Industry Associations Submit Letter Supporting Global Trade Reporting and Data Harmonization

In a letter to global regulators, eleven industry associations voiced their support for ISDA’s key principles for improving global trade reporting and data harmonization. The signatories include SIFMA, ISDA and MFA et.al. (together, the “Associations”).

ISDA’s principles consist of an outline of recommendations intended to address challenges that have emerged in the cross-border implementation of derivatives reporting requirements. ISDA recommends that:

  • regulatory reporting requirements for derivatives transactions be harmonized within and across borders;
  • policy-makers embrace and adopt the use of open standards, including legal entity identifiers, unique trade identifiers, unique product identifiers and existing messaging standards in order to improve quality and consistency in meeting reporting requirements;
  • if global standards do not exist, then market participants and regulators should collaborate and secure mutual agreement on common solutions to improve consistency and cross-border harmonization;
  • laws or regulations that prevent policy-makers from appropriately accessing and sharing data across borders should be amended or repealed; and
  • reporting progress should be benchmarked, tracked, measured and shared with market participants and regulators.

In the letter, the Associations noted that “significant progress” has been made to meet the G-20 requirement that all derivatives be reported to trade repositories. However, the Associations also said that a lack of standardization and consistency in reporting requirements within and across jurisdictions has led to concerns about the quality of the data being reported.

The Associations also warned that poor data quality and differences in reporting requirements reduce the value of the data for regulators and limit their ability to fulfill supervisory responsibilities. According to the Associations, adherence to ISDA’s data reporting principles will result in greater consistency in the content and format of the data being reported, which in turn will improve regulatory transparency.

The full list of associations that signed the letter includes SIFMA and the Asset Management Group of SIFMA, the Australian Financial Market Association, the Alternative Investment Management Association, the British Bankers Association, the German Investment Funds Association, the European Fund and Asset Management Association, the Futures Industry Association, the Global Foreign Exchange Division of the Global Financial Markets Association, the International Swaps and Derivatives Association, the Managed Funds Association and the Investment Association.

Lofchie Comment: The market benefits of regulators coordinating information requirements are not limited to cross-border regulators or even to swap transactions. The SEC and the CFTC could do a lot to harmonize a slew of reporting requirements. If they did, the result would be fewer burdens on market participants and more useful information to the regulators.

SEC Requests Comment on Exchange-Traded Products

The SEC announced that it is seeking public comment to help inform its review of the listing and trading of new, novel, or complex exchange-traded products (“ETPs”).

The SEC is examining key issues that arise when exemptions are sought by a market participant to trade a new ETP or when a securities exchange seeks to establish standards for listing new ETPs. Specifically, the request for comment addresses arbitrage mechanisms and market pricing for ETPs, legal exemptions and other regulatory positions related to the trading of ETPs, and securities exchange listing standards for ETPs. In addition, the request invites comment on how market professionals sell ETPs, especially to retail investors, and on investors’ understanding of the nature and use of ETPs.

According to the SEC, the expansion of ETP investment strategies in recent years has led to a significant increase in the number and complexity of these requests for comment. Therefore, the SEC determined that it would be beneficial to undertake an assessment of ETPs and receive public input on these issues.

The public comment period will remain open for 60 days following publication of the comment request in the Federal Register.

Lofchie Comment: We assume that the SEC’s review will include both structured notes and exchange-traded funds (“ETFs”). Given the high degree of retail involvement in these products, this is not an area where it is reasonable to rely on the sophistication of investors as protection. And given the importance of these products to the financial markets, firms would probably do well to consider what a good regulatory structure would look like (e.g., required disclosures? suitability procedures? conflict issues?  pricing? limits regarding inherent leverage or complexity?) If market participants do not take the time to provide their views, and support for their views, rules will be made without regard to those views.

See: SEC’s Request for Comment.

NY Department of Financial Services Releases Final Rules for Licensing Virtual Currency Businesses in New York

The New York Department of Financial Services (“NYDFS”) released a final “BitLicense” framework that establishes a licensing and regulatory regime for New York businesses engaged in activities related to Bitcoin and other virtual currencies.

According to NYDFS, the rules will apply to persons located in New York that engage in activities related to virtual currency, as well as persons outside of New York that engage in activities related to virtual currency with persons located in New York. The rules define a “person” as an individual, partnership, corporation, association, joint stock association, trust or other entity, however organized. While the final rules have been issued by the NYDFS, the effective date has not yet been announced.

The rules, which seem to be largely modeled after those that apply to broker-dealers, are divided into 13 sections, covering areas include (i) the process for obtaining and maintaining licenses, both for the firm and for its personnel, (ii) capital, (iii) custody, (iv) record keeping, (v) the development of an AML program, (vi) the establishment of a cybersecurity program and (vii) general compliance procedures. In addition, the rules contain a significant amount of detail with respect to any “change” in a firm’s business. Change refers to a change in ownership or a “material change” to a firm’s business (see Section 200.10 of the rules). Material change is a term defined to include, in effect, anything new about a firm’s business or any change that could result in something going wrong in a firm’s business.

Lofchie Comment: In a statement accompanying the new set of rules, Benjamin Lawsky, the Superintendent of the New York Department of Financial Services, stated that he had resisted pressure to “ban Bitcoin” (a view that he said was “Luddite”), and had instead attempted to develop regulations that would contribute to the “long-term health of the virtual currency industry.”

The new rules are fairly significant in scope and thus, add to the expense of the compliance burden. They provide a significant degree of power to regulators (essentially enabling the review and approval of any aspect of a firm’s business plan). Further, the rules are inherently ambiguous, insofar as the rule requirements are drafted in broad terms and there is no precedent to indicate how those requirements will be interpreted. It also remains to be seen how able the NYDFS will be to review and approve changes to a regulated firm’s business within a reasonable time period, particularly in the absence of any standards for approving or denying requests for such changes.

The rules seem like a heavy lift for a newly regulated firm. One wonders if it would not have been better to phase in the regulations over time. Whether the regulations are workable will likely depend on the manner in which they are enforced, given the great latitude given to the regulators. The two big dangers are (i) that the scope of the regulations discourage smaller firms, and (ii) that the time required for regulatory approvals of business changes makes it impractical to do business.

See: NYDFS Final BitLicense Rules; NYDFS Superintendent Benjamin Lawsky’s Remarks.

House Approves Bill to Reauthorize CFTC and Amend the Commodity Exchange Act

The House of Representatives approved the “Commodity End-User Relief Act” (H.R. 2289). This legislation would reauthorize the CFTC until 2019 and make material amendments to the Commodity Exchange Act.

The “Commodity End-User Relief Act” was introduced by House Agriculture Committee Chair K. Michael Conaway (R-TX), Rep. James Austin Scott (R-GA) and Rep. David Albert Scott (D-GA). It passed by a vote of 246 to 141, which demonstrates a moderately high degree of bipartisan support. As passed by the House, the bill was amended in a variety of ways that made it different from the version that had been approved by the House Agriculture Committee. Following passage of the Agriculture Committee bill, CFTC Chair Massad released a letter stating his opposition to it. In addition, the White House released a Statement of Administration Policy stating that it recommended a Presidential veto of the proposed bill because it would “hinder the CFTC’s progress in successfully implementing [its] critical responsibilities without providing the more robust and reliable funding that the agency needs.”

The following is a summary of the major provisions of the bill.

Statement of Policy: “In the past five years, the CFTC has finalized approximately 50 rules to enforce the new law. In that time span, the CFTC has also issued an unprecedented 258 ‘no-action’ letters, 56 exemptive letters and 43 statements of guidance, interpretation and advice in order to delay, revise, or exempt the application of these regulations upon various market participants. This haphazard patchwork of exemptions has been widely used in lieu of a thorough and well-reasoned rulemaking process. H.R. 2289 reauthorizes the CFTC through 2019 and makes reforms to CFTC operations to help ensure that all Commissioners’ voices are heard as a part of a more deliberative rulemaking process.”

Customer Protection – Residual Interest: Requires futures commission merchants (“FCMs”) to maintain written policies and procedures governing maintenance of “residual interest” in customer-segregated funds accounts, including cleared swaps customer collateral accounts, and requires SROs to establish rules governing the withdrawal, transfer, or disbursement of a member’s residual interest in customer segregated funds, in foreign futures and foreign options customer secured amount funds, and from cleared swaps customer collateral.

FCM Bankruptcy: Authorizes the CFTC to require that the property of a commodity broker that also is in Chapter 7 debtor-in-bankruptcy be included in customer property to the extent that customer property is insufficient to satisfy the net equity claims of the broker’s public customers.

Cost-Benefit Requirement: Modifying the cost-benefit analysis requirements for proposed rules of the Commodity Exchange Act (“CEA”) to track those set forth in Executive Order 13563 more closely, and requiring such analysis to be done by the Office of Chief Economist.

Strategic Technology Plan: Requires the CFTC to submit to certain congressional committees every five years a detailed strategic technology plan focused on the CFTC’s acquisition and use of technology.

Safeguarding of Market Data Held by CFTC: Requires CFTC staff to develop comprehensive internal risk control mechanisms to safeguard and govern the storage of all market data, including CFTC market data sharing agreements, as well as academic research performed at the CFTC using market data.

De Minimis Threshold: Requires a new affirmative CFTC rule or regulation in order to reduce the de minimis quantity of swap dealing that is currently set at $8 billion (and which is set to go down to $3 billion).

Capital and Margin Determinations: Permits swap dealers and major swap participants (“MSPs”) that are not banks to use financial models for calculating capital and margin requirements.

Bona Fide Hedging: Authorizes the CFTC to define a bona fide hedging transaction, as is consistent with certain CEA requirements.

Cross-Border: (1) directs the CFTC to issue rules governing cross-border regulation of derivatives transactions; (2) directs the CFTC to consider the swaps regulatory requirements of eight foreign jurisdictions with the largest swaps markets to be comparable to, and as comprehensive as, U.S. swaps requirements; (3) exempts from U.S. swaps requirements either a non-U.S. person or a transaction between two non-U.S. persons if the person or transaction is in compliance with the swaps regulatory requirements of specified foreign jurisdictions; and (4) entitles a petition for review to expedited CFTC consideration when it is requested by either a registered entity, a commercial market participant or a CFTC registrant with respect to a CFTC determination regarding foreign jurisdiction regulatory requirements.

Judicial Review of CFTC Rule: Allows the direct review of CFTC rules by the D.C. Circuit without requiring the review to go first to the federal district court.

Definition of Commodity Pool Operator: Provides that the term “commodity pool operator” does not include a person who serves as an investment adviser to an investment company registered pursuant to the Investment Company Act of 1940 if the investment company or adviser invests, reinvests, owns, holds or trades in commodity interests limited to only financial commodity interests.

Lofchie Comment: The bill is a reflection of a widely (though not universally) shared view that the hasty rulemaking activities of the CFTC, after the passage of Dodd Frank, resulted in damage to the economy and poisoned relationships with financial regulators around the world. There is no doubt that the proposed amendments would make it more difficult for the CFTC to adopt rules, insofar as the amendments would subject the CFTC to the requirement of a demonstration that its rules could be justified economically. On the other hand, it is not clear why the CFTC should be exempted from making this demonstration.  The SEC is subject to this requirement, as are numerous other federal agencies. If the White House is opposed to this requirement for the CFTC, then the White House should either (i) express its general opposition to any agency being subject to cost-benefit requirements or (ii) explain why its views on the CFTC are different. There is also a good argument to be made that the CFTC might actually have been more efficient in adopting rules if it had undertaken a more considered analysis. As things stand, the CFTC has been forced to issue literally hundreds of no-action letters to amend or delay its own rules.

There is no question that the CFTC is massively underfunded given its new responsibilities under Dodd-Frank. But this is a consequence of its own making. The CFTC under former Chair Gensler made no effort to pick and choose where its resources should be spent (a good example being the double regulation of SEC-registered investment companies as commodity pools), which meant that allocating money to the agency arguably was dumping it into a black hole. More deliberation and consensus-building up front may have led to more appropriate levels of funding.

FSOC Issues Staff Guidance Regarding Methodology Determinations for Stage 1 Thresholds

The Financial Stability Oversight Council (“FSOC”) issued a staff guidance (“Guidance”). The Guidance concerns the first stage of FSOC’s process for determining whether a non-bank financial company should be supervised by the Board of Governors of the Federal Reserve System (“FRB”) and become subject to enhanced prudential standards.

Dodd-Frank Section 113 authorizes FSOC to make determinations based on whether a non-bank financial company might pose a threat to the financial stability of the United States. To that end, FSOC issued a previous rule and interpretive guidance to clarify the three-stage process used for identifying and analyzing companies in making potential determinations.

In the Guidance regarding Stage 1 of the process, FSOC explained it applies six quantitative thresholds to a broad group of non-bank financial companies to identify a subset that merits further evaluation. The Guidance describes the six thresholds, and explains that a non-bank financial company that is targeted for further evaluation in Stage 1 may be subject to active review in Stage 2.

According to the Guidance, FSOC relies solely on information made available through existing public and regulatory sources in Stage 1. The Guidance explains that the “fundamental purpose” of Stage 1 is “to narrow the universe of nonbank financial companies that may be subject to active review in Stage 2.” The Guidance also notes that in Stage 2, FSOC retains the discretion to consider a non-bank financial company not identified by the Stage 1 thresholds if further analysis is needed to determine whether the company might pose a threat to financial stability in the United States.

Lofchie Comment: While it is good that FSOC is making some effort to formalize and publicize its process for designating non-banks as systemically significant, at the end of the day, the process continues to be discretionary and so remains wholly dissatisfactory to a society that prides itself on operating under the rule of objective law. Additionally, some of the terms according to which FSOC announced that it will pick systemically important financial institutions seem to me to be completely inappropriate. For starters, it seems improper to regulate a firm because it is the subject of credit default swaps; companies should be regulated because of their own activities, and not because other firms enter into derivatives to which they are not parties. Second, it is odd that the banking regulators treat securities lending and repurchase agreements as the equivalent of unsecured debts.

SEC Commissioner Gallagher Announces Updated Regulatory Chart

SEC Commissioner Daniel M. Gallagher published an updated chart that depicts all of the rules that are applicable to a U.S. financial services holding company in the wake of Dodd-Frank‘s enactment. The chart can be found on the SEC website.

The chart was updated to reflect the FINRA rules and amendments that have been implemented since July 2010.

Originally, the chart was published along with a transcription of a March 2, 2015 speech by Commissioner Gallagher. Accordingly, the chart was intended to “help the public fully grasp the breadth of recent rulemaking.”

Lofchie Comment: In case you thought the Commissioner’s chart wasn’t ugly enough, Dodd-Frank rule makers have ensured it’s going to get uglier, since their work is nowhere near complete. Of the new rules that have been added to the chart, how many are actually useful, how many are useless (and thus a waste of regulatory and market resources) and how many are demonstrably harmful?

See: Updated Chart; Commissioner Gallagher’s Announcement.

The Joint Services of Money & Credit

While credit cards provide transaction services, as do currency and demand deposits, credit cards have never been included in measures of the money supply. The reason is accounting conventions, which do not permit adding liabilities, such as credit card balances, to assets, such as money. But economic aggregation theory and index number theory are based on microeconomic theory, not accounting, and measure service flows. We derive theory needed to measure the joint services of credit cards and money. The underlying assumption is that credit card services are not weakly separable from the services of monetary assets. Carried forward rotating balances are not included, since they were used for transactions services in prior periods.

The theory is developed for the representative consumer, who pays interest for the services of credit cards during the period used for transactions. In the transmission mechanism of central bank policy, our results raise potentially fundamental questions about the traditional dichotomy between money and some forms of short term credit, such as checkable lines of credit.

I had the opportunity to present this paper, via video, along with my co-author Liting Su at the International Conference on Economic Recovery in the Post-Crisis Period  in Skopje, Republic of Macedonia (May 29-30, 2015). To see a video of this presentation, click here. (Download High Res .m4v) The paper can be found here.

CFTC Commissioner Giancarlo Discusses the Perils of Low Liquidity, Rips into FSOC

CFTC Commissioner J. Christopher Giancarlo delivered the keynote address before the Cato Summit on Financial Regulation, focusing on the importance of liquidity to reduce risks in financial markets.

Commissioner Giancarlo stated that liquidity is the “life blood” of successful financial markets. He explained that the risk involved in hedging instruments helps “moderate price, supply and other commercial risks,” which in turn frees up capital to boost economic growth. According to Commissioner Giancarlo, an “inferno of complex derivative products used for unfettered risk taking overseen by feckless regulators” contributed to the financial crisis. He noted, however, that the focus of regulation in the post-financial crisis environment has centered around an “incomplete narrative” of deregulated banks that engaged in excessive trading leverage through derivatives, rather than focusing on mortgages that the Federal government encouraged.

According to Commissioner Giancarlo, after the financial crisis, international regulators focused on rulemakings that sought to control borrowing and to leverage the financial system by prioritizing “capital reserves over investment capital, balance sheet surplus over market making and systemic safety over investment opportunity.” He noted that the CFTC has contributed to decreasing liquidity in the form of its “flawed” swap trading rules, and the “double charging of margin” on certain types of derivatives.

Furthermore, he said that regulators are creating a “piecemeal” international framework that is increasing fragmentation and decreasing liquidity in global markets. Commissioner Giancarlo argued that liquidity acts as a “shock absorber” that creates volatile pricing in markets, suggesting that the regulation that contributes to reduced trading liquidity in markets is contributing to the risk of the next financial crisis (citing to a “veteran” industry commentator at fn. 49).

Commissioner Giancarlo went on to discuss the Financial Stability Oversight Council’s (“FSOC”) “unmitigated failure” as a coordinator of regulatory reform. He stated that FSOC has unwisely spent its time designating financial and insurance firms as “too big to fail,” rather than focusing on the systemic risk posed by “liquidity draining regulations.” Commissioner Giancarlo recommended that FSOC “step up to its statutory duty” to analyze U.S. and cross-border regulations.

Lofchie Comment: This seems a good opportunity to link to the Cabinet’s three most recent stories regarding FSOC: (i) ICI Submits Comment Letters to Regulators and FSB Critical of Potential for G-SIFI Designation (with Lofchie Comment); (ii) SIFMA AMG Urges Regulators to Stop Efforts to Create Systemic Risk Methodology for Asset Managers and Funds (with Lofchie Comment); and (iii) Professors Submit Brief Supporting FSOC’s Authority (with Lofchie Comment and YouTube Selection).

See: Commissioner Giancarlo’s Remarks.

Joint Forum Releases Report on Credit Risk Management Across Sectors

The Joint Forum, which consists of the Basel Committee on Banking Supervision, IOSCO and the International Association of Insurance Supervisors, released a report titled “Developments in Credit Risk Management Across Sectors: Current Practices and Recommendations.”

The report provides insight into the current supervisory framework around credit risk, the state of credit risk management at firms, and implications for the supervisory and regulatory treatment of credit risk. The report is based on a survey that the Joint Forum conducted globally with 15 supervisors and 23 firms in the banking, securities and insurance sectors.

The Joint Forum put forth the following recommendations for consideration:

  • supervisors should be cautious about overreliance on internal models for credit risk management and regulatory capital;
  • supervisors should be cognizant of the growth of certain risk-taking behaviors and the resulting need for firms to have appropriate risk management processes, given the current low interest rate environment possibly generating a “search for yield” through a variety of mechanisms;
  • supervisors should be aware of the growing need for high-quality liquid collateral to meet margin requirements for OTC derivatives sectors. The Joint Forum should consider taking appropriate steps to promote the monitoring and evaluation of the availability of such collateral in their future work while also considering the objective of reducing systemic risk and promoting central clearing; and
  • supervisors should consider whether firms are accurately capturing central counterparty exposures as part of their credit risk management.

Lofchie Comment: The government and the regulators vastly oversold the benefits of central clearing without attending to the risks that it creates (e.g., that central counterparties are too big to fail, and that because they can demand unlimited initial margin, they may drain liquidity from the markets when there is a downturn). The new caution that banks must be mindful of their central counterparty risk has very negative implications for the economy. In the old pre-Dodd-Frank world, if a bank did not have confidence in the creditworthiness of one swap counterparty, or believed it was overly exposed to a particular swap counterparty, it could take its business elsewhere. In the Dodd-Frank world, the major clearinghouses have monopolistic or duopolistic positions with respect to certain products. Thus, if a bank does not have confidence in a clearinghouse, or believes it is too exposed to the clearinghouse, the bank would likely have to shut down its swaps business in a particular product, even though the transaction is sensible for the bank and good for its customer. In short, the belated realization that central counterparty risk may shut down transactions is not good news for the economy.

By coincidence, a related point is made in another story published today: Dodd-Frank regulations have effectively forced small FCMs out of business, with the result that tremendous amounts of risk are being concentrated in a very small number of huge FCMs.

Chairman Fischer Discusses Lessons from Financial Crises

Speaking at the International Monetary Conference in Toronto, Canada, Vice Chairman of the Board of Governors of the Federal Reserve System (the “FRB”) Stanley Fischer discussed lessons he has learned from the financial crises of the last two decades.

Drawing from three academic papers the Chairman published in 1999, 2011 and 2014 while working at the International Monetary Fund, the Bank of Israel and the FRB, respectively, Chairman Fisher discussed the following lessons:

  • Negative Interest Rates – Contrary to pre-Great Recession economic theory, central banks may use monetary policy to reduce interest rates below zero, although perhaps not much below minus one percent;
  • Active Fiscal Policy – Fiscal policy “works well, almost everywhere,” and can likely be made more expansionary at low real cost by borrowing to finance public works;
  • Financial Stability – The United States should experiment with using monetary policy (i.e., the interest rate) to address financial stability, in addition to macroprudential tools;
  • Moral Hazard – Resolution procedures for “too big to fail” financial institutions must permit equity and bond holders to lose all or most of the value of their assets; and
  • Continued Supervision – The United States must not allow successful reforms to breed complacency, and must continue to disincentivize bad conduct by, e.g., punishing individuals “severely” for misconduct personally engaged in.