Bank of England conference in honor of William A. Barnett – Call for papers extended

We are delighted to announce a conference in honor of CFS Director William A. Barnett at the Bank of England on May 23 – 24, 2017.

The call for papers has been extended to March 15, 2017.

Liquidity plays a pivotal role in financial markets, the banking sector, and the economy as a whole. Since the 2008-09 financial crisis, it has become increasingly necessary to understand the creation, dissemination, measurement and management of liquidity.

This conference seeks and invites proposals to understand and assess the macroeconomic implications of liquidity, the liquidity creation process, and the impacts of liquidity on financial markets and economic activity. Theoretical, empirical, quantitative, qualitative, institutional, and historical perspectives that address current theory and policy questions are welcome.

For details to attend the conference or submit papers:

Similarly, excellent peer reviewed papers will be considered for a special issue of the Journal of Financial Stability.

Treasury Secretary Nominee Clarifies Positions on Volcker Rule, Carried Interest

In written responses to the Senate Finance Committee, Treasury Secretary nominee Steven Mnuchin provided his views on a number of topics, including the carried interest on hedge funds and the Volcker Rule. Mr. Mnuchin stated that the administration’s tax plan would “recommend repealing carried interest on hedge funds.”

As to the Volcker Rule, Mr. Mnuchin suggested that the “proprietary trading” restrictions could be narrowed and the Volcker Rule applied only to FDIC-insured banks, not necessarily their affiliates. If confirmed as Chair of the Financial Stability Oversight Council, Mr. Mnuchin said he would “address the issue of the definition of the Volcker Rule to make sure that banks can provide the necessary liquidity for customer markets and address the issues” contained in a recent Fed working paper. Mr. Mnuchin stated that:

“I am supportive of the Volcker Rule to mitigate the impact that proprietary risk taking may have on a bank that benefits from federal deposit insurance. However, …we need to provide a proper definition of proprietary trading, such that we do not limit liquidity in needed markets….”

FINRA Prioritizes Compliance, Supervision and Risk Management in 2017

In a 2017 Regulatory and Examination Priorities Letter (“Priorities Letter”), FINRA identified compliance, supervision and risk management as primary areas for review.

FINRA stated that it will be focusing on the following issues, among others:

  • High-Risk and Recidivist Brokers. FINRA will enhance its approach to high-risk and recidivist brokers by reviewing firms’ (i) supervisory procedures for hiring or retaining statutorily disqualified and recidivist brokers, (ii) supervisory plans to prevent future misconduct, and (iii) branch office inspection programs and supervisory systems for branch and non-branch office locations.
  • Sales Practices. FINRA will evaluate firms’ (i) compliance and supervisory controls that are intended to protect senior investors, especially against microcap fraud schemes, (ii) reviews of product suitability and concentration in customer accounts, (iii) capacity to monitor the short-term trading of long-term products, (iv) procedures regarding registered and associated persons, and (v) compliance with social media supervisory and record-retention obligations.
  • Financial Risks. FINRA will examine firms’ (i) funding and liquidity plans, (ii) financial risk management practices, and (iii) implementation of the first phase of the new FINRA Rule 4210 margin requirements for covered agency transactions, which became effective on December 15, 2016.
  • Operational Risks. FINRA will assess firms’ (i) cybersecurity programs, (ii) internal supervisory controls testing, (iii) controls and supervision intended to protect customers’ assets, (iv) compliance with SEC Regulation SHO, (v) anti-money laundering programs, and (vi) application of exemptions and exclusions to municipal advisor registration requirements.
  • Market Integrity. FINRA will (i) monitor firms’ compliance with amended Order Audit Trail System rules, (ii) expand surveillance for cross-product manipulation to include trading in exchange-traded products, and (iii) supplement firms’ supervisory systems and procedures with “Cross-Market Equity Supervision Report Cards.” In addition, FINRA will (i) expand its Audit Trail Reporting Early Remediation Initiative to include Regulation NMS trade-throughs and locked and crossed markets, (ii) review firms’ compliance with Tick Size Pilot data collection obligations, and (iii) ensure that firms improve their Market Access Rule compliance by incorporating recommended best practices. FINRA also intends to review alternative trading systems’ customer disclosures and develop a pilot trading examination program in order to help “determine the value of conducting targeted examinations of some smaller firms that have historically not been subject to trading examinations due to their relatively low trading volume.” Lastly, FINRA will continue to expand its “fixed income surveillance program to include additional manipulation-based surveillance patterns, such as wash sales and interpositioning.”

Lofchie Comment: The new Priorities Letter offers a lot to talk about, since FINRA has managed to cover virtually every aspect of a firm’s business. It is incumbent on each firm to go through the letter carefully and scrutinize every relevant priority. The following areas might be of particular interest: (i) custody, (ii) seniors, (iii) improving the automation of “suitability” reviews (e.g., the ability to search for concentrated positions, or positions with excessive turnover), and (iv) cybersecurity training. Anti-money laundering enforcement actions have proved to be a treasure trove for financial regulators, so firms should continue to devote their attention to this area. Liquidity seems to be the odd item on FINRA’s list, since there are no real rules governing it, but rulemaking advances in that area should be expected in the near future, so regulators will be exploring ways to refine their understanding of best practices.

CFTC Commissioner Giancarlo Calls for “Clear-Eyed Attention” to Market Challenges

CFTC Commissioner Christopher Giancarlo addressed three “mega-trends” that are transforming global financial markets: technological disruptions, changing market liquidity and global fragmentation. In a speech before the ISDA Trade Execution Legal Forum, Commissioner Giancarlo called on the CFTC to “revisit its flawed swaps trading rules to better align them to market dynamics.”

In focusing on these mega-trends, Commissioner Giancarlo made clear that regulators must: (i) foster best practices for and harness the power of new trading technologies for the benefit of market participants and regulators; (ii) address the diminishing liquidity in trading markets; and (iii) review and reduce poorly designed rules and regulations that are causing “service-provider concentration and market fragmentation.”

Commissioner Giancarlo argued that “market regulators cannot continue to ignore the growing systemic risk caused by [global] market fragmentation,” and noted the importance of allowing U.S. swap intermediaries to “fairly compete” in world markets to reverse this fragmentation. Commissioner Giancarlo stated:

“Only with clear-eyed attention to the true challenges facing contemporary markets can we ever restore the market vitality that will be necessary for broad-based economic prosperity. Flourishing capital markets are the answer to U.S. and global economic woes, not diminished trading and risk transfer.”

In his criticism of post-crisis regulation, Commissioner Giancarlo observed that overseas market participants continue to avoid firms “bearing the scarlet letters of ‘U.S. person'” in certain swap markets to “steer clear” of the CFTC’s “problematic” regulatory regime.

On market liquidity, Mr. Giancarlo blamed prudential restrictions on bank capital along with the CFTC’s “flawed and restrictive swaps trading rules,” the evolution of some trading markets from dealer to agency models, and the impact of U.S. and European monetary policy for sudden volatility shocks that occur in today’s markets. He decried the practice by U.S. and foreign regulators to plow ahead with “capital constraining regulations” rather than to acknowledge and study the causes of changing market liquidity.

On disruptive technology, Mr. Giancarlo reiterated his opposition to proposed a Reg. AT provision allowing the CFTC to obtain trading system source code without a subpoena. He urged financial regulators to foster a regulatory environment “that spurs innovation” and allows market participants to develop and test innovation solutions “without fear of enforcement action and regulatory fines.”

He noted that the upcoming March 1, 2017 deadline for uncleared swap variation margin requirements “will pose a massive challenge for market participants.” Mr. Giancarlo concluded that “safe, sound and vibrant” global markets are needed for investment and risk management to escape the “new mediocre” of prolonged stagnation.

Lofchie Comment: During his term as Commissioner, Mr. Giancarlo pulled off a trifecta. He: (i) prevented the CFTC’s rules from getting any worse (i.e., neither the position limits rule nor Regulation AT was adopted in part because of Mr. Giancarlo’s work in calling attention to their deficiencies); (ii) kept the focus on issues affecting the market currently and likely to affect the market in the future; and (iii) remained civil yet steadfast with those with whom he had deep policy disagreements. In the new administration, his presence at the CFTC will be integral to the reexamination of the agency’s rules in order to determine what has been working and what has not.

CFTC Proposes Capital, Liquidity and Related Requirements for Swap Dealers

The CFTC approved proposed rules establishing minimum capital, liquidity, financial reporting and related requirements for CFTC-registered swap dealers (“SDs”) and major swap participants (“MSPs”). The proposed rules are a reproposal of rules previously proposed in 2011.

The proposed rules cover the follow areas related to SDs and MSPs:

  • capital requirements;
  • liquidity requirements;
  • financial recordkeeping and financial reporting;
  • obligation to notify regulators if a firm’s capital drops below certain levels; and
  • limitations on the withdrawal of capital and liquid assets.

The CFTC identified three approaches to allow firms to meet capital requirements:

  • an approach based on bank capital requirements that would be available to SDs that are subsidiaries of a bank holding company and thus subject to BHC capital requirements;
  • an approach modeled after the SEC’s capital requirements; and
  • a “tangible” net capital approach intended for a commercial enterprise, but that is also required to register as a swap dealer with the CFTC.

The proposal would establish certain liquidity, reporting and notification requirements, and would obligate entities covered by the proposal to keep current books and records in accordance with U.S. Generally Accepted Accounting Principles. Firms would be able to use models, although the models would have to be approved by the regulators. In addition, the rules provide for a “comparability” determination that will allow non-U.S. swap dealers that are not subject to regulation by the Federal Reserve Board to be subject to their home country capital rules.

There are currently 104 provisionally-registered swaps dealers (no registered major swap participants). Of those, 51 are not subject to the CFTC’s capital requirements because they are subject to U.S. bank requirements (including 36 which are non-U.S. banks having branches in the United States). Eight of the remaining swap dealers are already capital-regulated by the CFTC because they are FCMs, some of which are also SEC-registered broker-dealers. Of the remaining firms, some are subsidiaries of U.S. or non-U.S. bank holding companies or other entities subject to Basel-capital requirements that have sufficient capital to sustain their activities. Currently, there are no registered major swap participant and there is only one primarily commercial firm (Cargill) provisionally registered as a swap dealer with the CFTC.

In statements issued in connection with the reproposal, Chair Timothy Massad emphasized that the proposed requirements should avoid requiring all such firms to follow one approach. “Requiring all firms to follow one approach could favor one business model over another, and cause even greater concentration in the industry,” he said.

Commissioner J. Christopher Giancarlo expressed concerns regarding (i) the rule’s effect on smaller swap dealers and how much additional capital they may have to raise; (ii) the especially broad scope of the proposal; and (iii) the proposed capital model review and approval process.

Lofchie Comment: In terms of the substance of the rule requirements, the CFTC largely punted responsibility (and appropriately so) either to the banking regulators or to the SEC, both of which have significantly more expertise and staff to deal with these matters. It would have been messy for the CFTC and the SEC to take different approaches to capital requirements. Firms subject to regulation by both regulators would have been forced to comply with the more conservative set of rules in any case. In terms of process, the CFTC will wait and see what capital rules are eventually adopted by the SEC and then piggyback on them. For the CFTC, this is an entirely sensible way to go.  For firms that have an interest in the CFTC Rules, and will be subject to the “SEC version of the SEC rules, this means that they should concentrate on commenting on the actual SEC Rules, as the CFTC will likely follow along with whatever the SEC does.

In the Appendix, the CFTC reports the number of registered swap dealers and major swap participants. The numbers are revealing.

  • The CFTC stated that it had expected 300 swap dealers to register. Only 104 firms have done so. The costs associated with registration have likely caused numerous firms either to abandon dealing in swaps or to reduce their level of business below the de minimis level so as to not become subject to registration. Put differently, the regulations have led to a significant increase in the concentration of the swaps-dealing business. If the CFTC determines to reduce the level of business at which swap dealers are required to register, virtually all of the small unregistered swap dealers will further reduce their level of business or drop out of swaps dealing entirely. In short, Dodd-Frank has led to a significant accelerated concentration of swaps exposure.
  • There are no firms registered as a major swap participant. Not one. The registration requirements, applicable to large users of swaps that are not dealers, are absurd; it would be impossible for any non-dealer to comply with them. These provisions should be dropped from Dodd-Frank and the regulators should no longer waste time coming up with rules for registration categories that will apply to no one.
  • Congress gave no instruction as to how capital requirements could possibly be applied to a commercial entity that is a swap dealer. It simply does not work to have regulatory capital requirements (which largely require that a firm hold liquid financial assets) for commercial enterprises that own oil wells, related buildings and refineries. After years of struggling with how to make this round peg fit into a square hole, the CFTC essentially gave up (which was the rational thing to do). It set a low tangible capital requirement, which serves as an irrelevant fig leaf: a rule that the CFTC proposed merely because Congress required it to do so.

Currently, the CFTC does not have the expertise to supervise a models-based capital regime. Greater consideration should be given as to how this will work in practice.

OFR Paper Questions Whether Higher Capital Standards Reduce Bank Risks

An Office of Financial Research (“OFR”) working paper examined how risk-taking in the repurchase agreement (“repo”) market changed after the introduction of the Basel III supplementary leverage ratio (“SLR”) regulation for banks. The working paper found that broker-dealers owned by U.S. bank holding companies (“BHCs”) now borrow less in the repo market overall after the change, but a larger percentage of the borrowing is backed by more risky collateral.

The working paper considered that:

  • in theory, the SLR could incentivize BHC-owned broker-dealers subject to the SLR to: (i) reduce their activity in the repo market; (ii) reduce their use of lower risk collateral, such as government securities, to back repo; and (iii) increase their use of more price volatile collateral, such as equities;
  • such a change of behavior may: (i) have the unintended effect of reducing liquidity in the agency mortgage-backed securities (“MBS”) market; (ii) reduce the stability of BHC-affiliated broker-dealers’ repo funding, by limiting the ability to migrate triparty financing to blind-brokered and centrally-cleared repo venues in times of stress from a greater use of repo funding backed by non-government securities collateral; and (iii) encourage non-affiliated broker-dealers to play a large role in the repo market even as their regulatory regime has changed little post-crisis;
  • the leverage ratio as a risk-insensitive capital standard may encourage firms to increase the risk profile of their remaining activities – the SLR-driven results are relevant to ongoing policy discussions internationally about potentially increasing leverage ratio requirements for global systemically important banks;
  • regardless of whether a U.S. BHC-owned broker-dealer parent is above or below the SLR requirement, the announcement of this rule has disincentivized those dealers affiliated with BHCs from borrowing in triparty repo, particularly using Treasuries and agency MBS as collateral, and incentivized them to use riskier equity collateral; and
  • nonbank-affiliated broker-dealers are entering the repo market following the announcement of the SLR.

The working paper concluded:

Thus, the activity and importance of nonbank-affiliated broker-dealers in the triparty repo market appears to be growing in response to more stringent BHC capital standards that affect bank-affiliated dealers through consolidation.

This finding is persistent and may suggest the need to revisit regulatory requirements for broker-dealers, which have been subject to little change since the 2007-09 crisis, to prevent a buildup of risks in nonbank-affiliated broker-dealers.


Lofchie Comment: This paper demonstrates one of the more obvious flaws of the bank regulators’ new capital liquidity rules: simplistic, crude regulations (that do not distinguish between assets on the basis of their risk) have the effect of disincentivizing banks from holding safe assets, as opposed to risky assets, because both receive the same regulatory treatment. More specifically, the bank regulators have imposed regulations that are doing significant damage to the repo market for U.S. government securities and agency MBS market.  (For a defense of these capital liquidity requirements, see FDIC Vice Chair Defends Higher Leverage Ratio.)

Having demonstrated that the liquidity requirements have done damage to bank-affiliated broker-dealers, however, the paper seems to suggest that the same type of regulations should be extended to broker-dealers not affiliated with banks. The basis for this leap in logic is not clear. If a regulation is not working as intended, wouldn’t it make more sense to roll back the regulation going forward after receiving this feedback, rather than to extend it?

Streetwise Professor Claims “Brexit Horror Story” Highlights Dangers of Clearing Mandates

In his latest post on the Streetwise Professor blog, University of Houston Finance Professor Craig Pirrong described the “horror story” of systemic clearing mandates, and explained why he remains skeptical that regulators will “take heed of the lessons of Brexit and take measures to ensure that the next time it isn’t a head shot.”

Professor Pirrong argued that “clearing mandates have supersized the clearing system, and commensurately increased the amount of liquidity needed to meet margin calls.” He highlighted Brexit as a “harrowing example” of “how tightly coupled the system is,” and listed other risk factors that clearing corporations’ response to Brexit have demonstrated. Those risk factors include the following:

  • “[m]uch of the additional margin was to top up initial margin, meaning that the cash was sucked into the [central clearing parties] and kept there, rather than paid out to the net gainers, where it could have been recirculated”; and
  • “each [central clearing party] acted independently and called margin to protect its own interests” – which is “ironic, because one of the alleged justifications for clearing mandates was the externalities present in the [over-the-counter] derivatives markets.”

Professor Pirrong observed that Brexit might prove to be as instructive as it is “horrific”:

Horror stories are sometimes harmless ways to communicate real risks. Perhaps the Brexit event will be educational.

Nevertheless, he concluded, the “clearing mandate is a reality, and is almost certain to remain one.” Given that reality, he maintained, it is doubtful that “whatever is done will make the system able to survive The Big One.”

Lofchie Comment: With respect to central clearing, the systemic risk on which regulators have focused is that clearinghouses will fail. However, the greatest risk created by central clearing as mandated by Dodd-Frank is this: in an attempt to save themselves from the risk of failure, clearinghouses could use their ability to demand an unlimited amount of initial margin from clearing member participants and so drain needed liquidity from the financial system. In other words, clearinghouses likely would save themselves from going under by sucking all of the liquidity out of the financial system. This, in turn, could trigger the failure of clearing members, or their customers who are required to post additional margin. It also could cause a downward spiral of pricing, forcing market participants to liquidate positions in order to eliminate margin calls.

CFTC Commissioner Giancarlo Urges Regulators to Analyze Post-Dodd-Frank “Flash Crashes”

CFTC Commissioner J. Christopher Giancarlo called for a “thorough and unbiased analysis by U.S. financial regulators and their overseas counterparts of the systemic risk of unprecedented capital constraining regulations on global financial and risk-transfer markets.” Commissioner Giancarlo observed that there have been “at least twelve major flash crashes since the passage of the Dodd-Frank Act” including last week’s “abrupt ‘flash crash'” of the British pound. He asserted that:

[Regulators] can no longer continue to avoid the question of whether the amount of capital that bank regulators have caused financial institutions to take out of trading markets is at all calibrated to the amount of capital needed to be kept in global markets to support the health and durability of the global financial system [emphasis in original].

In reference to a Cabinet comment by Steve Lofchie on May 27, 2015, Commissioner Giancarlo asked the following question: “How big will the next flash crash have to be before we realize that markets in which few are able to take risks are markets that are very risky?”

Lofchie Comment: In addition to Commissioner Giancarlo’s concerns about market liquidity, his request for an “unbiased analysis” of the the systemic risk of “unprecedented capital constraining regulations on global financial and risk-transfer markets” is noteworthy. Regulators seem either reluctant or incapable of assessing whether their rulemakings have been successful, or whether certain benefits of the rulemakings might be outweighed by unintended consequences. On that topic, see this recent story about central clearing, in which we ask whether regulators are capable of judging their own work.


Comptroller Curry Asserts That Post-Crisis Financial System Is Stronger

Comptroller of the Currency Thomas J. Curry asserted that regulatory reforms since 2008 have improved capital, limited leverage, enhanced liquidity and improved supervision. In remarks at the 2016 Annual Robert Glauber Lecture at the Harvard Kennedy School, he stated that the U.S. “banking system is now as well capitalized as any in the world.”

Mr. Curry emphasized that:

  • Improving Capital. “The benefits of a strong banking system built on a strong capital base should not be forgotten in debates about striking the right balance in capital standards.”
  • Limiting Leverage. Leverage ratios should “serve as an additional line of defense, or backstop, to the risk-based capital measures.”
  • Enhancing Liquidity. Implementing the Liquidity Coverage Ratio and the proposed Net Stable Funding Ratio are “steps in the right direction.”
  • The importance of effective supervision is perhaps the crisis’ greatest lesson” – supervision is “the regulators’ primary means of affecting behavior and promoting a healthy risk culture.”

He asserted:

In the end, the measure of this work is whether the financial system is now stronger, more resilient, and more capable of satisfying the financial needs of the United States, and can adapt to changing consumer demands, market opportunities, and new technology. I think that answer is “yes.”

Mr. Curry cautioned regulators that “now is not the time to let our guard down” and observed that “[t]hose who have been in this business for more than one cycle know a downturn will come,” he concluded that “lessons from 2008 were not really new lessons,” after all, but reminders of basic principles.

Lofchie Comment: Regulators may want to consider tempering these kinds of victory speeches with a little less self-congratulation and a little more reflection. Just by the law of averages, not every rule works or is worthwhile. Regulators may want to allow for the possibility that the massive regulatory burdens that have been imposed since the financial crisis may require some reconsideration.

Regulators might ask, for example, why so many community banks are shutting down at such a rapid rate. Or they might consider whether the combination of: (i) expensive new regulatory burdens, (ii) diminution of powers to engage in previously profitable activities, (iii) the effect of abnormally low interest rates and interest rate spreads, and (iv) competition from new fintech firms that create significant new issues for banks of all sizes could negatively affect a bank’s ability to cover its costs and what that might mean to the economy.

IOSCO Requests Comments on Study of Liquidity in Corporate Bond Markets

IOSCO requested comments on a consultation report reviewing liquidity issues in the secondary corporate bond markets. The study found no reliable evidence that liquidity in these markets deteriorated markedly from historic norms for non-crisis periods.

According to IOSCO, industry perceptions of the development of bond market liquidity between 2004 and 2015 are mixed but “the majority of both buy-side and sell-side respondents to the IOSCO survey perceive market liquidity to have decreased.” The report stated “these perceptions were generally based on personal experience and not supported with data or data analysis.” IOSCO stated, however that “[w]hile some of the relevant metrics (turnover ratio, dealer inventories, and block trade size) might indicate potential signs of lower liquidity, most metrics reviewed show mixed evidence of changes in liquidity (bifurcation of trading, average trade size, and average number of counterparties or market makers) or some evidence of improving liquidity (trading volume, bid-ask spreads, and price-impact measures).”

IOSCO noted that:

 . . . there is no reliable evidence that regulatory reforms have caused a substantial decline in the liquidity of the market, although regulators continue to monitor closely the impact of regulatory reforms.

IOSCO requested comments from market participants on the conclusion that bond market liquidity has not substantially declined. IOSCO also requested information about:

  • specific dealer inventory levels (gross and net) of corporate bonds held for the purpose of market making in corporate bonds, between 2004 to the present date;
  • statistics concerning dealer quoting behavior;
  • the number of counterparties that various buy-side and sell-side firms are trading with;
  • orders that investors tried to execute but could not do so for various reasons; and
  • the time it takes participants to execute trades in secondary corporate bond markets.

Comments on the report must be submitted by September 30, 2016.

Lofchie Comment: Market participants are adamant that liquidity has declined. Regulators are adamant that liquidity has not declined or that, if it has declined, it is because of factors other than regulatory change. Who, then, is one to believe? Consider this: the regulators control the terms of this debate; they put out the reports. Before embracing their position, here are a few observations that should give one pause:

First, the report concedes that “regulatory requirements, e.g., higher capital and leverage requirements, have reduced dealer ability and willingness to allocate capital to proprietary and market making activities, hold positions (particularly large inventories) in corporate bonds over time, and actively trade corporate bonds.” Given these changes in market regulation, it would actually be rather weird if liquidity had not declined. In fact, for it to keep steady, there would have to be some material liquidity-boosting developments in the market, but IOSCO does not report any.

Second, the regulators describe market participants’ perception as not being based on any reliable evidence. What the regulators really mean when they say this is that market participants are making a judgment based on their perceptions (rather than on having done studies independently) because as the regulators themselves concede, the evidence really does exist; it is just mixed.

Third, that the regulators and market participants are drawing opposite conclusions based on “mixed evidence” could indicate that different factors are being viewed as important. The regulators are asserting, for example, that the “bid/ask” spread is an important measure of liquidity. Conversely, market participants are saying that the bid/ask spread is less important than the size of the trade to which the spread relates. If the size of the trade is very small, the fact that the bid/ask spread is narrow is of much less relevance to them. So who is right as to which evidentiary measure is important? Here is one view: the persons who are the best judges of a product (which for this purpose includes a “market”) are those who actually use it; i.e., the market participants.