ISLA Report Documents Link between Regulation and Securities Lending Market Behavior

The International Securities Lending Association (“ISLA”) released a report finding that there is “clear interconnectivity” between regulation and securities lending market behavior.” The report identifies trends in the market that are backed by detailed data collection. Trends highlighted in the report include: “UCITS funds appear to be less able to engage in lending due to regulation, corporate bonds appear to be less attractive as a collateral security due to higher bank balance sheet charges, and the demand to borrow High Quality Liquidity Assets (HQLA) continues to grow as a result of Basel III, EMIR and similar regimes that require the mobilisation of collateral. Specifically, the report noted the following:

  • on-loan balances increased 8.5% globally from €1.7 trillion to €1.8 trillion from the preceding 6 months;
  • mutual funds and pension plans continue to dominate the global lending pool;
  • government bonds account for 39% of all securities on-loan;
  • equity loan balances grew 13%, representing the largest proportion of outstanding loans;
  • the movement towards the use of non-cash collateral continued; and
  • equities represented 57% of the collateral pool held by tri-party service provider.

Lofchie Comment: There is an inherent limitation in ISLA’s report in that the statistics provided do not include data from the “repo” market. Since securities lending and repo are in many respects fungible transactions, it would be useful to know whether market counterparties are replacing one form of transaction with the other, or whether similar trends are appearing in both types of transactions.

Two observations from the report may resonate: first, the form of transactions in the securities lending markets is being driven by regulations. One has the sense that the regulators driving these rules do not feel comfortable dealing with securities lending, and appear to be mistakenly inclined to regulate the transactions in a manner similar to unsecured loans; i.e., as commercial banking transactions. Clearly, this faulty analogy is problematic. Second, the fact that various regulations strongly favor the use of government securities as collateral, (e.g., the regulations relating to derivatives as well as regulations regarding liquidity,) should logically result in market participants over-valuing holding government debt versus holding private corporate debt. This would generally seem to be a negative for the markets, particularly as it is obviously not the case that all government debt is free of credit risk, let alone market risk.

See: ISLA Securities Lending Market Report (September 2015).

Commissioner Gallagher Announces October 2 Departure from SEC

SEC Commissioner Daniel Gallagher, citing “the [growing] need to bring greater clarity to my tenure,” stated his intention to leave the SEC by Friday, October 2, 2015.

Lofchie Comment: The departure of Commissioner Gallagher will be a loss to the financial markets, as he has been among those who has evidenced the most practical understanding of how markets work. In addition, we think his development of a visual demonstration of the burdens of regulation imposed by Dodd-Frank is among the most compelling pieces of evidence as to the drag that the sheer volume of regulation (to say nothing of its “quality”) has imposed on the markets and the economy. See SEC Commissioner Gallagher Announces Updated Regulatory Chart (with Lofchie Comment) (June 4, 2015).

See: Commissioner Gallagher’s Resignation Statement.

44 Senators Submit Letter to SEC Urging Disclosure to Shareholders of Corporate Resources Used for Political Activities

In a letter addressed to SEC Chair Mary Jo White, a group of 44 senators expressed their support for a petition of rulemaking that would require public companies to disclose their political spending to shareholders pursuant to Section 14 of the Securities Exchange Act.

The letter conveyed the senators’ opinion that “because shareholders are the true owners of the corporation, a public company should be required to disclose to its owners how their money is being spent.” The senators observed that the SEC has received “more than 1 million public comments” supporting the petition, including comments from “leading academics,” a number of State Treasurers and two former SEC Chairmen. Despite this widespread support, the senators emphasized, “roughly 2.2% of all public companies in the U.S. make such disclosures, and they do so voluntarily.”

The senators requested that Chair White “reconsider the decision to remove [this rulemaking] from the SEC’s regulatory agenda” and make it “a top priority for the SEC in the near term.”

Lofchie Comment: As they used to say in law school, the senators’ argument proves too much. If the shareholders have the right to know how their money is spent, then why shouldn’t corporations be required to open all of their books to their shareholders? Why, in fact, should they keep any secrets from shareholders?

The real issue should be whether shareholders would benefit if corporations were required to make public disclosures of these expenses, including to non-shareholders who could use the information in ways that could be detrimental to companies and their shareholders. The fact that such a small percentage of companies have released such information in the past suggests that shareholders may not benefit, since such shareholders have not (to my knowledge) generally exercised their rights as shareholders, through the proxy process, to attempt to obtain the information.

If the senators’ true objective is to benefit shareholders, then they might suggest that the SEC simply require companies to put the issue to a vote by their shareholders, and allow the intended beneficiaries of the senators’ letter to decide what is best for themselves.

OCC Improves Treatment for Servicemembers, Lauds Cyber Security Efforts and Urges ”Responsible” Financial Services Innovation

Deputy Comptroller for Compliance Operations and Policy Grovetta Gardineer asserted that the OCC has taken steps to supervise and enforce better treatment of members of the armed forces under the Servicemembers Civil Relief Act of 2003 (“SCRA”) and under amended rules implementing the Military Lending Act (“MLA”). In a speech delivered before the Association of Military Banks of America, Ms. Gardineer discussed OCC directives to banks to improve SCRA compliance policies and procedures. She also discussed the expanded coverage of MLA rules under recent Department of Defense final amendments, including (i) creating a private right of action, (ii) giving administrative enforcement authority to the federal banking agencies and the Consumer Financial Protection Bureau (“CFPB”) and (iii) applying the rules for MLA protections to payday loans, vehicle title loans, refund anticipation loans, deposit advance loans, installment loans, and unsecured open-ended lines of credit and credit cards.

Ms. Gardineer reported that “cyber threats against financial institutions of all sizes are increasing and becoming more and more sophisticated.” In this regard, she mentioned the development by the Federal Financial Institutions Examination Council (“FFIEC”) of a cybersecurity assessment tool to help banks and examiners assess the maturity of cybersecurity programs. The tool (i) provides a common framework for assessment across institutions, (ii) allows regulators and bankers to track their progress and have a better view of the industry’s ability to withstand cyberattacks, and (iii) helps bankers and examiners to talk through issues facing individual bankers.

Finally, Ms. Gardineer suggested that the lack of innovation in the financial services industry threatens business, and added that more “responsible” approaches to meet the changing needs of consumers, businesses and communities will help banks continue to be a source of strength for the nation’s economy and for local communities. “We are seeing customers turn to alternative service providers in droves when traditional financial service providers can’t satisfy their appetites,” she said. “If the current financial service industry participants fail to innovate, someone else will, and today’s service providers will become historical footnotes.”

Lofchie Comment: In her criticism of banks’ failure to innovate, Ms. Gardineer suggested that “we can eliminate the misperception that it is too difficult to innovate in the regulated space – a perception that may be contributing to more and more innovation occurring outside the regulated financial industry.” That description of the problem completely misses the point. Is it really the case that banks do not innovate because of the “perception” that the regulators discourage innovation?

Ms. Gardineer reports that the OCC will address the question by assembling a “team of representatives . . . that includes policy experts, examiners, lawyers and others. . . .” Perhaps a different team with a different composition would be better suited to consider the subject of how to encourage innovation.

NFA Proposes Adoption of ISSPs

The NFA proposed the adoption of an Interpretive Notice to NFA Compliance Rules 2-9, 2-36 and 2-49. The notice would require member firms to “adopt and enforce written procedures to secure customer data and access” to their electronic Information Systems Security Programs (“ISSPs”) pursuant to Section 17(j) of the Commodity Exchange Act.

The NFA stated that, prior to drafting the notice, it had “reviewed guidance issued by other financial regulators” on cybersecurity, including FINRA’s February 2015 Report on Cybersecurity Practices, the SEC’s April 2015 Guidance Update and SIFMA’s July 2014 Small Firms’ Cybersecurity Guidance.

The NFA proposal stipulates that a written ISSP must (i) be approved within the member firm by an executive-level official and contain a security and risk analysis, (ii) describe the member firm’s ongoing education and training in information systems security for all appropriate personnel and (iii) be monitored and reviewed regularly for effectiveness, including with respect to safeguards deployed by the member, and make adjustments where appropriate.

Additionally, the NFA stated that firms “should have supervisory practices in place reasonably designed to diligently supervise the risks of unauthorized access to or attack of their information technology systems, and to respond appropriately should unauthorized access or attack occur.”

Lofchie Comment: The bottom line is this: in the event of a successful cyber attack, not only is the victimized firm’s business at risk, but the officers of the firm also may be charged with supervisory failure if they are deemed to have failed to install adequate computer defenses. While there is no question that firms should install defenses against cyber attacks, it is worrisome that individuals and firms can be charged with regulatory failure in the absence of any standards for adequate supervision, particularly since cyber attackers are universally understood to be quite sophisticated, and it is unlikely that any firm can be completely confident about its cyber defenses.