous reports and little substantive debate does not demonstrate a careful design unless one is grading on a curve (and the professors’ students are doubtless all above average).

The professors quote a variety of financial figures that, according to them, demonstrate MetLife’s systemic significance. Yet their central argument is that “quantitative measures [are] unduly narrow or even misleading”. Should it not be sufficient for them to persuade us to concede to FSOC’s collective wisdom and “predictive” prowess?

The Unwind: What’s Next for Global Markets…

At the annual Capital Markets Credit Analysts Society dinner meeting,
I delivered remarks “The Unwind: What’s Next for Global Markets.”

Comments addressed how a series of “never befores” will impact
markets.  For instance, “never before” has there been such:
– Large scale intervention by central banks,
– Growth in the financial regulator apparatus and labyrinth of rules
governing markets,
– Distortions across a wide range of financial markets.

Three potential pathways for the future include: 1) growth solution,
2) game remains the same, and 3) unwind.

Global markets are likely to migrate from the “game remains the same”
into the “unwind” scenario within the next 12 to 18 months.  A series
of early warning indicators will help navigate which scenario elapses
over time.

For the full remarks:

SEC Commissioner Stein Issues Dissenting Statement Regarding Certain Waivers to Firms Involved in FX Rate Manipulation

SEC Commissioner Kara M. Stein issued a dissenting statement regarding the SEC Order granting waivers for disqualifications to certain financial entities that plead guilty to foreign exchange rate manipulation. The financial entities described include those that have well-known seasoned issuer (“WKSI”) status.

Commissioner Stein explained that the disqualifications were triggered for generally the same behavior: a criminal conspiracy to manipulate exchange rates in the foreign currency exchange spot market. She stated that there are “compelling reasons” to reject the requests to waive the automatic disqualifications required by securities laws. Commissioner Stein emphasized that the recidivism and repeated criminal conduct of the financial institutions should lead to revocations of prior waivers, noting that the SEC has granted at least 23 WKSI waivers to these five institutions in the past nine years, excluding Bad Actor waivers.

Commissioner Stein stated that it is “troubling” that the SEC consistently grants waivers for criminal conduct, especially when the SEC refuses to enforce its own “explicit requirements for such waivers.” Commissioner Stein said that issuing these waivers “effectively rendered criminal convictions of financial institutions largely symbolic.”

Lofchie Comment: Commissioner Stein is consistent in her opposition to the routine granting of waivers of WKSI disqualifications. But the reason waivers are routinely granted is not that granting them renders criminal convictions “largely symbolic” (a description that ignores the fact that the relevant firms paid out billions of dollars in penalties and face further litigation, and that individuals may also face additional penalties). The reason waivers are routinely granted is because: (i) the government has extracted the full amount of penalties that are either attainable or reasonable, or both, in light of the crimes or (ii) WKSI disqualification is not a penalty that is particularly suited to the relevant crime. The routine grant of the waivers suggests that they should be automatic and that disqualifications should be imposed only in particularly appropriate circumstances.

SEC Proposes Amended Reporting and Disclosure Requirements for Investment Companies and Advisers

The SEC approved two rulemaking proposals at its open meeting about the modernization of investment company and investment adviser reporting. The proposals pertained to the reporting and disclosure of information.


Investment Adviser Act Rule Changes, Including to Form ADV

The following aspects of the changes are most relevant to investment advisers:

(i) The changes would require an investment adviser to provide additional general information about its business, such as the physical locations where its employees are based, how the firm’s CCO is compensated, how the firm uses Web sites and social media, as well as significant information about wrap fee accounts and the adviser’s own assets.

(ii) The changes would facilitate the registration of, and obtain more information regarding, separate legal entities that are affiliated and that may effectively operate as a single advisory business even though they don’t comprise a single legal entity (so-called “umbrella registration”).

(iii) Detailed books and records requirements would be imposed on both the calculation of performance information and the distribution of such information.

(iv) The changes would require investment advisers to provide information about “gross notional exposure” and the “weighted average amount of borrows” in separately managed accounts. Larger advisers would be required to provide information as to “six different categories of derivatives” based on “commonly used metrics . . . [that would be] comparable to the information collected on Form PF regarding private funds.”

A link to a more detailed summary of the IAA/ADV rule changes appears below.

Investment Company Act Rule Changes

The proposed amendments for investment companies’ reporting and disclosure requirements would create new monthly and annual portfolio reporting forms (Form N-PORT and Form N-CEN, respectively).

Form N-PORT would require registered funds other than money market funds to provide, on a monthly basis, portfolio-wide and position-level holdings data, including: (i) the pricing of portfolio securities; (ii) information regarding repurchase agreements, securities lending activities and counterparty exposures; (iii) the terms of derivatives contracts; and (iv) discrete portfolio level and position level risk measures.

New Form N-CEN would replace Form N-SAR and require funds to report certain census-like information annually. The proposal also would require funds to report data in an structured data format which would aggregate the data across all funds and link the reported information with information from other sources.

In addition, the proposal would allow mutual funds and other investment companies to provide shareholder reports by making them accessible on a Web site, and require that derivative disclosures be “displayed prominently in the financial statements.”

Commissioner Piwowar’s Statement

SEC Commissioner Piwowar voiced his support for the proposals. However, he also expressed concern about the requirement that funds must include the legal identifier recognized by the Global LEI Regulatory Oversight Committee or the Global LEI Foundation, which in his view could result in the SEC helping to “establish a monopoly for the provision of legal identifiers.” Commissioner Piwowar also conveyed his reservations about the derivative investment disclosure requirements, placing particular emphasis on the possiblity that index providers may not be willing to allow the components of their indices to be disclosed publicly, which could negatively impact funds that make such investments as well as the index providers.

Lofchie Comment: Among the proposals, the most significant for investment advisers pertain to the disclosure of financial information for separately managed accounts. The new requirements would be in addition to those by Form PF, in addition to what’s required of registered investment companies, in addition to those by the CFTC, in addition to those by the NFA and in addition to those for information gathered by FSOC. Rather than adding to the reporting and recordkeeping burden, is it not reasonable to suggest that the SEC and all of the other regulators get together and decide jointly what they need/require/desire/insist upon? They could do so as a group that represents the government as a whole and not as individual regulators.

Further, the additional information requirements are “comparable to the information collected by Form PF”. Anyone knowledgeable about finance can read the questions in Form PF and tell that the data collected is meaningless because the questions are nonsensical. If the government is going to impose further recordkeeping and reporting requirements on the financial industry, then it should at least make the effort to ensure that the data it collects is valuable.

See: Cadwalader Summary of IAA/ADV Rule Changes; Cadwalader Summary of ICA Rule Changes.

CFS Monetary Measures for April 2015

Today we release CFS monetary and financial measures for April 2015. CFS Divisia M4, which is the broadest and most important measure of money, grew by 3.1% in April 2015 on a year-over-year basis versus 2.8% in March.

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:

FINRA Requests Comments on Amendments to Rules Governing Communications with the Public (FINRA Reg. Notice 15-16)

FINRA issued a regulatory notice requesting comments on proposed amendments to the FINRA rules governing communications with the public.

The proposed amendments would revise the filing requirements in FINRA Rule 2210 (“Communications with the Public”) and FINRA Rule 2214 (“Requirements for the Use of Investment Analysis Tools”) and the content and disclosure requirements in FINRA Rule 2213 (“Requirements for the Use of Bond Mutual Fund Volatility Ratings”).

FINRA intends for the proposed amendments to tighten the scope of firm filing requirements by requiring new firms to file only their Web sites and material changes to their Web sites with FINRA within 10 business days after first use for a one-year period, rather than 10 business days prior to first use. FINRA expects to continue to review new firms’ communications for adherence with applicable standards by focusing on their Web sites after they are filed with FINRA, and reviewing applicants’ Web sites as part of the new firm application process.

Comments on the proposal must be submitted by July 2, 2015.

Lofchie Comment: Any regulatory rule change that is practical, and that serves the interests of both firms and businesses – as this one does – should be supported and commended.

CFTC Chair Massad Sends Letter to Congressman Criticizing Legislation to Reauthorize the CFTC

In a letter to House Agriculture Committee Chairman Mike Conaway (R-TX), CFTC Chairman Timothy Massad criticized the “Commodity End-User Relief Act” (H.R. 2289) (the “Bill”) which would reauthorize the CFTC agency for five years, saying many of the provisions outlining the CFTC’s regulatory powers are unneeded or unduly restrictive, and “would make it harder to fulfill our mission.”

The Bill is similar to legislation passed by the House during the last Congress. The Bill would codify and clarify Congressional intent where certain customer protections are concerned, reform the CFTC’s operations, amend certain end-user provisions of the Dodd-Frank Act, and make technical corrections to the Commodity Exchange Act.

In particular, Chair Massad expressed concerns regarding the Bill’s provisions that are designed to enhance the CFTC’s cost-benefit analysis, require compliance with certain administrative procedural requirements, achieve greater global harmonization with foreign regulators over swap rules, and codify into law relief provided to end-users. In the letter, Chair Massad pleaded with the Committee “to keep in mind the principle challenges facing the Commission include resource constraints and bolstering our enforcement and surveillance programs.”

Lofchie Comment: The cost-benefit requirements of the Bill are in Section 202, on page 10. Substantively, it is fairly hard to argue with the list of items that the CFTC would be required to consider before adopting a rule. Further, given that the SEC and numerous other regulators are required to consider the costs and benefits of the rules that they adopt, it is not obvious why the CFTC should be exempted from this requirement. Accordingly, rather than simply opposing the requirement as inconvenient, we think that Chair Massad should make the case as to why: (i) the CFTC should be exempted from performing cost-benefit analyses that other similar government agencies are required to perform or (ii) the list of factors that the CFTC would be required to consider is not appropriate (and if that is the case, which factors would be appropriate).

Brief on “The Intrafirm Complexity of Systemically Important Financial Institutions”

The Financial Stability Board (FSB) describes a systemically important financial institution, or SIFI, as a financial institution “whose disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.”

Regulatory efforts traditionally have focused on the size aspect of this definition, often by delineating a specific threshold (e.g., $250bn in total consolidated assets) that would subject a firm to increased supervisory scrutiny.  Yet despite the ease of implementation, a size-based threshold is in many ways unsatisfactory, precisely because it does not take into account the level of complexity of a firm’s business activities. In addition, size is but one of the criteria mentioned in the SIFI definition.

Further, much of the academic literature has concentrated on the interconnectedness among financial participants, with the goal of identifying central “nodes” – i.e., those firms that are central to maintaining the interrelationships within the network.

In contrast, there has been comparatively little development of metrics concerning the complexity of the individual firms that comprise the system – the other key attribute highlighted in the SIFI definition.  My new paper with coauthors Daniel Rockmore (Dartmouth College), Nick Foti (University of Washington), Gregory Leibon (Dartmouth College) and J. Doyne Farmer (Oxford University) takes on this challenging task by proposing complexity metrics that are designed to inform supervisory judgment regarding the SIFI designation.

In our paper, we use the structure of an individual firm’s control hierarchy (a network representation of the institution and its subsidiaries) as a proxy for institutional complexity. This mathematical representation (and various associated metrics) provides a consistent way to compare the complexity of firms with often very disparate business models.

By quantifying the level of complexity of a firm, the approach also may prove useful should firms need to reduce their level of complexity either in response to business or regulatory needs.  The network encoding and associated metrics open the door for the use of simulations to assess potential changes in complexity. Such simulations could provide a helpful tool for understanding the supervisory implications of altering a firm’s control hierarchy in the process of winding down a firm (such as in the case of the dismantling of Lehman Brothers), or in arranging a rapid acquisition, (e.g., in the cases of the JP Morgan Chase acquisition of Bear Stearns, the Wells Fargo acquisition of Wachovia, or the Bank of America acquisition of Washington Mutual).

More generally, these metrics provide a means of comparing the organizational possibilities with an eye toward reducing, rather than increasing, systemic risk in the wake of a change in firm structure.

We apply our proposed metrics to a sample of 29 firms: 19 banks that have received the SIFI designation, five that have not, and five insurance companies.  Between 2011 and 2013, firms appear to have reduced their complexity.  Contrary to conventional wisdom, the results suggest that some of the SIFI-designated institutions may not pose any greater supervisory challenge than their non-SIFI counterparts, since there is little difference in the complexity of their control hierarchies. In contrast, the insurance companies in the sample are more complex according to the metrics presented in the paper, despite being smaller in size, having fewer subsidiaries, and being less geographically or industry-diverse than the banks.

A pdf version of this brief can be downloaded here.

“The Intrafirm Complexity of Systemically Important Financial Institutions,” by Robin L. Lumsdaine, Daniel N. Rockmore, Nick Foti, Gregory Leibon, and J. Doyne Farmer can be downloaded via SSRN (

SEC Equity Market Structure Advisory Committee Holds First Meeting

The Equity Market Structure Advisory Committee (the “Committee”) of the SEC held its first meeting. The participants focused on Regulation NMS Rule 611, also known as the “Order Protection Rule” or “Trade-through Rule.”

The SEC established the Committee in February 2015 to provide a formal mechanism through which the SEC could receive advice and recommendations on equity market structure issues.

Chair Mary Jo White delivered the opening remarks. She emphasized that market complexity is a key characteristic of equity markets and “deserves close attention.” Complexity, Chair White explained, involves the highly competitive, high-speed, high-volume and yet fragmented nature of equity markets. According to Chair White, one negative aspect of the complexity in equity markets stems from the perception that some complexity is “unnecessary” – an aspect she described as “complexity that is not directed primarily toward producing better markets for investors and public companies.” Chair White recommended that regulators and market participants who wish to evaluate equity market structure look closely at current rules to determine how and to what extent regulations have “needlessly fostered complexity.”

Commissioner Piwowar spoke at the meeting next, offering his optimistic support for a “robust and animated” dialogue about the SEC’s review of market structure. In forthcoming discussions, Commissioner Piwowar said, market participants should review and analyze the Regulation NMS in the context of when it was adopted versus its impact 10 years after it was passed. He explained that Regulation NMS and any potential changes to it should be measured against “the goals and concerns that were articulated at the time it was adopted.”

Lofchie Comment: In a public statement dated May 11, 2015, Commissioner Aguilar disputed the notion that the regulatory framework had contributed substantially to the complexity of the current market structure. (See SEC Commissioner Aguilar Discusses U.S. Equity Market Structure (with Lofchie Comment)). He also disputed that such complexity had made the possibility of market failures or dislocations more likely, as was the case in the Flash Crash. By contrast, Chair White’s remarks inclined toward the view that the regulations had contributed to market complexity and complexity to market disruptions. Perhaps the question of regulatory complexity is itself so complicated that the answer defies proof one way or the other.

CFTC Commissioner Giancarlo Questions Position Limits Rulemaking

CFTC Commissioner J. Christopher Giancarlo delivered a speech before the USA EnergyRisk Summit. The speech focused on whether the proposed CFTC position limits rulemaking is necessary in the energy markets.

According to Commissioner Giancarlo, evidence presented at the CFTC’s recent Energy and Environmental Markets Advisory Committee (“EEMAC”) meeting suggests that (i) the “run up in oil prices before the financial crisis did not bear any of the signs of excessive speculation,” and (ii) “speculators are not responsible for the significant declines in oil prices over the last nine months.”

Commissioner Giancarlo reported that EEMAC also heard evidence indicating that energy derivatives markets are “generally functioning well, especially in the spot months, with no evidence that excessive speculation is causing any price movements, much less sudden and unreasonable ones.” He stated that based on what EEMAC heard, major energy markets “exhibit reasonable liquidity” and any regulations aimed at excessive speculation seem to be “a solution to a nonexistent problem.”

Additionally, Commissioner Giancarlo explained, the EEMAC meeting suggested that the current problem is caused not by excessive but inadequate speculation. He noted that in determining whether position limits are necessary or appropriate, the CFTC does not consider data on any over-the-counter swap. Given this lack of data, he stated, “it is hard to believe” that the CFTC has set necessary and appropriate limits “if it doesn’t even understand the true scope of the market.” According to Commissioner Giancarlo, EEMAC discussed two potential changes to address the “negative impact of the CFTC’s proposal on liquidity”: (i) tasking the CFTC with utilizing a system of position accountability, and (ii) having the CFTC review and update its deliverable supply estimates.

Commissioner Giancarlo stated that EEMAC also heard evidence suggesting that the CFTC’s proposal “unduly focuses on ‘limiting the activity of commercials in hedging in the markets,'” which would increase the risk of pricing commodities. In his own view, the overall effect of the CFTC’s bona fide hedging framework would be to “impose a federal regulatory edict in place of business judgment in the course of risk hedging activity by commercial enterprises.” He encouraged the CFTC to allow greater flexibility by permitting commercial enterprises to adapt to developments and advances in hedging practices.

Commissioner Giancarlo recommended that the position limits rulemaking be guided by two principles: (i) following data and (ii) being attentive to the true costs and benefits of the rulemaking for hedgers and taxpayers.

Lofchie Comment: The argument that speculators are responsible for driving up the price of energy by hoarding it seems divorced from reality. Outside of the CFTC and the political debate over speculators and position limits, the question whether hoarders are driving up the price of oil is not seriously discussed. For example, the Administrator of the U.S. Energy Information Administration (“EIA”) testified recently before the Senate Committee on Energy and Natural Resources that energy prices are affected by macro factors – such as the state of sanctions against Iran or the development of technology – factors that operate on a far broader scale than that of the ability of speculators to hoard oil (here is the testimony).