SEC Commissioner Urges New Approach to Equity Market Structure Regulation

SEC Commissioner Hester M. Peirce advocated for a more holistic retrospective review of equity markets regulation that focuses on the “assumptions underlying those rules” rather than the most recent adoptions.

At SIFMA’s market structure conference, Ms. Peirce encouraged regulators to address challenges in equity markets without accepting the current regulatory framework as a structure for all future reforms. Ms. Peirce explained that the regulators have focused on making “regulatory tweaks” to restrict market behavior instead of taking a holistic approach by questioning assumptions and the current regulatory status quo. As an example, Commissioner Peirce cited the Order Protection Rule, which, according to Ms. Peirce, has significantly impacted equity markets without sufficient justification. Additionally, Ms. Peirce argued that the rule “distorts” market behavior by (i) incentivizing broker-dealers to prioritize price in execution decisions above customer needs, (ii) increasing underlying issues of securities information processor feeds by expanding their importance, (iii) compelling brokers to subscribe to exchanges’ private data feeds as well as public tapes, and (iv) increasingly homogenizing trading facilities and exchanges. Ms. Peirce questioned whether the SEC should be exploring alternatives to the rule rather than continuing to offer up new regulatory tweaks that try to control the distorted behavior the rule itself creates.

Ms. Peirce advised regulators to consider:

  • acknowledging that efforts to “micromanage” communications and trade between market participants have been demonstrably ineffective;
  • eliminating burdensome market communication rules rather than proposing specific rules to remedy issues;
  • revising statutory and regulatory requirements, which currently deter new entrants and reduce diversity within investor services; and
  • favoring a more “agile” regulatory system for trading equities to address changing technology and investor needs, rather than a national market system.

Lofchie Comment: Regulation NMS was adopted over two dissents that were issued by SEC Commissioners Cynthia Glassman and Paul Atkins. The reasoning behind those dissents has been materially borne out. A reexamination of assumptions is in order.

Treasury Reports on Successful Deregulation Efforts

The U.S. Treasury Department (“Treasury”) issued a report listing its regulatory reform accomplishments. In the report, Treasury outlined the steps it had taken to execute Treasury-specific orders issued by President Trump, which include Executive Order 13777 (“Enforcing the Regulatory Reform Agenda”) and Executive Order 13771 (“Reducing Regulation and Controlling Regulatory Costs”). Since the release of E.O. 13777, Treasury:

  • reduced regulatory costs by (i) withdrawing 62 items from its Regulatory Agenda and (ii) moving 50 rules from active to long-term status;
  • proposed rulemakings to remove 298 duplicative, obsolete or unnecessarily burdensome tax regulations;
  • recommended the “reform or withdrawal of recent significant IRS regulations” in an October 2017 report;
  • urged the U.S. financial regulatory system (in a series of reports) to make the regulation of banks and credit unions, capital markets, and asset management and insurance more effective and precise;
  • pushed for the Financial Stability Oversight Council to implement reforms to prior designated non-bank financial companies as systemically significant; and
  • published a “critical evaluation” of the ban by the Consumer Financial Protection Bureau on arbitration clauses in financial contracts, which would have cost businesses and consumers billions before it was nullified by a Congressional Review Act resolution.

Lofchie Comment: Leaving aside the quality or benefit of individual regulations issued during the prior administration – an issue that can be fiercely debated – the sheer volume of new requirements was simply overwhelming to the markets. Keeping up with rulemaking became a major business; often more important than doing business. Respite is welcome.

FRB Governor Advocates for Cyclical Protections in Event of Economic Downturn

Board of Governors of the Federal Reserve System (“FRB”) Governor Lael Brainard urged the FRB and banking institutions to “safeguard” capital and liquidity protections as cyclical pressures increase.

In remarks at the Global Finance Forum in Washington D.C., Ms. Brainard stated that despite the overall strength of the banking system, there are areas of financial vulnerability. She stated that measures should be implemented to ensure that the system can withstand negative shocks. According to Ms. Brainard, areas of financial vulnerability include asset valuation and business leverage (in the non-financial business sector), that are high in comparison to “historic norms.”

Ms. Brainard summarized the FRB’s next regulatory steps. She reported that the FRB is close to (i) completing the net stable funding ratio to ensure that large banking firms maintain a stable funding profile past a one-year projection, and (ii) implementing Dodd-Frank Act limits on large counterparty exposures, which will reduce the ripple effect of financial distress. Ms. Brainard additionally advocated for efforts to improve the Volcker Rule so it can better serve its underlying purpose of prohibiting banking firms from certain speculative activities. She expressed her support for market-wide “minimum haircuts for securities financing transactions,” and for recalibrating the regulatory framework to reduce the burden on smaller banking firms.

Senate Votes to Repeal CFPB Auto-Loan Financing Regulatory Guidance

The U.S. Senate voted to repeal Consumer Financial Protection Bureau (“CFPB”) regulatory guidance on auto-loan financing, which purported to regulate discriminatory dealer markups on car loans to consumers.

The CFPB’s auto-lending regulatory guidance (“Bulletin“), although not a formal rule, allowed the CFPB to pursue legal claims against car dealerships that allegedly charged minority consumers higher interest rates on their auto loans. By enforcing regulatory guidance rather than developing a rule, the CFPB avoided the Administrative Procedures Act’s rulemaking process and related requirements.

In remarks before the Senate, Committee Chair Mike Crapo (R-ID) criticized the regulation, which he stated was implemented as an end run around required rulemaking procedures. Mr. Crapo also questioned the agency’s ability to enforce the rule, as Dodd-Frank does not authorize the CFPB to regulate auto-dealers. Citing an internal CFPB memo, Mr. Crapo referenced the CFPB’s decision not to develop a rule because it had “no regulatory authority” over auto-dealers. By sidestepping the legal process, Senator Crapo said, the CFPB had denied individuals and businesses the “vital” opportunity to provide feedback on the potential impact of the regulation.

House Financial Services Committee (“FSC”) Chair Jeb Hensarling (R-TX) supported the repeal, asserting the financial harm its enforcement has caused to credit-worthy consumers. The White House also commented on the matter, stating that the Bulletin reduces consumer choice and limits auto dealers’ ability to offer loans to consumers. If it is continued, Mr. Hensarling stated, then banks, credit unions and finance companies holding outstanding loans would face significant liability.

Committee Ranking Member Sherrod Brown (D-OH) denounced the vote and warned that preventing the CFPB from issuing future fair lending guidance could “permanently weaken federal anti-discrimination laws.”

The measure must now go to the House.

Lofchie Comment: Senator Brown’s criticism of the Senate’s action was phrased in dramatic language. His argument is flawed. According to Senator Brown, the Senate was acting to repeal what was intended to be mere “regulatory guidance,” which essentially advises parties as to what the law actually is. Assuming that he is correct in this statement, then the repeal of the guidance has no legal effect whatsoever: the law remains what it is. If in fact the guidance did change the law in any material way, then the “guidance” was really a rulemaking in sheep’s clothing, and the CFPB should have subjected the guidance to a formal rulemaking process. In short, either (i) repeal of the guidance is essentially legally meaningless or (ii) the guidance was illegally promulgated in violation of the Administrative Procedures Act.

In fact, the problem with the CFPB’s lender guidance is even more profound. The guidance was issued based upon a study conducted by the CFPB that was widely criticized as being based on extremely flawed data. Whether one agrees with that view or not, the CFPB was able to publish the study without dissent or a meaningful internal vetting process, and the guidance was not put through a rulemaking and comment process. That Dodd-Frank provides the head of the CFPB with such unchecked authority is a fundamental flaw in the legislation; one that Congress now has the opportunity to correct.

SEC Proposes “Retail Best Interest” Standard for Broker-Dealers; Fiduciary Interpretation for Advisers

The SEC proposed to (i) require broker-dealers to act in the “best interests” of retail customers when making a recommendation of any securities transaction or investment strategy and (ii) affirm and clarify the various types of obligations that investment advisers owe to their clients. The proposal was approved by a four-to-one vote. SEC Commissioner Kara M. Stein dissented.

Under Regulation Best Interest, a broker-dealer would not be permitted to place its own interests ahead of those of its retail clients. The proposed regulation provides that a broker-dealer will satisfy the best interest standard if it complies with the following obligations:

  • Disclosure: disclose material information about the relationship with the retail customer, including material conflicts of interest;
  • Care: act with reasonable “diligence, care, skill and prudence to (i) understand the product; (ii) have a reasonable basis to believe that the product is in the retail customer’s best interest; and (iii) have a reasonable basis to believe that a series of transactions is in the retail customer’s best interest”; and
  • Conflict of Interest: implement policies and procedures reasonably designed to identify and address conflicts of interest arising from financial incentives, and to disclose any other material conflicts of interest.

The SEC stated that the “Commission believes that material conflicts of interest associated with the broker-dealer relationship need to be well understood by the retail customer and, in some cases, mitigated or eliminated” [at fn 17].

As to litigation that might arise under Regulation Best Interest, the release states that the Regulation “would not alter a broker-dealer’s obligations under the general antifraud provisions of the federal securities laws . . .  [nor would it] create any new private right of action.” On the other hand, the SEC stated, “scienter would not be required to establish a violation of Regulation Best Interest.” Further, “as compared to a broker-dealer’s existing suitability obligations under the antifraud provisions of the federal securities laws . . . a broker-dealer would not be able to satisfy its ‘Care Obligation’ . . . through disclosure alone.”

In addition, the SEC proposed an interpretation reaffirming and/or clarifying certain aspects of the fiduciary duty that investment advisers owe to their clients. These duties owed by an adviser to a customer include (i) a “duty of care” (including the obligation to provide advice in the client’s best interest, a duty to seek best execution, and a duty to provide advice and monitoring over the course of the relationship) and (ii) a “duty of loyalty.” The SEC also asked for comments as to whether adviser regulation should be expanded so that it mirrors broker-dealer regulation. In particular, the SEC requested comments as to whether (i) the employees of investment advisers should be subject to federal licensing and qualification requirements; (ii) advisers should be required to provide more detailed statements of the fees that they charge; and (iii) advisers should be either subject to capital requirements or forced to obtain fidelity bonds that might compensate clients for losses due to the advisers’ misconduct.

Finally, the SEC proposed a rule that would require broker-dealers and investment advisers to provide retail investors with a short-form “relationship summary” detailing (i) certain information related to services offered, including the legal standard that applies to each type, (ii) associated fees, and (iii) conflicts of interest.

There will be a 90-day public comment period on these proposed rules and interpretations after their publication in the Federal Register.

Lofchie Comment: There is quite a lot here (the Release for Regulation Best Interest tops 400 pages), including a good deal that could have a significant effect on the products that firms offer and the way in which broker-dealers conduct business. For example, broker-dealers will need to examine closely (i) the types of products that they offer (particularly proprietary, complex or structured products), (ii) the manner in which they compensate their employees, (iii) the manner in which they charge fees to their customers and (iv) the provision of different benefits to different customers (see pages 53-4).

The obligations that may be imposed on advisers, though not fundamentally different than those that are understood to exist today, may have been increased. The Fiduciary Release (which runs a mere 38 pages) says at page 21 that they have not been increased; just clarified. However, the release suggests the possibility for significantly expanded private rights of action and litigation under the Advisers Act. For example, the Advisers Act is described as having “establishe[d] a federal fiduciary standard for investment advisers” (fn. 10) . . . that is “made enforceable by the antifraud provisions of the Advisers Act.” As to the specific duties imposed on advisers, firms should consider, for example, (i) their obligations to obtain information regarding each client’s situation through the “client investment profile,” (ii) their obligation to provide investment advice that takes account of the client’s entire circumstances (going beyond the particular investments recommended or purchased), and (iii) the adviser’s obligation to provide advice to a client “at a frequency that is both in the best interest of the client and consistent with the scope of advisory services agreed. . . . The duty to provide advice and monitoring is particularly important for an adviser that has an ongoing relationship with a client.”

President Trump Names FRB, CFTC Nominees

President Donald J. Trump nominated Dan Berkovitz to serve as a CFTC Commissioner and Michelle Bowman and Richard Clarida to serve on the Board of Governors of the Federal Reserve System.

Mr. Berkovitz was nominated to serve the remainder of a five-year term. He is a partner at WilmerHale and vice chair of the American Bar Association Committee on Futures and Derivatives. Mr. Berkovitz previously was CFTC General Counsel and Deputy Representative to the Financial Stability Oversight Council. He also served as a senior staff lawyer for the Senate Permanent Subcommittee on Investigations and Deputy Assistant Secretary in the Department of Energy Office of Environmental Management.

Ms. Bowman was nominated to serve the remainder of a 14-year term set to expire in 2020. She is currently the Kansas State Bank Commissioner and previously was an executive at Farmers and Drovers Bank. Ms. Bowman served in government in several capacities including as a staffer for Senator Bob Dole, Counsel for several House committees, Director of Congressional and Intergovernmental Affairs at the Federal Emergency Management Agency, and Deputy Assistant Secretary and Policy Advisor to Secretary Tom Ridge at the Department of Homeland Security.

Mr. Clarida was nominated to serve a four-year term as Vice Chair of the FRB. Mr. Clarida is currently the Lowell Harriss Professor of Economics at Columbia University. He is also a Global Strategic Advisor for PIMCO and a member of the Council on Foreign Relations. Mr. Clarida previously served as Assistant Secretary for Economic Policy at the U.S. Treasury and was a Senior Staff Economist with President Ronald Reagan’s Council of Economic Advisers.

CFS Monetary Measures for March 2018

Today we release CFS monetary and financial measures for March 2018. CFS Divisia M4, which is the broadest and most important measure of money, grew by 5.0% in March 2018 on a year-over-year basis, maintaining the same growth rate as in February.

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’

CFTC Chair Characterizes New Approach to Swaps Regulation as “Principles Based”

In advance of the release of a new framework for swaps reform, CFTC Chair J. Christopher Giancarlo declared that the CFTC would return to its “historic character” as a “principles-based regulator.”

In remarks at the Sims Lecture at Vanderbilt Law School, Mr. Giancarlo stated that it is crucial for the CFTC to rely on its core principles when interpreting the application of the law. Mr. Giancarlo stated that the agency had strayed from its “principles-based” approach with respect to the swap market reforms under the Dodd-Frank Act. He confirmed that the CFTC is taking steps to improve the regulation of the swaps market. Among other initiatives, the CFTC will be releasing an improved framework known as “Swaps Reform Version 2.0.”

Mr. Giancarlo also called for the agency to continuously review past policy applications to confirm that they remain optimized for the purposes intended and to rely on its core principles in areas where legislation is outdated. As an example, Mr. Giancarlo noted that legislation has not kept pace with technology, specifically with respect to cryptocurrency. He stated: “[w]hen it comes to the challenge of crypto, it is clear that our governing statutes were not designed for this technology.”

Lofchie Comment: CFTC Chair Giancarlo’s remark that the CFTC had strayed from its prior principles-based approach is notable. The assertion permits re-examination of the CFTC’s trading rules with respect to swaps, where the details of the CFTC’s requirements arguably diverged substantially from existing market practices and have drawn criticism from both sell- and buy-side market participants.

CFPB Acting Director Calls for Agency Restructuring

In testimony before the Senate Banking Committee, Consumer Financial Protection Bureau (“CFPB”) Acting Director Mick Mulvaney outlined his recommendations for curbing the power and authority of the CFPB. Mr. Mulvaney addressed recent recommendations from the CFPB Semi-Annual Report.

Mr. Mulvaney echoed his request for Congress to (i) require the CFPB to obtain funding through Congressional appropriations, (ii) require legislative approval for major rules, (iii) install an independent Inspector General to oversee operations, and (iv) ensure that the CFPB is accountable to the president. Committee Chair Mike Crapo (R-ID) said that the “fundamental structure” of the CFPB should be altered in order to foster greater transparency and accountability. He called for a “bipartisan commission,” as opposed to the current single-director structure, and expressed support for Mr. Mulvaney’s request for funding dictated by Congressional appropriations rather than drawn from the Federal Reserve.

Committee Ranking Member Sherrod Brown (D-OH) charged that Mr. Mulvaney was appointed illegally, and accused him of waging a “war on working families” while “handing out favors to Wall Street and shady lenders.” Mr. Brown asserted that Mr. Mulvaney has given outsized salaries to his appointees at the CFPB, and condemned his decision not to pursue enforcement actions against payday lenders. Senator Elizabeth Warren (D-MA) denounced Mr. Mulvaney’s plans to “kill” the CFPB, and argued that he is “hurting real people [in order] to score cheap political points.”

In a previous letter to Senator Warren, Mr. Mulvaney said that his recommendations are intended to better align CFPB function with Congressional intent. Mr. Mulvaney said that the CFPB is uniquely insulated from congressional and executive oversight, and argued that changing the structure of the agency is necessary in order to make it “permanently accountable and transparent.”

Lofchie Comment: Mr. Mulvaney argues that the CFPB should be made into an ordinary regulatory agency, accountable to Congress and with leadership composed of members of both political parties. Senator Warren’s argument that Mr. Mulvaney is “killing” the CFPB by suggesting that Congress should have authority over it is very strange, particularly given the conventional wisdom that Democrats will attain a majority in at least one house of Congress in the next election.

Rather than denounce Mr. Mulvaney, Senator Warren and Senator Brown might consider adopting his suggestions, which would give the Democrats institutional representation at the CFPB and continuing non-partisan insight as to its activities. In this way, the Senators would improve the long-term operation of the CFPB by allowing for genuine Congressional control over its budget, activities and leadership; and by assuring that there would be CFPB Commissioners representative of both parties.

CPMI and IOSCO Publish Revised CCP Stress Testing Framework

The Committee on Payments and Market Infrastructures (“CPMI”) and IOSCO published revised guidance for regulators on designing and operating supervisory stress tests for central counterparties (“CCPs”).

The report, Framework for supervisory stress testing of central counterparties, provides a “non-prescriptive approach” to stress testing of CCPs. The framework is macroprudentially oriented; that is, it is intended to be used to analyze systemic effects of multiple CCPs responding to the same stress event(s). As previously covered, the CPMI and IOSCO requested feedback on an earlier draft, which informed this final version.

The report outlines the following:

  • questions to consider before executing a supervisory stress test;
  • establishing distinct roles and responsibilities for all participants;
  • key elements for creating stress test scenarios;
  • determining data needs and measures for data validation;
  • applying risk exposures to scenarios and aggregating results; and
  • using test results and adhering to disclosure requirements.

Lofchie Comment: The real question is not whether the CCPs can survive; the real question continues to be whether they can survive without bringing down their participants. The regulators need to expand their analysis to consider the risk that when the CCPs are in trouble, they will demand more capital and collateral from their participants, thereby sucking liquidity out of the system, and forcing a further selldown of the market as CCP participants liquidate customer and proprietary positions.