IOSCO Examines Impact of Storage Infrastructure on Market Pricing of Commodity Derivatives

IOSCO issued a report on the impact of storage and delivery infrastructure on the market pricing for commodity derivatives. The report is composed of six parts: (i) an introductory discussion of the importance of the physical delivery infrastructure to the financial markets, (ii) an overview of regulatory issues, including whether a regulator has the authority to regulate derivatives exchanges as well as clearinghouses that also serve as warehouses, (iii) an overview of operational issues, such as physical storage procedures, and storage and loading costs, (iv) a discussion of governance and conflicts of interest, e.g., whether persons who control a warehouse also are participants in the derivatives markets, (v) access to information and (vi) conclusions. The report concludes with recommendations for the development of industry best practices in order to avoid a breakdown in storage infrastructure or disruptions in the marketplace.

Lofchie Comment: Over the past several years, it has been asserted that derivatives prices in the aluminum market were manipulated by the warehouses, but the CFTC seems to have found no evidence to support those accusations. See Senate Agriculture Committee’s Stabenow Calls on “CTFC” to Review Alleged Manipulation of Aluminum Market (with Lofchie Comment)IOSCO to Survey Effects of Storage Warehouses on Price Formation in Commodity Derivatives Markets (with link to Streetwise Professor).

Financial Industry Associations Recommend Adoption of Global and Preventative Cybersecurity Policy

ISDA, SIFMA, Asia SIFMA (“ASIFMA”) and the European Banking Association (“EBA”) (collectively, “the Associations”) outlined a set of principles that they deemed “essential” to the formation of effective cybersecurity, data and technology policies. The Associations submitted these principles to the Financial Stability Board and IOSCO for review.

The Associations identified “two crucial issues that must be recognized before effective policymaking can be established”: (i) cybersecurity, data protection and technological advancement are international issues that require global solutions, and (ii) cybersecurity threats, risks and technological advances shift faster than regulations and standards can respond.

The Associations asserted that the purpose of effective regulation is to ensure that enough people, processes and technologies are in place to manage risks. They concluded that effective prudential frameworks and policies must permit companies to conduct their own risk assessments and determine which kinds of technology are best at meeting their respective security needs.

Lofchie Comment: The Associations recognized that (i) the regulators tend to know less materially than the industry about cybersecurity, and (ii) industry participants have every incentive to improve their cybersecurity defenses. The philosophical question presented is whether the regulators can resist the temptation to adopt prescriptive rules. Such rules are more likely to impede the work that firms do than they are to be useful.

To find examples of overly prescriptive rules, one only has to review Dodd-Frank’s rules on risk management, which require completely unrelated types of risk to be reported to the same manager, even though doing so runs contrary to the operations of any rationally managed  business. The end result is that firms are burdened with two types of reporting lines: one for the real and reasonable world, and one that must meet prescriptive regulatory requirements.

SEC Commissioner Talks Disclosure in the Digital Age

Commissioner Kara M. Stein called on the SEC to create a “Digital Disclosure Task Force” – which would include investors, companies and technology experts – to “envision what disclosure should look like in the Digital Age.”

At the 48th Annual Rocky Mountain Securities Conference, the Commissioner asserted that the electronic data gathering and reporting (“EDGAR”) system, serving as the SEC’s central data repository, “has not changed much” since it was rolled out in 1995, and needs a redesign to “catch up to the new digital world.”

Commissioner Stein noted that as part of a second ongoing SEC initiative, the “Disclosure Effectiveness” project, a recent SEC Concept Release on Business and Financial Disclosures failed to ask important questions relating to: (i) corporate governance disclosures; and (ii) how to best measure corporate performance (i.e., whether non-GAAP measures present a true and fair view of company performance).

To achieve effective disclosure, Commissioner Stein recommended that regulators not only solicit written comments, but also conduct investor testing to “truly understand what investors and our markets need.” She also commented on sustainability disclosure to differentiate companies and to foster investor confidence, trust and employee loyalty.

Commissioner Stein argued that in providing information, disclosure must be digitalized for investors to “effortlessly and electronically get what they need, when they need it, nothing more and nothing less.” With the advent of structured data, machine readable data can facilitate more real-time or on-demand data availability for investors.

Lofchie Comment: Commissioner Stein’s suggestion that the SEC should attempt to find out what disclosures investors really want makes sense. Both the SEC and Congress should embrace it. Recent “social” disclosure requirements (e.g., conflict minerals, compensation ratios, and diversity and contributions to come) are political rather than financial in nature.

Commissioner Stein is correct that the best way to find out what investors want is to ask them. Accordingly, it would make sense to require issuers to ask their investors (in their proxy statements, perhaps) whether they actually desire such disclosure and at what cost. Perhaps investors in some companies/industries will want “social” disclosures of the sustainability type noted by Commissioner Stein. Others may not. The Commissioner’s suggestion that what investors want may change over time is also noteworthy. Today, investors may want (or not want) conflict mineral/compensation/diversity/contribution disclosures. Next year, investors may decide that they do not (or do) want them. Let the market decide.

FINRA Reminds Firms of Options Reporting Requirements (FINRA Reg. Notice 16-17)

FINRA reminded member firms of their obligation under FINRA Rule 2360(b)(5) to report large options positions to the Large Options Positions Reporting (“LOPR”) system. FINRA outlined the options reporting requirements and summarized guidance that was issued previously.

Specifically, the FINRA notice addressed reporting obligations and guidance relating to the reporting of standardized and conventional option positions, the aggregation of accounts and positions, reporting formats and specifications, changes to account information, in-concert reporting, position maintenance records, rejections, and effective supervision practices.

Lofchie Comment: Firms should be aware that much of this reporting can be difficult to complete correctly, particularly when it concerns the aggregation of positions held by accounts under common control.

 

Federal Reserve Board Proposes Rule to Stay Contractual Requirements for GSIBs

The Board of Governors of the Federal Reserve System (the “FRB”) proposed a rule that would subject certain systemically important bank entities to restrictions regarding the terms of their non-cleared qualified financial contracts (“QFCs”). The proposal requires these global systemically important banking organizations (“GSIBs”) to amend contracts for common financial transactions to prevent the immediate cancellation of the contracts if the firm enters bankruptcy or a resolution process.

Under the proposal, GSIBs, their subsidiaries, and the U.S. operations of foreign GSIBs (in each case, “covered entities”):

  • would be required to ensure that QFCs limit any default rights and restrictions on the transfer of the QFCs to the same extent that such rights and restrictions would be limited under Dodd-Frank and the Federal Deposit Insurance Act; and
  • would be prohibited (generally) from becoming parties to QFCs that would allow a QFC counterparty to exercise default rights against the covered entity based on that entity’s entry into a resolution proceeding under Dodd-Frank, the Federal Deposit Insurance Act, or any other resolution proceeding of an affiliate of the covered entity.

The proposal also would amend some of the FRB’s capital and liquidity rule definitions.

According to the FRB’s press release, the Office of the Comptroller of the Currency is expected to issue a “substantively identical” proposal that would apply to national banks and federal savings associations that are GSIB subsidiaries.

Comments on the FRB’s proposal are due by August 5, 2016.

Lofchie Comment: If implemented, the FRB’s proposal would require yet another set of contractual revisions. It’s a wonder that anyone has enough time to negotiate new trades, given the number of hours required to amend existing contracts under rules that have been adopted by various regulators to date.

 

SEC Investor Education Office Offers Advice on “Stop” and “Stop-Limit” Orders

The SEC Office of Investor Education and Advocacy (“OIEA”) issued a bulletin offering advice to investors about when to use “stop” and “stop-limit” orders to buy and sell stocks.

The OIEA recommended that, when using a “stop” order, investors consider the following factors:

  • The stop price is a trigger that causes a stop order to become a market order. For that reason, the execution price for a market order received by an investor can deviate significantly from the stop price, especially in a fast-moving market where prices change rapidly.
  • A stop order could be triggered by a short-term, intraday price that might lead to an execution price that is substantially worse than the stock’s closing price for the day.
  • Different brokerage firms have different standards for determining when the stop price has been reached (e.g., the last-sale price versus the quotation price).

In addition, the OIEA urged investors to keep the following factors in mind when using a “stop-limit” order:

  • The stop price is a trigger that causes a stop-limit order to become a limit order that will be executed at a specified price. As in the case of all limit orders, a stop-limit order may not be executed if the price of the stock moves away from the specified limit price.
  • Like stop orders, a stop-limit order can be triggered by a short-term, intraday price that can result in an execution price that is inferior to the stock’s closing price for the day.
  • Different broker firms might have different standards for determining whether the stop price of a stop-limit order has been reached, as they might have different standards in making the same determination for a stop order.

Lofchie Comment: Firms should provide standardized educational documents to their retail clients that would clarify the mechanics and limitations of various types of orders, as well as the possible results of those orders in a volatile market.

GAO Calls on Congress to Rationalize Financial Regulatory Structure

In its annual report, the Government Accountability Office (“GAO”) encouraged Congress to make legislative changes to the financial regulatory structure in order to improve (i) the efficiency and effectiveness of oversight, (ii) the parity between consumer and investor protections, and (iii) the consistency of financial oversight for similar institutions, products, risks and services. GAO also called on Congress to consider whether aligning the authority of the Financial Stability Oversight Council with its mission to respond to systemic risks necessitates legislative changes.

The GAO report covers a range of governmental functions. Regulation of financial services is discussed on pages 7-8 and, in more detail, at pages 63-71. According to the GAO, “a pattern of inconsistencies and inefficiencies . . . continue[s] to persist because of the fragmented regulatory structure” (at page 65).

Lofchie Comment: The GAO Report focused on government expenditure and regulatory fragmentation. Implicit in the Report is that such fragmentation has an enormous cost for the private sector. Examiners from different agencies investigated the same institution for what is essentially the same activity. The result was minimal differences between regulators’ assessments of near-identical products for roughly twice the cost.

House Passes Bill to Promote Investment Fund Research Reports

The House of Representatives passed a bill that directs the SEC to provide a safe harbor with respect to the publication of research reports on certain investment funds. Such a safe harbor would distinguish such reports from being considered “prospectuses.” The “Fair Access to Investment Research Act of 2016” (H.R. 5019) allows the SEC a limited amount of time in which to implement the safe harbor. Further, the bill specifies that certain of FINRA’s rules do not apply to such communications. The bill was sponsored by Representative J. French Hill (R-AR). and passed 411-6.

Lofchie Comment: To allow firms to publish research reports on open-end companies seems to make good sense even if the firms are participating in the distribution of the same companies’ shares. Both Congress and the SEC should be looking for ways to ease the restrictions of regulations governing the production of investment research, since research provides real public benefits even in instances involving conflicts of interest.

That said, this bill is an example of Congress becoming too prescriptive in its instructions to the SEC and other financial regulators. Even with respect to legislation that moves the law in a positive direction – which this bill could do – Congress would be better served if it managed the SEC more loosely, except where the SEC clearly is defying the intent of Congress. In the long run, it would be better to require the SEC to provide the means for broker-dealers to publish research on investment companies (subject to various restrictions, perhaps, such as the establishment of information walls between research analysts and sales teams), and it would be better for Congress to afford a more generous time period to the SEC in which to act.