SEC Advisory Committee Considers Bond Market Liquidity

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 Proposes New Liquidity Reporting Requirements

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?

Treasury Releases Recommendations for Capital Markets Regulatory Reforms

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.

SEC Issues Report on Access to Capital and Market Liquidity

The SEC Division of Economic and Risk Analysis (“DERA”) issued a report on how Dodd-Frank and other financial regulations have impacted (i) access to capital and (ii) market liquidity.

The report contains analyses of recent academic work, as well as original DERA analyses of regulatory filings. The report is divided into two major parts: “Access to Capital – Primary Issuance” and “Market Liquidity.” Highlights of the DERA report include the following:

Access to Capital – Primary Issuance

  • Primary market security issuance has not decreased since the implementation of Dodd-Frank regulations.
  • Capital from initial public offerings has “ebb[ed] and flow[ed] over time,” and the post-crisis downturn is “broadly consistent with historical patterns of IPO waves.”
  • The introduction of the JOBS Act brought an increase in small-company IPOs, and “IPOs by [emerging growth companies] may be becoming the prevailing form of issuance in some sectors.”
  • Regulation A amendments, including an increase in the amount of capital allowed to be raised, resulted in an increase in Regulation A offerings.
  • JOBS Act crowdfunding provisions have allowed some firms to use crowdfunding to raise pre-revenue funds.
  • The private issuance of debt and equity increased significantly between 2012 and 2016, and amounts raised through exempt offerings were much higher than those raised through registered securities.

Market Liquidity

  • There is no evidence that the Volcker Rule has resulted in decreased liquidity, particularly with regard to U.S. Treasury Market liquidity.
  • Trading activity in the corporate bond trading markets has tended either to increase or to remain static.
  • The number of dealers participating in corporate bond markets has remained similar to pre-crisis numbers.
  • Dealers have reduced capital commitments, which is in line with regulatory changes, such as the Volcker Rule, that “potentially reduc[e] the liquidity position in corporate bonds.”
  • For small trades, transaction costs generally have decreased; DERA suggested that this might be due in part to the emergence of alternate trading systems as platforms for trading corporate bonds.
  • For certain larger or longer maturity corporate bonds, transaction costs have increased since post-crisis regulatory changes.

DERA noted that it is difficult to quantify the effects of particular regulatory reforms, and that a variety of factors may contribute to market conditions.

Lofchie Comment: The conclusion reached by the Division of Economic and Risk Analysis – that there is no clear link between the Volcker Rule and decreased liquidity – contrasts sharply with the recent U.S. Treasury Report, which concluded that the rule’s “implementation has hindered marketmaking functions necessary to ensure a healthy level of market liquidity.” Similarly, a September 2016 study by FRB staff found that the Volcker Rule has had a “deleterious effect” on corporate bond liquidity. According to that study, dealers that are subject to Volcker requirements become less likely to provide liquidity during times of market stress.

Notably, DERA found that intraday capital commitments by dealers have declined by 68%. It is difficult to understand how a reduction in dealer inventory of this scale has no effect on liquidity. If that is really the case, then DERA should do more to identify the countervailing reasons that would explain the constancy of liquidity.

SEC Commissioner Kara Stein Addresses Capital Markets Issues

SEC Commissioner Kara Stein shared her views on the current state of U.S. capital markets and addressed several key issues.

In remarks before the Healthy Market Structure Conference held in Boston, Commissioner Stein asserted that the relationship between issuers and investors should not be viewed as a “zero-sum game”; that both sides of the market spectrum benefit from strong market structures that address the needs of all participants.

Focusing on the issue of the decline of initial public offerings, Commissioner Stein explained that private equity capital and capital available through private debt allow companies to fund operations without turning to the public market. In an era of low interest rates, she said, companies often view debt financing as a tenable method of funding growth. Commissioner Stein admitted, however, that the regulatory environment has made “going public” less attractive. As a consequence of the decline, there has been a reduced volume of information available to the public, making price discovery more difficult for both public and private companies. She questioned whether a system that is affected by perpetual price discovery difficulties will eventually cause significantly adverse liquidity effects.

Commissioner Stein noted the effect of emerging technologies and their contribution to information disparities. In particular, she expressed concern about the effects of “dark pools” on price discovery. Commissioner Stein expressed hope that the SEC would move forward on initiatives to improve access to information as well as market transparency. She highlighted a 2016 SEC proposal regarding order routing disclosures and a 2015 SEC proposal regarding dark pool disclosure requirements as ripe for finalization.

Lofchie Comment: Commissioner Stein’s remarks point out a core conundrum. “More” regulation may have some benefits, but as the cost of those benefits increases, more issuers and investors determine that the costs of regulation outweigh those benefits. Regulators must confront honestly the trade-offs between the regulatory burdens that they impose and the number of issuers that will elect to operate under those burdens. Finding the right trade-off point is difficult, but before the search can begin, regulators must concede that there is a trade-off.

OCC Releases Semiannual Risk Report

The Office of the Comptroller of the Currency (“OCC”) described the principal risks facing national banks and federal savings associations in its Semiannual Risk Perspective for Spring 2017 (the “Report”).

In the Report, the OCC identified the following key risk themes:

  • strategic risk due to a changing regulatory climate, low interest rates and competition from nonfinancial firms, including fintech companies;
  • increased credit risk and relaxed underwriting standards due to strong risk appetite and competitive pressures;
  • elevated operational risk as a result of increased reliance on third-party service providers and attendant cybersecurity risks; and
  • high compliance risk as banks navigate money laundering risks and new consumer protection requirements.

OCC supervisory priorities for the next 12 months will remain broadly the same as in 2016 and will include the objective of identifying and assigning regulatory ratings and risk assessments. The OCC also pledged a continued commitment to monitoring and evaluating risks presented by third-party service providers.

In remarks on the Report, Acting Comptroller of the Currency Keith A. Noreika stated:

“The OCC employs a risk-focused approach to supervision, and tailors examination strategies to the individual risks of each of its supervised institutions and will pay close attention to these key risk areas over the next six months.”


Lofchie Comment: A material portion of the “risk” that banks face, according to the report, is regulatory risk. The Comptroller’s remark that “[m]ultiple new or amended regulations are posing challenges” to banks and the financial system also echoes the comment made by the SEC’s Investor Advocate in his recent report to Congress that he would “encourage Congress to consider giving the [SEC] a respite from statutory mandates” (at 3). It is clear that the very rate and extent of regulatory change has itself become a threat to the financial system.

FRB Governor Powell Examines Liquidity Risks in Central Clearing

At the Federal Reserve Bank of Chicago Symposium on Central Clearing, Board of Governors of the Federal Reserve System (“FRB”) Governor Jerome H. Powell detailed the risks faced by central counterparties (“CCPs”) and their members.

Because they advocated for central clearing, Mr. Powell noted, global authorities (i) have a responsibility to make sure that CCPs do not become a point of failure in the system and (ii) must ensure that bank capital rules do not discourage central clearing.

Regarding bank capital, Mr. Powell argued that the supplementary leverage ratio for U.S. global systemically important banks fails to account for the relatively low risk of central clearing, as compared to riskier activities, and could discourage central clearing. He explained that the Basel Committee on Banking Supervision is considering a “risk-sensitive” approach to evaluating counterparty credit risk for certain centrally cleared derivatives, which could help to encourage central clearing. He also noted that the FRB is considering implementing a “settlement-to-market” approach for some cleared derivatives that would treat daily variation margin as a settlement payment, which means that banks would not have to hold capital against it.

On the subject of liquidity, Mr. Powell outlined the risks associated with central clearing. He noted the challenges that CCPs face with regard to outgoing and incoming payment flows. In the event of a member default, for instance, CCPs would need to be able to convert large amounts of non-cash collateral into cash in order to make payments to non-defaulting parties. For that reason, they must have lines of credit and ready access to the repurchase market. Mr. Powell’s example of a payment flow challenge led him to consider where CCPs should store their available cash. He mentioned central bank deposits as a safe and flexible option.

Mr. Powell also described the risks associated with incoming payment flows. Market volatility can trigger events that lead to an abnormal number of margin calls, which, in the first instance, requires liquidity on the part of clearing members to meet the margin call. It also requires a series of payments to be made simultaneously, so that the CCPs can obtain funds from the settlement bank quickly to meet margin requirements for its members. (In most instances, clearing members have an hour to meet intraday margin calls.) By way of example, Mr. Powell noted that data from the CFTC suggests that the top five CCPs requested $27 billion in additional margin over the two days following the Brexit referendum, which is about five times the average amount. Fortunately, members and CCPs were prepared in that instance, and were able to make the necessary payments.

In order to manage liquidity risk, Mr. Powell suggested, regulators should conduct expanded stress tests for CCPs:

“Conducting supervisory stress tests on CCPs that take liquidity risks into account would help authorities better assess the resilience of the financial system. A stress test focused on cross-CCP liquidity risks could help to identify assumptions that are not mutually consistent; for example, if each CCP’s plans involve liquidating Treasuries, is it realistic to believe that every CCP could do so simultaneously?”

He also urged regulators to (i) facilitate innovations that help to reduce liquidity risks, such as exploring the utilization of distributed ledger technology, (ii) make Federal Reserve bank accounts available to major CCPs, and (iii) take global market implications into account when developing solutions for managing liquidity risk for CCPs.

Lofchie Comment: The CFTC and the banking industry have long argued that the Basel III capital rules that require banks to reserve against collateral posted to a central clearing agency are mistaken. Governor Powell is coming around belatedly to that view. The existence of central clearing parties does not decentralize risk; it concentrates it. Yet a further risk of clearing emphasized in Governor Powell’s remarks is the power that the clearing agencies have to suck tremendous amounts of liquidity out of the market: $27 billion of additional margin in the two days following Brexit. (What this means is that, in demanding more margin to protect their own liquidity in a financial crisis, clearing agencies may bring down everyone else.)

It is certainly time for a full review of the benefits and risks of central clearing. Many of the concerns raised by clearing skeptics are being proved valid.

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.


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.