New Study Shows Post-Crisis Regulations Hurt Bond Liquidity

In an article posted on the Liberty Street Economics blog of the Federal Reserve Bank of New York, authors Tobias Adrian, Nina Boyarchenko and Or Shachar (collectively, the “authors”) explained the results of a recent study, which indicated that corporate bond liquidity has been adversely affected by post-crisis regulation.

The authors analyzed FINRA Trade Reporting and Compliance (“TRACE”) data in order to evaluate trade activity and measure corporate bond market liquidity. By utilizing the information provided by TRACE reports, the authors were able to determine which parent bank holding company (“BHC”) corresponded to a dealer in a particular trade. The authors then calculated bond liquidity by using common corporate bond liquidity metrics and incorporating constraints based on the balance sheet of the relevant BHC.

The economists stated that the results demonstrate the negative impact on bond liquidity of post-crisis regulation. Further, the authors argue that actual trading behavior data supports this conclusion.

Lofchie Comment: The results of this study are welcome and expected. For quite some time, the regulators seemed to deny there was any proof that the Dodd-Frank regulations damaged liquidity, notwithstanding both evidence to the contrary and common sense (how could regulations that heavily burden trading not impact liquidity?). That said, the fact that the regulations impair liquidity does not mean that the regulations are bad. All it means is that the regulations create trade-offs; one can reasonably argue that the diminished liquidity is worthwhile. It is important, however, that the regulators admit that the trade-offs exist (“it’s all good” is not the way the world works: regulations have both costs and benefits).

CFTC “Modernizes” Recordkeeping Requirements

The CFTC amended its rules to modify the methods by which records must be kept. Under Rule 1.31, firms will no longer be required to (i) retain electronic records in their original format, (ii) keep records in a “non-rewritable, non-erasable format,” or (iii) employ a third-party technical consultant for certain filing requirements. The adopted amendments, including corresponding technical changes regarding recordkeeping, will become effective 90 days after publication in the Federal Register (see also, previous coverage).

Lofchie Comment: Will the CFTC rule changes cause the SEC to revisit its own rules? It would seem to be the right thing to do.

Sargen: Time to Consider Europe


  • Emmanuel Macron’s election as President of France has buoyed European markets, as it is the third election this year in which populist candidates have been defeated.  Moreover, with Angela Merkel’s party scoring key wins in regional elections, her chances of being re-elected in the fall are high.
  • In addition to lessened political risks, investors have been attracted by better-than-expected economic performance in the European Union (EU) this year.  Germany’s economy has been the locomotive, and Macron’s election has raised hopes that France will finally embark on much-needed structural reforms and that a renewed Franco-German partnership will revive the EU, as well.
  • Weighing these considerations, this may be a good time to add exposure to European equity markets: Profit growth has surged recently and political risk has lessened, while the discount on European stocks relative to the U.S. is in line with long-term norms.  The main risks are that Macron may not be able to deliver reforms and a populist leader could become Italy’s next President.

Background: EU Political Risks Lessen, while European Economies Improve

At the start of this year, a key issue relating to Europe was the prospect that elections in several countries – notably, Austria, Holland, France, Germany and Italy – could result in populist victories that would threaten the EU’s viability in the wake of last year’s vote in the UK in favor of Brexit.  France’s election was perceived to be the most important, because Marine Le Pen, the far right candidate, advocated that France should leave the EU and the euro.  While the odds of this happening were low, investor concerns heightened leading up to the first round elections, when there was a possibility Le Pen and far-left candidate, Jean-Luc Mélenchon, could be the two finalists.  In the event, Emmanuel Macron, a centrist politician who campaigned as a reformer, emerged as the front runner and went on to defeat Le Pen handily in the run-off.

In the wake of these developments, European equity markets rallied at one point by 5%, led by an 8% advance for the CAC.  The rally not only reflects investor relief that France will remain a core member of the EU, but also that the tide of populism on the continent has been contained:  The French election is the third in a row in which populist candidates were defeated, and recent state elections in Germany indicate that Angela Merkel’s prospects for being re-elected Chancellor appear very good.

At the same time, the EU has experienced better-than-expected economic performance, led by Germany: The 2.5% annualized rise in German GDP in the first quarter was the biggest in four quarters, and was well above potential (1.8% according to European Commission estimates.)  Investment in machinery and equipment also picked up in the quarter, suggesting a broadening of the expansion, which had been led by personal consumption.  German GDP in real terms is now 8.5% above its pre-crisis peak in 1Q 2008, well above other EU members.  Meanwhile, unemployment in Germany has fallen below 4% from a peak of more than 10% during the crisis.

For the EU as a whole, real GDP growth was 2% annualized, the best showing in the past two years. The improvement in growth is linked to the European Central Bank’s policies to keep interest rates near zero while expanding its balance sheet via asset purchases.  In addition, the 10% depreciation of the euro against the dollar in the past three years helped boost exports.

As in the United States, so-called “soft data” such as purchasing managers’ indexes and sentiment readings show a marked pick-up since the latter part of 2016.  Indeed, according to Credit Suisse, the latest PMI readings are consistent with EU growth accelerating to 3% (see Figure 1).  We would note, however, that hard economic data does not yet indicate the improvement in business sentiment.  Nonetheless, the latest EC forecast calls for the EU to grow by 1.7% this year, which is a considerable improvement from the past few years.

Figure 1:  European PMI Surveys Point to Stronger Growth 

Source: Thomson Reuters, Markit, Credit Suisse.

Another positive development is headline CPI has accelerated this year and is approaching the ECB’s 2% target, after running close to zero in 2015-2016.  This suggests the threat of deflation is waning, and the ECB can consider normalizing interest rates if this pattern continues.  That said, we believe the ECB will be very cautious about tightening monetary policy.

Will Macron Transform France and the EU?

To some extent, the boost in European equities since the first round of the French elections can be attributed to a relief rally that Marine Le Pen was not elected.  Beyond this, in the wake of Macron’s very decisive victory, some observers have asked whether the election could represent a turning point for France and the EU: Macron is a reformer who also seeks closer ties between France and Germany, which constitute the core of the euro-zone.

Soon after his election, Macron visited German Chancellor Angela Merkel, and both pledged to work closely to draw up a “road map” of reforms for the EU, including the possibility of implementing treaty changes, if necessary.  Merkel noted that work first needed to be conducted on reforms that are needed before changes in the EU treaty would be implemented.  One of the most important is the need for greater fiscal sharing if the EU is to evolve from a monetary union to a fiscal union. To go down that route, however, Germany wants to be confident France is committed to structural reforms that will make its economy more dynamic.  The reason: Germany undertook a comprehensive set of labor market reforms in the previous decade that are credited for reviving its economy.

For his part, Macron has called for a “revolution” to simplify France’s Labor Code, which is a 3,600 page document that regulates nearly every aspect of employer-employee relations.  This will not be easy to pull off, however, as he will encounter strikers and protesters, as previous French Presidents have.  For example, Francois Hollande, Macron’s processor, backed away from embarking on labor reforms in the face of stiff opposition.  Other reforms being considered include cutting the corporate tax rate from 33% to 25%, and reducing the size of France’s bloated government.  The latter goal, however, is modest, as Macron seeks to slow the expansion of government rather than to reduce its size, which is the largest among the leading industrial countries.

Having formed a new political party, Macron must first build a coalition with existing parties, so that he can gain a legislative majority in the parliamentary elections in June.  Those he has recruited so far lean strongly to the left, with many coming from the reform faction of the Socialist Party.  To appeal to the right, Macron is credited with making a wise choice of Édouard Philippe as Prime Minister.  Still, it appears unlikely Macron will win an outright majority, and he therefore may have to rule with a coalition.  Consequently, it remains unclear how successful he will be in achieving reforms that France desperately needs.

The Case for European Equities

The principal reasons for considering European equities are that (i) earnings prospects have improved with the economic upturn, while (ii) Macron’s election and the rejection of populism in several key European countries have lessened political risk.

The improvement in European corporate profits is shown in Figure 2.  It illustrates how far they lagged the U.S. market when economic growth trailed that in the U.S., and how they have improved recently.  Among developed countries, European stock markets traditionally have been the most levered to economic performance, and this continues to be the case, as earnings growth in Europe has exceeded that in the U.S. recently.  Moreover, the percentage of European companies beating expectations is the highest in a decade.  An additional factor supporting corporate profitability has been the weak euro.  Although it has firmed against the dollar recently, it is still relatively cheap on a purchasing-power basis.

Figure 2:  European Corporate Profits Lag the U.S. Until Recently
12-month trailing EPS, Index, Jan 2006 = 100

Source: Datastream, JPMAM. April 28, 2017.

On the surface, it appears European equities may offer good relative value, as the discount of European multiples to the U.S. is about 15%.  The latter, however, is close to the average of the past decade or so, when one takes into account differences in the sector compositions.  Therefore, we consider European equities to be reasonably valued relative to the U.S.

The other major consideration is that political risk in Europe has diminished considerably with Macron’s election and the likelihood that Angela Merkel will be re-elected Chancellor of Germany.  This has contributed to inflows of funds into European markets recently.  The principal risk for investors is disappointment that Macron may not be able to deliver on his reform agenda.  Another risk is that populism could resurface in the Italian presidential elections that must be held no later than a year from now.

Weighing these considerations, I believe now may be a good time to add to European equities, after years of being cautious about European markets.

CFTC Amends Rules to Protect Whistleblowers

The CFTC adopted several rule amendments in order to better protect whistleblowers from retaliation or intimidation by their employers and to establish a new review process for whistleblower claims. The amendments are based on a reinterpretation of the CFTC’s anti-retaliation authority under the Commodity Exchange Act (“CEA”).

The amendments create a new rule – Rule 165.20 – that (i) prohibits retaliation against a whistleblower or anyone else assisting in an investigation, (ii) authorizes the CFTC to bring civil enforcement actions against employers who retaliate against whistleblowers, and (iii) makes explicit that the anti-retaliation protections apply whether or not an award is made. One effect of the amendments will be to allow both the CFTC and a whistleblower to bring legal actions against employers for retaliation.

The newly adopted amendments make the following changes:

  • Rule 165.19 prohibits employers from taking action to prevent potential whistleblowers from communicating directly with the CFTC;
  • Rule 165.5(b) rescinds the requirement that, in order for a whistleblower to receive an award, they must be the original source of the information provided;
  • Rules 165.2(i)(2) and 165.2(l)(2) expand the list of entities to which a whistleblower can report misconduct before reporting to the CFTC and still maintain award eligibility;
  • Rules 165.2(i)(3) and 165.2(l)(2) expand the timeframe in which a whistleblower must file a Form TCR (i.e., a Tip, Complaint or Referral Form) from 120 to 180 days;
  • Rules 165.5(a)(3) and 165.11(a) allow a whistleblower to receive an award in both a Related Action and a covered judicial or administrative action;
  • Rule 165.11(b) prevents a whistleblower from receiving an award for a Related Action if they have received an SEC award for the same action;
  • Rules 165.15(a)(2) and 165.7(f)-(l) replace the Whistleblower Award Determination Panel with a Claims Review Staff, and implement an enhanced review process mirroring that of the SEC.

In addition, the CFTC rule amendments make other changes related to form filing, recordkeeping and confidentiality. The amendments also harmonize rules concerning the CFTC and the SEC whistleblower programs. The amendments will become effective 60 days after their publication in the Federal Register.

Lofchie Comment: The mythic image of the “whistleblower” is that of a brave individual facing down a giant corporation (and preferably of the future subject of a movie). Sometimes whistleblowing does work like that. At other times, a whistleblower is just someone out for money (or revenge). What does a company do when it becomes aware of a whistleblower who has gone straight to the government with an accusation, without first attempting to remedy the matter internally, and the allegations turn out to be (legally) mistaken or factually untrue? Can an employee who is concerned about being dismissed raise an allegation strategically as a defense against being fired? These are difficult real-world questions. Big companies doubtless will try to live with the whistleblower rather than risk allegations of mistreatment. For smaller companies, it’s a harder situation.

SEC to Reconsider Decision Approving Quadruple-Leveraged ETFs

According to a Wall Street Journal report, the SEC may reevaluate a decision by the Division of Markets and Trading to approve a proposed rule change that permits the listing and trading of the first quadruple-leveraged exchange-traded funds (“ETFs”). The report states that the decision “has been put on hold” and will be reviewed by SEC commissioners.

CFTC Launches FinTech Innovation Initiative

The CFTC launched “LabCFTC,” an initiative designed to “promot[e] responsible FinTech innovation to improve the quality, resiliency, and competitiveness of the markets the CFTC oversees.” The initiative, which will include the creation of a FinTech innovation office in New York City, is intended to address the regulatory challenges of increasingly automated trading, and to foster a regulatory environment more receptive to emerging FinTech companies. The initiative will consist of two major components:

  • GuidePoint will offer guidance to FinTech companies on how innovations may fit into the existing regulatory framework and help innovators navigate the regulatory process; and
  • CFTC 2.0 will implement emerging technologies in order to improve the CFTC’s effectiveness and efficiency.

CFTC Acting Chair J. Christopher Giancarlo emphasized that regulatory organizations must keep pace with technological innovation, and cooperate and engage in dialogue with FinTech companies, as the influence of technology on financial markets continues to expand:

“Good regulation should not inhibit technological innovation. Rather, innovation should foster better and smarter regulation. Regulators must engage in a constant and evolving dialogue with innovators precisely because we need to understand the impact they are having on the very marketplaces we are charged to supervise. We must partner with them, experiment with them, learn from them and innovate alongside them, if we are ever to keep pace with the digitization of modern markets and protect their 21st century participants.”

CFTC Commissioner Sharon Bowen lauded the initiative and suggested that the CFTC needs an expanded budget in order to keep up with the evolving marketplace.

Lofchie Comment: During his tenure as a Commissioner, the now-Acting Chair Giancarlo was constant in his attention to (i) making the CFTC more efficient through improved use of technology and (ii) exploring how technology can improve regulated markets without the regulators becoming a roadblock. (See generally news regarding Mr. Giancarlo and technology.) The latter focus area demonstrates an understanding that regulators too often lack. Change is inevitable. It takes special care and leadership to foster a regulatory environment that does not slow down or inhibit that change.

SEC Names General Counsel, Chief Counsel and Deputy Chief of Staff

The SEC named Robert Stebbins as General Counsel. Previously, Mr. Stebbins was a partner at Willkie Farr & Gallagher. The SEC named Jaime Kilma as Chief Counsel. Ms. Kilma served most recently as SEC Co-Chief of Staff, and before that, as Counsel to SEC Commissioners Michael S. Piwowar and Troy A. Paredes. The SEC also named Sean Memon as Deputy Chief of Staff. Mr. Memon joins the SEC from Sullivan and Cromwell.

CFS Monetary Measures for April 2017

Today we release CFS monetary and financial measures for April 2017. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.4% in April 2017 on a year-over-year basis versus 3.9% in March.

For Monetary and Financial Data Release Report:

For more information about the CFS Divisia indices and the data in Excel:

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’

FDIC Vice Chair Urges Partitioning of Nonbanking Activities

FDIC Vice Chair Thomas Hoenig discussed his recent proposal to require that banks partition certain nonbanking activities (see previous coverage for more detail).

At a Conference on Systemic Risk and Organization of the Financial System held at Chapman University, California, Mr. Hoenig described a shift in the banking industry towards consolidation among the largest banks. He noted some of the key factors that have led to this trend: (i) technological developments and financial engineering, (ii) 1990s legislation easing the strain of banking regulations, (iii) significant mergers of commercial and investment banks, and (iv) fallout from the 2008 financial crisis, including the introduction of the Dodd-Frank Act in 2010.

Mr. Hoenig noted that, while the Dodd-Frank Act included some structural changes (such as the Volcker Rule), Congress, in large part, chose “regulatory control over structural change.” Mr. Hoenig warned that such over-reliance on regulation potentially could slow down economic growth. He instead advocated for structural change, suggesting that:

“. . . universal banks would partition their nontraditional activities into separately managed and capitalized affiliates. The safety net would be confined to the commercial bank, protecting bank depositors and the payment system so essential to commerce. Simultaneously, these protected commercial banks would be required to increase tangible equity to levels more in line with historic norms, and which the market has long viewed as the best assurance of a bank’s resilience.”

Mr. Hoenig recommended implementing a variety of other safeguards to supplement the partition, such as setting limits on the amount of debt the ultimate parent companies could downstream to subsidiaries. He also mentioned the possibility that, by allowing for resolution through bankruptcy, his proposal could reduce regulatory burdens, including the elimination of risk-based capital and liquidity, the Comprehensive Capital Analysis and Review, Dodd-Frank Act Stress Testing, the Orderly Liquidation Authority, Living Wills, and parts of the Volcker Rule.

Lofchie Comment: One problem with the proposal is the distinction it makes between traditional and nontraditional activities. This distinction is based upon the time in which a particular type of financial activity was created and the substance of the activity. For example, entering into swap transactions (particularly as to rates and currencies) and clear swaps and futures should be viewed as core banking activities: they are activities that are completely about credit intermediation. To assert that they are not “traditional” banking activities because they were not done in the 1950s or the 1850s would be not so different from stating that email is not a traditional form of bank communication. It may not be traditional, but it is the modern version of the telephone, and it is core to what banks do.

Federal Register: CFTC Solicits Comments on KISS Initiative

The CFTC is soliciting comments on Project KISS (“Keep It Simple, Stupid”), an initiative focused on simplifying rules and practices in order to make compliance less costly. As discussed previously, the CFTC is asking those who comment on Project KISS to concentrate on enhancements rather than rewrites or repeals. The request for comments was published in the Federal Register, and comments are due by September 30, 2017.

Lofchie Comment: Firms are advised to take this offer seriously, as there is no doubt that Commissioner J. Christopher Giancarlo would like to make changes that would bring down the expenses of doing business. While an invitation to rethink a larger part of the rule structure would be more alluring than a KISS, it’s only a first date.