Testimony on Monetary Policy

Mickey D. Levy (Chief Economist of Berenberg Capital Markets for the Americas and Asia) testified before the House Financial Services Committee on monetary policy.

He focused on how non-monetary factors including a growing web of government taxes, regulations and mandated expenses were harming the economy.

His line of thinking is of special note as these themes have been revealed over the years by CFS Divisia monetary aggregates and components.

His Testimony Resetting Monetary Policy is available online – http://financialservices.house.gov/uploadedfiles/hhrg-114-ba19-wstate-mlevy-20161207.pdf

President Obama Signs SEC Small Business Advocate Act of 2016

President Obama signed the SEC Small Business Advocate Act of 2016 (H.R. 3784) (the “Act”) into law. The Act establishes an Office of the Advocate for Small Business Capital Formation and a Small Business Capital Formation Advisory Committee within the SEC.

The Act adds Section 4(j) to the Exchange Act in order to create the Office of the Advocate for Small Business Capital Formation. The investor advocate (“Advocate”) is to be chosen by the SEC from a selection of individuals who have “experience in advocating for the interests of small businesses and encouraging small business capital formation.” The Advocate may not be a current employee of the SEC.

According to the Financial Services Committee Report, creating the Advocate’s role was necessary because the SEC Office of Small Business Policy (part of the Division of Corporation Finance) is a “functional office rather than an advocacy office.” In the Report, the Financial Services Committee concluded that the Office of the Advocate is a “logical outcome of the JOBS Act, since the SEC has taken little to no action to advance the many recommendations the agency has received from its annual Government-Business Form on Small Business Capital Formation to help small businesses and [emerging growth companies] access the capital markets.”

According to the Congressional Summary of the Act, the Advocate will:

  • “assist small businesses and small business investors in resolving significant problems they may have with the SEC or with self-regulatory organizations;
  • “identify areas in which such businesses and investors would benefit from changes in SEC regulations or the rules of such organizations;
  • “identify problems that small businesses have with securing access to capital, including any unique challenges to minority-owned and women-owned small businesses;
  • “analyze the potential impact on such businesses and investors of proposed SEC regulations and proposed rules that are likely to have a significant economic impact on small businesses and small business capital formation;
  • “conduct outreach to such businesses and investors to solicit views on relevant capital formation issues;
  • “propose to the SEC changes in its regulations or orders, and propose to Congress legislative, administrative, or personnel changes, to mitigate problems identified and to promote the interests of such businesses and investors;
  • “consult with the Investor Advocate on such proposals and advise the Investor Advocate on small business-related issues; submit annual reports on its activities to specified congressional committees; and
  • “be responsible for planning, organizing, and executing the annual Government-Business Forum on Small Business Capital Formation.”

In addition, the Act adds Section 40 to the Exchange Act in order to create the Small Business Capital Formation Advisory Committee. The Committee will consist of (i) the Advocate for Small Business Capital Formation; (ii) ten to twenty persons who are market participants; and (iii) three non-voting members, each of whom will be selected separately by the Investor Advocate, the North American Securities Administrators Association and the Small Business Administration, respectively.

According to the Congressional Summary, the Committee will advise the SEC on achieving its goals of protecting investors, maintaining markets and facilitating capital formation with respect to:

  • “capital raising by emerging, privately held small businesses and publicly traded companies with less than $250 million in public market capitalization through securities offerings;
  • “trading in the securities of such businesses and companies; and
  • “public reporting and corporate governance requirements of such businesses and companies.”

CFS Monetary Measures for November 2016

Today we release CFS monetary and financial measures for November 2016.  CFS Divisia M4, which is the broadest and most important measure of money, grew by 5.4% in November 2016 on a year-over-year basis versus 5.8% in October.

CFS Divisia indices can be found on our website at http://www.centerforfinancialstability.org/amfm_data.php.  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’

SIFMA Calls on SEC to Reject Proposed Exchange Fees

SIFMA commented on proposed exchange rules that would provide information and establish fees for various trading and execution services, and for connectivity to market data feeds. SIFMA argued that the proposed rules exhibit a “lack of competitive forces and no restraint on pricing,” and that the proposed fees would constitute a denial of access.

SIFMA urged the SEC to reject the proposed rules by contending that they are in violation of the Securities Exchange Act of 1934, which requires national securities exchange rules not to “impose any burden on competition not necessary or appropriate in furtherance of the purposes of [the Exchange Act],” and obligates them to:

  • “provide for the equitable allocation of reasonable dues, fees, and other charges among its members and issuers and other persons using its facilities”; and
  • be designed to “perfect the operation of a free and open market and a national market system,” to “protect investors and the public interest,” and not to “permit unfair discrimination between customers, issuers, brokers, or dealers.”

Lofchie Comment: Broker-dealers and exchanges are locked in a perpetual battle over the fees that exchanges are permitted to impose.

SEC Chair White Presses Ahead with New Regulations

SEC Chair Mary Jo White issued a response to the Senate Banking Committee’s November 30 letter cautioning federal agencies not to finalize pending rules during the departing administration’s last days. According to Chair White, many of the SEC’s planned initiatives are “ready for Commission consideration.” She stated her intention to move forward with them before the change in administrations.

Chair White referred to comparable post-election periods in the past. She noted that the SEC enacted a number of substantive rules during transition periods after the 2000 and 2008 elections. The SEC should not “deviate from its historical practice of independently carrying out its duties,” she said.

Chair White listed several items that were ready for an SEC vote, including the following:

  • the adoption of rules to establish capital, margin and segregation requirements for security-based swap dealers and major security-based swap participants;
  • the adoption of rules regarding recordkeeping, reporting and notification requirements for security-based swap dealers and major security-based swap participants;
  • the adoption of rules regarding the orderly liquidation of certain broker dealers; and
  • the adoption of Investment Company Act Rule 30e-3, which concerns an optional method for investment companies to use to transmit shareholder reports by web posting.

Lofchie Comment: How much of the letter is devoted to formalities and how much concerns important issues is difficult to say, since some of the proposed rules are not significant to market participants; e.g. the rules on orderly liquidation and shareholder reports. At least three new Commissioners will be joining the SEC in the next few months. Surely, it is appropriate to allow those Commissioners to decide for themselves whether to proceed with the swap dealer rules as proposed or to amend them. In other words, given that these rules have been years in the making, is there an urgent reason to adopt them before the new Commissioners are seated?

Office of Financial Research Reports on Potential Threats to Financial Stability

The U.S. Office of Financial Research (“OFR”) reported that the U.S. financial system showed improved resilience over the past year but that it faces several threats stemming from global disruptions and “financial system evolution.” The findings were published in the 2016 Annual Report to Congress and in the 2016 Financial Stability Report.

OFR Director Richard Berner highlighted the key vulnerabilities uncovered by the reports:

“. . . Those created by global economic and financial disruptions, by continued risk-taking amid still-low long-term interest rates, by risks facing U.S. financial institutions, and by challenges in improving financial data.”

Both reports cited the following factors and developments as specific threats:

  • potential spillovers from Europe stemming from the long-term uncertainty posed by the Brexit vote;
  • credit risks in U.S. nonfinancial corporations posed by the rapid growth of high debt levels;
  • cybersecurity incidents stemming from electronic transactions;
  • the concentration of risk in central counterparties (“CCPs”) caused by clearing from CCPs;
  • pressure on U.S. life insurance companies;
  • systemic footprints of the largest U.S. banks and the substantial risks inherent in large bank failures; and
  • deficiencies in data and data management.

In the reports, the OFR also discussed the role of shadow banking in the financial system.

Lofchie Comment: A number of the systemic threats in the reports are due in large part to government intervention in the markets; e.g., the high debt levels that result from extremely low interest rates, and the increase in size of very large banks, which arguably is exacerbated by the costs of regulation that weigh most heavily on smaller firms.

The most notable threat acknowledged by the OFR is that which is created by central counterparties: “We are concerned that, although clearing swaps transactions through central counterparties reduces the risk from the other party defaulting in two-way swap transactions, it also concentrates risk in the CCP itself.”

“No kidding,” one is tempted to say. The government’s acknowledgment of this risk, which resulted from Dodd-Frank’s supposed magic bullet, is beneficial if remarkably belated. (Kudos to University of Houston Finance Professor Craig Pirrong, who predicted the threat many years earlier in posts on the Streetwise Professor blog.)

Chair Massad Describes the CFTC’s Efforts on Behalf of Commercial End-Users

CFTC Chair Timothy Massad detailed the agency’s past efforts and his remaining agenda on behalf of commercial end-users. In an address at the American Gas Association 9th Annual Energy Market Regulation Conference, Chair Massad outlined actions the CFTC undertook in support of commercial end-users:

  • the exemption of commercial end-users from the CFTC’s rule on margin for uncleared swaps;
  • clarifying when commonly used agreements that include volumetric optionality provisions are forward contracts, and not subject to swaps rules;
  • eliminating certain reporting and recordkeeping obligations and announcing that trade options would not be subject to position limits;
  • customer protection improvements regarding collection of margin;
  • simplifying recordkeeping requirements;
  • granting delayed reporting for contracts in illiquid markets;
  • amending CFTC swap dealer rules so that “local, publicly-owned utility companies can continue to effectively hedge their risks in the energy swaps market”;
  • the exemption of certain transactions in the regional transmission organization and independent system operator markets from most provisions of CFTC rules other than the authority to pursue fraud and manipulations in these markets;
  • clarifying that community development financial institutions and small banks may choose not to clear a swap subject to the CFTC’s clearing requirement; and
  • ensuring that end-users can use the Congressional exemptions given to them regarding clearing and swap trading even if they enter into swaps through a treasury affiliate.

He then described several pending actions (position limits, capital requirements for swaps dealers and major swap participants, the de minimis threshold, and the modernization of recordkeeping requirements), as well as new challenges (cybersecurity, automated trading and the changing nature of liquidity and clearinghouse resilience).

On the issue of recently reproposed rules for limiting speculative futures and swaps positions, Chair Massad stated that the CFTC has a responsibility to “implement a balanced rule that achieves the objectives Congress has established,” and that he hopes the reproposal can be finalized in the near future.

Chair Massad asserted that end-users were “not the cause of the crisis.” He stated that there is a need to make sure that implementing reforms do not create undue burdens on these businesses. In a look back on his legacy at the CFTC, Chair Massad stated:

“We worked to keep the focus of regulation on those who create the most risk, and made rules less prescriptive in some areas. And we have worked to strengthen relationships with international regulators and harmonize regulations across borders.”


Lofchie Comment: In his remarks, Chair Massad stated:

“When I and my fellow Commissioners, Sharon Bowen and Chris Giancarlo, joined the CFTC together in June of 2014, it already had written most of the rules required by the Dodd-Frank Act. However, there were many criticisms and concerns. We inherited the task of finishing and improving this framework.” [Emphasis supplied.]

In many ways, Chair Massad’s freedom to re-examine and re-think the regulations adopted under former Chair Gensler was limited. That is, Chair Massad was limited to working at the edges, always declaring that any amendments made under his stewardship were merely “fine-tuning,” finishing a “framework” that he had inherited. See, e.g.Chair Massad Updates CFTC Priorities (need to fine-tune swap regulations); CFTC Chair Massad Discusses CFTC Rulemaking in an International Context (with Lofchie Comment) (fine tuning of cross-border regulations); Chair Massad Discusses CFTC’s Market Risk Strategy and Priorities for “Fine-Tuning” Flawed Rules (with Zwirb Comment). It is quite clear, however, that the CFTC’s rules were (and are) in need of an entirely fresh eye. This requires more of a Zen mindset than the one he brought to the task. See, e.g.Zen Mind, Beginner’s Mind by Shunryu Suzuki. The next CFTC administration should be better positioned in this regard.

CFTC Commissioner Giancarlo Calls for “Clear-Eyed Attention” to Market Challenges

CFTC Commissioner Christopher Giancarlo addressed three “mega-trends” that are transforming global financial markets: technological disruptions, changing market liquidity and global fragmentation. In a speech before the ISDA Trade Execution Legal Forum, Commissioner Giancarlo called on the CFTC to “revisit its flawed swaps trading rules to better align them to market dynamics.”

In focusing on these mega-trends, Commissioner Giancarlo made clear that regulators must: (i) foster best practices for and harness the power of new trading technologies for the benefit of market participants and regulators; (ii) address the diminishing liquidity in trading markets; and (iii) review and reduce poorly designed rules and regulations that are causing “service-provider concentration and market fragmentation.”

Commissioner Giancarlo argued that “market regulators cannot continue to ignore the growing systemic risk caused by [global] market fragmentation,” and noted the importance of allowing U.S. swap intermediaries to “fairly compete” in world markets to reverse this fragmentation. Commissioner Giancarlo stated:

“Only with clear-eyed attention to the true challenges facing contemporary markets can we ever restore the market vitality that will be necessary for broad-based economic prosperity. Flourishing capital markets are the answer to U.S. and global economic woes, not diminished trading and risk transfer.”

In his criticism of post-crisis regulation, Commissioner Giancarlo observed that overseas market participants continue to avoid firms “bearing the scarlet letters of ‘U.S. person'” in certain swap markets to “steer clear” of the CFTC’s “problematic” regulatory regime.

On market liquidity, Mr. Giancarlo blamed prudential restrictions on bank capital along with the CFTC’s “flawed and restrictive swaps trading rules,” the evolution of some trading markets from dealer to agency models, and the impact of U.S. and European monetary policy for sudden volatility shocks that occur in today’s markets. He decried the practice by U.S. and foreign regulators to plow ahead with “capital constraining regulations” rather than to acknowledge and study the causes of changing market liquidity.

On disruptive technology, Mr. Giancarlo reiterated his opposition to proposed a Reg. AT provision allowing the CFTC to obtain trading system source code without a subpoena. He urged financial regulators to foster a regulatory environment “that spurs innovation” and allows market participants to develop and test innovation solutions “without fear of enforcement action and regulatory fines.”

He noted that the upcoming March 1, 2017 deadline for uncleared swap variation margin requirements “will pose a massive challenge for market participants.” Mr. Giancarlo concluded that “safe, sound and vibrant” global markets are needed for investment and risk management to escape the “new mediocre” of prolonged stagnation.

Lofchie Comment: During his term as Commissioner, Mr. Giancarlo pulled off a trifecta. He: (i) prevented the CFTC’s rules from getting any worse (i.e., neither the position limits rule nor Regulation AT was adopted in part because of Mr. Giancarlo’s work in calling attention to their deficiencies); (ii) kept the focus on issues affecting the market currently and likely to affect the market in the future; and (iii) remained civil yet steadfast with those with whom he had deep policy disagreements. In the new administration, his presence at the CFTC will be integral to the reexamination of the agency’s rules in order to determine what has been working and what has not.

NY Fed President Discusses Regulatory Progress, Calls for Cultural Reform at Banks

Federal Reserve Bank of New York (“NY Fed”) President and CEO William C. Dudley discussed regulatory efforts to bolster the safety of the financial system in the wake of the financial crisis. Mr. Dudley explained that two types of initiatives have contributed to regulatory progress: (1) those that were designed to enhance firms’ ability to absorb shocks, such as capital and liquidity requirements, and (2) those that reduce structural vulnerabilities within the financial system.

Mr. Dudley highlighted reforms to the tri-party repo system, the shift from bilateral settlement to central clearing in the derivatives industry, and the increased resiliency and strength of central counterparties, as important indications that recent regulatory initiatives have decreased structural vulnerabilities.

Mr. Dudley also called for reforms that would address issues of bank culture and conduct. According to Mr. Dudley, banks should be “attentive” to incentives put in place to encourage better behavior and establish social norms. He also urged bank leaders to foster an atmosphere that encourages people to speak up when they witness questionable behavior.

Mr. Dudley delivered his remarks during a panel discussion on the status of financial regulation at the G30’s 76th Plenary Session.

Lofchie Comment: As he has done in the past, Mr. Dudley has been consistent in expressing this view of regulatory developments. Suffice to say that others have expressed different views on many of these regulatory developments. For example, some have argued quite convincingly that the move to central clearing creates as many risks as it resolves (and that the new risks are more serious). Seee.g.Streetwise Professor Claims “Brexit Horror Story” Highlights Dangers of Clearing Mandatessee also OFR Paper Questions Whether Higher Capital Standards Reduce Bank Risks.

CFTC Proposes Capital, Liquidity and Related Requirements for Swap Dealers

The CFTC approved proposed rules establishing minimum capital, liquidity, financial reporting and related requirements for CFTC-registered swap dealers (“SDs”) and major swap participants (“MSPs”). The proposed rules are a reproposal of rules previously proposed in 2011.

The proposed rules cover the follow areas related to SDs and MSPs:

  • capital requirements;
  • liquidity requirements;
  • financial recordkeeping and financial reporting;
  • obligation to notify regulators if a firm’s capital drops below certain levels; and
  • limitations on the withdrawal of capital and liquid assets.

The CFTC identified three approaches to allow firms to meet capital requirements:

  • an approach based on bank capital requirements that would be available to SDs that are subsidiaries of a bank holding company and thus subject to BHC capital requirements;
  • an approach modeled after the SEC’s capital requirements; and
  • a “tangible” net capital approach intended for a commercial enterprise, but that is also required to register as a swap dealer with the CFTC.

The proposal would establish certain liquidity, reporting and notification requirements, and would obligate entities covered by the proposal to keep current books and records in accordance with U.S. Generally Accepted Accounting Principles. Firms would be able to use models, although the models would have to be approved by the regulators. In addition, the rules provide for a “comparability” determination that will allow non-U.S. swap dealers that are not subject to regulation by the Federal Reserve Board to be subject to their home country capital rules.

There are currently 104 provisionally-registered swaps dealers (no registered major swap participants). Of those, 51 are not subject to the CFTC’s capital requirements because they are subject to U.S. bank requirements (including 36 which are non-U.S. banks having branches in the United States). Eight of the remaining swap dealers are already capital-regulated by the CFTC because they are FCMs, some of which are also SEC-registered broker-dealers. Of the remaining firms, some are subsidiaries of U.S. or non-U.S. bank holding companies or other entities subject to Basel-capital requirements that have sufficient capital to sustain their activities. Currently, there are no registered major swap participant and there is only one primarily commercial firm (Cargill) provisionally registered as a swap dealer with the CFTC.

In statements issued in connection with the reproposal, Chair Timothy Massad emphasized that the proposed requirements should avoid requiring all such firms to follow one approach. “Requiring all firms to follow one approach could favor one business model over another, and cause even greater concentration in the industry,” he said.

Commissioner J. Christopher Giancarlo expressed concerns regarding (i) the rule’s effect on smaller swap dealers and how much additional capital they may have to raise; (ii) the especially broad scope of the proposal; and (iii) the proposed capital model review and approval process.

Lofchie Comment: In terms of the substance of the rule requirements, the CFTC largely punted responsibility (and appropriately so) either to the banking regulators or to the SEC, both of which have significantly more expertise and staff to deal with these matters. It would have been messy for the CFTC and the SEC to take different approaches to capital requirements. Firms subject to regulation by both regulators would have been forced to comply with the more conservative set of rules in any case. In terms of process, the CFTC will wait and see what capital rules are eventually adopted by the SEC and then piggyback on them. For the CFTC, this is an entirely sensible way to go.  For firms that have an interest in the CFTC Rules, and will be subject to the “SEC version of the SEC rules, this means that they should concentrate on commenting on the actual SEC Rules, as the CFTC will likely follow along with whatever the SEC does.

In the Appendix, the CFTC reports the number of registered swap dealers and major swap participants. The numbers are revealing.

  • The CFTC stated that it had expected 300 swap dealers to register. Only 104 firms have done so. The costs associated with registration have likely caused numerous firms either to abandon dealing in swaps or to reduce their level of business below the de minimis level so as to not become subject to registration. Put differently, the regulations have led to a significant increase in the concentration of the swaps-dealing business. If the CFTC determines to reduce the level of business at which swap dealers are required to register, virtually all of the small unregistered swap dealers will further reduce their level of business or drop out of swaps dealing entirely. In short, Dodd-Frank has led to a significant accelerated concentration of swaps exposure.
  • There are no firms registered as a major swap participant. Not one. The registration requirements, applicable to large users of swaps that are not dealers, are absurd; it would be impossible for any non-dealer to comply with them. These provisions should be dropped from Dodd-Frank and the regulators should no longer waste time coming up with rules for registration categories that will apply to no one.
  • Congress gave no instruction as to how capital requirements could possibly be applied to a commercial entity that is a swap dealer. It simply does not work to have regulatory capital requirements (which largely require that a firm hold liquid financial assets) for commercial enterprises that own oil wells, related buildings and refineries. After years of struggling with how to make this round peg fit into a square hole, the CFTC essentially gave up (which was the rational thing to do). It set a low tangible capital requirement, which serves as an irrelevant fig leaf: a rule that the CFTC proposed merely because Congress required it to do so.

Currently, the CFTC does not have the expertise to supervise a models-based capital regime. Greater consideration should be given as to how this will work in practice.