SEC Provides Relief Related to MiFID II Research Payment Provisions

The SEC issued three no-action letters to enable market participants to comply with the research provisions of MiFID II while complying with the applicable requirements of U.S. securities laws. MiFID II is due to come into effect on January 3, 2018. The issues addressed by each letter arose because investment advisers subject to MiFID II (“MiFID Managers“) will be required to separate out payments for research from commissions they pay broker-dealers for execution services.

1. Relief for Broker-Dealers from Regulation as Investment Advisers. The Division of Investment Management issued a letter permitting broker-dealers to receive cash payments for research services from MiFID Managers without being subject to regulation as “investment advisers” under the Investment Advisers Act of 1940 (the “Advisers Act“). The relief is required, as such cash payments may constitute “special compensation” for advisory services that may cause a broker-dealer to fall outside the scope of the broker-dealer exclusion from the definition of “investment adviser” in Section 202(a)(11)(C) of the Advisers Act.

The relief applies both where a MiFID Manager pays for research from its own account, and from a separate MiFID-qualifying “research payment account” (an “RPA“), which is an account funded with client money for the purpose of paying for research. Further, the relief extends to payments by non-EU managers that are contractually required to comply with the research payment provisions of MiFID II (e.g., a non-EU sub-adviser appointed by a MiFID Manager). The Division granted the relief for 30 months from the implementation of MiFID II.

2. Aggregation of Orders by Investment Advisers. The Division of Investment Management issued a second letter permitting investment advisers to aggregate client orders if clients pay the same pro rata share of execution costs, even if they pay different amounts for research. Under prior guidance, the SEC permitted investment advisers to aggregate client orders where clients shared all transaction costs (which could include research costs) on a pro rata basis. As MiFID II will result in different clients paying different sums for research, the SEC relief limits the cost-sharing requirement to execution costs. The letter requires investment advisers to implement specified policies and procedures to ensure that they otherwise aggregate (and subsequently allocate) client orders fairly.

3. Reliance on Section 28(e) Safe Harbor by Advisers Making Cash Payments for Research with Client Funds. Section 28(e) of the Exchange Act establishes a safe harbor that permits investment advisers to use client funds to purchase “brokerage and research services” for their managed accounts without breaching their fiduciary duties to clients. The Division of Trading and Markets issued a letter to permit a MiFID Manager to use client funds to make payments for research through a client-funded RPA in reliance on Section 28(e). The relief was requested because Section 28(e) arrangements typically contemplate that an investment adviser will make a single “bundled” commission payment to a broker-dealer to cover both execution and research services. Under MiFID II, a MiFID Manager will be required to make separate payments for execution and research services, and retain control of any RPA account used to make payments for research services with client money. The letter acknowledges that, notwithstanding these different payment mechanics, a MiFID Manager should be permitted to rely on Section 28(e) provided the executing broker-dealer is contractually obligated to pay for research through use of an RPA, and the arrangement otherwise meets the requirements of Section 28(e).

While SEC Chair Jay Clayton said that the relief represents a “measured approach” that allows U.S. market participants to comply with MiFID II without significantly changing the U.S. regulatory approach, Commissioner Kara Stein argued that the relief merely “kicks the can down the road” without addressing key policy questions regarding the U.S. approach to the transparency of fees relating to research and trading.

Lofchie Comment: Notwithstanding Commissioner Stein’s comment as to kicking the can down the road, kudos to Chair Clayton for adopting a fairly long-term no-action letter that gives both regulators and market participants an opportunity to see what the effects of the MIFID rule changes might be, whether the U.S. rules should be changed, and, if so, what those rule changes should be. It is a waste of Commission and industry resources to adopt short-term no-action letters that must be continually renewed. While thirty months may seem a long time, the reality is that the SEC still has significant Dodd-Frank rulemaking on its plate, as well as numerous other issues that are also pressing, such as market structure and corporate disclosure.

Further, it should be pointed out that the SEC issued the no-action letters because the Europeans have adopted regulations that are inconsistent with the U.S. Securities Exchange Act. While Commissioner Stein is right in asserting that Section 28(e) of the Securities Exchange Act may not be good public policy, there are very good arguments to be made that it is; i.e., that the Section encourages the production of investment research. This is the determination that Congress made when it adopted the statutory provision. If the determination seems no longer correct, then, at least insofar as U.S. market participants are concerned, it is the U.S. Congress that should reverse the determination, not the Europeans.

Senator Warren Warns Against Easing Oversight of Big Banks

In an op-ed published by Bloomberg, Senator Elizabeth Warren (D-MA) argued against any measures to reduce the regulation of banks with more than $50 billion in assets.

Senator Warren explained that Dodd-Frank mandates the Board of Governors of the Federal Reserve System (“FRB”) to impose stricter rules and apply more careful oversight to banks with more than $50 billion in assets. According to Senator Warren, the FRB has done a good job of “aggressively tailor[ing]” rules to ensure that banks with just over $50 billion in assets are not treated the same as banks with more than $250 billion in assets. This tailoring process is “ongoing,” and includes recent efforts to lower stress-testing requirements for banks with less than $250 billion in assets.

Senator Warren contended that big banks continue to advocate and lobby for raising the $50 billion threshold to $250 billion, or to have it replaced with a “multi-factor test.” She criticized both approaches, arguing that even banks at the lower end of the threshold pose significant risks to the financial system. Senator Warren posited that the correlated nature of these banks’ portfolios could lead to several of them failing at once. Lowering the threshold would only provide “negligible” benefit, she argued. Senator Warren suggested that changing the threshold would lead not to increased lending, but rather to “additional stock buybacks, mergers, and executive bonuses.”

Lofchie Comment: Senator Warren’s arguments might be more compelling if she tried to fit them more closely to particular facts or concerns. Because she chooses to argue in generalities, her claims have the appearance of generic political statements as opposed to attempts to discuss better financial regulation. As a result, the Senator remains consistent in her views on regulation: more is always better.

Given the authority that the Federal Reserve Board has over banks, it is an overstatement to suggest that banks might escape the Fed’s scrutiny. No one is suggesting that the Fed would not regulate bank holding companies. Further, the federal banking regulators have substantial authority over executive compensation and stock buybacks. That authority is not going to disappear. Lastly, it is not clear why Senator Warren believes that some reduction in regulation would lead to an increase in bank mergers. Heavy regulation results in increased fixed costs, which favors the very largest entities. One need not look far for proof. Since the adoption of Dodd-Frank, there has been increased financial industry consolidation (particularly in areas regulated by the CFTC, where the regulatory increases have been greatest; e.g., the number of FCMs is approximately halved).

Perhaps there are good arguments for maintaining the regulations that Senator Warren supports. If that is the case, Senator Warren would do better, to the extent that her interest is regulatory policy, to make those arguments with a good bit more specificity.


MFA Recommends Greater Harmonization of CFTC/EU Swaps Trading Rules

The Managed Funds Association (“MFA”) published a comparative analysis of U.S. and European Union (“EU”) derivatives trading regimes, and made recommendations for further cross-border harmonization. The MFA found the two regimes to be aligned in many important areas. The MFA identified two areas where harmonization could be improved: (1) the calibration of the transparency regime in the EU, and (2) whether prearranged trading is permitted for instruments subject to the trading obligation in the EU.

The MFA made the following observations and recommendations:

  • Pre-trade transparency/modes of execution: evaluate European Securities and Markets Authority (“ESMA”) “transitional transparency calculations” to ensure that liquidity classifications are appropriate and market participants receive adequate liquidity. The CFTC should consider allowing greater flexibility for execution on swap execution facilities.
  • Prohibition on prearranged trading: ensure that prearranged trading is prohibited by ESMA except for block trades.
  • Post-trade transparency: the length of public reporting delays differs between EU and U.S. regimes; ESMA should continue to evaluate transitional transparency calculations and should consider limitations on the use of the extended deferral program of four weeks.
  • Straight-through processing: given that U.S. and EU rules are substantially similar, monitor to ensure that rules are faithfully implemented by trading venues.
  • Impartial/non-discriminatory access to trading venues: given that U.S. and EU rules are substantially similar, monitor to ensure that rules are faithfully implemented by trading venues.
  • Process for determining the derivatives subject to a trading obligation: the CFTC should consider undertaking greater oversight of the “made-available-to-trade” process.
  • Scope of instruments covered by a trading obligation: instruments subject to regulation under both U.S. and EU regimes are substantially similar.
  • Access to trading venue rulebooks: EU regulators should encourage trading facilities to disclose their rulebooks to market participants.

Lofchie Comment: CFTC Chair Giancarlo favors greater flexibility as to the means by which swaps are executed. Having a buy-side group support this direction should be further proof that the Chair is going in the right direction.

Another recommendation by MFA that is worth strong support (and Congressional amendment of Dodd-Frank) is the “made available to trade” process under which an exchange can effectively force a particular type of swap to be traded on exchange (if that type of swap is centrally cleared). Giving an exchange this type of power, where the exchange may be completely self-interested in its use of this authority, is, to put it politely, a very bad idea. Only the CFTC should have the authority to force any particular type of swap to be traded only on-exchange.

Treasury Criticizes CFPB Arbitration Rule

The U.S. Department of the Treasury (“Treasury”) released a report (“Report”) criticizing the Consumer Financial Protection Bureau’s (“CFPB”) arbitration rule (“Rule”). The Rule restricts mandatory arbitration clauses in certain consumer financial contracts. The Rule works by (i) restricting providers from using pre-dispute arbitration agreements that prohibit class action lawsuits, (ii) mandating that providers include language in their arbitration agreements that reflects this limitation, and (iii) imposing requirements that providers submit records related to pre-arbitration agreements to the CFPB for monitoring purposes.

Under the Rule, companies still would be able to include arbitration clauses in their contracts for the resolution of individual disputes. However, in contracts that are subject to the rule, the clauses would have to contain language stating explicitly that they could not be used to stop consumers from being part of class actions in court.

In the Report, Treasury claimed that the CFPB did not appropriately consider whether the Rule would promote customer protection or benefit the public. Instead, Treasury said, the review process undertaken by the CFPB to consider the potential effects of the rule was wholly inadequate. In particular, Treasury argued that:

  • the Rule is expected to generate more than 3,000 additional class action lawsuits that will impose heavy costs on businesses, and these costs will be passed on to consumers in the form of higher borrowing expenses;
  • class action lawsuits do not often result in recovery for most plaintiffs, and affected plaintiffs rarely claim settlement funds when awarded;
  • plaintiffs’ attorneys will receive a financial windfall from the resulting uptick in class-action suits;
  • the CFPB failed to consider whether an improved disclosure regime would benefit consumers more than an outright ban on mandatory arbitration clauses;
  • the CFPB failed to consider the amount of class-action suits that lack merit; and
  • the CFPB had no basis for its claim that the Rule would increase compliance with federal consumer finance laws.

Treasury contended that the CFPB Rule “would upend a century of federal policy favoring freedom of contract to provide for low-cost dispute resolution.” According to Treasury, the CFPB conducted a sub-standard analysis of the Rule before adopting it, and did not show that the Rule will have tangible benefits for consumers.

Lofchie Comment: This may be viewed as a dispute between Obama-holdover regulators who favor “retail” customers and the new Trump regulators who favor “institutions.” More cynically, this may be viewed not so much as protecting “retail” investors as it is throwing a potentially nice-sized bone to class-action lawyers.

The Treasury should be concerned with the risk to individual banks that is posed by class-action lawsuits. If small banks start getting hit with class-action lawsuits that are expensive to defend or settle, both Congress and the FDIC are likely to regret this rulemaking. Let’s see what happens when a small bank is put under real financial stress by being named in a class-action suit.

CFTC Director of International Affairs Talks Cross-Border Regulation

In an interview conducted by CFTC Chief Market Intelligence Officer Andrew Busch, CFTC Director of International Affairs Eric Pan discussed cross-border regulation including the recent equivalence agreement between the U.S. and the European Union (“EU”).

Director Pan explained that regulatory reforms must be developed in a manner that does not fragment the cross-border market or cause significant disruptions. He highlighted deference as an important “cooperative” policy, explaining that “everyone should be responsible for their home market,” but, when jurisdictions are also regulating firms that do business in other jurisdictions, they “should defer to the regulatory authorities of those other jurisdictions.” Mr. Pan stated that regulators want to ensure that no duplicative or conflicting rules exist across jurisdictions. He asserted that regulators all wish to implement robust regulations without also imposing heavy compliance costs and unnecessary burdens.

On recent CFTC and European Commission (“EC”) cooperation efforts (equivalence decisions on margin requirements for uncleared swaps and a common approach for regulating trading platforms), Director Pan said the size of the two markets and complexity of the regulated areas makes the agreements particularly significant. He said that the regulators are not looking to “weaken regulation,” but instead to find the most effective way to deploy agreed-upon high standards. Mr. Pan warned against EU plans to facilitate central counterparty relocation in light of Brexit, saying that it could have consequences for both the United States and EU member nations.

Lofchie Comment: Mr. Pan’s interview is directed largely at an audience of European regulators. He carries a combined message of carrot (deference to European regulators as to home market regulation) and stick (don’t force central counterparties to move to continental Europe in the wake of Brexit). This carrot and stick approach reiterates the message previously delivered by CFTC Chair Giancarlo. See CFTC Chair Giancarlo Warns European Officials against Unilateral Changes to CCP RegulationCFTC Chair Giancarlo Advocates for Increased Cross-Border Deference.

FRB Governor Describes Impact of FinTech on Banking and Payment Services

In remarks at the 41st Annual Central Banking Seminar in New York, Board of Governors of the Federal Reserve System (“FRB”) Governor Jerome H. Powell described the effect of FinTech on retail banking and payment services, and the role of the Federal Reserve in facilitating responsible innovation in those areas.

Governor Powell asserted that technological innovations, and the increased availability of data and analytics tools, have challenged traditional banking models. Governor Powell described the ability of FinTech to facilitate access to credit through alternative lending platforms that analyze non-traditional metrics to evaluate the financial health of a loan applicant. At the same time, he said, techniques such as “screen scraping” accentuate the necessity of heightened vigilance and raise questions about data security and consumer protection.

In the area of retail payments, FinTech developments now allow for instant payments via smartphone applications. Governor Powell said that enhancements such as integration with mobile messaging and increased security through two-factor authentication, biometrics, IP address verification, and geolocation data offer “tangible” benefits to consumers. He also examined the role of banks in payment innovations, noting that the ability to hold and transfer funds means that cooperation between banks and FinTech companies remains important. He encouraged a collaborative effort to ensure wide-scale improvement to retail payment systems.

Governor Powell suggested that the U.S. lags behind other countries in creating an advanced payment system, and emphasized the FRB’s role as a “leader and catalyst for change.” He explained that the Faster Payments Task Force recently made several recommendations for implementing “safe, ubiquitous, faster payments capabilities,” and that the FRB followed up on the recommendations by identifying several key strategies to achieve the stated goal. Governor Powell also said that the FRB formed a team to develop a proposal for a governance framework, and is considering providing settlement services for real-time retail payments. Finally, Governor Powell committed to the continued support of the Secure Payments Task Force. He shared that the FRB will (i) commission a study to analyze payment security vulnerabilities, and (ii) form work groups to explore approaches to reduce the cost of specific payment security vulnerabilities.

Lofchie Comment: On the one hand, Governor Powell insists that banks continue to be important to the financial system. On the other hand, he says that FinTech firms are racing ahead using technology to perform traditional banking tasks better and faster than banks (or most banks, at least).

These messages are not entirely contradictory. Banks, of course, are essential to the financial system. Individual banks, however, are not. Challenges from new technology providers, combined with materially increased regulatory costs, put individual banks in the midpoint of a rock and a hard place. Technology businesses tend to favor firms that can scale up. How will the banking regulators deal with the challenges to small banks? Proclaiming the significance of small banks in the payment system is well and good, but it won’t keep the doors open, as competition from nonbanks increases and the costs of being a regulated bank rise. How do the regulators think that banks, particularly small banks, will make money and survive? Should the regulators do more to relieve the cost pressure on small banks? Should regulators prepare for the possibility of bank closures?

CFTC Provides Guidance on Virtual Currencies

The CFTC published a “primer” that (i) provides a high-level overview of virtual currencies, (ii) outlines the CFTC’s oversight of the space and (iii) cautions market participants of the risks associated with virtual currencies.

The primer outlines potential use-cases for virtual currencies and blockchain, as well as situations in which CFTC jurisdiction is indicated. The report notes that virtual currencies are commodities, but acknowledges that, beyond preventing fraud or manipulation, the CFTC generally does not oversee “spot” markets in commodities; i.e., short-term trades settled by the delivery of the relevant product.

The primer, produced by the CFTC’s “LabCFTC,” is intended to be the first in a series of publications intended to help market participants understand technological innovation in the financial space and the CFTC’s role.

Lofchie Comment: The division of authority between the CFTC and the SEC can be quite complex.  That said, the CFTC is absolute correct in noting the fact that “virtual currency” or an “ICO” may be both (i) a “commodity” for purposes of the Commodity Exchange Act and (ii) a “security” for purposes of the securities laws.  The primer also correctly acknowledges that the CFTC does not have authority over ordinary cash-market transactions in a commodity, but only in derivative or certain financing transaction with respect to a commodity.  Accordingly, persons trading in these assets must be mindful that the terms of the transaction will determine the financial regulations to which they are subject.

CFS Monetary Measures for September 2017

Today we release CFS monetary and financial measures for September 2017. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.8% in September 2017 on a year-over-year basis versus 4.1% in August.

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’

Index Investing and Active Management…

The asset management industry has been disrupted by the trend toward increased index investing.  Over the years, CFS has explored this phenomenon.  As we look to dig deeper, we encourage members and friends to share insights, papers, or studies.

Although it is rare for us to distribute company research, BlackRock’s “Index Investing Supports Vibrant Capital Markets” is well worth a read.  The piece addresses many elements in the active versus passive debate as well as establishes useful concepts from a practitioners’ point of view.

Key themes include:

  • Index investing is still small or less than 20% of global equities,
  • Asset owners and managers sport different strategies and interests,
  • The balance between active and index management may ultimately be self regulating,
  • Passive owner corporate voting records are mixed between favoring both management versus activist investors.

As the trend will influence the future of the industry, many have raised questions regarding the impact of the move toward index investing in financial stability more broadly.

CFS welcomes and encourages view points and research on all sides of the discussion.  Please email any papers to Lauren Cooper, manager of communications ( or me.

“Index Investing Supports Vibrant Capital Markets” can be found at:

CFTC, EU Make Comparability Determinations on Margin Requirements for Uncleared Swaps

The CFTC approved a comparability determination that European Union (“EU”) margin requirements for uncleared swaps are comparable in outcome to relevant CFTC Regulations. The European Commission announced a similar equivalence decision that the CFTC uncleared margin rules are comparable to the EU’s requirements.

The CFTC determination generally allows swap dealers that comply with the EU margin requirements, in circumstances enumerated in the CFTC Regulation 23.160, to be deemed to be in compliance with CFTC requirements. Such swap dealers would remain subject to CFTC examination and enforcement authority. CFTC Letter 17-22, which extended exemptive relief to certain swap dealers that are subject to both U.S. and European margin requirements for uncleared swaps, is no longer applicable.

In addition, the CFTC announced that the CFTC and the EC have agreed to a “common approach” for certain authorized trading venues. Under the common approach, the CFTC plans to grant relief to certain EU trading venues from the swap execution facility (“SEF”) registration requirement, provided they satisfy the “comparable and comprehensive” standard for exemptive relief under CEA Section 5h(g). The EU would propose a corresponding equivalence decision recognizing CFTC-authorized SEFs and designated contract markets as eligible venues.

CFTC Chair J. Christopher Giancarlo characterized the cooperative efforts as an important step in cross-border harmonization:

“These cross-border measures will provide certainty to market participants. It will ensure that our global markets are not stifled by fragmentation, inefficiencies, and higher costs. Indeed these measures are critical to maintaining the integrity of our swaps markets.”


Lofchie Comment: This is a significant step by the CFTC both in improving relationships with the Europeans and in accomplishing Chair Giancarlo’s goals of facilitating the ability of firms to transact globally and undoing the geographic market fragmentation that had resulted from the post Dodd-Frank regulatory regime.  One can guess that the Chair will next turn attention to improving the rules for trading on U.S. swap execution facilities, which will benefit the competitiveness of the United States as a financial center.