Comptroller of the Currency Describes Regulatory Approach to Fintech Innovation

Comptroller of the Currency Thomas J. Curry described the approach of the Office of the Comptroller of the Currency (“OCC”) to regulatory initiatives and methodologies concerning fintech innovation. In remarks at the Chatham House “City Series” Conference titled “The Banking Revolution: Innovation, Regulation and Consumer Choice,” Mr. Curry posed the question: are regulators prepared for the “Uber moment” of fintech disruption? He observed that investments in fintech grew from $1.8 billion to $24 billion worldwide over the past five years. Mr. Curry listed regulatory responses to those developments, and emphasized that the OCC has (i) outlined guiding principles for its regulatory approach to innovation, and (ii) established a team dedicated to implementing those principles including the appointment of a Chief Innovation Officer to lead the effort.

Mr. Curry cautioned that pilot projects are “important tools companies should use to test the viability of retail products and the effectiveness of their systems before rolling them out more widely.” He argued against the idea that regulators should create a “safe space” in order to allow companies to try out new products, since “[i]t is the company’s responsibility to ensure products and processes are safe before rolling them out.” Mr. Curry urged each company to design pilots carefully by controlling their scope and duration, and by working with regulators closely.

Mr. Curry pointed out that the OCC is still deciding whether to grant national charters to fintech companies that conduct banking activities. He noted that the OCC plans to “issue a paper soon to describe thoughts on this important question and seek comment on approach.”

Lofchie Comment: Will an institution that “works with regulators” to test new products be able to keep pace with changes in the market? Consider the difficulty of numerous legal questions that regulators elect not to answer even when their response effectively would be the law, and even when the absence of that response forces firms to take on legal risks. Will regulators truly be prepared to judge when business technology products are ready to be launched?

SEC Explains Methodology for Analyzing Comments on Proposal to Restrict Derivatives Use

The SEC Division of Economic and Risk Analysis (“DERA”) set forth the methodology it used to analyze comments received on a proposal for the use of derivatives by registered funds and business development companies.

According to DERA, most commenters proposed that Investment Company Act Rule 18f-4 should measure a fund’s derivatives exposure using notional amounts adjusted to reflect the risks of the underlying reference assets. These SEC-adopted risk-based adjustments would be derived from standardized schedules used for other regulatory purposes.

DERA evaluated aspects of the proposal that included (i) the internal consistency of using risk-adjustment and haircut schedules across asset classes, and (ii) categories created for the purposes of risk adjustment and risk weighting with respect to the rule.

Lofchie Comment: In its analysis, DERA seemed not to differentiate between the use of derivatives for speculation and for hedging. Apparently, DERA assumed that the derivatives would be used only for speculation.


Streetwise Professor Claims “Brexit Horror Story” Highlights Dangers of Clearing Mandates

In his latest post on the Streetwise Professor blog, University of Houston Finance Professor Craig Pirrong described the “horror story” of systemic clearing mandates, and explained why he remains skeptical that regulators will “take heed of the lessons of Brexit and take measures to ensure that the next time it isn’t a head shot.”

Professor Pirrong argued that “clearing mandates have supersized the clearing system, and commensurately increased the amount of liquidity needed to meet margin calls.” He highlighted Brexit as a “harrowing example” of “how tightly coupled the system is,” and listed other risk factors that clearing corporations’ response to Brexit have demonstrated. Those risk factors include the following:

  • “[m]uch of the additional margin was to top up initial margin, meaning that the cash was sucked into the [central clearing parties] and kept there, rather than paid out to the net gainers, where it could have been recirculated”; and
  • “each [central clearing party] acted independently and called margin to protect its own interests” – which is “ironic, because one of the alleged justifications for clearing mandates was the externalities present in the [over-the-counter] derivatives markets.”

Professor Pirrong observed that Brexit might prove to be as instructive as it is “horrific”:

Horror stories are sometimes harmless ways to communicate real risks. Perhaps the Brexit event will be educational.

Nevertheless, he concluded, the “clearing mandate is a reality, and is almost certain to remain one.” Given that reality, he maintained, it is doubtful that “whatever is done will make the system able to survive The Big One.”

Lofchie Comment: With respect to central clearing, the systemic risk on which regulators have focused is that clearinghouses will fail. However, the greatest risk created by central clearing as mandated by Dodd-Frank is this: in an attempt to save themselves from the risk of failure, clearinghouses could use their ability to demand an unlimited amount of initial margin from clearing member participants and so drain needed liquidity from the financial system. In other words, clearinghouses likely would save themselves from going under by sucking all of the liquidity out of the financial system. This, in turn, could trigger the failure of clearing members, or their customers who are required to post additional margin. It also could cause a downward spiral of pricing, forcing market participants to liquidate positions in order to eliminate margin calls.

SEC Officials Describe the Potential for Data Analytics to Improve Disclosure and Research

In separate speeches, SEC Investor Advocate Rick A. Fleming and Division of Economic and Risk Analysis Deputy Director and Deputy Chief Economist Scott W. Bauguess described how the SEC might employ data analytics to improve disclosure and the value of research using big data.

Mr. Fleming identified “wish list” priorities for the SEC: (i) “embrace the Legal Entity Identifier with the goal of making public company disclosure to the SEC interoperable with disclosure to other reporting regimes,” (ii) require the block-tagging of narrative text disclosures, and (iii) “require detail-tagging within narrative text disclosures.” Mr. Fleming stated: “by prioritizing structured data, and particularly the tagging of text . . . the [SEC] could drive even greater innovation in cost-effective enhancements to the packaging and delivery of information.” Mr. Fleming delivered his speech at the XBRL US Investor Forum 2016: “Finding Value with Smart Data.”

Mr. Bauguess described the consequences of the “proliferation of analytical methods enabled by big data.” He asserted that the rise of big data resulted in, among other things: (i) fewer limitations in the scope of potential empirical studies by researchers who have access to extensive computer resources; and (ii) an increase in the capacity to focus on assessing the robustness of the empirical methods that underlie the conclusions of studies. Despite these advances, Mr. Bauguess observed, human judgment “remains essential in making the output of [SEC] analytical models and methods actionable.” Mr. Bauguess delivered his speech at the Midwest Regional Meeting of the American Accounting Association.

IOSCO Reports on Implementation of Post-Crisis Recommendations for Securities Markets

The IOSCO Board reported on the implementation of the G20/Financial Stability Board’s (“FSB”) post-crisis recommendations to strengthen securities markets. The Board report includes insight and analysis on the implementation of recent reforms and is based on self-reporting by national authorities in FSB jurisdictions. The report focused on (i) hedge funds; (ii) structured products and securitization; (iii) oversight of credit rating agencies; (iv) measures to safeguard the efficiency and integrity of markets; and (v) supervision and regulation of commodity derivative markets.

Highlights of the report:

  • hedge funds – all responding jurisdictions which permit or have hedge funds reported implementation of the G20 and IOSCO recommendations relating to registration, disclosure and oversight of hedge funds. Almost all reported implementation of recommendations in relation to international information and enhancing counterparty risk management;
  • structured products and securitization – most responding jurisdictions reported the introduction of measures to strengthen supervisory requirements or best practices for investment in structured products, and to enhance disclosure of securitized products as recommended by the Financial Stability Forum (now the FSB) in 2008 and IOSCO in a number of reports from 2009 onwards; and
  • oversight of credit rating agencies – all responding jurisdictions implemented G20/FSB recommendations to require registration and provide appropriate oversight of FSB jurisdictions in line with IOSCO’s Code of Conduct Fundamentals for Credit Ratings Agencies.

In addition, the report stated that the implementation of G20/FSB recommendations “is still progressing” in the areas of (i) measures to safeguard the integrity and efficiency of financial markets, and (ii) the supervision and regulation of commodity derivatives markets.