Senator Roberts Demands Explanation for CFTC’s “Misguided Accounting Practices”

U.S. Senate Committee on Agriculture, Nutrition & Forestry Senator Pat Roberts (R-KS) called attention to an audit report on the CFTC’s financial statements that was released by the CFTC Office of Inspector General (“OIG”). In a letter to CFTC Chair Timothy E. Massad, Senator Roberts claimed that the report showed “multiple transgressions” and raised “serious questions about the CFTC’s leasing and accounting practices that go beyond issues relating to the regional offices.”

Conducted by independent certified public accounting firm KPMG LLP, the audit report:

  • identified “material weaknesses in internal control over financial reporting and non-compliance with applicable laws and regulations”;
  • alleged that the CFTC’s “errant accounting practices conflict with U.S. generally accepted accounting principles . . . and have culminated in the improper recording of its lease obligations”; and
  • found that the CFTC’s FY 2015 and 2014 financial statements “understate obligations in the hundreds of millions of dollars.”

Senator Roberts noted that a 2011 SEC OIG report, titled “Improper Actions Relating to the Leasing of Office Space,” contained similar results concerning CFTC leasing practices. He stated: “considering the similarity between the agencies, the similarity of the issues, the public Congressional inquiries and the gravity of errant accounting, I am bewildered as to how [the] CFTC finds itself in this current state of affairs.” He expressed the additional concern that “the manner in which [the CFTC] is accounting for its leases is at odds with proper Senate appropriation procedure. Obligating funds and indebting the federal government without possessing the appropriated funds is a serious matter.”

Senator Roberts requested that the CFTC submit “prompt responses” to a set of inquiries by February 17, 2016 so that he could gain “a clearer perspective of the circumstances surrounding how and why [the] CFTC’s errant accounting practices have materialized.”

Lofchie Comment: The irony of CFTC Commissioner Bowen’s call for harsher enforcement penalties is that it comes at a time when the CFTC itself is being challenged for, in this instance, accounting misconduct. This is not to suggest there has been any material wrongdoing by the CFTC, though in light of the current enforcement culture, it does not seem to matter whether a failure is material or intentional. Current enforcement culture seems to be: however harsh the penalty might be, it cannot be harsh enough.


CFTC Commissioner Giancarlo Discusses 6 Mega-Trends Facing Financial Markets

CFTC Commissioner J. Christopher Giancarlo identified 6 mega-trends facing 21st century financial markets. His comments were drawn from a guest lecture delivered on December 1, 2015 at Harvard Law School and recently released in a podcast.

Commissioner Giancarlo identified the following “overarching challenges”:

Cyber threats. “Unfortunately, cyber-hostilities will not end any time soon. They will be relentless for . . . years to come. As mega-trends go, cyber-risk is the number one threat to 21st century financial markets. . . . As market leaders and regulators, we must make it our first priority in time and attention. We must leave no step untaken or precaution unavailed to thwart cyber-destruction of the world’s financial markets.”

Disruptive technology. “[E]xponential digital technologies are rapidly changing the very nature of human identity, work, leisure and society. . . . The only effective way for a regulatory agency to stay abreast of the rapid advances of trading automation is to be informed through an ongoing, bottom-up process.”

Giancarlo voiced the following concerns regarding proposed rules for the registration and regulation of automated trading: “First, the apparent window-dressing of requiring risk controls and testing that are already widely adopted by industry. Second, the high cost and burdens the rule places on small market participants. And third, the rule’s inconsistencies regarding what firms must comply with it.”

Central bank (government) intervention. “[The Federal Reserve] has become the multi-trillion dollar ‘Washington Whale’. . . . The Fed is having an increasingly direct and immediate impact on [all] markets, from corporate bonds to equities and foreign exchange rates, to developing nations’ sovereign debt.  It has reduced the heterogeneity of the investor base, herding it into one-way bets on anticipated changes in Fed policy rather than traditional fundamental credit or value analysis.

Market illiquidity. “In trying to stamp out risk, global regulators are instead harming trading liquidity. . . . The question that must be asked is whether the amount of capital bank regulators are causing financial institutions to take out of trading markets is at all calibrated to the amount of capital need to be kept in markets to support market health and durability. I understand how prudential regulators want banks to limit trading capital to limit their insolvency risk. But what is missing is any analysis of how much trading capital is appropriate to limit broad liquidity risk. Those of us with direct responsibility of overseeing financial markets need to ask that question and demand that analysis, even if bank prudential regulators will not. Once again, Dodd-Frank provides no answers.”

Market concentration. “[A] wave of market consolidation has taken place across the financial landscape, concentrating the provision of essential market services to fewer and fewer institutions. . . . Unfortunately, global financial markets are now undergoing a pronounced reduction in the bio-diversity of market service providers, with deleterious effect on market safety and soundness. Market regulators must find a way to reverse this trend, that threatens the systemic safety that Dodd-Frank was meant to preserve.”

Deglobalization. “[T]he 2008 financial crisis and the political and response . . . seems to have reversed the course of financial market globalization. . . . [T]here is a fundamental mismatch between [the CFTC’s swaps trading] regulatory framework and the distinct liquidity and trading dynamics of the global swaps markets. This mismatch, and the application of the framework worldwide, has caused numerous harms, foremost of which is driving away global market participants from transacting with entities subject to CFTC swaps regulation, resulting in fragmented global swaps markets.”

Commissioner Giancarlo concluded: “Regulators and others with responsibility for financial markets must take steps to address these challenges:  prioritize cyber-risk resiliency; foster best practices for new trading technologies; counter the distortions caused by central bank market intervention; acknowledge and address the diminishing liquidity in trading markets; and review and reduce the numerous poorly designed rules and regulations that are causing service-provider concentration and market fragmentation.”

Commissioner Giancarlo delivered his remarks as part of the Fidelity Guest Lecture Series on International Finance at Harvard Law School, which was previously covered in the Cabinet News.

NYSDFS Proposes Enhanced Requirements for AML Compliance

The New York State Department of Financial Services (“NYSDFS”) proposed rules that would further define the anti-money laundering (“AML”) compliance obligations of banks and other money service businesses, such as check cashers and money transmitters.

The rules are intended to (i) clarify the required attributes of a “transaction monitoring and filtering program” and (ii) require the chief compliance officers of regulated institutions to file annual certifications regarding compliance by their institutions. Specifically, the proposals would require a financial institution to:

  • maintain a “transaction monitoring program” for potential Bank Secrecy Act / AML violations and suspicious activity reporting;
  • maintain a “watch list filtering program” to interdict “transactions, before their execution, that are prohibited by applicable sanctions, including OFAC and other sanctions lists, politically exposed persons lists, and internal watch lists”; and
  • submit annual certifications of compliance with the proposed requirements executed by chief compliance officers or their functional equivalents to the NYSDFS by April 15, 2016.

An acceptable “transaction monitoring program” would require:

  • the identification of all data sources that contain relevant data;
  • valuation to ensure accurate and complete data flows;
  • governance and management oversight;
  • a vendor selection process;
  • adequate funding of the program;
  • qualified personnel or outside consultants; and
  • periodic training.

An inaccuracy in the filing would subject the signatory to criminal penalties.

The proposal follows a four-year series of NYSDFS investigations into terrorist financing and sanctions violations at financial institutions that “uncovered (among other issues) serious shortcomings in the transaction monitoring and filtering programs of these institutions” and found that a “lack of robust governance, oversight and accountability at senior levels of these institutions has contributed to these shortcomings.”

According to New York Governor Andrew M. Cuomo, “[g]lobal terrorist networks simply cannot thrive without moving significant amounts of money throughout the world. At a time of heightened global security concerns, it is especially vital that banks and regulators do everything they can to stop that flow of illicit funds.”

The proposal will be published in the New York State Register. A 45-day notice and comment period will begin on the date of publication.

Lofchie Comment: Why is the oversight of AML a matter of particular concern for state banking regulators? Wouldn’t it be better to leave the enforcement of AML requirements to federal banking regulators? It would be interesting to know how much money the state collects for AML violations.

The person who signs the NYSDFS form has a high-risk job. Never mind that it would be impossible for that person to be sure their employer had (or indeed could) comply with the strict requirements of the rule; never mind that the form does not even include a materiality standard; never mind that the required “minimum standards” are impossibly high and, ultimately, subjective. The real problem is that one accepts the job along with the underlying expectation that New York State seemingly wants to charge violations and collect big fines. For a compliance officer charged with a deficient certification, the penalties are huge (without even considering the risk of fines, jail time and public humiliation); that officer also is likely to become unemployable.

Even so, the officer probably needs the work. After all, the economy is tough.

House Passes Bill to Include Municipal Bonds under the Liquidity Coverage Ratio Rule

The U.S. House of Representatives passed a bill requiring federal banking regulators to include municipal bonds under the “Liquidity Coverage Ratio: Liquidity Risk Measurement Standards; Final Rule” (79 Fed. Reg. 15 61439).

H.R. 2209 requires the appropriate federal banking agencies to treat certain municipal obligations as “level 2A liquid assets.” The bill was sponsored by Representatives Luke Messer (R-IN) and Carolyn Maloney (D-NY) and passed the House unanimously.

Specifically, the bill:

  • amends the treatment of certain municipal obligations under the Federal Deposit Insurance Act to direct federal banking agencies to treat any municipal obligation as a high-quality level 2A liquid asset if the obligation is liquid, readily marketable and investment-grade as of the calculation date;
  • calls on the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System and the Comptroller of the Currency to amend the rule titled “Liquidity Coverage Ratio: Liquidity Risk Measurement Standards; Final Rule” in order to implement this Act.

According to Representative Maloney, the “decision to exclude investment grade municipal bonds from the liquidity buffer was senseless, and municipalities across the country were being hurt as a result. The Federal Reserve has concluded a fix is necessary and there is strong bipartisan consensus in support of correcting this problem.”

Lofchie Comment: Leaving aside the issue of whether the liquidity requirements are set at the right levels, the question is whether this is good public policy or a subsidization of lending to governmental entities that bypasses the private sector. Notably, Representative Maloney describes banking regulators as “senseless” when they take any action that may burden governmental entities. Apparently, when they impose burdens on the private sector, they become Solomonic.

CFTC Chair Massad Cites Progress in Commodity Market Regulation

CFTC Chair Timothy E. Massad outlined CFTC actions involving recordkeeping and margin requirements for uncleared swaps. In a speech before the Commodity Markets Council, he asserted that the CFTC has made “significant progress” in “protecting end-users from overly onerous regulatory burdens.”

Chair Massad highlighted several recent actions concerning the regulation of the swaps market. They included the following:

  • Recordkeeping. The CFTC revised a rule to allow members of exchanges and swap execution facilities who are not registered with the CFTC – such as end users – to delete pre-trade communications and text messages. The amended rule also states that commodity trading advisors do not have to record oral communications regarding their transactions.
  • Centralized Treasury Units. The CFTC worked on legislation with lawmakers on Capitol Hill and in the Administration that would assist end users who employ “centralized treasury units.”
  • De Minimis Exception. The CFTC released a staff report that takes a “fresh look” at the issue. Although the report does not recommend a precise level for the de minimis limit, it invites public comment on the data and methodology to be used.

Chair Massad also discussed several “matters” on the CFTC’s agenda:

  • Trade Options. This CFTC proposal would eliminate the obligation of commercial participants to report trade options to swap data repositories.
  • Position Limits. The CFTC proposed modifications to the provisions of the rules that would “streamline the process for waiving aggregation requirements when one entity does not control another’s trading, even if they are under common ownership.” The CFTC also is considering “the possibility of further modifications, which would have the exchanges play a greater role in granting exemptions for non-enumerated hedges.”
  • Clearinghouse Strength and Resiliency. “[C]onsiderable efforts” are being made domestically and internationally to ensure that clearinghouses are strong and safe, including developing recovery and resolution planning standards for stress-testing. The CFTC approved the registration of Eurex Clearing. However, a determination of “equivalence” has yet to be issued by the European Commission.
  • Cybsecurity. The CFTC unanimously approved two new rules to (i) enhance cybersecurity protections and (ii) minimize the risk that automated trading will cause market disruptions. The rules will require adequate risk controls, monitoring and other measures.

Chair Massad expressed his disappointment with the lack of a budgetary increase for the CFTC in the 2015 federal spending bill:

[T]he CFTC’s appropriation simply doesn’t match our responsibilities. The markets we oversee are critical to commercial businesses, and profoundly affect the prices all Americans pay for many goods and services in our daily lives. Sensible regulation requires adequate resources, and is a good investment for our economy. So we’ll continue working to ensure Congress understands the important work we do, he said.

Chair Massad delivered his keynote speech before the Commodity Markets Council at its 2016 program on the State of the Industry.

Lofchie Comment: Given the scope of its responsibilities under Dodd-Frank, the CFTC is underfunded. Many of those responsibilities might be ill-conceived, but that is not the fault of the CFTC; the blame belongs with Congress. Indeed, Chair Massad has pointed out that the CFTC is in the process of reducing some of the burdens it had imposed previously. Even so, progress in that direction should be faster.

That said, it is difficult to feel sympathy for an agency that continues to push for rules that will be enormously burdensome to implement, for both the agency itself and for the economy as a whole. In light of the events of the past few years, on what possible policy basis can the CFTC justify the imposition of position limits on energy? Haven’t events made clear that the ability of energy speculators to withhold energy from the market and drive up prices would prove trivial compared to the power of sovereign nations – e.g., Saudi Arabia, Iran, Russia and private suppliers of oil, including in the United States – to pump more oil into the market and take advantage of any supposedly artificial price bump? If the regulators continue to expend resources on rules predicated on flimsy premises, does it make sense to increase their funding?

Treasury debt ceiling: Inside the Fed’s `D-Day’ War Games…

Yesterday staff on the House Financial Services Committee released a report critical of Treasury activities during the debt ceiling crisis. Treasury told Congress that the department was unable to prioritize debt payments to keep the government from violating its borrowing limit.

Of course, Treasury had the ability to prioritize payments. Emerging economies have done this for years!

The 322-page report includes documents received under subpoena highlighting table top exercises to precisely prioritize debt payments –

I am quoted in Bloomberg’s “Inside the Fed’s `D-Day’ War Games for Breach of U.S. Debt Limit” –

NYSE Proposes Actions to Improve the Stability of the Exchange Markets

The NYSE proposed a number of actions that are intended to “improve the stability” of the exchange markets in adverse environments while at the same time “maintaining the efficiency of trading.” Its proposals and suggestions are part of a response that began with its study of the flash crash on August 24, 2015.

Areas proposed by the NYSE for action and study included the following:

  • disseminating order imbalance information until a security opens;
  • discontinuing the acceptance of stop-loss orders;
  • widening market collars for opening and reopening auctions;
  • expanding maker exemptions from Reg. SHO; and
  • revising the rules that pertain to “clearly erroneous trades.”

The NYSE stated that it expects “better outcomes due to structural changes, along with increased preparedness of participants.” The structural changes include increasing (i) the availability of liquidity by “removing the fear of ‘cancelled trades'” due to erroneous trade rules and expanding harmonization across markets and (ii) the “guardrails provided by broker-dealers” in order to achieve improved outcomes for retail investors. The NYSE acknowledged that “[t]he proposed solutions will not be a panacea for all of the challenges of broad-market volatility.” The NYSE also suggested areas of further study.

Lofchie Comment: The NYSE’s most interesting proposal was for stop-loss orders (which the NYSE acknowledged come largely from retail investors) not to be accepted during times of market downturn. This effectively would prevent retail investors (who cannot watch the markets interminably) from selling automatically when institutional investors (who always watch the markets) sell deliberately. It is reasonable to argue that this would protect retail investors by limiting their ability to cause, or sell into, market panic that is likely to be followed by a rebound. On the other hand, if the markets really are crashing and not just behaving strangely before a correction, then prohibiting stop-loss orders will cause retail investors to remain stuck in the market while institutional investors are able to sell out. As well intended as this prohibition might be, it also is likely to hurt retail investors. It is simply untrue that the right way to “protect” retail investors is to deprive them of the ability to trade – especially when others still are able to do so.

Academics Deconstruct the Flash Crash of 2010

Three professors analyzed granular data to explore the causes of the 2010 “Flash Crash.” They concluded that the crash was caused by “prevailing market conditions combined with the introduction of a large equity sell order implemented in a particularly dislocating manner.” In a paper titled “The Flash Crash: A New Deconstruction,” the professors supported the findings of a joint CFTC-SEC Staff Report and argued that it is “highly unlikely that, as alleged by the United States Government [in CFTC v. Sarao, that] Navinder Sarao’s spoofing orders, even if illegal, could have caused the Flash Crash, or that the crash was a foreseeable consequence of his spoofing activity.”

University of California, Santa Cruz Economics Professor Eric M. Aldrich, Stanford University Business Professor Joseph A. Grundfest and University of California, Santa Cruz Astrophysics Professor Gregory Laughlin developed a simulation model that (i) formalized the “insights upon which the [joint CFTC-SEC Staff] Report relied”; (ii) “demonstrated the existence of a market instability when liquidity thins,” to which algorithmic traders responded by acting “in concert to drive a rapid, linear decline in price that is very similar to what was observed on May 6, 2010”; and (iii) determined that “such declines are exacerbated by large sell orders.”

The professors stated that these conclusions “may have to be amended as a result of further analysis of anomalies discovered in the FINRA Trade Reporting Facility.” They provided two interpretations of the data-feed anomalies indicating that the anomalies reflected either (i) a “symptom of the Flash Crash that resulted as traders fell further behind in their reporting obligations in a manner that did not violate rules or regulations in effect in the market” or (ii) a “combination of confusion over transactions prices combined with sharply declining markets [that] could have led algorithmic traders to withdraw liquidity and then to restore it only after this source of price-information uncertainty was resolved.”

Lofchie Comment: Kudos to the professors for providing a fulsome analysis of the CFTC’s assertions. Anyone who possesses common sense and some degree of knowledge of the way in which markets work (including their unpredictability) should have recognized the absurdity of the CFTC and the Department of Justice’s assertion that Mr. Sarao caused the flash crash. Seee.g.“Finance Professor Calls CFTC Allegations that Nav Sarao Caused Flash Crash ‘Outrageous’ (with Lofchie Comment and Video Selection).” Streetwise Professor Pirrong also deserves recognition for pointing out how far-fetched the CFTC’s accusations have been from the very beginning.

In its November 2015 press release – long after rationality should have prevailed – the CFTC continued to attempt to pin the flash crash on Mr. Sarao. Let’s hope that the regulators will drop their charges against Mr. Sarao soon. Even if he is guilty of the spoofing charges made against him, the government’s conduct towards him should be considered. With power, they say, should come responsibility. After all, the damage done by the government’s allegation is not limited to the accused. Because of that allegation, the government’s resources were wasted and, therefore, we all are damaged. Further, because of the allegation’s aftermath, regulators who try to avert future crashes may be sent down a false path when they misidentify the cause of crashes past.