Senator Sherrod Brown Criticizes President-Elect Trump’s Pick for SEC Chair

In response to the selection of Jay Clayton as nominee for SEC Chair, U.S. Senator Sherrod Brown (D-OH) opined that “[i]t’s hard to see how an attorney who’s spent his career helping Wall Street beat the rap will keep President-elect Trump’s promise to stop big banks and hedge funds from ‘getting away with murder.'”

Lofchie Comment: Football Outsiders (a statistics site for football fans) includes a generic complaint form for readers to use when they disagree with the results of a given analysis but do not wish to engage in substantive discussion. Similarly, the Trump administration might find it useful to provide a generic form for those who wish to complain about a given individual from the private sector who is tasked with serving in the government:

[Mr./Ms.] [Name] is [completely/wholly/totally/horrendously/shockingly/
fabulously/absolutely] [unqualified/unfit/unsuited] to serve as [name of post] for the [name of agency] because that person previously worked in the private sector where the individual’s job included [ [helping a corporation make money] / [defending a person against a governmental or regulatory action] / [interaction with governments of countries other than the United States] ].

Notwithstanding Senator Brown’s remarks, many of President Obama’s appointees also had significant Wall Street careers prior to their government service, including CFTC Chair Gensler and Secretary of the Treasury Lew. Having had a career in the private sector ought not to generate a generic salvo.


SEC Chair White Urges Successor to Prioritize Globally Accepted Accounting Standards

SEC Chair Mary Jo White called on the “next Chair” of the Commission to prioritize the development of “high-quality, globally accepted accounting standards,” which are “imperative for the protection of U.S. investors and companies and the strength of our markets”:

“I strongly urge the next Chair and Commission to build on our past efforts and give the goal of high quality globally accepted accounting standards the focus and support this critical issue deserves.”

In a public statement, Chair White noted that as of September 2016, foreign companies that apply International Financial Reporting Standards (“IFRS”) in SEC filings represent “a worldwide market capitalization in excess of $7 trillion across more than 500 companies.” U.S. companies use IFRS in making acquisitions, establishing joint ventures and preparing financial information for management and boards of directors, she stated.

“In light of these global realities,” Chair White urged the “next SEC Chair” to:

  • work with the Financial Accounting Standards Board (“FASB”) to “provide clear and reliable financial information as business transactions and investor needs continue to evolve globally”;
  • work closely with the SEC Chief Accountant and be an active member of the IFRS Foundation Monitoring Board; and
  • ensure that the SEC carefully monitors “how the needs and interests of investors and issuers may change in the future and seek opportunities to guide and accelerate the development of high-quality, globally accepted accounting standards.”

In addition, Chair White encouraged the IFRS and the Financial Accounting Standards Board to “continue their productive collaboration,” particularly by adopting a “sequential” approach to the convergence of their respective accounting standards.

Lofchie Comment: Some of the most unfortunate incidents that occurred during Chair White’s tenure were the recurrent attacks she suffered under Senator Warren’s acerbic scrutiny. Those attacks were wholly undeserved, since the Senator’s objective was to compel the SEC to focus on adopting rules that had a significant political purpose (such as the disclosure of political contributions) but only tangential relevance to the SEC’s aims, as opposed to rules that should be more important to the SEC, such as those that improve economic transparency. (Seee.g.Senator [Warren] Urges President to Replace SEC Chair.)

To Chair White’s credit, she did not allow these attacks to distract the SEC from pursuing its core mission. Even in her parting words to the Commission, Chair White fixed her attention on the task at hand: improving economic disclosures that may benefit investors and the U.S. economy.

FINRA Prioritizes Compliance, Supervision and Risk Management in 2017

In a 2017 Regulatory and Examination Priorities Letter (“Priorities Letter”), FINRA identified compliance, supervision and risk management as primary areas for review.

FINRA stated that it will be focusing on the following issues, among others:

  • High-Risk and Recidivist Brokers. FINRA will enhance its approach to high-risk and recidivist brokers by reviewing firms’ (i) supervisory procedures for hiring or retaining statutorily disqualified and recidivist brokers, (ii) supervisory plans to prevent future misconduct, and (iii) branch office inspection programs and supervisory systems for branch and non-branch office locations.
  • Sales Practices. FINRA will evaluate firms’ (i) compliance and supervisory controls that are intended to protect senior investors, especially against microcap fraud schemes, (ii) reviews of product suitability and concentration in customer accounts, (iii) capacity to monitor the short-term trading of long-term products, (iv) procedures regarding registered and associated persons, and (v) compliance with social media supervisory and record-retention obligations.
  • Financial Risks. FINRA will examine firms’ (i) funding and liquidity plans, (ii) financial risk management practices, and (iii) implementation of the first phase of the new FINRA Rule 4210 margin requirements for covered agency transactions, which became effective on December 15, 2016.
  • Operational Risks. FINRA will assess firms’ (i) cybersecurity programs, (ii) internal supervisory controls testing, (iii) controls and supervision intended to protect customers’ assets, (iv) compliance with SEC Regulation SHO, (v) anti-money laundering programs, and (vi) application of exemptions and exclusions to municipal advisor registration requirements.
  • Market Integrity. FINRA will (i) monitor firms’ compliance with amended Order Audit Trail System rules, (ii) expand surveillance for cross-product manipulation to include trading in exchange-traded products, and (iii) supplement firms’ supervisory systems and procedures with “Cross-Market Equity Supervision Report Cards.” In addition, FINRA will (i) expand its Audit Trail Reporting Early Remediation Initiative to include Regulation NMS trade-throughs and locked and crossed markets, (ii) review firms’ compliance with Tick Size Pilot data collection obligations, and (iii) ensure that firms improve their Market Access Rule compliance by incorporating recommended best practices. FINRA also intends to review alternative trading systems’ customer disclosures and develop a pilot trading examination program in order to help “determine the value of conducting targeted examinations of some smaller firms that have historically not been subject to trading examinations due to their relatively low trading volume.” Lastly, FINRA will continue to expand its “fixed income surveillance program to include additional manipulation-based surveillance patterns, such as wash sales and interpositioning.”

Lofchie Comment: The new Priorities Letter offers a lot to talk about, since FINRA has managed to cover virtually every aspect of a firm’s business. It is incumbent on each firm to go through the letter carefully and scrutinize every relevant priority. The following areas might be of particular interest: (i) custody, (ii) seniors, (iii) improving the automation of “suitability” reviews (e.g., the ability to search for concentrated positions, or positions with excessive turnover), and (iv) cybersecurity training. Anti-money laundering enforcement actions have proved to be a treasure trove for financial regulators, so firms should continue to devote their attention to this area. Liquidity seems to be the odd item on FINRA’s list, since there are no real rules governing it, but rulemaking advances in that area should be expected in the near future, so regulators will be exploring ways to refine their understanding of best practices.

CFTC Chair Timothy Massad Resigns

CFTC Chair Timothy G. Massad tendered his resignation to President Obama. He will leave the CFTC on January 20, 2017. In a statement, which was accompanied by a 16-page summary of the CFTC’s accomplishments during his two-and-a-half-year tenure, Chair Massad asserted that the Commission had realized his agenda:

“I came to the CFTC with a number of priorities, and I am proud we have made significant progress in every area.”

Chair Massad highlighted accomplishments during his tenure. The CFTC:

  • ensured that “commercial businesses [could] continue using the derivatives markets efficiently and effectively to hedge routine commercial risk and engage in price discovery”;
  • “worked to ensure clearinghouses are stronger and more resilient through enhanced risk surveillance, new supervisory stress testing, and the development and completion of recovery and wind down plans and rules”;
  • “largely finished implementing the regulatory framework for swaps”;
  • “improved international coordination”;
  • “engaged in robust enforcement efforts”; and
  • took action to “address the new challenges and opportunities in the derivatives markets, particularly cyber threats, clearinghouse resilience, and the increased use of automated trading.”

Chair Massad emphasized that he “worked to make sure the rules focus on where the greatest risk exists, in transactions between large financial institutions,” and to ensure they were “largely harmonized with other domestic and international requirements.” He also noted that the clearinghouses are “stronger and more resilient,” through enhanced risk surveillance, new supervisory stress testing, and the development and completion of recovery wind down plans and rules.

Study Finds Volcker Rule Has “Deleterious Effect” on Corporate Bond Liquidity

The Board of Governors of the Federal Reserve System staff members and a Cornell University finance professor examined the impact of the Volcker Rule on corporate bond illiquidity and dealer behavior during times of market stress. In a recent working paper, the authors concluded that the rule creates a less liquid market for corporate bonds because the dealers that are covered by it become “less willing” to offer liquidity during such times.

The economists focused on the downgrading of investment-grade corporate bonds due to the increased risk of “forced selling.” They reported that:

  • when compared to a control group of BB-rated bonds, downgraded bonds exhibited a “larger price impact of trading”;
  • the larger price impact grew after the implementation of the Volcker Rule;
  • bond market illiquidity during “stress periods is now approaching levels see[n] during the financial crisis”; and
  • dealers covered by the Volcker Rule have decreased their involvement in dealer-customer trades and are “less willing to commit capital.”

The authors concluded that the effect of the rule on dealers has been pronounced:

Overall, our results show that the Volcker Rule has had a real effect on dealer behavior, with significant effects only on those dealers affected by the Volcker Rule and not all bond dealers.

The working paper is an academic study drafted as part of the Finance and Economics Discussion Series, Division of Research & Statistics and Monetary Affairs of the Federal Reserve Board in Washington.

Lofchie Comment: The consensus among both buy- and sell-side market participants is that there has been a decline in liquidity. One would expect liquidity to decline as a result of the Volcker Rule for a number of reasons. For one thing, it is difficult for a bank to demonstrate to regulators that its trading activities are permissible market-making and not impermissible proprietary trading. As a result, banking organizations are likelier to withdraw from the market than to risk regulatory repercussions. It would be surprising if the Volcker Rule did not diminish liquidity.

For the past several years, banking regulators refused to acknowledge the likelihood of the Volcker Rule’s negative effect on liquidity. To bolster their refusal, regulators have reiterated that the bid-ask spread in highly rated bonds has stayed the same or declined, even as they pointedly ignored the fact that the size of trades has decreased and disregarded the impact of diminished liquidity on bonds that are less highly rated. (See FDIC Chair Gruenberg Asserts That Post-Crisis Reforms Strengthen the Financial System.)

As the authors of the paper observed, the fact that the Volcker Rule resulted in diminished liquidity does not mean that the Volcker Rule is a failure, per se, or that its consequences are negative overall. What it does mean is that the rule has demonstrably and materially negative consequences. The important question is this: do the benefits of the Volcker Rule outweigh its disadvantages?

Unfortunately, that question is not answered by this study, nor has it been debated by the regulators. Those who have an interest in defending the rule cannot be trusted to address the issue fairly and have refused to admit any downside thus far. (Comparee.g.Comptroller Curry Asserts That Post-Crisis Financial System Is Stronger and Regulators Examine Current Developments in U.S. Treasury Markets (with Delta Strategy Group Summary) with CFTC Commissioner Giancarlo Calls for “Clear-Eyed Attention” to Market Challenges.)

The failure of regulators to concede potential issues with various rulemaking decisions would be problematic enough if it were confined to the Volcker Rule. Sadly, it is not. That same failure derails regulators’ discussions of mandatory central clearing. What could make the problem even worse is the possibility that the downsides of the new rules may compound each other; i.e., both the Volcker Rule and mandatory central clearing requirements have material negative effects on liquidity (albeit for different reasons: Volcker, because it discourages market-making; central clearing, because it drains cash and liquid assets from the system, as Houston University Finance Professor Craig Pirrong argues in a recent Streetwise Professor blog entry), thus making the markets far more prone to share downward breaks.

This is not to say that the new rules are all bad; it is to say that they may be bad in toto or in part, and that their negative consequences must be acknowledged.

May the new year allow these issues to be seen with new eyes.

GAO Issues Report on Agency Coordination and Financial Market Impact of Latest Dodd-Frank Rules

The Government Accountability Office (“GAO”) issued a report on efforts by regulatory agencies to analyze and coordinate Dodd-Frank Act rules that became effective between July 2015 and July 2016. The GAO also examined the impact of select Dodd-Frank Act rules on financial market stability.

The GAO concluded that the CFTC and prudential regulators “coordinated domestically and internationally” and “largely harmonized their respective rules” to develop regulations on margin requirements for over-the-counter swaps. The GAO found that the CFPB “followed its internal guidance for coordinating with relevant agencies throughout the rulemaking process” in adopting the integrated mortgage disclosure rule.

The GAO determined that regulators issued final rules for approximately 75% of the 236 provisions of the Dodd-Frank Act that the GAO is monitoring. GAO noted that delayed implementation of Dodd-Frank Act requirements by the financial services industry, as well as factors outside of its provisions like monetary policy, can make it difficult to isolate the effect of the Dodd-Frank Act on the financial marketplace. That said, the GAO found that, among other actions, Dodd-Frank Act implementation has had the following effects on the financial services industry:

  • large bank systemically important financial institutions have increased in size but have become less vulnerable to financial distress;
  • designated nonbanks are more resilient and less interconnected than in prior years; and
  • increased percentages of collateral for swaps by banks may help protect against credit loss.

However, the GAO stated that:

“The full impact of the Dodd-Frank Act remains uncertain because some of its rules have not been finalized and insufficient time has passed to evaluate others.”

The GAO will continue to monitor the implementation of “prior recommendations intended to improve, among other things, financial regulators’ cost-benefit analysis, interagency coordination, and impact analysis associated with Dodd-Frank regulations.”

Lofchie Comment:  There is not much in this report to get excited about. That the regulators are cooperating with respect to rulemaking is generally a good thing, but it does not necessarily say anything about the quality of the rules being adopted. The numbers demonstrating that banks have become more “resilient” are so high-level that they are of no particular value.