About Steven Lofchie

Steven Lofchie is Senior Fellow of Legal Studies at the Center for Financial Stability and Co-chairman of the Financial Services Department at Cadwalader, Wickersham & Taft LLP.

Federal Reserve Board Governor Powell Advocates Additional Regulatory Reform

At the Salzburg Global Seminar, Federal Reserve Board Governor Jerome H. Powell lauded the progress made by the U.S. financial system since the financial crises, particularly in the increased liquidity and improved loss-absorbing capacity of banks. Mr. Powell identified five “key areas” that would benefit from additional regulatory reform:

  • Small banks: Continue to improve regulations governing call reports and the frequency of examinations by simplifying the general capital framework for community banks.
  • Resolution plans: Extend the living will submission cycle from once a year to once every two years, and focus every other filing on key topics of interest and material changes from the previous year.
  • Volcker Rule: Work together with the other four Volcker Rule agencies to reevaluate the rule and ensure that it delivers policy objectives effectively.
  • Stress testing: Evaluate stress testing and comprehensive capital analysis and review, including through public feedback, in order to improve transparency of process.
  • Leverage ratio: Reexamine enhanced supplementary leverage ratio in order to adhere to the proper calibration of leverage ratio and risk-based capital requirements.

 

SEC Economist Examines Role of Artificial Intelligence

SEC Division of Economic and Risk Analysis Acting Director and Chief Economist Scott Baugess discussed the development and use of artificial intelligence and machine learning within the SEC, challenges presented by artificial intelligence technologies, and the future of these technologies within the SEC.

Mr. Baugess explained that progress in development of artificial intelligence technologies has made it necessary for regulators to examine the potential uses and impacts of this technology on the regulatory environment. He observed that while there is obvious value in potentially being able to more effectively predict investor behavior, “latent variables,” such as fraud which is not seen until it is found, make understanding likely outcomes an especially difficult task. Because of these unobservable outcomes and other difficulties such as translating languages, the application of machine learning to regulating financial markets is less straightforward than it is in other contexts.

Machine learning has been utilized by the SEC in various capacities, including to analyze tips, complaints and referrals and to identify abnormal disclosures. Mr. Baugess noted that machine learning is also useful for detecting potential investment adviser misconduct by identifying outlier reporting behaviors. While acknowledging the value of this form of analysis, he cautioned that reliance on machine learning technologies, such as feeding the results of unsupervised learning algorithms into machine learning, can lead to false positives, or instances where misconduct or SEC rule violation is errantly identified.

Mr. Baugess concluded by emphasizing that although machine learning will improve the SEC’s ability to identify possible fraud or misconduct, he expects that “human expertise and evaluations” will always be necessary in the regulation of capital markets.

Lofchie Comment: This is technology expertise that the SEC should consider outsourcing. Perhaps the SEC should call up the credit card companies and ask them for some lessons in catching fraudulent transactions.

SEC Chair Clayton Expresses Concern over Decline of U.S. IPO Activity

At an SEC Investor Advisory Committee (the “Committee”) meeting focused on capital formation, SEC Chair Jay Clayton described negative market consequences stemming from a decline in the number of initial public offerings (“IPOs”). He stated:

“The substantial decline in the number of U.S. IPOs and publicly listed companies in recent years is of great concern to me. Some companies have shifted capital raising activities to the private markets, where many Main Street Americans have limited access. High-quality companies may choose to go public at a later stage, after much of their early growth has already been achieved. Other companies may choose to stay private. This ultimately results in fewer opportunities for Main Street Americans to share in our economy’s growth, at a time when we are asking them to do more on their own to save and invest for their future and their children’s futures.”

The June 22, 2017 Committee meeting included a panel on “Capital Formation, Smaller Companies, and the Declining Number of Initial Public Offerings.” A presentation prepared by Cowen Inc. President Jeffrey M. Solomon contained recommendations for improving the small cap market, such as relaxing rules associated with running small funds, as well as exploring measures to make the equity market structure more conducive for small caps.

In general, Chair Clayton explained, the SEC is focused on protecting retail investors, particularly older investors, by providing enhanced resources that can help them to make informed decisions. He added that the SEC will continue to prioritize price transparency for retail investors in the fixed-income markets.

Lofchie Comment: The priorities and concerns of the new SEC Chair are consistent with the traditional missions of the SEC; e.g., the promotion of capital formation and investor protection. This is likely to result in less attention to more political issues, such as conflict minerals and executive compensation disclosures.

Bitcoin Exchanges Targeted in Cyberattacks

At least two prominent bitcoin exchanges were targeted by cyberattacks that interrupted normal operations and trading.

BTC-e and Bitfinex were targeted by distributed denial-of-service (“DDoS”) attacks, a form of cyberattack which typically uses multiple compromised systems to flood a target with message traffic that exceeds its processing capacity.  The attacks temporarily disrupted service for both exchanges but reportedly did not cause a loss of funds or protected information. According to a CNBC report, service interruptions like those caused by the DDoS attacks could allow traders to “manipulate the bitcoin market.”

Both exchanges have resumed normal service.

Federal Register: Treasury Asks Public to Help Reduce Regulatory Burdens

The U.S. Treasury Department (“Treasury”) requested recommendations and information from the public to identify Treasury regulations that can be “eliminated, modified, or streamlined in order to reduce burdens.”

The request was issued in response to Executive Order 13777 (“Enforcing the Regulatory Reform Agenda”), which requires regulatory agencies to form task forces that help to implement previous orders focused on regulatory reform. The Treasury asked that submissions (i) identify regulations by titles and citations to the Code of Federal Regulations, and (ii) explain how the regulations could be modified, if appropriate, or why they should be eliminated.

Comments must be submitted by July 31, 2017.

Lofchie Comment: The Treasury’s request for public input follows immediately on the heels of their real-world critique of problems with the current regulatory system (see Treasury Gets Specific, Recommends Significant Regulatory Reform). Market participants should take up the Treasury on this request for comment. The new regulators appear to be concerned with real, practical problems, such as duplicate or ambiguous regulatory requirements, regulatory costs, diminished liquidity and market fragmentation.

Treasury Gets Specific, Recommends Significant Regulatory Reform

The U.S. Treasury Department (“Treasury”) released a report pursuant to President Trump’s February Executive Order establishing core principles for improving the financial system (see previous coverage). Drafted under the direction of Treasury Secretary Steven T. Mnuchin, the report is the first of a four-part series on regulatory reform and covers the financial regulation of depository institutions. Subsequent reports will focus on areas including markets, liquidity, central clearing, financial products, asset management, insurance and innovation.

The report contained the following Treasury recommendations, among others:

  • Capital and Liquidity: (i) raise the threshold for participation in company-run stress tests to $50 billion in total assets (from the current threshold of more than $10 billion), (ii) tailor the application of the liquidity coverage ratio appropriately to include only global systemically important banks and internationally active bank holding companies, and (iii) remove U.S. Treasury securities, cash on deposit with central banks, and initial margin for centrally cleared derivatives, from the calculation of leverage exposure.
  • Volcker Rule: modify the Volcker Rule significantly, by (i) providing a full exemption for banks with $10 billion or less in total assets, and (ii) evaluating banks with greater than $10 billion in total assets based on the volume of their trading assets. Treasury also recommended a number of other measures to reduce regulatory burdens and simplify compliance, such as further clarifying the distinction between proprietary trading and market-making.
  • Stress Testing: increase the asset threshold from $10 billion to $50 billion, and allow regulatory agencies to make discretionary decisions for a bank with more than $50 billion in assets based on “business model, balance sheet, and organizational complexity.”
  • Consumer Financial Protection Bureau (“CFPB”): restructure the CFPB to provide for accountability and checks on the power of its director, or subject the agency’s funding to congressional appropriations. (Treasury criticized the “unaccountable structure and unduly broad regulatory powers” of the CFPB, and concluded that the structure and function of the agency has led to “regulatory abuses and excesses.”)
  • Residential Mortgage Lending: ease regulations on new mortgage originations to increase private-sector lending and decrease government-sponsored lending.

Treasury also outlined its support for the idea of creating an “off-ramp” from many regulatory requirements for highly capitalized banks. This approach would require an institution to elect to maintain a sufficiently high level of capital, such as a 10% non-risk weighted leverage ratio.

Lofchie Comment: At last, a regulatory discussion that says something more than “there was a financial crisis, so there must be more rules, and more rules will make us safer.” This report reads as if it was informed by real work experience. It is a recognition of both the costs and benefits of financial regulation.

The report is not an attack on government. While critical of Dodd-Frank, Treasury acknowledges the better aspects of it, particularly improvements in bank capital ratios. In sum, Treasury is making the point that Dodd-Frank is seven years old; hundreds of rules have been adopted under it, and the time has come to see what aspects of it are working or not. (If there is anyone out there who believes after seven years of Dodd-Frank that it’s all going swimmingly, that person is just not paying attention.)

The biggest question is whether those who have disagreements with the recommendations will argue why the particulars are wrong, or whether the debate will simply be about the evils of Wall Street and the Administration. After seven years of Dodd-Frank (did someone break a mirror?), it really is time to talk specifics.

House of Representatives Passes Financial CHOICE Act

On June 8, 2017, the House of Representatives passed the “Financial CHOICE Act of 2017” (H.R. 10) (the “CHOICE Act”). The vote was 233 to 186, largely along partisan lines. The CHOICE Act had been approved by the House Financial Services Committee on May 4, 2017. The bill is a major overhaul of the current financial services regulatory regime including a partial repeal of Dodd-Frank. (For previous Cabinet coverage of general provisions of the bill, see House Republicans Release Revised CHOICE Act.)

Financial Services Committee Chair Jeb Hensarling (R-TX) stated that the CHOICE Act would have a significant impact on the economic wellbeing of the United States:

“[The CHOICE Act] stands for economic growth for all, but bank bailouts for none. We will end bank bailouts once and for all. We will replace bailouts with bankruptcy. We will replace economic stagnation with a growing, healthy economy.”

FINRA Economists Report Mixed Progress in Securitized Asset Liquidity

FINRA’s Office of the Chief Economist published a research note authored by two staff members that examined the liquidity of securitized assets over the course of the last several years. The authors utilized FINRA Trade Reporting and Compliance Engine (“TRACE”) data to evaluate liquidity in (i) real estate securities (including MBSs, CMBSs, CMOs, and TBAs) and (ii) other categories of asset-backed securities, including credit cards, automobiles, and student loans. They found that bid-ask spreads are almost universally down and the price impact of trades has fallen in every security since 2012. However, the number and volume of new issues of securitized assets have not recovered to pre-crisis levels and trading volume is generally down for most categories of securitized assets.

FINRA also published a similar analysis dealing with corporate bond liquidity.

Lofchie Comment: Regulators tend to emphasize bid/offer spread as the key data point for assessing market liquidity. However, that is only one measure of liquidity, and arguably not a very important one. The metric that the regulators should focus on more is the amount of the available liquidity; i.e., the size of the bids and offers. In any case, the authors of this study concede that trading volume in certain products is materially down, which would obviously suggest that available liquidity is materially down, notwithstanding that the spreads between bids and offers have decreased.

DOL Debate on Fiduciary Rule Continues

Controversy over the decision by U.S. Labor Secretary Alexander Acosta to go live with the Fiduciary Rule continues.

The Labor Secretary was quoted as having given testimony to the effect that the process by which the rule was adopted was materially flawed and indicating that he intended to reconsider the rule, after it has gone into effect.

In a recent editorial published by The Hill, former SEC Commissioner Paul Atkins urged Secretary Acosta to again consider delaying implementation of the Fiduciary Rule, which is scheduled to become applicable on June 9, 2017. Secretary Acosta had announced on May 22, 2017 that the DOL would not delay the rule’s effective date any further. Mr. Atkins argued that in its current form, the rule threatens to result in meaningfully adverse economic consequences.

Mr. Atkins urged Secretary Acosta to delay the implementation date, cooperate with the SEC in developing fiduciary standards, and conduct a thorough study of the rule’s potential impact that would take more recent data into account. He suggested that the SEC’s June 1, 2017 request for comments on developing standards of conduct affords the DOL a channel through which to legally delay the effective date.

Mr. Atkins criticized the procedural history and development of the rule. He asserted that Secretary Acosta should pay particular attention to the DOL’s lack of cooperation with the SEC, and cited a 2016 U.S. Senate report that he believes indicates that appointees during the Obama administration “actively undermined SEC participation in the rule’s design.” Mr. Atkins also challenged the DOL’s claim that the rule will save investors $17 billion, and referred to an article in which former SEC economist Craig Lewis accused the DOL of “significantly overestimat[ing]” those potential savings.

Lofchie Comment: As Mr. Atkins points out, there are many good reasons for the DOL to delay the implementation of the fiduciary rule, including the current legal challenge before the U.S Court of Appeals for the Fifth Circuit, and the debatable assertion of “$17 billion” in savings made in a 2015 Council of Economic Advisers’ Report supporting the adoption of the rule. Further, the existence of two regulators, the DOL and the SEC, that each have independent suitability rules applicable to the same set of relationships and transactions, is simply bad government from a structural standpoint.

Given that, and given the criticism of the rule voiced by Secretary Acosta himself, it is somewhat unclear why the Secretary is not choosing to delay the Rule’s effective date.  The Secretary appears to be underestimating the disruption that may be caused by allowing a rule to go effective and then subsequently rescinding it or modifying it, as opposed to getting it right the first time.

Supreme Court Rules that SEC Disgorgement Claims Are Time-Limited

In Kokesh v. Securities and Exchange Commission (“Kokesh”), the Supreme Court held that a five-year statute of limitations applies to claims for the disgorgement of ill-gotten gains obtained through violations of federal securities laws. Kokesh follows the holding of Gabelli v. SEC in which the Supreme Court determined that the statute of limitations period applies when the SEC seeks monetary penalties.

In Kokesh, Justice Sonia Sotomayor (writing for a unanimous Supreme Court) held that disgorgement “bears all the hallmarks of a penalty” under 28 U.S.C. § 2462. The Court’s analysis was shaped by two guiding principles for determining whether sanctions represent penalties: (i) such penalties typically exist where the wrong that is to be redressed was committed against the public, and (ii) the purpose of a penalty is to deter similar conduct rather than to compensate a victim for loss. In Kokesh, the Supreme Court held that SEC disgorgement constitutes such a penalty.