From China / Central Banking East and West since the Crisis…

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:
    1. Speculative activity skyrockets.
    2. Net speculative long positions increase and push valuations upward.
    3. 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.

SEC Commissioner Offers Recommendations on Implementing G20 Swaps Reforms

SEC Commissioner Hester M. Peirce offered recommendations to regulators on implementing G20 swaps reforms. Ms. Peirce said that the G20 reforms were not foolproof and encouraged regulators to exercise “healthy skepticism” when implementing them.

In remarks before the International Regulators Conference, Ms. Peirce said that “poorly designed regulations” played a role in the 2007-2009 financial crisis. She cited the “favorable regulatory treatment given to highly rated securitization tranches.” She stated that, among other things:

  • “central clearing is not a panacea” and brings its own risks;
  • regulators should attend to market feedback and market professionals’ knowledge when considering rulemaking; and
  • regulators must consider more flexible regulation rather than a one-size-fits-all approach.

In implementing the regulatory framework for security-based swaps, Ms. Peirce advised, the SEC should:

  • reexamine proposed and final regulations to ensure that the regulatory framework serves its intended purpose;
  • devise clear rules and provide guidance instead of relying on staff no-action letters;
  • streamline regulatory processes so that the agency can promptly respond when implementation issues arise;
  • ensure that the compliance periods for rules provide the market with sufficient time to prepare for and then comply with requirements; and
  • provide that multiple rule sets do not overly burden market participants.

In addition, Ms. Peirce advocated for regulatory cross-border deference as international regulators develop their framework for security-based swaps. According to Ms. Peirce, regulatory cross-border deference will ensure that the global over-the-counter derivatives market can serve the risk management needs of companies throughout economies.

Lofchie Comment: Commissioner Peirce’s call for the regulators to be self-critical is welcome. Likewise are her suggestions that both the causes of the financial crisis and the regulatory responses to it be critically re-examined.

There are, however, important challenges to her stated goals. Is it possible to have multiple regulators both be open to ongoing regulatory review and revision and, at the same time, to conform their own rules? It is certainly good news that the CFTC and the SEC are cooperating now; but will the agencies be able to sustain such cooperation over the long term?

CFTC Commissioner Advocates for International Regulatory Cooperation

CFTC Commissioner Rostin Behnam advocated for international regulatory cooperation to address the risks posed by benchmark reforms, margin, Brexit, cross-border regulation and FinTech. In a speech at the 2018 ISDA Annual Japan Conference, Mr. Benham weighed in on the following:

  • Benchmark Reforms. Mr. Behnam emphasized the importance for global regulatory authorities to work with one another as well as private sector entities to facilitate the transition away from various inter-bank offer rates. He praised the work being done by, among others, the UK FCA, Japanese regulators, and, in the United States, the public-private partnership of the Alternative Reference Rates Committee (“ARRC”). Mr. Behnam encouraged market participants to examine LIBOR-fallback language in existing contracts and highlighted the work of market participants and regulators to develop alternative contract language to facilitate this approach. He also broadly encouraged participants to transact in SOFR-referenced derivatives markets, noting that a move to SOFR could help avoid the consequences of “zombie LIBOR.” Mr. Behnam noted that, while he is aware of “some preference” for continuing with LIBOR, regulators are generally “anticipating a clear and certain break from LIBOR.” He also highlighted the work of the CFTC Market Risk Advisory Committee, in particular its Interest Rate Benchmark Reform Subcommittee. He expressed his hope that the subcommittee would “complement” the work of the ARRC.
  • Initial Margin. Mr. Behnam stated that the full phase-in of initial margin requirements in 2020 raises “a number of potential challenges for the marketplace.” He stressed that the CFTC and U.S. bank regulators are listening to concerns of market participants about 2020 implementation and are gathering information to understand the situation to “avoid catastrophe.” He highlighted the work and recommendations of, among others, ISDA and SIFMA, and while not committing to their suggested approach, said that the CFTC and other regulators would “bundle” efforts toward “appropriate recommendations and guidance.”
  • Cross-Border Regulation. Mr. Behnam said that CFTC Chair J. Christopher Giancarlo’s recent whitepaper announcing his vision of the agency’s approach to applying its statutory authority over swaps activities to cross-border activities merely reflected his ambitions and views. Mr. Behnam distanced himself from the white paper, stating that he thinks the CFTC should build its internal consensus in accordance with formal, statutory procedures while considering the needs of and affording deference towards global regulators. He noted that the timing for turning the white paper proposals into formal rulemaking is “unclear,” and noted that Mr. Giancarlo had suggested that it would be “several quarters” for such a sea change to progress. Mr. Behnam said that the sufficient time was needed, expressing his view that aspects of Mr. Giancarlo’s proposals would depart from CFTC policy and “may even conflict with our governing statute and prior [CFTC] interpretations thereof or lead to gaps in certain protections afforded to U.S. persons transacting overseas.”
  • FinTech. Mr. Behnam urged regulators to approach FinTech with “an open mind and a healthy respect for [regulators’] role in the markets.”

Lofchie Comment: Commissioner Benham’s remarks included some pointed criticisms of CFTC Chair Giancarlo. In reference to the White Paper that Chair Giancarlo published on cross-border regulation, Mr. Benham asserted that CFTC commissioners ought to act only through formal commission action, such as the issuance of concept releases or formal rule makings.

There is nothing in the law that limits the ability of CFTC commissioners to take individual public stands on regulatory issues. If it were improper for a CFTC Commissioner to express a personal view, then it would be not only improper to publish a White Paper, but also improper for a commissioner to deliver a speech or other public statement that has not been ratified by the entire commission. Both Commissioner Benham’s speech and Chair Giancarlo’s White Paper present the standard disclaimer that the views expressed are those of the author and not the views of the Commission or staff.

Financial regulation benefits tremendously from debates about policy that are backed by views as to market behavior and facts. Commissioner Benham’s disagreement with Chair Giancarlo approach ought to focus on the substance of the Chair’s well considered views, and not with its existence.

CFTC Chair Proposes Alternative Cross-Border Framework

CFTC Chair Christopher J. Giancarlo proposed an alternative cross-border swaps framework to “better balance systemic risk mitigation with healthy swaps market activity in support of broad-based economic growth.”

In a new white paper, he previewed weeks ago, Mr. Giancarlo outlined his views on the current CFTC approach to regulating cross-border activities and suggested a new approach that would encourage greater cooperation with non-U.S. jurisdictions. Mr. Giancarlo recommended, among other things:

  • Non-U.S. Central Clearing Parties (“CCPs”): expanding the use of the CFTC’s exemptive authority for non-U.S. CCPs that are subject to similar regulations in their home country and do not pose risk to the U.S. financial system;
  • Non-U.S. trading venues: terminating the bifurcation of the global swaps market into separate U.S. person and non-U.S. person marketplaces by exempting non-U.S. trading venues, in regulatory jurisdictions that have adopted similar G20 swaps reform, from having to register with the CFTC as swap execution facilities;
  • Non-U.S. swap dealers: regulating non-U.S. swap dealers whose swap-dealing activity poses a material risk to the U.S. financial system;
  • Clearing and trade execution requirements: allowing non-U.S. persons to rely on substituted compliance as to swap clearing and trade execution requirements in comparable jurisdictions; and
  • Arrange, negotiate, or execute swap transactions: taking a “territorial approach to the U.S. swaps trading activity,” as non-incidental swaps trading activity in the United States should be subject to U.S. swaps trading rules.

Lofchie Comment: Market participants should be aware that while Chair Giancarlo is, in many respects, advocating for less U.S. regulation, and more deferences to home country regulators, he is not advocating for a deregulatory approach. In fact, in a number of regards, he would expand the scope of U.S. swaps regulation, perhaps most significantly as to swaps that are “arranged, negotiated or executed” in the United States by non-U.S. swap dealers. It is not clear what additional steps he would take in regard to the regulation of non-U.S. swap dealers whose activity pose a material risk to the U.S. financial system (or by what criteria he would determine which swap dealers posed such a risk).

Beyond the substance of what Chair Giancarlo is proposing, what is really fascinating is the manner in which he is pushing the direction of the CFTC, and how he prepared for that push even while being a Commissioner in the minority party; that is, through the publication of white papers, he has established himself as an intellectual and thought leader for the direction of regulation.  This has not only established his acumen – he has also freed himself from the constraints of the bureaucratic process.  There are probably not too many other regulators who would be able to exert influence in this manner, but one possibility is SEC Commissioner Peirce.

CFTC Chair Touts Cross-Border Regulatory Deference as Best Alternative

CFTC Chair J. Christopher Giancarlo called on European Union (“EU”) regulators to “commit to an equivalence determination process that focuses on achieving comparable regulatory outcomes and not rule-by-rule exactitude.” In a speech at the Eurofi Financial Forum, Mr. Giancarlo highlighted the importance of U.S. deference toward non-U.S. regulators as to their control over markets and market participants within their jurisdiction; he called on EU policymakers and regulators to adopt a similarly deferential approach to the cross-border application of European swaps regulation to U.S. markets and market participants.

Mr. Giancarlo previewed a forthcoming white paper that will offer recommendations on the application of the agency’s swap rules to cross-border activities. He criticized current EU legislative proposals that raise doubts with respect to the continuance of the policy of cross-border deference and cautioned that failing to adopt an approach of cross-border deference would “turn [global regulation] down that very different path of overlapping and confounding cross-border regulation with its high regulatory cost and constraints on economic growth.”

Lofchie Comment: When he was the CFTC’s Chair, Mr. Gensler asserted that the United States would adopt rules governing the global derivatives markets and market participants, and that Europe would just have to accept that reality. Europe didn’t. Asia didn’t. Joint Cautionary Letter from the EU, France, Japan and the UK to the CFTC on U.S. Cross-Border Swaps Regulation (with Lofchie Comment). Mr. Gensler was being very aggressive. The hand he played was not helped by the fact that the CFTC’s regulations were not so great. The rest of the world responded with a collective no thanks.

Current CFTC Chair Giancarlo is reversing course. It does not make sense for the CFTC to attempt to regulate European and Asian markets. But how will Europe react? Chair Giancarlo suggests that, however Europe acts, the United States will respond in kind.

International Regulators Launch “Global Financial Innovation Network”

Several international regulatory agencies collaborated in the creation of the “Global Financial Innovation Network” (“GFIN”). The new network will focus on regulatory issues related to emerging technologies. There are 11 regulatory agencies in the new network including the Consumer Financial Protection Bureau and the UK’s Financial Conduct Authority.

In a draft consultation document, the agencies explained three major functions of the initiative: (i) information- and knowledge-sharing among regulators, (ii) collaboration in exploring major policy questions and (iii) “cross-border trials” instituted to aid companies as they deal with multi-jurisdictional regulatory challenges. The network is intended to serve as a resource for FinTech companies navigating the complicated web of international regulation. The regulators anticipate that GFIN will increase the speed at which innovative products are able to reach international markets. They also argue that the GFIN will promote transparency and investor protection.

The GFIN proposed the following as its organizational mission statement:

“The GFIN is a collaborative policy and knowledge-sharing initiative aimed at advancing areas including financial integrity, consumer wellbeing and protection, financial inclusion, competition and financial stability through innovation in financial services, by sharing experiences, working jointly on emerging policy issues and facilitating responsible cross-border experimentation of new ideas.”

The GFIN is requesting feedback on its proposed objectives, functions and structure. Comments must be submitted by October 14, 2018.

President Trump Imposes Sanctions against Iran

The Trump administration issued a new Executive Order (the “New Iran E.O.”) imposing certain U.S. sanctions against Iran, effective August 7, 2018.

Consistent with President Trump’s May 8 announcement ending U.S. participation in the Joint Comprehensive Plan of Action (Iran nuclear deal), the New Iran E.O. restores sanctions related to, among other things: (i) the Iranian government’s purchase or acquisition of U.S. dollars; (ii) Iran’s trade in gold and precious metals; (iii) the sale, supply or transfer to or from Iran of graphite, raw or semi-finished metals, and software for integrating industrial processes; (iv) significant transactions related to Iran’s national currency, the rial, and the maintenance of significant funds or accounts outside the territory of Iran denominated in the Iranian rial; (v) the purchase, subscription to, or facilitation of the issuance of Iranian sovereign debt; and (vi) Iran’s automotive sector.

In addition, certain wind-down authorizations expired at 11:59 p.m., EDT, on August 6, 2018, namely, those related to (i) the importation into the United States of Iranian-origin carpets and foodstuffs; (ii) activities related to the export or reexport to Iran of commercial passenger aircraft and related parts and services; and (iii) activities undertaken pursuant to General License I that relating to contingent contracts for activities related to passenger aircraft-related licensing.

In connection with the above, the U.S. Treasury Department Office of Foreign Assets Control (“OFAC”) issued FAQs regarding the New Iran E.O., and updated certain existing Iran sanctions-related FAQs.

 

CFTC Chair Evaluates Challenges Facing Derivatives Market

CFTC Chair J. Christopher Giancarlo assessed the challenges facing the CFTC and the United States in the global competition as a center for the derivatives markets. In an address at the West Texas Legislative Summit, Mr. Giancarlo warned that the CFTC must be proactive if the United States is to retain its preeminent position in the global financial markets.

Mr. Giancarlo described the significance of the commodity derivatives market and its impact on pricing. He pointed out that even those who do not participate in such markets are still affected and that 90 percent of companies in the Fortune 500 use derivatives to hedge. He highlighted the challenge of global competition, particularly China’s domestic futures market, specifically alluding to the country’s recent opening to international participation, which has “competitive implications” for the United States. To maintain “world leadership,” he said, it is urgent that derivatives markets in the United States maintain “openness, orderliness, and liquidity” to sustain global economic leadership.

Mr. Giancarlo emphasized the importance of establishing a regulatory framework that is “ahead of the curve,” and advocated for the “SMART-REG” approach he first outlined in 2014. This approach, he said, is intended to “solve problems – real problems, not invented ones.”

Mr. Giancarlo asserted that under his leadership, the CFTC has “emphasized greater care and precision in rule drafting, more thorough econometric analysis, and a reduced docket of new rules and regulations to be absorbed by market participants.”

Lofchie Comment: Chairman Giancarlo went beyond a discussion of the derivatives markets to discuss the underlying commodities markets. In explaining the success of the shale revolution in the United States, he described a “combination of American technological innovation, North American geology, U.S. property law, the skilled and entrepreneurial American workforce and our dynamic capitalist economy.” Chairman Giancarlo continues to be a voice of clarity and an educator in an often confused debate about the value of markets and the limits of governments as providers of services and products.

It is not so long ago that the Union of Soviet Socialist Republics collapsed in economic failure. That collapse seemed as if it would put an end to any debate as to the benefits of government ownership of the means of production. But today that debate is revived, or at least there are new advocates for it. To the extent that these advocates are taken seriously, it is important that advocates for private enterprise and for market competition not be shy to point out successes, face criticisms and to make comparisons as to the successes of different systems.

UK-US Financial Regulation: The Benefits of Greater Coherence

“UK-US Financial Regulation: The Benefits of Greater Coherence” illustrates the importance of “regulatory coherence” across borders.

Authors Ike Brannon, Bob Jennings, and Julie Chon delve into the longstanding and seminal UK and US relationship from a financial regulatory perspective.  They examine pathways to deepen and formalize cooperation with the aim to strengthen the international financial system.

As always, comments, critique, complement, or alternative thoughts are eagerly sought.

View the paper.
http://www.centerforfinancialstability.org/research/US_UK_Regulatory_Coherence.pdf

FinCEN Calls Attention to Transactional Red Flags Associated with International Corruption

The U.S. Treasury Department Financial Crimes Enforcement Network (“FinCEN”) issued an advisory describing how corrupt foreign “politically exposed persons” (“PEPs”) access the U.S. financial system. The advisory provides guidance on the (i) risks that U.S. financial institutions face when providing banking services to PEPs and their financial facilitators and (ii) types of suspicious transactions that may trigger reporting obligations under the Bank Secrecy Act.

The advisory includes the following non-exclusive list of red flags that may help identify methods used to hide the proceeds of human rights abuses and other illicit international activities:

  • using third parties when it is not normal business practice;
  • using third parties to shield the identity of a PEP;
  • using family members or close associates as legal owners;
  • using corporate vehicles such as limited liability companies (LLCs) to hide ownership, involved industries or countries;
  • receiving information from PEPs that is inconsistent with publicly available information;
  • transactions involving government contracts that (i) are awarded to companies in a seemingly unrelated line of business, or (ii) originate from or are going to shell companies that appear to lack a general business purpose;
  • documents supporting transactions regarding government contracts that include (i) charges that are higher than market rates, (ii) overly simplistic information or (iii) insufficient detail;
  • payments connected to government contracts that come from third parties that are not official government entities; and
  • transactions involving property or assets expropriated or otherwise taken over by corrupt regimes, including senior foreign officials or their cronies.

The advisory also provides examples of suspicious activities by PEPs and their financial facilitators, such as:

  • moving funds repeatedly to and from countries with which the PEP does not have ties;
  • requesting to use services of a financial institution or a designated non-financial business or profession (“DNFBP”) not normally associated with foreign or high-value clients;
  • holding substantial authority over or access to state assets and funds, policies and operations; and
  • controlling the financial institution or DNFBP that is a counterparty or correspondent in a transaction.

The advisory indicated that FinCEN would update these red flags and typologies in the future, and reminded financial institutions of their obligation to identify suspicious transactions and file suspicious activity reports (SARs) under the Bank Secrecy Act.