Database of Sovereign Defaults Updated

David Beers (formerly of the Bank of Canada, now at the Bank of England) and Jamshid Mavalwalla (Bank of Canada) have produced an update (PDF) to a database (Excel) of sovereign defaults. Coverage now extends from 1970 to 2015. The database shows, country by country and for all countries combined, who was in default, by how much, and to what groups (IMF, World Bank, Paris Club countries, foreign currency bond holders, etc.)

Another useful feature of the database is that it has a score showing how reliable the data are, in the authors’ view. It is all too often forgotten in economics, especially when comparing or combining figures across countries, that the underlying data may vary widely in their reliability, sometimes because of outright falsification, but more usually because of difficulties in measurement. Pointing out where data are of lower quality can spur researchers to go out and find better data or more accurate ways of estimation for filling in gaps.

(Thanks to David Beers for bringing the database to my attention.)

OFR Examines Newly Collected Data on Securities-Lending Activity

The Office of Financial Research (“OFR”) examined securities-lending activity based on pilot data collected by staff from the OFR, the Federal Reserve System and the SEC. In a recent working paper, the OFR specified that the three annual reports by the Financial Stability Oversight Council (“FSOC”) identified a dearth of data on securities-lending activity. In light of this, FSOC and the other regulators collected pilot data from seven large lending agents in order to address this “critical data need.”

The regulators collected data concerning 75 characteristics of securities loans, including the type of collateral received, the duration of the loan, the fee paid, the type of parties involved, and the type of securities loaned.

The research pilot did not capture data from all securities-lending agents, or from bilateral activity conducted without agent participation. The OFR noted that additional data would complement the pilot data:

A more broad-based permanent data collection would provide consistent and comprehensive coverage of this activity. A securities lending data collection could complement the bilateral repo data collection currently under consideration because both are considered necessary for effective monitoring of financial stability.

The OFR concluded that appropriate standards should be used to ensure the quality of additional data, including the Legal Entity Identifier and the categorization of financial instruments. OFR stated further: “[s]taff from U.S. regulators are working with international regulatory bodies to examine potential steps to harmonize reporting requirements, definitions and concepts.”

Lofchie Comment: Though the information in the working paper is useful, the banking regulators seem overly focused on risks posed by securities-lending transactions relative to other substantial risks to the economy. For that reason, the OFR should broaden its scope. Here are two closely related areas for the OFR to examine: (i) state and municipal insolvency (Puerto Rico is not the end of the story), and (ii) public and private pension obligations (e.g., what are the combined risks of underfunding, increased longevity, and a zero-interest-rate environment?). The OFR also might consider the risk of a further drop in oil prices, or the consequences of a major cyber event. If they really want to be big-picture thinkers and consider major threats to our economy, then they may want to start going to the movies. Securities-lending risks pale before the economic risks of attacks by zombies, space invaders and other shady beings.

NY Fed Publishes Review on Behavioral Risk Management in the Financial Services Industry

The Federal Reserve Bank of New York (“NY Fed”) published a special issue of its Economic Policy Review, in which economists outlined behavioral risk management in the financial services industry. The special issue explores the roles of financial culture, governance and reporting, and includes articles on the following topics:

  • the effect of corporate culture in the banking industry and a proposed framework for diagnosing and changing corporate culture in ways that support banks’ growth strategies more effectively;
  • the role of culture in the financial industry and a proposal that would change that culture through “behavioral risk management”;
  • how governance, culture, and risk management affect risk-taking in banks;
  • how deferred cash compensation can enhance stability in the financial services industry;
  • the effect of the 2007 financial crisis on compensation in financial firms, and a proposed cash-holding requirement that would induce financial firms to adopt a more conservative approach to risk-taking;
  • how to address the corporate governance problems of banks by imposing a more rigorous standard of conduct on bank directors;
  • the role of financial reporting and transparency in corporate governance;
  • the consequences of accounting policy choices for individual banks; and
  • the relationship between the amount of information disclosed by bank holding companies and their subsequent performance.

Lofchie Comment: Several articles in the Economic Policy Review take the position that the cultural (and other organizational and management) issues that arise at banks are not fundamentally different from those that arise at other large institutions (including governments), but may be different in degree. In an article that is worth reading, Ohio State University Banking and Business Professor Rene M. Stulz frames the position in the following terms: “One might be tempted to conclude that good risk management reduces the exposure to danger. However, such a view of risk management ignores the fact that banks cannot succeed without taking risks that are ex ante profitable. If good risk management does not mean low risk, then what does it mean?”

Some of the writing on executive compensation in the review seems unduly biased towards regulatory intervention and dismissive of economic considerations, particularly the article on delayed compensation authored by Mehran and Tracy, which effectively dismisses the cost of losing personnel through punitive pay policies with the observation that corporate CEOs did not quit their jobs in the wake of the added responsibilities imposed on them by Sarbanes-Oxley or FDICA (an inexact analogy that the authors seem to believe so dispositive as to hardly require discussion).

SEC Dismisses Charges that Broker-Dealer Customer Committed Call Options Fraud

The SEC found that “the Division of Enforcement has not met its burden to show” that a “retail” investor violated anti-fraud regulations by allegedly failing to make delivery when call options he wrote were exercised. The SEC found, however, that the broker-dealer, through which the investor had executed trades, had failed to close out “fail to deliver” positions in accordance with Reg. SHO Rules 204 and 204T, and ordered that it pay over $2 million in disgorgement and a $2 million penalty.

Regulation SHO Rule 204 generally requires broker-dealers to close out “fail to delivers” after a certain period. One strategy used to restart the clock, and thus avoid the buy-in requirement, is for a potentially failing investor to buy shares for delivery and at the same time, sell a call option that is certain to be exercised on the same shares. This so-called “buy-write” transaction has the effect of restarting the three-day buy-in period, but without actually resulting in any delivery of stock, since the purchase of the stock and the sale of the stock through the call option just net each other out.

In this case, the compliance officer for the broker-dealer firm was aware of the SEC position on the use of such transactions. The SEC opinion quoted a warning given by the compliance officer to the firm:

The troublesome part is that the SEC characterized, and found as a violation, the fail to deliver close-out process used [by other firms] as “sham reset transactions.” In both cases, the firms would either use married-put or buy-write transactions to close-out their Regulation SHO fails-to-deliver. Our customers have been engaging in buy-write transactions, or simply selling deep-in-the money calls after we process buy-ins in their accounts. The end result in all situations is similar: the shares are bought-in, but the subsequent exercise or assignment of the option that night results in a continuation of the fail.
(at page 35)

While the SEC found that the broker-dealer had tolerated misconduct by the firm’s retail customers, the SEC emphasized that the Division of Enforcement failed to provide sufficient evidence that the particular retail investor charged had ill-intent or knew that his conduct was improper. The SEC found, therefore, that the relevant scienter requirement under the anti-fraud provision was not met. The SEC further explained that:

. . . there is no evidence or allegation that [the investor] deceived his broker about his intent or ability to deliver shares. The only question is whether he knew or should have known that he was deceiving downstream purchasers about his ability or intent to deliver shares. The record does not provide sufficient evidence to make such a finding. Among other things, [the investor] was open about his trading strategy, even describing it in a public blog post. . .

The SEC also dismissed constitutional arguments raised by the defendants that the SEC administrative law judge was not properly “appointed” and that a dual “for-cause” removal restriction for an administrative law judge was inappropriate.

Lofchie Comment: The question that the case raises is not whether the strategy of avoiding a buy-in of a failed short delivery is legal – the SEC had previously established that it viewed the “buy [stock]-write [put option]” strategy, which is not inherently illegal, as improper when used as a device to evade, or in this case, to abet the evasion of, the requirement to buy-in failures to deliver on short sale trades. The question rather is who has responsibility to know that it is not permissible. Essentially, the SEC ruled that the “retail” customer entering into the trades could not be expected to know the SEC’s position on buy-write trading, but that the broker-dealer that was effecting the trades should have known that the strategy was improper and thus should not have effected the trades.

For broker-dealers, the takeaway lesson of this case is that they have an obligation to monitor for, and prevent, this type of trading by their customers, even where the broker-dealers are only acting as agents in effecting the trades.

Futures Industry Association Examines Treasuries Market Reporting

The Futures Industry Association Principal Traders Group (“FIA PTG”) argued that the extraordinary volatility in the U.S. Treasuries market on October 15, 2014 “called attention to the market’s changing dynamics” and “highlighted the need to consider changes to address the market’s unusual lack of transparency.” Tracing the regulatory response after that spike in volatility, FIA PTG reviewed subsequent actions that addressed market transparency including a joint staff report in 2015 by multiple regulators, the U.S. Treasury Department’s request for comments on the Treasuries market structure and, importantly, FINRA’s recent proposal that would require two-sided reporting from Treasuries market participants.

FIA PTG argued that FINRA should reconsider its two-sided reporting proposal. According to FIA PTG, the “European Market Infrastructure Regulation requires dual reporting ostensibly to ensure accuracy and quality in data reporting,” but “research published by a dozen associations” found that “‘confirmation execution rates are generally at or above 90%, whereas pairing rates at trade repositories used in dual-sided reporting regimes are around 60%.'” The associations’ research also concluded that two-sided reporting increases the costs and complexity of the market and inflicts additional burdens on market participants. FIA PTG observed that “much of the data from the U.S. Treasury market may already exist at the platform, clearing firm/prime broker or relevant designated contract market, making two-sided reporting also redundant.”

FIA PTG concluded:

FIA PTG remains hopeful that regulators will consider not just the desired outcome of enhanced transparency, but also the efficiency and cost-effectiveness of the means of achieving transparency.


Lofchie Comment: Imposing reporting requirements just adds more cost on non-dealers. Regulators should not underestimate the operational difficulty for end users of having to develop procedures and systems in order to comply with new operational requirements. Any individual new requirement may seem trivial to the regulator who imposes it, but the number of regulators is very numerous, and the number of regulations even more so. The cost burdens of so many regulators, rules and requirements challenges small and medium firms to turn a profit and, thus, to survive. The result is an increasing likelihood that only big firms, that are able to spread regulatory costs over a substantial volume of transactions or clients, will remain.

CFTC Releases Staff Report on Swap Dealer De Minimis Exception

The CFTC issued a Final Staff Report on whether to lower the Swap Dealer De Minimis Exception threshold. Unless the CFTC takes further action, the threshold is scheduled to decrease from $8 billion to $3 billion in December 2017. The scheduled threshold change is provided under Regulation 1.3(ggg), jointly issued by the SEC and the CFTC in May 2012, stating that “a person is not considered to be a swap dealer unless its swap dealing activity exceeds an aggregate gross notional amount threshold of $3 billion over the prior twelve-month period, subject to a phase-in period during which the threshold would be set at $8 billion.” The Final Report, prepared by the Division of Swap Dealer and Intermediary Oversight, reviewed available data and comments by interested parties in order to determine how changes to the current $8 billion de minimis threshold might affect the swap markets.

In the Report, CFTC staff noted that if the de minimis threshold was lowered to $3 billion, approximately 84 additional entities trading in interest rate swaps (“IRS”) and credit default swaps (“CDS”) might have to register as swap dealers. Conversely, if the threshold was raised to $15 billion, approximately 34 fewer entities trading in IRS and CDS might need to register as swap dealers.

CFTC staff concluded that only a substantial increase or decrease in the de minimis threshold would have a significant effect on the amount of IRS and CDS activity that is covered by swap dealer regulation, as measured by notional amount, transactions, or unique counterparties. For that reason, staff made no recommendations concerning whether to (i) set the threshold at the current $8 billion dollar level, (ii) allow the threshold to fall to $3 billion, as scheduled, or (iii) delay the threshold reduction in order to afford enough time for the CFTC to obtain better data.

CFTC Commissioner J. Christopher Giancarlo issued a separate statement in which he criticized the Final Staff Report for failing to make any recommendations, and expressed disappointment with the CFTC for not eliminating, or at least extending, the automatic phase-in of the $3 billion threshold. Commissioner Giancarlo argued that the CFTC “has already witnessed the negative results of setting a de minimis threshold too low, as was the case with utility special entities,” and maintained that dropping to such a level in the broader swap marketplace would “cause many non-financial companies to curtail or terminate risk-hedging activities with their customers, limiting risk-management options for end-users.”

Lofchie Comment: The Report raises a basic question. If the de minimis threshold dropped to $3 billion, will firms that deal in swaps totaling from $3 to $8 billion: (i) register with the CFTC as swap dealers, or (ii) reduce or eliminate their swap-dealing activities? The most likely answer is that most firms would not register, since the costs of regulation would be too high to allow them to stay in the market as smaller regulated dealers. CFTC staff should have made a stronger effort to answer the question. Staff might have attempted to estimate (i) the cost of registering as a swap dealer, and (ii) the profits of dealing in swaps. It is fair to conclude that unless the first amount is materially greater than the second, small firms likely would leave the market.

Instead of focusing on the effect that a reduction in the swap dealer threshold might have on the number of firms willing to deal in swaps, CFTC staff chose to concentrate on a far less significant question: how many additional swaps would smaller dealers enter into if they were required to register? According to the Final Staff Report, the number of additional swaps appears to be immaterial, which suggests that the threshold should not be reduced, particularly if the reduction could chase small dealers out of the market.

CFS Monetary Measures for July 2016

Today we release CFS monetary and financial measures for July 2016. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.9% in July 2016 on a year-over-year basis versus 5.9% in June.

CFS Divisia indices can 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:

Bloomberg terminal users can access our monetary and financial statistics by any of the four options:

3) {ECST} –> ‘Monetary Sector’ –> ‘Money Supply’ –> Change Source in top right to ‘Center for Financial Stability’
4) {ECST S US MONEY SUPPLY} –> From source list on left, select ‘Center for Financial Stability’

Market Structure Debate Principles: White Paper…

Under the leadership of senior fellow Bradley J. Bondi, the Center for Financial Stability (CFS) organized a nonpartisan working group with a wide range of market participants, academics, lawyers, and public officials to focus on the structure and operations of the U.S. equities markets.

CFS hosted discussions in New York and Washington, D.C., synthesized the comments from those events, and circulated a draft to the working group and other market participants for additional feedback.

After additional review and consideration, key principles include:

  • Avoid Rhetoric and Generalizations,
  • Craft Clear, Transparent, and Predictable Regulations,
  • Structure Markets to Serve a Diverse Clientele,
  • Use a Careful Regulatory Process,
  • Develop Cost-Effective – Yet Impactful – Regulation, and
  • Deepen Diversity in the Decision-Making Process

The CFS Working Paper offers guidance, rather than specific policy recommendations, to the SEC and other policymakers considering changes to the equity market structure.

To view the full paper:

AFL-CIO Sets the Record Straight; Claims SEC Chair Mischaracterized Stance on Disclosure Initiative

The American Federation of Labor and Congress of Industrial Organizations (“AFL-CIO”) Office of Investment Director Heather Slavkin Corzo complained that SEC Chair Mary Jo White mischaracterized the AFL-CIO’s position on the SEC’s disclosure initiative. Director Corzo took issue with a July 22, 2016 response to questions posed by Senator Elizabeth Warren, in which SEC Chair White suggested that despite the challenges, the AFL-CIO supported the SEC initiative to eliminate or modify disclosure. The SEC Chair had stated:

[T]he AFL-CIO … noted that “redundancy adds volume to an already cumbersome report but provides little value to investors” and that “where possible, duplicative information should be eliminated.” Comments like these have provided insights on the challenges of improving disclosure effectiveness for investors, including by illuminating the complexities in considering eliminating, modifying or adding any disclosures.

Ms. Corzo suggested that the quote used by Chair White “implied that [the AFL-CIO] disagree[s] with the issues raised by Senator Warren,” and emphasized that “[t]his is not the case.” Ms. Corzo reiterated the position that was taken by the AFL-CIO in a November 20, 2015 letter to the SEC: “We are deeply concerned that this review seems intended to limit investors’ access to information which undermines the [SEC’s] core purposes of investor protection and facilitation of capital formation.” Ms. Corzo also referenced a July 21, 2016 comment letter, in which the AFL-CIO made the following assertion:

[The AFL-CIO does not] believe any investors are worse off for access to too much information. Conversely, [it] believe[s] that additional disclosures tend to provide useful information. The problems with unwieldy corporate reporting lie in the form and style of the disclosure.


Lofchie Comment: Inasmuch as Senator Warren and the AFL-CIO are united in their support for a number of disclosure measures that are considered to be either helpful to union members (such as executive pay ratio disclosures) or politically advantageous (such as political contribution disclosures), it is not surprising that the AFL should come to the Senator’s aid in a given dispute with the SEC Chair. The question is this: should the SEC mandate disclosures based on (i) investors’ concerns, (ii) political interests, or (iii) whatever interests motivate any particular Senator?


SEC Office of Investor Education and Advocacy Reviews Mutual Fund Classes

The SEC Office of Investor Education and Advocacy outlined common types of mutual fund classes and emphasized investor consideration of financial position, time horizon and sales charges when choosing a mutual fund class.

Lofchie Comment: Firms should consider reviewing this SEC Bulletin with their retail sales personnel. For firms that discover that their retail sales personnel are selling classes of shares that might not be appropriate, more training may be necessary regarding client suitability profiles.