University of Houston Finance Professor Craig Pirrong rejected current conjecture that recent market sell-offs are due to technology, such as automated, algorithmic or high-frequency trading.
In a recent blog post, Professor Pirrong addressed concerns that increasing automation is responsible for a lack of liquidity during downturns, stating “by virtually every measure, the increasing automation in markets has led to greater liquidity.” Moreover, he asserted that the fact that market makers pull back from supplying liquidity during downturns is not unique to HFT; according to Professor Pirrong, this occurred in similar downturns “long before markets went electronic.” The same is true for so-called “momentum trading,” which Professor Pirrong said “is something else that long predates the rise of the machines.”
Because stock market movements are often unexplainable, large moves of an adverse nature often result in a “search for villains and scapegoats,” an exercise that, according to Professor Pirrong, is fruitless. He further noted that:
“[t]he bottom line is that the stock market sometimes decline substantially, without any obvious cause. Indeed, the cause(s) of some of the biggest, fastest drops remain elusive decades after they occurred. This is true across virtually every institutional and technological trading environment, making it less likely that any particular selloff is uniquely attributable to a change in technology. Furthermore, large market moves in the absence of any decisive event or piece of news is not inconsistent with market “rationality”, or due to some behavioral anomaly (which is inherently human, by the way).”
Barbara Novick (BlackRock Vice Chairman and CFS Advisory Board Member) discussed financial industry transitions at the recent CFS Global Markets Workshop.
Presentation highlights include:
– Indexed equity strategies remain relatively small,
– Challenges of applying macroprudential tools to market finance,
– Potential risks to the US financial system from the future of Libor to bondholder rights to pension underfunding, among others.
For accompanying slides:
Federal Reserve Board (“FRB”) Vice Chair for Supervision Randal K. Quarles considered proposed changes to the FRB’s large bank stress testing regime that would increase transparency and efficiency.
In a speech at the Brookings Institution, Mr. Quarles said that the FRB is seeking to improve the measurement of trading book-related risks, and that a “single market shock” approach in existing stress testing practice does not adequately capture risks in firms’ trading books. He said that the proposed changes “are not intended to alter materially the overall level of capital in the system or the stringency of the regime.”
Mr. Quarles discussed changes to the Comprehensive Capital Analysis Review (“CCAR”) indicating that the FRB will reconsider whether any part of the regulatory capital rule (the stress capital buffer or “SCB”) proposal will remain for the 2019 CCAR. He said that he intends to request that the FRB exempt firms with less than $250 billion in assets from the 2019 CCAR quantitative assessment and supervisory stress testing in light of the FRB’s recent tailoring proposal. In addition, Mr. Quarles expressed his support for “normaliz[ing] the CCAR qualitative assessment” by (i) removing the public objection tool and (ii) evaluating firms’ stress testing practices through “normal supervision.”
Mr. Quarles stated that elements of the proposal to integrate stress testing with the stress capital buffer will be amended after receiving public comment. As a result, the SCB, which was scheduled for the 2019 stress test cycle, will be delayed. Mr. Quarles said that the first SCB may go into effect after 2020.
I had the pleasure of presenting “Central Banking East and West since the Crisis,” at a discussion hosted by the Shanghai Development Research Foundation (SDRF) and Friedrich Ebert Stiftung.
Key takeaways include:
- Much has changed in China and central banking in the last decade.
- Most analysis of central bank balance sheets fails to incorporate the impact of the People’s Bank of China (PBOC) on the provision of global liquidity. This is a critical error – especially as the Chinese yuan (CNY) moves toward reserve currency status.
- The Federal Reserve, PBOC, Bank of Japan, and Bank of England were early providers of global liquidity in the aftermath of the crisis. Yet, after 2011, central bank liquidity created distortions.
- Extraordinary monetary policies were far from costless.
- Analysis of speculative activity in futures markets after large injections of central bank liquidity reveals that:
- Speculative activity skyrockets.
- Net speculative long positions increase and push valuations upward.
- The volatility of investor positioning or investor switching behavior also increases.
- Removal of excess central bank liquidity remains one of the most formidable challenges for markets today.
For slides accompanying the presentation: www.CenterforFinancialStability.org/speeches/ShanghaiDRF_101518.pdf
On a parenthetical note, after over two decades of travel to China, this was one of my most extraordinary visits.
Federal banking regulators testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs on progress toward implementing the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Act”). As previously covered, the Act makes targeted changes to key areas of Dodd-Frank, which will primarily benefit smaller banking organizations with simpler business models. Testimony was provided by Comptroller of the Currency Joseph M. Otting; Federal Reserve Board (“FRB”) Vice Chair for Supervision Randal K. Quarles; FDIC Chair Jelena McWilliams; and National Credit Union Administration (“NCUA”) Chair J. Mark McWatters.
Mr. Otting, Mr. Quarles and Ms. McWilliams described various agency initiatives, including (i) the issuance of a notice of proposed rulemaking (“NPR”) that grants federal savings associations greater flexibility to exercise national bank powers without changing their charters, (ii) the issuance of a joint NPR to revise the statutory definition of a high-volatility commercial real estate exposure acquisition, development and construction loan, (iii) the adoption of interim final rules modifying the liquidity coverage ratio rule and (iv) the issuance of a joint agency proposal to raise the total asset threshold from $1 billion to $3 billion to allow well-capitalized insured depository institutions to be eligible for an 18-month examination cycle.
Mr. Otting noted that the Office of the Comptroller of the Currency also intends to:
- implement an exemption from appraisal requirements for certain rural real estate transactions;
- reduce the regulatory burden on banks for calculating and reporting regulatory capital;
- reduce reporting requirements on Call Reports;
- increase the required frequency of stress testing and reduce the required number of scenarios; and
- revise the leverage ratio requirements for the largest U.S. banking organizations.
Mr. Quarles stated that the FRB prioritized:
- issuing a proposed rule tailoring enhanced prudential standards for banks with assets between $100 billion and $250 billion;
- reviewing requirements for firms with assets between $250 billion and the globally systemic important bank threshold; and
- revisiting the threshold for the application of enhanced prudential standards to foreign banks.
Ms. McWilliams outlined the FDIC’s plans, which include:
- rule amendments to reflect the exemption for certain loans secured by real property;
- a proposed rule as to the community bank leverage ratio;
- updates to Call Report Instructions to reflect the reporting change from brokered to non-brokered treatment of specified reciprocal deposits; and
- reductions in reporting requirements for “covered depository institutions” with less than $5 billion total assets in the first and third quarter Call Reports.
Mr. McWatters discussed the NCUA’s recent actions and noted that the agency began to (i) update its examiner guidance and examination procedures, (ii) review credit union compliance in line with its risk-focused examination program and (iii) work with state supervisory authorities and other federal regulators to implement regulatory amendments.
In testimony before the U.S. House Committee on Financial Services, SEC Division of Investment Management (the “Division”) Director Dalia Blass outlined the following underlying aims of the Division: (i) improve the retail investor experience; (ii) modernize the regulatory framework and engagement; and (iii) utilize resources efficiently. The Division is working on the following rule proposals or potential rulemaking areas:
- propose Regulation Best Interest;
- modernize fund disclosure both by reviewing the content of disclosures and by allowing funds to provide shareholder reports online;
- improve disclosure as to variable annuities;
- finalize a rule for the issuance of exchange-traded funds (“ETFs”), so that the SEC exemptive process can more efficiently process exemptive relief requests for ETFs not within the scope of the rule;
- reduce obstacles to publishing research on investment funds in compliance with the Fair Access to Investment Research Act of 2017;
- harmonize and improve registration and reporting requirements for business development companies and closed-end registered investment companies (“RICs”);
- regulate the use of derivatives by RICs;
- publish guidance regarding valuation procedures;
- update investment adviser marketing rules;
- improve investment company liquidity disclosures;
- support fund innovation as to cryptocurrency-related holdings; and
- review the proxy process.
Lofchie Comment: While the SEC talks the talk as to facilitating innovation, walking the walk is far more difficult. ETFs, for example, have become a significant product in the financial markets, and yet the SEC is only now considering a rule to routinize their issuance. As to cryptocurrency funds, one really has to question whether the SEC wants them to go forward, or is hoping that interest in the product is a bubble that will pop before the SEC is pushed to act. Compare SEC Rejects Another Nine Proposed Bitcoin ETFs with SEC Commissioner Peirce Calls on SEC to Embrace Innovation and Allow Cryptocurrency Risk-Taking.
Board of Governors of the Federal Reserve System Vice Chair for Supervision Randal K. Quarles encouraged regulators to reconsider the capital and liquidity requirements for foreign banks operating in the United States. He also proposed a return to the pre-financial crisis regulatory goal of maximizing the flow of capital worldwide.
In an address at Harvard Law School, Mr. Quarles stated that the current U.S. approach to foreign banks, which prioritizes increasing the resiliency of their U.S. operations, should be reconsidered. He argued that the events of the last financial crisis, when foreign banks recovered through the combined efforts of the United States and their home country governments, created the current U.S. approach, which prioritizes ensuring that the United States has sufficient resources to address another such event. He stated that while most regulators seem to believe that intermediate holding company (“IHC”) and attendant requirements are appropriate, the regulation of the IHC could be modified without harming financial stability. He suggested that if the United States recalibrated its requirements, other jurisdictions would, too. This outcome, he argued, would increase the flow of capital, which should be the goal of regulators.
At its inaugural meeting, the SEC’s Fixed Income Market Structure Advisory Committee (“FIMSAC”) discussed bond market liquidity. FIMSAC was established in order “to provide a formal mechanism through which the Commission can receive advice and recommendations on fixed income market structure issues.”
In opening remarks, SEC Chair Jay Clayton explained that there is significant growth in the corporate bond and municipal bond markets and emphasized that fixed income markets have direct and indirect impacts on other markets. As a result, he said, these markets demand substantial attention from the SEC.
Commissioner Kara Stein highlighted the importance of growing fixed income markets and the transition of these markets from voice-based to electronic trading. She pointed to the impacts of the shifting markets: “spreads are tighter, trade sizes are smaller, and liquidity is increasingly concentrated in certain bonds.” Commissioner Michael Piwowar added that bond market liquidity is an important area of focus, as “fears of possible liquidity shocks persist.” He encouraged further analysis to inform the next steps that might be taken by regulators.
The meeting included perspectives from industry members on bond market liquidity.
The SEC also announced that it will not renew the charter for the Equity Market Structure Advisory Committee, which recently expired. Instead, the SEC will “organize targeted roundtables on discrete equity market structure issues, which will feature experts on each topic representative of a broad diversity of viewpoints.”
Lofchie Comment: Under the prior Administration, regulators simply refused to acknowledge that there were problems in the fixed income markets, perhaps because it would have meant acknowledging that there had been negative consequences to Dodd-Frank. The fact that spreads in certain securities declined, as Commissioner Stein noted, is not evidence of improved liquidity if the size of the orders as to which those spreads relate has declined substantially, or if those orders relate to a materially lesser number of securities. Leadership at the SEC seems to be returning to the regulatory basics: trying to figure out how the market works and how it can be improved.
FINRA requested comments on proposed amendments to FINRA Rule 4521 (Notifications, Questionnaires and Reports). The amendments are intended to “improve FINRA’s ability to monitor for events that signal an adverse change in the liquidity risk of the firms that would be subject to these new requirements.” The proposed amendments would require certain broker-dealers to notify FINRA within 48 hours of the occurrence of a material negative event with respect to the firm’s access to liquidity.
The amendments also include a new Supplemental Liquidity Schedule (“SLS”) that these broker-dealers would be required to file along with their FOCUS reports. Specifically, these firms would be required to report “information related to specified financing transactions and other sources or uses of liquidity” including the financing term, collateral types, and large counterparties.
The amendments would apply to carrying or clearing firms that have more than $25 million in total credits and firms with at least $1 billion aggregate amounts outstanding under repurchase agreements, securities loan contracts and bank loans. According to FINRA, approximately 110 firms would be subject to the new requirements, about half of which would be subsidiaries of bank holding companies.
Among the events that would trigger the requirement to notify FINRA of adverse liquidity events are the early termination by a counterparty of its financing agreement with a broker-dealer, a counterparty indicating that it will no longer provide financing to the broker-dealer, and a significant increase in the level of collateral required by a material counterparty.
Comments on the proposed amendments must be submitted by March 8, 2018.
Lofchie Comment: This rule will be adopted, in one form or another. Accordingly, firms planning to comment should focus on the specifics of the proposal’s requirements – most significantly, the information that they would be required to monitor. Firms should also consider whether the triggers for notification to the regulators have been set at an appropriate level.
Here are a few questions to consider: will the imposition of reporting requirements as to liquidity eventually result in the adoption by FINRA of substantive liquidity requirements? Once an information requirement is adopted, will the SEC and FINRA be satisfied with firms using their own judgment as to an acceptable level of liquidity?
The U.S. Treasury Department (“Treasury”) released a second report pursuant to President Donald J. Trump’s Executive Order establishing core principles for improving the financial system (see coverage of first report). The new report details plans to reduce burdens of capital markets regulation (see also Fact Sheet on report).
The report recommends supporting and promoting access to capital markets, reducing regulatory costs, making changes to market structure and modifying derivatives regulation to facilitate risk transfer.
In a “Table of Recommendations” (beginning on page 205), Treasury lists proposed recommendations. Some highlights include:
- Public Companies and IPOs (e.g., decrease the cost of being a public company by eliminating the conflict minerals rule);
- Challenges for Smaller Public Companies (e.g., increase the level at which a company may be considered “small”);
- Expanding Access to Capital Through Innovation (e.g., allow accredited investors to invest freely in crowdfunded offerings);
- Maintaining the Efficacy of Private Markets (e.g., expand the definition of accredited investor);
- Market Structure and Liquidity, Equities (e.g., allow smaller companies to limit the exchanges on which they trade to facilitate the development of centralized liquidity);
- Market Structure and Liquidity, Treasuries (e.g., provide greater support for the repo market);
- Market Structure and Liquidity, Corporate Bonds (e.g., improve liquidity);
- Securitization and Capital (e.g., simplify capital regulation of banks);
- Securitization and Liquidity (e.g., treat certain securitizations as liquid assets);
- Securitization and Risk Retention (e.g., provide exemptions from the risk retention requirements);
- Securitization and Disclosures (e.g., reduce the number of required reporting fields for registered deals);
- Derivatives and Harmonization Between the CFTC and SEC (e.g., the SEC should adopt its security-based swap rules);
- Derivatives and Margin Requirements for Uncleared Swaps (e.g., there should be exemptions from initial margin requirements between bank affiliates of a bank “consistent with the margin requirements of the CFTC and the corresponding non-US requirements”);
- Derivatives and CFTC Use of No-Action Letters (e.g., rules should be fixed so it is not necessary to rely on no-action letters);
- Derivatives and Cross-Border Issues (e.g., the U.S. regulators should work with global regulators on issues such as privacy);
- Derivatives and Capital Treatment in Support of Central Clearing (e.g., required capital should be reduced on centrally cleared transactions);
- Derivatives and Swap Dealer De Minimis Threshold (e.g., there should be no reduction in the de minimis threshhold for dealer registration);
- Derivatives and Definition of Financial Entity (e.g., modify the definition, presumably with the goal of reducing the central clearing requirement);
- Derivatives and Position Limits (e.g., adopt rules but provide hedging exemptions);
- Derivatives and SEF Execution Methods and MAT Process (e.g., permit a broader range of trading mechanisms);
- Derivatives and Swap Data Reporting (e.g., improve standardization of reporting requirements);
- Financial Market Utilities (e.g., consider providing “Fed access” to certain clearing corporations);
- Regulatory Structure and Processes, Restoration of Exemptive Authority (e.g., restore the SEC’s and CFTC’s plenary exemptive authority under the statutes that they monitor);
- Regulatory Structure and Processes, Improving Regulatory Policy Decision Making (e.g., adopt clear rules);
- Regulatory Structure and Processes, Self-Regulatory Organizations (e.g., better define the roles of the SROs in rulemaking); and
- Internal Aspects of Capital Market Regulation (e.g., U.S. regulators should seek to reach “outcomes based non discriminatory substituted compliance arrangements” with foreign regulators to mitigate “the effects of regulatory redundancy and conflict”).
Lofchie Comment: The prior Administration viewed financial markets as creators of risk that had to be controlled; this Administration appears to view financial markets as creators of growth that would benefit from decreased controls. This is simply a tremendous difference in perspective and tone.
There will and should be a fair amount of discussion over these many and specific recommendations. One broad recommendation, however, stands out: restoring to both the SEC and the CFTC complete exemptive authority as to the requirements of the statutes that they enforce. Depriving the regulators of this authority in the wake of the Congressional enthusiasm for Dodd-Frank had limited the regulators ability to fix Congressional mistakes and over-reaches in drafting. The prior Administration had simply become so locked into defending Dodd-Frank against any criticism that it had become impossible for the regulators to consider, or even discuss, what aspects of it might be working or not. The new Administration does not bear the burden of justification.