ISDA Report Concludes That Single-Name CDS Market Has “Positive Impact”

An ISDA-commissioned review of the “empirical academic literature” concluded that single-name credit default swaps (“CDS”) have a “positive impact on the supply of credit to many reference entities underlying traded CDS, suggesting the ability of lenders to hedge their credit exposures can make them more willing to extend credit.”

The review examined over 260 published academic articles and working papers. It determined generally that single-name CDS spreads:

  • contain valuable information about the probability and severity of adverse credit events that an underlying reference entity may experience during the life of a CDS;
  • reflect a risk premium that protection sellers demand in compensation for exposure to reference-entity-specific and systematic risks (both credit-related and non-credit-related);
  • are anticipatory and contain information regarding future announcements about the credit risk and financial condition of an underlying reference entity;
  • are used by financial institutions to achieve their desired risk/return profiles and commercial objectives;
  • have a beneficial effect on the supply of credit to borrowers that are reference entities underlying traded CDS;
  • are the primary market for price discovery, as compared to corporate bonds, and often precede equity markets in processing new information about underlying reference entities; and
  • when first introduced, have an adverse effect on the liquidity of related debt and equity markets.

Lofchie Comment: Market participants enter into swaps for a reason: swaps provide benefits. It would be preferable for regulators to devise a regulatory scheme that maximizes the benefits of swaps to the economy (including to issuers that are the subjects of those swaps) rather than one that minimizes the number of swap transactions.

Financial Trade Associations Ask Congress to Consider Costs of Restricting Permissible Banking Activities

SIFMA, The Clearing House, American Bankers Association Financial Services Roundtable and the Financial Services Forum (collectively, the “Associations”) voiced joint opposition to the potential repeal of merchant banking and other permissible bank powers recommended in a recent report issued by the FRB, the FDIC, and the OCC.

The Associations asserted that the recommendations are “unfortunate and ill-considered” and pointed out that, “[f]or the last 15 years bank holding companies have successfully used the merchant banking authority granted to them by law to finance start-ups and growing companies, fueling jobs and economic growth.” The Associations argued that the federal agencies proposing the repeal failed to adequately assess the cost of their recommendations:

The regulators . . . have not provided a cost-benefit analysis or a robust justification for such sweeping changes to laws which were heavily negotiated over a very long period of time and by several administrations. While the regulators did not believe that the costs of regulation were worth considering here, we believe Congress should and will consider such costs.


Lofchie Comment: Banking regulators seem to respond to any examination of risk with a proposal to limit the scope of the banking activity. This line of reasoning ignores the potentially important benefit of these activities, including the ability to make a profit, the potential diversification of a bank’s revenues and the benefits of allowing a bank to spread its operational costs by utilizing its banking skill set for a broader range of activities.

MSRB Proposes Markup Disclosure Requirement for Municipal Securities Transactions

The MSRB proposed amendments to MSRB Rules G-15 and G-30 (“proposed rule change”) that would require dealers to provide retail investors with “meaningful and useful pricing information” to help them assess the cost of their municipal bonds transactions. The proposed rule change would require dealers to disclose markups from the “prevailing market price” of the bonds to retail customers on principal transactions in which the dealer buys (or sells) a municipal security to a retail customer and on the same day enters into an offsetting transaction of equal or greater size in the same security. If approved by the SEC, the proposed markup disclosure rule will become effective no later than one year after the SEC approval.

The MSRB reasoned that retail investors in municipal securities receive less information than investors in the equity market about the cost of their respective transactions. According to MSRB Executive Director Lynnette Kelly, the issue could not be addressed until now:

Changes in technology and in the municipal market have made it possible for investors to receive similar transaction information as investors in the equity market. This is a meaningful and historic shift for the municipal market.

The MSRB wants dealers to understand how the rule would (i) apply to different trading situations, and (ii) accommodate the practical realities of the municipal market. Specifically, the MSRB guidance addresses:

  • “establishing the prevailing market price for contemporaneous customer transactions”;
  • “the ability of dealers to calculate their compensation at the time of disclosure to a customer”;
  • “the frequent absence of pricing information for sufficiently comparable municipal securities”; and
  • “the implications of transactions with affiliated dealers.”

Lofchie Comment: When it comes to securities regulation, whatever requirement applies to equities will apply to debt, eventually.

CFTC Commissioner Giancarlo Criticizes U.S. Regulators’ Refusal to Delay Swaps Margin Rules

CFTC Commissioner J. Christopher Giancarlo reprimanded U.S. prudential regulators and the CFTC for ordering swap dealers to meet a contested September 1 deadline for the implementation of certain margin requirements that are applicable to uncleared swaps.

In March 2015, IOSCO and the Basel Committee on Banking Supervision published a final policy framework establishing (i) standards for margin requirements for uncleared swaps, and (ii) a phased-in implementation period for the requirements with an initial implementation date of September 1, 2016. Last week, regulators in Australia, Hong Kong and Singapore announced that their implementation of the requirements would be delayed, which followed the pattern of a similar announcement by the European Commission several months before. Notwithstanding these announced delays, the CFTC and U.S. prudential regulators decided to proceed with the original implementation date.

Commissioner Giancarlo called that decision a “failure of U.S. trade negotiation,” and cited it as “yet another example of the failure of U.S. policymakers to negotiate harmonization in regulations . . . in a manner that does not place American markets at a competitive disadvantage.”

In his statement, Commissioner Giancarlo stated he was astonished at regulators’ “blindness to commercial reality,” and noted that American markets now will have a higher margin structure, which he emphasized will give a competitive advantage to major overseas derivatives markets. He also emphasized ramifications of the decision that could prove dangerous to the economy:

Even from a practical standpoint, the coming days will be enormously challenging for U.S. market participants as dealers are still working to finalize account documentation. Some observers warn of a liquidity crunch because certain dealers will not be ready to trade with other dealers. Unfortunately, U.S. regulators appear more concerned with sticking to an arbitrary deadline than the health of American markets and American market participants.

Commissioner Giancarlo warned that the United States will lose its negotiating leverage in the event of further delays.

Lofchie Comment: Kudos to Commissioner Giancarlo for prioritizing commercial realities. When Dodd-Frank first was adopted, certain U.S. regulators asserted that the rest of the world would follow their example whether or not the rules made any sense. That assertion has proved to be incorrect. In many cases, the Europeans have gone their own way (sometimes adopting more sensible rules, sometimes adopting rules that seem even less sensible), but they have not adhered to the strictures of U.S. regulators. Knowing now that the Europeans will follow their own path, U.S. regulators should not place U.S. firms at a material competitive disadvantage.

GAO Urges Department of Commerce to Fulfill Conflict Mineral Obligations

The Government Accountability Office (“GAO”) examined (i) company disclosures filed in 2015 in response to the SEC conflict minerals regulations, (ii) challenges to companies’ due diligence efforts concerning the processing facilities in conflict minerals supply chains, and efforts to mitigate those challenges, and (iii) actions by the Department of Commerce (“Commerce”) regarding its conflict minerals-related requirements under the Dodd-Frank Act.

In a report titled: “SEC Conflict Minerals Rule: Companies Face Continuing Challenges in Determining Whether Their Conflict Minerals Benefit Armed Groups,” the GAO determined that:

  • as a result of country-of-origin inquiries, the number of companies that filed specialized disclosure forms (“Forms SD”) with the SEC and reported that they knew or had reason to believe they knew the source of the conflict minerals in their products rose in 2015 by an increase of 19% over the previous year (based on a generalizable GAO-reviewed sample of filings);
  • after an estimated 79 percent of the companies that filed a Form SD performed due diligence, an estimated 67 percent reported they were unable to confirm the source of the conflict minerals in their products, and about 97 percent reported they could not determine whether the conflict minerals financed or benefited armed groups in the Democratic Republic of the Congo (“DRC”) and adjoining countries;
  • facilities that process conflict minerals pose challenges to the disclosure efforts of companies filing Forms SD because (i) these facilities rely generally on documentary evidence about the origin of conflict minerals, which evidence can be susceptible to fraud, and (ii) processing operations involve multiple levels that can introduce the risk of fraud and increase costs associated with disclosures;
  • industry and other stakeholders have developed or are pursuing methods for mitigating these risks, such as chemical “fingerprinting” to verify documentary evidence; and
  • as of July 2016, the Department of Commerce had not submitted a report, as required in January 2013, assessing the accuracy of the Independent Private Sector Audits (“IPSA”) filed by some companies that filed Forms SD, nor had it developed a plan to do so.

The GAO urged the Secretary of Commerce to submit a plan to the appropriate congressional committees that would outline steps to be taken within associated timeframes. Those steps included the following:

  • assessing the accuracy of IPSAs and other due diligence processes described under Section 13(p) of the Securities Exchange Act;
  • developing recommendations for processes to be used when executing such audits, including ways to improve the accuracy of and establish standards of best practices for such audits; and
  • acquire the necessary knowledge, skills and abilities to carry out these responsibilities.

Lofchie Comment: If ever a rule were designed to fail cost-benefit analysis, the SEC manifesto on conflict minerals is it. When 97% of companies are not sure where the money is going, chances are that the data is useless.

SEC Urges FINRA to Reexamine U.S. Treasury Securities Regulation

The SEC Division of Trading and Markets (“Division”) sent a letter to FINRA CEO Robert Cook recommending that FINRA review its rules in order to (i) identify instances in which the rules apply to private securities, but not to U.S. government securities transacted by FINRA members, and (ii) expand the scope of the rules to apply to governments.

In particular, the Division suggested that FINRA review the following rules:

  • FINRA Rule 2090 (“Know Your Customer”);
  • FINRA Rule 2242 (“Debt Research Analysts and Debt Research Reports”);
  • FINRA Rule 5240 (“Anti-Intimidation/Coordination”);
  • FINRA Rule 5270 (“Front Running of Block Transactions”);
  • FINRA Rule 5320 (“Prohibition against Trading ahead of Customer Orders”);
  • FINRA Rule 5280 (“Trading ahead of Research Reports”); and
  • NASD Rule 1032(f) (“Categories of Representative Registration: Securities Trader”).

The Division asked FINRA to review its rules as soon as possible, and provide a “preliminary schedule of how and when FINRA intends to address any identified gaps,” by October 7, 2016.

Lofchie Comment: Since the SEC’s recommendation is not terribly controversial, FINRA likely will seek to act on it reasonably promptly. FINRA members should expect changes to these rules to become effective and should determine whether the implementation will require any time-consuming operational changes. The only real issue here is when the changes will be made.

Historically, the FINRA rules have not applied fully to transactions in U.S. government securities because the U.S. Treasury Department (“Treasury”) believed that the burdens imposed by regulation would add costs to the market. The Treasury wanted the market to be as inexpensive as possible because it believed that leaner costs could lower the price of funding government debt. That logic now is being discarded, and probably rightfully so. It seems unlikely that applying existing rules to a new set of securities would result in a substantial increase in costs. Many firms might voluntarily apply some of these rules to government securities already.

In light of the potential regulatory changes, it is worth remembering that banks that are registered government securities dealers pursuant to Section 15C of the Securities Exchange Act, are not required to become FINRA members and are not subject to the FINRA Rules.

Investment Adviser Profession Is Growing, Says New Report

The Investment Adviser Association (“IAA”) and National Regulatory Services, a Reed Elsevier company and part of Accuity, published a significant analysis of the state of the investment adviser industry.

The IAA explained that the data is derived from Form ADV, Part 1, filed by all SEC-registered investment advisers as of April 8, 2016. The 2016 Evolution Revolution report determined that:

  • the number of SEC-registered investment advisers continues to increase;
  • the industry continues to experience strong across-the-board job growth while, simultaneously, the number of advisers who provide advice only through an interactive website increased substantially – up by nearly 60 percent to 126 (although remaining insignificant in terms of total number of advisers);
  • small businesses are the core of the federally registered investment adviser industry;
  • Aggregate Regulatory Assets Under Management (“RAUM”) managed by SEC-registered advisers remains substantial, but is flat relative to last year;
  • the largest firms manage more than half the assets, but smaller firms are growing at a faster pace;
  • SEC-registered investment advisers now serve more than 36.4 million clients – up substantially from last year, a 22.4% increase;
  • individuals comprise the largest categories of advisory clients, with pension plans coming in second. Almost 61 percent of advisers serve high net worth individuals, non-high net worth individuals, or both, while 46.6 percent reported that at least one of their clients is a pension or profit-sharing plan (not including plan participants or state or local pension plans);
  • most advisers focus on one category of client. More than 87 percent of advisers report that the majority of their clients can be attributed to a single category of client; and
  • the number of private funds and registered private fund advisers is growing. 4,448 advisers reported advising 32,445 private funds with a total gross asset value of $10.5 trillion (up from 4,350 advisers, 30,342 private funds, and $10.4 trillion in total gross asset values respectively in 2015). Hedge funds and private equity funds are equally represented (35.8 percent each) in this space.

IAA President and CEO Karen Barr remarked that:

This year’s findings demonstrate that the investment adviser industry remains robust and continues to expand, serving significantly more clients than ever before and contributing to substantial job growth. The trend toward automated advice for retirement plan participants, and the growth in new and existing “robo-platforms” and other web- and app-based investing tools, are major themes in this year’s report.


Lofchie Comment: While this report may be of primary interest to those providing services to investment advisers, it should be valuable for regulators as well. The report offers a realistic understanding of the industry that they are regulating. The report demonstrates that most of the regulation of investment advisers is, as a practical matter, the regulation of small businesses, and, therefore, the requirements that fall on the majority of advisers should be tailored towards small businesses. Perhaps the SEC should consider devising a simplified regulatory regime responsible for the oversight of investment advisers that manage only the accounts of individual investors and whose assets under management fall below a specified amount.

In addition, the report reflects how much information can be obtained from the data that advisers already report. Rather than imposing additional requirements, regulators should be consolidating various existing reporting requirements and doing a better job of coordinating their demands for information from market participants so that each regulator is not creating its own expensive (and eccentric) set of data requests.