GAO Report Examines Regulatory Analyses and Coordination Efforts Conducted by Federal Financial Regulators

The U.S. Government Accountability Office (“GAO”) issued a study describing the extent to which regulators responsible for adopting rules under Dodd-Frank conducted economic analysis of various rulemakings and the extent to which the regulators coordinated their rulemakings. The study also attempted to determine the benefits of Dodd-Frank.

GAO found that regulators coordinated on 34 of the 54 Dodd-Frank rulemakings reviewed. According to GAO, regulators face data and modeling challenges in their consideration of the costs and benefits of their rulemakings, particularly for more complex rules intended to address systemic risk or market stability.

Regarding the the Volcker Rule, GAO found that interagency coordination led regulators to adopt a common rule, and that regulators voluntarily coordinated efforts during the rule’s implementation. For swaps rulemakings, GAO found that regulators coordinated domestically and internationally; however, such coordination did not always result in harmonized rules, and key differences among some of the rules raised compliance and market efficiency concerns among market participants.

The report found that some updates in indicators suggest that large U.S. bank holding companies’ leverage decreased and liquidity improved since Dodd-Frank’s passage. Additionally, GAO’s updated regression analysis suggested that Dodd-Frank continued to have little effect on the funding costs of these companies, and may be associated with improvement in their “safety and soundness.”

Furthermore, the report found that although the margin rules for uncleared swaps have not been finalized, indicators suggest that holding companies have been requiring their counterparties to post a greater amount of collateral against derivatives contracts.

Lofchie Comment: The report contains good data, though there is a limited amount of useful information. For example, the report indicates that a regulator conducted a particular study, but does not discuss whether the study served a specific purpose. It is, therefore, difficult to assess whether the study represents anything more than a nod to a statutory obligation.

Generally, the GAO was able to combine a high degree of honesty with a gentle tone in critiquing the various regulators whose work it audited. The supporters of Dodd-Frank will find little in the report to suggest that the statute has been successful. The report indicates that the capital leverage ratio at banks improved for a variety of reasons, but it does not address whether the Dodd-Frank’s requirements (as opposed to just the presence of higher ratios) are sound economically. More negatively, the report suggests that the swaps regulations fragmented capital markets, to the detriment of both the United States and Europe. Likewise, the report suggests that the general level of economic analysis supporting Dodd-Frank rulemaking is fairly weak.

See: GAO Full Report; Highlights of the Report.

SEC Releases Staff Analysis on Reporting and Dissemination of Security-Based Swap Information

The SEC made available analyses of data on the reporting and dissemination of security-based swap transaction information through two memorandum.

The memos, which are available on the SEC’s website, examine the effect of the CFTC-mandated post-trade transparency in the index credit default swaps (“CDS”) market on total credit exposure, trading volume, and trade size in the index CDS market. They also discuss if and how dealers may hedge any large notional exposures that result from executing trades with their customers.

The first memo, titled “Analysis of Post-Trade Transparency under the CFTC Regime,” found that there is little empirical evidence that the introduction of post-trade transparency in the index CDS market resulted in reduced trading activity, liquidity, or risk exposure.

The second memo, titled “Inventory Risk Management by Dealers in the Single-Name Credit Default Swap Market,” provides some description of the manner in which dealers may hedge CDS transactions.

Lofchie Comment: It would be helpful if the data underlying the SEC’s economic analysis would be made available to third parties who could also analyze it. That said, the SEC’s report on trade transparency did not find any appreciable damage done by increased transparency nor did it address the question of whether the transparency actually provided a material benefit. Of course, a rule should be justified by the good it will do, rather than by the likelihood it will avoid damage.

See: Analysis of Post-Trade Transparency under the CFTC Regime; Inventory Risk Management by Dealers in the Single-Name Credit Default Swap Market; SEC Press Release.


SEC Regulation SCI Could Push Trading Costs Higher

According to an MFA blog post, the new SEC Regulation Systems Compliance and Integrity (“Reg. SCI”) could lead to higher trading fees for money managers and curtailing operations or closure for some smaller equity trading venues.

The rule would require all trading venues to submit alternative plans for operations in the event of a system breakdown, and require regular testing by the venues to ensure that those alternative plans would work.  In its initial proposal, the SEC said that the estimated initial cost of organizations subject to the regulation would be up to a collective $242 million, with another $191 million in annual costs.

The original story, which was published in Pensions and Investments, quotes Christopher Nagy, founder and CEO of the market structure research firm KOR Group, as saying that “[t]he exchanges will have to pay for the testing, and that will be passed on to execution firms, the brokers.”  Nagy explained that this will raise the bar for the cost of entry and will likely reduce the number of automated trading systems and smaller brokerage firms, causing further cost issues.

Lofchie CommentOne of the ironies of the new regulations is that, for all of the chatter about “too big to fail,” substantial new regulations that impose fixed heavy costs drive up the price of doing business and make it impossible for small firms to succeed.  This is not to say that new regulations are bad (or good), but rather to point out the obvious:  the more heavily regulated the activity, the more likely it is that a small number of very large firms will be able to absorb the relevant regulatory costs.  If the regulators are convinced that reducing risk requires the imposition of substantial “safety” regulations and their accompanying substantial costs, then the regulators must acknowledge that the result of those safety regulations is a highly concentrated industry of very large players.  Put differently, where regulatory actions are creating a concentrated market, the policy consequence should be recognized and embraced.

See: MFA Blog Post; Pensions and Investments Article.
Related news: MSRB Comments on the SEC’s Proposed Regulation SCI (July 3, 2013).


SEC Commissioner Piwowar Speaks on Cost-Benefit Analysis and Flash Boys

SEC Commissioner Michael Piwowar spoke at the First Annual Conference on the Regulation of Financial Markets regarding the important role that economic analysis and academic research plays in securities regulation.

Commissioner Piwowar stated that, during his tenure at the SEC, he has seen economists become more involved with respect to rulemakings, enforcement and inspections of regulated entities. He explained that the SEC Division of Economic and Risk Analysis (“DERA”) provides the foundation of economic analysis, at the front end of tackling regulatory problems, that serves as an essential component to the SEC’s market knowledge. He noted that DERA was “instrumental” in creating Staff Guidance on Economic Analysis in SEC Rulemakings, which stated that high-quality economic analysis “serves as an essential part of SEC rulemaking” and helps to inform the SEC of the likely economic consequences of regulation.

Furthermore, Commissioner Piwowar stated, he “sees the need for the SEC to conduct a multi-year comprehensive review of equity market structure” to allow the SEC and its staff to understand and explore how the equity market structure has evolved. Specifically, Commissioner Piwowar identified some “threshold questions” that should guide the rulemaking process. The questions involve exploring what drives the supposed “need for speed,” and why traders are directing flow to so-called “dark pools” rather than “lit” markets.  A comprehensive review, Commissioner Piwowar explained, will allow us to “put everything on the table for discussion and approach the review with a completely open mind.”

Lofchie Comment: One of the oddities of the bifurcation of swaps rulemaking is that the SEC and the CFTC have pursued opposing processes for adopting rules. The CFTC rushed to adopt many rules as quickly as possible, often in piecemeal fashion, while the SEC moved more deliberately, adopting all of its swap rules as a unified set. Likewise, the two Commissions have taken opposite views as to their obligations to conduct cost-benefit analyses. The SEC seems to take cost-benefit analysis very seriously to the extent that it has imposed robust requirements on itself. By contrast, the CFTC has not acted as though it is particularly constrained by the requirement of a cost-benefit analysis, either because its statute is differently worded or because of philosophical differences. Generally, the CFTC seems to have started with the conclusion that the financial crisis would have been averted if the swap rules had been in place and, thus, the swap rules (or the position limits rules, for example) provide a great benefit and are worth the cost. 

Leaving aside the question of which Commission is “right” in its approach, the fact that the two Commissions are taking such different approaches will almost certainly result in the SEC’s producing a body of swaps regulation that is quite different from the body of regulation produced by the CFTC. To take one example: even if the SEC attempts to adopt a set of cross-border rules that mirrors the cross-border guidance produced by the CFTC, the SEC will likely find it impossible to produce a cost-benefit analysis that justifies these rules (the CFTC avoided this difficulty by not performing the analysis). As different approaches lead to different results, so the different processes of the SEC and the CFTC will give us different rules governing cross-border swaps.

See: Commissioner Piwowar’s Remarks.


House Agriculture Committee Approves Bipartisan Legislation to Reauthorize CFTC

The House Agriculture Committee approved the Customer Protection and End User Relief Act (H.R. 4413) by voice vote. The Bill, which was introduced on April 7, 2014, would reauthorize and improve the operations of the CFTC and address concerns relating to market certainty and customer protection.

The bill was reported out of Committee on April 9, 2014.  Among the most significant aspects of the bill, are (i) the express imposition of cost-benefit requirements on the CFTC and (ii) the required changes that the bill would make in the administration of the CFTC.

The proposed cost-benefit provision would amend the existing one in Sec. 15(a) of the Commodity Exchange Act to make it more comprehensive and robust. In essence, the new language would make the cost-benefit consideration consistent with the cost-benefit analysis requirements of President Obama’s Executive Order 13563 for the entire executive branch to which the CFTC agreed some time ago when flaws in the way it went about cost-benefit analysis relating to Dodd-Frank rules were exposed by the agency’s Inspector General. This will codify such requirements in the statute.

Among the new items that the CFTC would be required to take into account and, presumably, to evaluate in its cost-benefit analyses would be:

  • considerations of the impact on market liquidity in the futures and swaps markets;
  • available alternatives to direct regulation;
  • the degree and nature of the risks posed by various activities within the scope of its jurisdiction;
  • the costs of complying with the proposed regulation or order by all regulated entities, including a methodology for quantifying the costs (recognizing that some costs are difficult to quantify);
  • whether a proposed regulation or order is inconsistent, incompatible or duplicative of other Federal regulations or orders; and
  • whether, in choosing among alternative regulatory approaches, the CFTC selects those which maximize net benefits (including potential economic and other benefits, distributive impacts and equity).

In addition, the legislation would make the Chief Economist and the Division Directors answerable to the Commission, not the Chairman alone as in current practice.

Lofchie Comment: While the proposed cost-benefit provisions of the bill are clearly a reaction to the conduct of former CFTC Chairman Gensler, the same would appear to be true of the statutory provision giving the Commission as a whole (and not merely the Chairman) authority with respect to Chief Economist and the Division Directors. Shared authority with respect to these important posts could go a long way toward reducing the future risk of fostering an imperial head of an agency who is able to exercise authority on a remarkably unchecked basis.

See: H.R. 4413; Summary of Legislation; House Agriculture Committee Press Release.
See also: FIA Statement on Bill.
Related news: House Agriculture Committee Introduces Legislation to Reauthorize CFTC (April 9, 2014).