ISDA Asserts That SEF Rules Diminish Global Liquidity Pools

ISDA published a research note titled Cross-Border Fragmentation of Global Interest Rate Derivatives: The New Normal? The research note is the fourth in a series that charts the changes in global liquidity pools since the U.S. swap execution facility (“SEF”) rules were implemented in October of 2013.

Significantly, the report found that the new rules have contributed to the separation of trading between U.S. and European markets with respect to European interest rate swaps. According to the report, before the implementation of U.S. SEF rules, approximately twenty-five percent of euro interest rate swaps (“IRS”) activity was composed of trades between European and U.S. dealers. Currently, that percentage is down to about ten percent.

Lofchie Comment: Evidence of the damage done to the United States as a global financial center by various Dodd-Frank rules is mounting. SEF rules in particular do not reduce systemic risk. To the extent to which these rules actually serve to separate markets and reduce global liquidity, their consequences are the opposite of their intended purpose.

SEC Equity Market Structure Committee Holds Meeting

The SEC Equity Market Structure Advisory Committee discussed (i) exchange access fees and (ii) the current regulatory models for trading venues.

In her opening remarks at the October 2015 meeting, SEC Chair Mary Jo White discussed the “maker-taker” fee structure, which “attracts order flow to a venue and incentivizes the venue’s market participants to provide liquidity at the most competitive prices.” Chair White also reported that the committee would consider “fundamental changes in trading venue management and operation.” Those possible changes included (i) the growth of trading conducted through automated trading systems, (ii) the impact of demutualization, and (iii) the emergence of exchange group affiliations and other developments.

In his public statement, SEC Commissioner Luis A. Aguilar entreated SEC staff to (i) “work toward developing a robust contingency plan for the exchanges’ vital infrastructure,” (ii) consider whether other aspects of market structure should be “buttressed” with contingency plans, (iii) address new market paradigms created by technological advances and (iv) work on a maker-taker pilot program that is less complex than the current tick pilot program.

Commissioner Aguilar revealed that this “may be the last time” he would have an “opportunity to address the Committee as a commissioner.” He closed with some “longer-term questions” that he hoped the SEC would consider for future meetings:

  • How will retail investors’ increasing reliance on professional asset managers affect the structure and regulatory framework of our equity markets?
  • Is there adequate liquidity for institutional investors, who now play a greater role in our equity markets?
  • What causes liquidity to become more “brittle” and “apt to flee during periods of market stress,” and does market structure contribute to that effect?
  • What does the “aggressive growth of indexing in recent years,” and its concentration of investment activity in the largest and most liquid stocks, mean in terms of market stability and volatility?
  • How has the growing use of so-called systematic trading strategies such as risk parity affected the stability of our markets?
  • How should the SEC address the problem of excessive intermediation in our equity markets?
  • Are public exchanges still an attractive destination for smaller and emerging companies, or are venture capital and private equity firms more popular now?

Lofchie Comment: The last question, which is not about “markets” but rather the costs of going public, is the big one. This is the type of question that the SEC should not only study but examine continuously: how do issuers decide where to raise capital or whether to go public? Is it better to go public in the United States or to stay private? Is it better to go public in the U.S. market, or to go public abroad and hope that shares of any attractive company eventually will filter back to the United States?

Professor Warns That Central Clearing Creates Unacceptable Liquidity Risks

In a blog post titled “Creeping Recognition That Regulation Has Created a Liquidity Death Star,” University of Houston finance professor Craig Pirrong argued that clearing and collateral mandates transform credit risk into liquidity risk, which increases systemic risk. According to Professor Pirrong, (i) variation margining causes spikes in the demand for liquidity, “exacerbating the liquidity squeeze” in stressed market conditions, and (ii) clearing “creates tight coupling because failures – or even delays – in making variation margin payments can put the clearinghouse into default or force it to liquidate collateral in an illiquid market.”

In spite of this, Professor Pirrong said, awareness of the danger of spikes in liquidity demand right when liquidity supply evaporates remains “sadly insufficiently widespread” among regulators.

Professor Pirrong expressed astonishment that regulators persist in thinking they are solving systemic risk problems “by imposing a mechanism that will sharply increase liquidity demand and restrict liquidity supply during periods of market stress . . . even though every major financial crisis in history has been at root a liquidity crisis.”

Lofchie Comment: Numerous pieces posted in the Cabinet have highlighted concern about the liquidity risks caused by central clearing organizations that use their ability to demand more margin, which can precipitate a spiraling sell-off as customers and clearing firms liquidate assets and positions to raise margin, which causes prices to decrease, which requires further sell-offs. See, e.g., FRB Governor Powell Discusses Expanding the Central Clearing of OTC Derivatives (with Lofchie Comment) (Nov. 6, 2014). Though Professor Pirrong’s views on central clearing are pessimistic, his blog post does not deal with another issue that should cause him to be even more pessimistic: not only will the clearinghouses call for more variation margin on positions (which in theory should merely reflect the movement of capital from one party to another); they also will demand more initial margin from both parties, which could suck liquidity out of the financial system. That is because one of the biggest differences between bilateral derivatives contracts and central clearing systems is that in the bilateral world, large institutions generally do not have the ability to demand more initial margin from each other. In a centrally cleared world, the central clearing party has the unlimited ability to keep itself safe by raising initial margin requirements.

Although it is good that regulators finally are paying attention to the risks created by central clearing, the problem is that they are focusing on the wrong risk. The biggest risk is not that a central clearing corporation might fail. It is, as we said in the 2014 story cited above, “the ability of a major [central clearing party] to survive by dragging down everyone else.”

CFS Discussion on “America’s Bank” with Author Roger Lowenstein…

The Center for Financial Stability (CFS) thanks Roger Lowenstein for “America’s Bank: The Epic Struggle to Create the Federal Reserve.” “America’s Bank” is a gift for anyone interested in understanding the nuances and struggles behind the creation of the Federal Reserve.

Perhaps, of greatest importance, “America’s Bank” highlights lessons for today’s Fed stretching from governance to the size of the institution relative to the economy.

We are grateful to Roger Lowenstein for sitting down with CFS.  The following are excerpts from the conversation.

Best regards,
Lawrence Goodman

Lawrence Goodman
Center for Financial Stability, Inc.
1120 Avenue of the Americas, 4th floor
New York, NY  10036
1 212 626 2660

SEC Commissioner Aguilar Calls for Government Involvement in Fighting Cybercrime against SMBs

SEC Commissioner Luis A. Aguilar emphasized in a public comment that “cybercrime represents a very real, and very serious threat” to small and midsize businesses (“SMBs”) and recommended potential solutions to fight cybercriminals despite SMBs’ typically limited resources.

Commissioner Aguilar explained that SMBs constitute easier targets than larger organizations due to a lack of: (i) sufficient in-house expertise to deal with cyberattacks; (ii) written policies in place to respond to a data breach; (iii) financial resources; and (iv) “taking cybersecurity as seriously as they should.”

Commissioner Aguilar suggested that consideration be given to the following means of assisting SMBs with respect to cyber:

  • government-provided educational programs addressing cybersecurity, such as the development of the National Institute of Standards and Technology’s Framework for Improving Critical Infrastructure Cybersecurity;
  • identifying ways of fostering economies of scale for cybersecurity solutions, such as: (i) tax credits for vendors to reward cost-effective cybersecurity solutions tailored to the unique needs of SMBs; (ii) a cyber-insurance market with the government acting as a reinsurer “during its adolescence”; or (iii) establishing a program, “akin to the National Flood Insurance Program, to help buttress the private market in the event of catastrophic, wide-spread attacks”;
  • government assistance to provide additional resources to mount a legitimate cyber defense; and
  • government support to law enforcement agencies to target the “100 top-tier authors of malware.”

Commissioner Aguilar concluded that “A vibrant and dynamic partnership between the public and private sectors could do much to level the playing field” for SMBs.

Commissioner Aguilar’s remarks were originally published in the autumn 2015 edition of the Cyber Security Review.

Lofchie Comment: Commissioner Aguilar’s proposals to help SMBs can be roughly divided into two types: (i) those programs in which the government is to itself conduct an activity and (ii) those programs where the government is to award or compensate others. In the first category, we would put (a) providing educational programs and (b) going after bad guys. In the second category, we would put (a) providing tax credits for cyber programs developed to assist SMBs and (b) providing insurance akin to flood insurance.

The first set of these seems a much better use of the government’s resources; certainly, no one other than the government can go after bad guys. The second set seems well-intentioned, but is not that easy to implement. How is the government really to practically determine which cyber programs are best suited for small businesses? As to the notion of a national insurance program, it is not hard to imagine it being impossible to administer and becoming a financial disaster if payouts are required.

To put all this differently, the questions raised by Commissioner Aguilar’s proposals are not actually about policy goals: we would all hopefully agree that cybercrime is a bad thing, and that assistance to SMBs in avoiding becoming victims of cybercrime is a good thing. So the questions that are raised are (a) what can government reasonably achieve here (can it really determine which cybersecurity programs are truly deserving of tax breaks?) and (b) how should the government spend its money accordingly (relating to cyber-insurance)?

CFTC Chair Massad Examines Market Structure and Risk

CFTC Chair Timothy Massad discussed aspects of the Treasury market that he said are important to include in the conversation about the general oversight of that market.

Chair Massad began by reviewing the findings in a joint staff report by U.S. financial regulators. The findings indicated a high correlation between prices and activity in the Treasury futures and cash markets. In response, Chair Massad suggested that the market fluctuations of October 15, 2014 – when a sudden large price movement in U.S. Treasuries was reversed within minutes – are happening to other products. He reported that the CFTC measured the frequency of “flash events” in Treasury futures and five of the most active contracts. It found that “movements of a magnitude similar to Treasuries on October 15th were not uncommon.”

Discussing the automation of trading, Chair Massad took a position that was largely positive. He acknowledged the tremendous significance of automated trading to the market and noted that, for some products, automated trading “accounts” for almost two-thirds of trading volume. He also reported that “[e]lectronic trading has contributed to a substantial improvement in transparency in the markets.” Before electronic trading, he said, traders often were unable to “maintain tight and deep spreads during volatile conditions. They likely took long coffee breaks.” However, he indicated that the CFTC probably would propose a number of measures to reduce the likelihood of technological glitches or other unfortunate reactions caused by automated trading.

Chair Massad delivered his remarks before the Conference on the Evolving Structure of the U.S. Treasury Markets at the New York Fed.

Lofchie Comment: Overall, Chair Massad’s assessment seemed fairly realistic; i.e., that electronic trading is not going away, and that markets sometimes move for reasons that cannot be easily explained. He also advanced what seemed to be limited and reasonable proposals for rule changes that could diminish the likelihood (though nothing could eliminate it) of future flash crashes.

All of that good stuff aside, the CFTC issued a number of press releases several months ago that a singled out a U.K. trader by the name of Sarao (who may have engaged in illegal trading activity) as the likely cause of the flash crash. The CFTC also published an academic study to support this allegation. On its face, the notion that the CFTC could trace the cause of the flash crash to the activities of a single trader acting in a completely routine, if illegal, manner seemed completely absurd. See, e.g., Finance Professor Calls CFTC Allegations That Nav Sarao Caused Flash Crash ”Outrageous” (with Lofchie Comment and Video Selection) (Apr. 24, 2015); CFTC Charges UK Trader Company with Spoofing Scheme That Contributed (Allegedly) to ”Flash Crash” Day in 2010 (with Lofchie Comment) (Apr. 21, 2015); Article Casts Doubt on Significance and Causes of Flash Crash (Apr. 23, 2015).

Chair Massad’s remarks make clear that the CFTC’s claims about Mr. Sarao were not justified. For starters, Chair Massad reported that flash events are relatively routine and in fact occur in many different markets. He also conceded that markets move for a number of different reasons and, sometimes, for no reason at all. In other words, (i) Sarao’s behavior, even if bad, was extremely common, (ii) flash events are likewise quite common in many different types of markets and (iii) it’s often difficult to know why markets move. Given Chair Massad’s contextualization of the crash, the CFTC should apologize to Mr. Sarao for trying to blame the flash crash on him. Even if Mr. Sarao were guilty of the trading violations of which he is accused, it is simply not right for a government agency to tarnish an individual’s name as the CFTC did Mr. Sarao’s.

CFS Monetary Measures for September 2015

Today we release CFS monetary and financial measures for September 2015. CFS Divisia M4, which is the broadest and most important measure of money, grew by 3.8% in September 2015 on a year-over-year basis versus 4.3% in August.

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:

Sincerely yours,
Lawrence Goodman

CFTC Chair Discusses Regulatory Oversight and Technological Innovation

CFTC Chair Timothy Massad called on market regulators to consider ways to transform regulatory oversight, both domestically and internationally, in light of technological innovation and market transformation.

Chair Massad began by discussing the future of the swaps market. He stated that the framework being created by the CFTC and other G-20 nations will “provide a basis for further growth of our derivatives markets.” He contemplated the extent to which the regulation of OTC swaps should follow the model that exists in the futures market. Moving forward, he concluded, a framework must be created that can also evolve.

Chair Massad stressed the need for product innovation in the derivatives market. Specifically, he discussed a number of steps that were taken by the CFTC regarding bitcoin, and recognized that bitcoin “raises many important issues” for law enforcement agencies, tax authorities and other regulators. Chair Massad also noted that benchmark integrity has been a “priority issue” in enforcement actions, and that the CFTC must ensure that efforts to safeguard integrity in the administration of benchmarks do not have an adverse effect on innovation.

Additionally, Chair Massad discussed issues raised by the growth of automated trading, and called for regulators to give greater consideration to its impact on liquidity, fairness, volatility and systemic risk. He emphasized that the CFTC currently is focused on the operating risks that arise from the automation of order origination, transmission and execution. It is considering proposing additional standards in order to minimize the potential for disruptions and other problems.

Finally, Chair Massad spoke about recent international progress in achieving consistency in the regulation of OTC swaps, such as the G-20 Leaders’ agreement on basic reforms. Chair Massad acknowledged that there is “no area of financial regulation where rules are harmonized across borders,” but encouraged regulators to keep this in perspective while moving forward with regulation.

Chair Massad delivered his keynote address before the World Federation of Exchanges’ Annual Meeting in Doha, Qatar.

Lofchie Comment: It is difficult to know what to make of this speech. Chair Massad seems to be calling for more innovation as well as more regulation. While these goals weren’t always inherently inconsistent with one another, the markets have reached the point over the past several years at which the goals have become incompatible. Now Chair Massad must decide if he wants to acknowledge that over-regulation is damaging to the markets, and to determine if he is open to the genuine reconsideration of any material part of the CFTC’s post-Dodd-Frank rulemaking. Of course, the easier and less ambitious path is to continue to “fine tune” without taking on the real task of reexamination.

SEC Staff Report Provides Private Funds Industry with Stats and Trends

The SEC released a report collected from Form PF and Form ADV filings that provides statistics and trends about the private funds industry.

The staff report includes statistics about the distribution of borrowings, an analysis of hedge fund gross notional exposure to net asset value and a comparison of average hedge fund investor and hedge fund portfolio liquidity.

Additionally, the report discusses the following categories of information about hedge funds and advisers:

  • number of funds and advisers;
  • gross and net assets:
  • aggregate assets by fund type over time;
  • borrowings;
  • parallel managed accounts;
  • fund domiciles and adviser main offices;
  • beneficial ownership;
  • derivatives;
  • high frequency trading;
  • information reported by large hedge fund advisers:
  • economic leverage;
  • industry concentration;
  • portfolio turnover;
  • region and country exposure;
  • qualifying hedge fund specific information:
  • gross exposure by strategy;
  • liquidity;
  • central clearing;
  • liquidity fund specific information; and
  • private equity fund specific information.

Chair Mary Jo White noted in relevant remarks at the MFA Outlook 2015 Conference that “the public availability of aggregated information should help to address persistent questions, and to some degree misconceptions, about the practices and size of the private fund industry.”

Chair White also highlighted the following industry trends and practices in the findings of the report: (i) the total notional value of derivatives reported on Form PF, while increasing, has decreased relative to total net assets; (ii) more than half of all large hedge fund advisers report aggregate economic leverage less than two and a half times their total reported hedge fund net assets; and (iii) the data indicates that fewer than 100 reporting hedge funds, representing less than $70 billion in combined net assets, manage some portion of their funds using high-frequency trading strategies.

Lofchie Comment: The report should lend further support to the notion that the activities of the private fund industry do not present major threats to the stability of the economy, and that FSOC, which is dominated by the banking regulators, should dial back the level of rhetoric as to the need to impose controls over investment decisions made by private funds.