Report on Repo Market Financing Raises Concerns

The Bank for International Settlements (“BIS”) published a Report that found that changes in the availability and cost of repurchase agreement (“repo”) financing are affecting the ability of repo markets to support the financial system. The Report was prepared by a study group organized by the BIS Committee on the Global Financial System (“CGFS”) that included staff members from international regulatory agencies, the Board of Governors of the Federal Reserve System and the New York Fed.

The study group examined repo transactions backed by government bonds and concluded that banks in some jurisdictions appear to be less willing to undertake repo market intermediation than they were before the crisis. Key “drivers” behind these changes include “exceptionally accommodative monetary policy” and regulatory changes that have made intermediation more costly. However, the study group cautioned that it would be premature to establish correlations between policy changes and changes in the market given “differences in repo markets across jurisdictions and the fact that repo markets are in a state of transition.”

To improve repo market functioning, the study group recommended that a series of temporary measures be implemented, including steps to reduce the “scarcity of certain collateral.”

Lofchie Comment: It seems regulators are beginning to acknowledge that new regulations may have had some negative effects on the financial markets, financial market participants, investors and the economy. Seee.g.Federal Reserve Governor Daniel Tarullo Reconsiders the Volcker RuleComptroller Reviews Regulatory Environment for Community Banks and Mutual Associations. This is a welcome development. It is the start of a conversation about the fact that some rules do more harm than good and that not every examination of a rule has to be a partisan or political event.

Sargen on China – U.S. Tensions…Diminish for Now


  • Notwithstanding adverse political news at home, the Trump rally has continued amid favorable economic news and investor optimism about pending corporate and personal income tax cuts.  Diminished tensions between the Trump Administration and China have also lessened the risk of a trade war.
  • The key event was President Trump’s reaffirmation of the “One China” policy to President Xi in a telephone exchange earlier this month.  At the same time, Defense Secretary Mattis talked about the need for a diplomatic rather than military solution to the dispute in the South China Sea, which the Foreign Ministry in China welcomed.
  • With Steve Mnuchin assuming the helm as Treasury Secretary, market participants are awaiting the stance the Treasury will take on whether to declare China a “currency manipulator.”  Press reports suggest the Trump Administration may change tactics, so that China is not singled out.
  • The bottom line: The risk of an escalation in tensions between the U.S. and China has lessened, and it appears moderates in the Trump Administration are calling the shots.   Nonetheless, circumstances could change if the dispute in the South China Sea heats up or if China’s trade surplus with the U.S. were to increase.

President Trump Moderates His Stance on China

At a time when the Trump Administration has been engulfed with a series of adverse political developments, market participants appear oblivious to them, and the so-called Trump rally lives on.  The principal reasons are that news on the economic front has been favorable, consumer and business confidence readings remain high, and investors are focused on the prospect for significant cuts in both corporate and personal tax rates.

In addition, a potential negative factor –namely, the prospect for a trade war between the U.S. and China – has also diminished recently.  The key development was a sudden reversal in President Trump’s stance toward China.  Throughout the presidential campaign, Mr. Trump took a hard line on China, claiming that its trade policies were unfair, and on several occasions he called for imposing tariffs of 35% on Chinese imports into the U.S.  Immediately after assuming office, President Trump upped the ante by congratulating the leader of Taiwan and by indicating he was open to reviewing the One China policy that China’s leaders regard as non-negotiable.

During the past month, however, the Trump Administration has softened its stance considerably.  In a telephone conversation with China’s leader, Xi Jinping, the President retreated from his earlier statement, and he indicated the White House had agreed to honor the One China policy “at the request of President Xi.”

The timing of the call was significant, coming just before President Trump met with Japanese Prime Minister Shinzo Abe to discuss the commitment of the U.S. to East Asia. It also coincided with a trip to Japan and South Korea by Defense Secretary Mattis, during which he talked of the need for a diplomatic rather than military solution to the dispute over islands in the South China Sea. The Foreign Ministry in Beijing welcomed the remarks and the Chinese press called them a “mind-soothing pill” that “dispersed the clouds of war.”1

Looking behind the scenes, these developments suggest that moderates in the Administration such as Secretary of State Rex Tillerson, Defense Secretary James Mattis and National Economic Council Director Gary Cohn are calling shots on China policy for the time being.  This is reassuring to those who worried that Peter Navarro, Wilbur Ross, and Robert Lightziger, who have a more protectionist bent, could be in charge of trade policy.

Is China a Currency Manipulator?

With Steven Mnuchin now confirmed as Treasury Secretary, market participants will now be watching to see whether the Treasury declares China to be a “currency manipulator,” as Mr. Trump suggested during the presidential campaign.  Since 2015, the criteria that the Treasury has used for making such a designation has been three-fold: (i) the country has a large current account surplus, defined to be in excess of 3% of GDP; (ii) it has a large bilateral trade surplus with the U.S.; and (iii) it intervenes in the currency markets to weaken its currency versus the U.S. dollar.

Based on these criteria, China meets only one condition – namely, it has a large bilateral surplus with the U.S.  Its overall current account surplus, by comparison, has fallen steadily over the past decade, and is currently less than 3% of GDP.  And while the Chinese authorities intervene regularly in the foreign exchange markets, since 2014 they have been primarily sellers of U.S. dollars.  The reason: China has experienced massive capital flight that far exceeds its currency account surplus, and the authorities have been trying to limit the depreciation of the RMB versus the dollar.

Weighing these considerations, the Treasury in the past has refrained from declaring China to be a currency manipulator.  If it were to do so now, the rationale would be political rather than economic.  Even then, it is unlikely the Trump Administration would want to escalate the issue at this time when it already has moderated its stance.

A recent Wall Street Journal article (February 14, 2017) stated that the White House is exploring a new tactic to discourage China from undervaluing its currency.  Under the plan the Commerce Secretary would designate the practice of currency manipulation as an unfair subsidy, without singling out China, and U.S. companies could then bring complaints to the Commerce Department.  While this tactic is in keeping with the stance adopted by previous administrations, Chinese officials reportedly are bracing for an unprecedented number of trade disputes, and they are considering possible retaliatory actions.

Avoiding a Full Scale Trade War

Both the United States and China for the time being are seeking to avoid a full scale trade war that would produce a “lose-lose” situation.  Investors, nonetheless, must consider the possibility of such an outcome in the future, especially if China’s bilateral trade surplus with the U.S. were to widen, while the RMB would weaken further against the dollar.

The latter outcome remains a distinct possibility for two reasons.  First, U.S. import demand is likely to surge if the U.S. economy continues to gain traction, and imports from China would in turn be boosted. Second, a stronger economy is likely to bring the Fed into play, and a widening in interest differentials between the U.S. and China would place added pressure on the RMB. In these circumstances, the Trump Administration could very well come down on the side of those who contend China is manipulating its currency, even if the Chinese authorities intervene to limit the depreciation of the RMB.

In these circumstances, markets are likely to focus on whether any sanctions imposed by the U.S. are targeted to specific items or are broadly based and severe. In the former case, markets would likely take the news in stride, as there are numerous instances in which the U.S. has imposed sanctions on select items.  However, if the Trump Administration were to up the ante by imposing broad-based sanctions – including high tariffs across a wide range of goods – markets would likely sell off, as investors would anticipate retaliation by the Chinese authorities and other countries that are affected.

Our assessment is the risk of a full scale trade war has lessened for the time being.  However, political developments such as a widening in the dispute over islands in the South China Sea or adverse developments in the U.S. could result in an escalation of trade tensions at some point.  In this respect, the risk of a trade war cannot be ruled out entirely.

1See Goldman Sachs report “Top of Mind,” February 6, 2007.

Sargen on Trump’s Trade Policy


  • During the election campaign, Donald Trump ran for office on restoring lost jobs in manufacturing by renegotiating trade deals and imposing tariffs on imports from countries that are deemed to hurt American workers. Now that he is President, market participants are focusing on what he will do.
  • One of his first decisions will be his stance on a “border adjustment tax” (BAT), a key provision in the House Republican tax bill that is intended to incent U.S. companies to produce at home rather than abroad.  In an interview last week, Mr. Trump indicated he favors a simpler approach of imposing stiff duties on countries that disadvantage U.S. workers and U.S. based companies that shift production abroad.[1]
  • A key problem with the President’s trade policy, however, is that it runs counter to market forces.  Because the dollar’s value is mainly driven by capital flows, stronger growth and rising U.S. interest rates threaten to propel it higher.  Also, the President’s fiscal stance of lowering tax rates but not broadening the tax base would likely balloon both the budget and trade deficits.
  • The bottom line: President Trump’s efforts to reduce the trade deficit and restore lost jobs in manufacturing are likely to fail.  Moreover, his policy of raising tariffs is bound to invite retaliation in which all parties would lose.

President Trump’s Views on Trade and the Dollar

Throughout the Presidential campaign, Donald Trump articulated a stance on international trade that reflects his long-standing views.  At the core, his world view is mercantilist: International trade is a zero sum game with winners and losers, and the losers are countries that run trade deficits.

While Mr. Trump’s views on trade are at odds with the post-war order, in which free trade was seen as a means for promoting world growth, he was by no means the only candidate to abandon free trade principles.  Indeed, in the wake of the 2008 financial crisis, for the first time in modern history no presidential candidate ran on a pro free-trade platform.  Where Mr. Trump stood apart from other candidates was his call to renegotiate existing trade arrangements and his threats to impose heavy duties on countries and U.S. businesses that are deemed to pursue policies that harm U.S. workers.

Now that he is president, Mr. Trump has announced the United States will withdraw the U.S. from the Trans-Pacific partnership, and he is planning to meet with the leaders from Mexico and Canada to discuss NAFTA.  One of the first legislative decisions Mr. Trump will make is his stance on the issue of a border adjustment tax (BAT), which is a key provision in the House Republican tax bill. The BAT is called a “destination based cash flow tax,” because it does not include export revenues in corporate taxes, while it excludes imported items from costs. The Republican leaders in the House favor the idea because: (i) it incents businesses to produce at home rather than abroad; and (ii) it is estimated to raise $1 billion in tax revenues over a decade that would help fund the proposed cut in the corporate tax rate to 20% from 35%.

The BAT concept is very controversial, because it is untested and critics contend it could be disruptive to businesses with global supply chains.  Proponents contend this is not the case, because they claim there would be offsetting movements in the dollar.  For example, if U.S. exporters were able to reduce the price of a product sold abroad, it would increase demand for dollars and boost the value of the dollar.  Accordingly, some economists estimate that if the corporate tax rate were lowered to 20% the dollar would likely appreciate by about that amount, although that issue is subject to debate.

In a recent Wall Street Journal interview, Mr. Trump stated the BAT proposal was too complex, and he favors a simpler approach of raising tariffs on imported goods including those from overseas’ operations of U.S. based companies.  He also expressed concern that the dollar was “too strong” in part because China holds down its currency, the yuan: “The yuan is ‘dropping like a rock,’ Mr. Trump said, dismissing recent Chinese actions to support it as being done simply ‘because they don’t want us to get angry.”

It remains to be seen what the final legislative outcome will be.  Some commentators believe the House Republican leaders will continue to press for a BAT; however, to gain the President’s approval, they will have to compromise on provisions of the pending tax bill.  As discussed below, the House Republican tax bill is intended to be revenue-neutral, whereas the proposal that Mr. Trump favors would increase the budget deficit significantly.

An Inconsistent Trade Policy: Lessons from the 1980s

Whatever the outcome, President Trump’s approach to trade and the dollar is flawed, in my opinion, because it ignores the impact of market forces on the dollar and the trade balance.  In this regard, there are several valuable lessons from the experience of the Reagan presidency in the 1980s that apply today.

One of the main lessons is that the dollar’s value is determined primarily by international capital flows, rather than international trade flows.  During the Reagan era, for example, the combination of a resurgent U.S. economy and high U.S. interest rates relative to those abroad attracted massive capital inflows that sent both the dollar and the U.S. trade deficit to then record levels.

U.S. interest rates today, of course, are considerably lower than in the 1980s; nonetheless, they are still well above those abroad. The dollar currently is at a 14-year high on a trade-weighted basis, and it has surged since the presidential election.  Should the U.S. economy accelerate, as President Trump is seeking, the Fed is likely to tighten monetary policy further, which would drive the dollar even higher.  Similarly, if China continues to experience capital flight, the Chinese yuan is likely to depreciate further, despite efforts of the authorities to limit the decline.

A second lesson is the trade imbalance is likely to widen considerably if the budget deficit increases materially, as was the case in the 1980s, when the U.S. ran “twin deficits” (see chart). The intuition is that increased government spending on the military and infrastructure is likely to boost imports but do little to increase exports. More fundamentally, the national income identity holds where the imbalance on trade is equal to the sum of the budget imbalance and the saving-investment imbalance in the private sector. If the latter is unchanged, the trade deficit increases directly with the change in the budget deficit.

U.S. Budget and Trade Imbalances as a Percent of GDP

Source: Bureau of Economic Analysis, Dept. of Commerce.


In this regard, a lot hinges on the type of tax legislation that is forthcoming. Specifically, there is an important difference between the House Republican tax bill, which is designed to be deficit-neutral, with the plan that Mr. Trump campaigned on, which independent research institutions estimate would add about $6 trillion to federal debt outstanding over the next ten years. The primary reasons are the Trump plan calls for deeper cuts in the corporate tax rate to 15% versus 20% in the pending House bill, and the Trump plan does not seek to broaden the tax base, whereas the House bill does.

The bottom line, therefore, is that if President Trump’s efforts to boost economic growth via tax cuts and increased government spending unfold, the trade deficit is likely to expand considerably.

The Worst Outcome: A Needless Trade War

While President Trump’s trade policies are unlikely to produce the results he is seeking, the worst outcome for financial markets would arise if the policies culminated in an unnecessary trade war with China, Mexico, and other countries.

It is hard to tell at this juncture whether President Trump’s call for duties in the neighborhood of 35% on imported items from certain countries is a negotiating ploy to extract a better deal, or whether he is serious and will follow through.  Based on his selection of Cabinet appointees to handle trade matters, however, this threat should not be taken lightly.  They include Peter Navarro, a China critic to head the new National Trade Council, Wilbur Ross as Secretary of Commerce, and Robert Lighthizer, a lawyer who represents industries seeking government protection via trade barriers.  At the same time, President Trump appears determined to declare China a currency manipulator, even though the Chinese Government has spent one trillion dollars in foreign exchange reserves in an attempt to limit the yuan’s depreciation against the dollar.

Should the Administration pursue such a course of action, it would inevitably invite retaliation, either in terms of reciprocal duties on goods from the U.S. and/or diminished purchases of U.S. treasuries.  One may wonder why the U.S. would run this risk when unemployment is below 5% and overseas economies are fragile.  And while financial markets have shrugged off the possibility thus far, global investors are likely to turn wary if a trade war were to materialize.

One of the most disturbing aspects of all this is how world leaders today have lost sight of the benefits that free trade has conveyed on the U.S. and global economy during the post-war era.  From the early 1980s, when globalization took off, until the mid-2000s,    there was a fairly steady expansion of both world trade and economic growth, with world trade expanding at roughly twice the pace of global GDP growth, and free trade policies played a critical role (see chart).  However, in the wake of the 2008 financial crisis, both global growth and the volume of world trade slowed markedly. This development, in turn gave rise to populism around the world, which threatens to bring increased protectionism that could undermine what was achieved during the post-war order.

Growth in Volume of World Goods Trade & Real GDP, 1980-2015

Source:  International Monetary Fund, World Economic Outlook Database, October 2016.

[1] See WSJ article, “Donald Trump Warns on House Republican Tax Plan,” January 16, 2017.

SEC Chair White Urges Successor to Prioritize Globally Accepted Accounting Standards

SEC Chair Mary Jo White called on the “next Chair” of the Commission to prioritize the development of “high-quality, globally accepted accounting standards,” which are “imperative for the protection of U.S. investors and companies and the strength of our markets”:

“I strongly urge the next Chair and Commission to build on our past efforts and give the goal of high quality globally accepted accounting standards the focus and support this critical issue deserves.”

In a public statement, Chair White noted that as of September 2016, foreign companies that apply International Financial Reporting Standards (“IFRS”) in SEC filings represent “a worldwide market capitalization in excess of $7 trillion across more than 500 companies.” U.S. companies use IFRS in making acquisitions, establishing joint ventures and preparing financial information for management and boards of directors, she stated.

“In light of these global realities,” Chair White urged the “next SEC Chair” to:

  • work with the Financial Accounting Standards Board (“FASB”) to “provide clear and reliable financial information as business transactions and investor needs continue to evolve globally”;
  • work closely with the SEC Chief Accountant and be an active member of the IFRS Foundation Monitoring Board; and
  • ensure that the SEC carefully monitors “how the needs and interests of investors and issuers may change in the future and seek opportunities to guide and accelerate the development of high-quality, globally accepted accounting standards.”

In addition, Chair White encouraged the IFRS and the Financial Accounting Standards Board to “continue their productive collaboration,” particularly by adopting a “sequential” approach to the convergence of their respective accounting standards.

Lofchie Comment: Some of the most unfortunate incidents that occurred during Chair White’s tenure were the recurrent attacks she suffered under Senator Warren’s acerbic scrutiny. Those attacks were wholly undeserved, since the Senator’s objective was to compel the SEC to focus on adopting rules that had a significant political purpose (such as the disclosure of political contributions) but only tangential relevance to the SEC’s aims, as opposed to rules that should be more important to the SEC, such as those that improve economic transparency. (Seee.g.Senator [Warren] Urges President to Replace SEC Chair.)

To Chair White’s credit, she did not allow these attacks to distract the SEC from pursuing its core mission. Even in her parting words to the Commission, Chair White fixed her attention on the task at hand: improving economic disclosures that may benefit investors and the U.S. economy.

NY Fed Issues New Policy on Counterparties for Market Operations

The Federal Reserve Bank of New York issued a comprehensive overview of its counterparty framework, which includes a new policy on counterparties for all domestic and foreign market operations. The new counterparty policy is the result of a multi-year review of the framework for counterparty relationships across the full range of the trading desk operations in domestic and foreign financial markets.

Highlights from the new policy include:

  • reducing the minimum net regulatory capital (“NRC”) threshold for broker-dealer counterparties from $150 million to $50 million, in order to broaden the pool of eligible firms;
  • raising the minimum Tier 1 capital threshold for the banks, branches, and agencies of foreign banking organizations from $150 million to $1 billion, to better align the Tier 1 threshold with the new NRC threshold (which is measured with respect to Tier 1 capital of the bank holding company); and
  • introducing a 0.25% minimum U.S. government market share threshold as a means to more directly quantify the business capabilities of firms that express interest in becoming a primary dealer.

Under the new policy, counterparties will be expected to:

  • operate in accordance with the Best Practices for Treasury, Agency Debt and Agency Mortgage-Backed Securities Markets (published by the New York Fed-sponsored Treasury Market Practices Group) and FX market best practices guidance (such as the Global Preamble, promulgated by the New York Fed-sponsored Foreign Exchange Committee);
  • provide insight to regulators on an ongoing basis into developments in the markets in which they transact;
  • meet any minimum capital thresholds or other standards that are set forth by their primary regulator;
  • provide information (as needed) for counterparty risk management and monitoring; and
  • establish a compliance program that is consistent with the sound practices observed in the industry, and support adherence to the terms of its counterparty relationship with the Federal Reserve Bank of New York.

The Federal Reserve Bank of New York also provided the following materials for firms interested in becoming a counterparty:

The new policy and eligibility criteria are immediately effective.

Lofchie Comment: It is notable that the New York Fed reduced the capital requirements for primary dealers, while at the same time increasing those requirements for counterparties to foreign exchange transactions. Further, one could question whether reduced capital requirements for primary dealers reflect diminished market interest in operating as a primary dealer.

ISDA Analyzes Key Trends in Clearing

In its latest Research Note, ISDA examined recent trends in the clearing business in the United States and the European Union.

The ISDA Research Note found, among other things, that:

  • shifts occurring in the business models of futures commission merchants (“FCMs”) due to the impact of new capital requirements and rising operational costs have led to significant changes in the market share of top FCMs in the United States;
  • some derivatives users were dislocated from their existing FCMs and needed to establish relationships with new FCMs in order to continue using swaps mandated for clearing;
  • FCMs are imposing increased costs on smaller derivatives users (survey results in the United States estimated fees from $60 to $150K over the life of a cleared swap); and
  • monthly mandatory minimum clearing fees and minimum revenue thresholds among larger clearing members in the European Union could range from $100,000 to $280,000 per year, and that range of costs is becoming increasingly common in the United States.

In conclusion, ISDA noted, one of the main effects of the increased cost of cleared swaps is this: end users are being pushed to choose alternative hedging measures and/or accept greater risks by either not hedging or using imperfect hedges.

Lofchie Comment: The bottom line of ISDA’s analysis is that, (i) despite all of the outcry about too-big-to-fail, regulatory costs weigh most heavily on smaller institutions, whether buy-side or sell-side, and (ii) increasing the costs of entering into derivatives transactions makes hedging more expensive, which increases risk in the economy generally, even if the risk of derivatives specifically is decreased. To put this in practical terms, if a small firm is prevented from hedging with derivatives in a way that would reduce that firm’s risk, then (a) the risk of derivatives seems to be reduced (since you can’t default on a derivative into which you can enter), but (b) the actual risk to the business (and to the economy generally) is increased because the small firm can’t hedge.

Streetwise Professor Examines “Fundamental Tension” Underlying CCP Resolution Authority

In response to reports that the European Commission (“EC”) is finalizing legislation on Central Counterparty (“CCP”) recovery, University of Houston Finance Professor Craig Pirrong outlined the sources of “fundamental tension” that underlie the final resolution authority. Citing a statement in the EC’s Executive Summary Sheet that the contemplated framework is likely to involve “a public authority taking extraordinary measures in the public interest, possibly overriding normal property rights and allocating losses to specific stakeholders” (emphasis supplied), Professor Pirrong concluded that the prospect of trampled rights “calls into question the prudence of creating and supersizing entities with such latent destructive potential.”

Professor Pirrong argued that the resolution authority potentially will “impose large costs on members of CCPs, and even their customers, [which] raises the burden of being a member, or trading cleared products,” and consequently, disincentivizes membership. He also asserted that “[t]he prospect of dealing with an arbitrary resolution mechanism will affect the behavior of participants in the clearing process even before a CCP fails, and one result could be to accelerate a crisis, as market participants look to cut their exposure to a teetering CCP, and do so in ways that push[] it over the edge.” According to Professor Pirrong, the irony is that these measures to protect CCPs will lead to a “reduced supply of clearing services, and reduced supply of the credit, liquidity and capital that [such CCPs] need to function.”

In addition, Professor Pirrong cautioned that with discretionary power comes “inefficient selective intervention” and the potential to influence costs. “[T]his makes it inevitable,” he warned, that the body will be subjected to intense rent-seeking activity that will mean that its decisions will be driven as much by political factors as efficiency considerations, and perhaps more so: this is particularly true in Europe, where multiple states will push the interests of their firms and citizens.”

CFTC Commissioner Bowen Urges International Regulators to Adopt Similar Rules

CFTC Commissioner Sharon Y. Bowen argued that “regulations and international financial standards need to be broadly aligned, but also be strong enough to ward off undue systemic risk and flexible enough to allow for growth.” In an address before the CFTC Annual Symposium for International Market Authorities, Commissioner Bowen set forth her perspective on the remaining CFTC rulemakings concerning position limits, capital requirements for swap dealers, corporate governance, Regulation AT and cybersecurity. She also weighed in on international developments affecting U.S. markets that “underscore the need for cooperation.”

  • Position Limits: Commissioner Bowen asserted that “a strong position limits rule would not only work to reduce excessive speculation, which can be a major source of systematic risk, but would also make it more difficult for certain market participants to engage in market manipulation successfully.” She noted that CFTC staff has “included within the proposed rule various enumerated hedge exceptions, as well as a process and standard for exchanges to provide market participants the ability to hedge in certain situations.” She hoped that the rule would be finalized within the next few months.
  • Capital Requirements: Commissioner Bowen anticipates that the CFTC will propose capital requirements for swap dealers and major swap participants before the end of the year. While she acknowledged that imposing onerous capital requirements, “such as 35% or even 50% of a portfolio, would inhibit trading and could slow economic growth,” she noted that “[r]equiring a firm to hold a few million dollars in capital against a multi-billion dollar trading book isn’t a regulation that will actually reduce systemic risk and protect firms from imploding. Instead, that kind of de minimis requirement is just a fig leaf.”
  • Corporate Governance: Commissioner Bowen argued for a robust corporate governance rule, including fitness standards that require board directors to have a base understanding for matters under their review, limiting the tenure of independent members of audit and compensation committees, and requiring firms to disclose the level of diversity on their boards.
  • Regulation AT: Commissioner Bowen said that she was “particularly proud of how [proposed Reg. AT] addresses the massive dangers posed by faulty code within algorithmic trading systems.” She noted that the proposed Regulation AT would impose stringent testing requirements on algorithmic trading systems, including testing of new codes prior to use, and regular backtesting using historical data.
  • Cybersecurity: Commissioner Bowen stated that the proposed cybersecurity rule would impose specified testing requirements on DCOs, DCMs, SEFs and SDRs to address the threat of cyber breaches.
  • International Cooperation: Commissioner Bowen cautioned against regulators “drop[ping] to the lowest common denominator when it comes to regulation” and urged global regulators to “fight to craft regulations and international standards that are workable, but provide robust protections to the financial system and to investors.” She encouraged global regulators to consider adopting similar rules as those of the CFTC, emphasizing that: “[u]ltimately, we’re all in this together, and I’d rather have an excellent regulation that is widely adopted across the globe to a perfect regulation that is only adopted here in America.” Commissioner Bowen commended global regulatory cooperation during “Brexit” and opined that the incident demonstrates the importance of strong international cooperation.

Lofchie Comment: Commissioner Bowen’s warning that a single country’s regulators should not go it alone is true. The comment might best be directed at her own agency, the CFTC. There is no other regulator whose conduct has made it such an obvious target of her warning.

SEC Chair White Describes Challenges to Global Securities Regulation

In remarks before the Legal Practice Division at the International Bar Association Annual Conference, SEC Chair Mary Jo White discussed the SEC’s “robust and wide-ranging work” to regulate the global securities marketplace.

Chair White emphasized:

  • current work by the SEC to modernize regulation of the asset management industry, “which is of particular interest to other domestic and international authorities assessing potential systemic risks to financial stability.” In this regard, Ms. White noted the SEC’s imposition of “new required reporting about separately managed accounts and their use of derivatives and borrowing”;
  • the “significant supervisory challenge” of being able to examine non-U.S. based registrants for compliance with SEC laws and regulations; and
  • the SEC Foreign Corrupt Practices Act enforcement program, “which is so dependent on international cooperation for its success.”

Lofchie Comment: It is noteworthy that SEC Chair White links the SEC’s “modernization” of the regulation of the asset management industry to systemic risk. The idea that the SEC should regulate the asset management industry to protect clients is obvious; likewise, that the SEC should regulate the industry to prevent any trading or investment misconduct of advisers from injuring third party market participants is obvious. That the SEC should be regulating investment advisers so as to limit systemic risk is far less obvious and, in fact, questionable. It is not merely that the SEC would not seem to have the expertise, resources or focus to take on this task in light of its other obligations; it goes beyond that. By what authority should the SEC be imposing limits on what investment managers, particularly managers of private funds, buy and sell? Could the SEC tell fund managers that they are too concentrated in oil and that they must diversify into solar, or into healthcare? This seems to be a function that the government should take not take on.

Regarding the SEC’s efforts to collect information regarding the use by advisers of leverage and derivatives, we have commented numerous times that the SEC’s Form PF (designed in connection with the Financial Stability Oversight Commission) is – to anyone who understands how leverage, derivatives, and bankruptcy work – a massive collection of data that is almost completely useless.

CFTC Commissioner Giancarlo Criticizes U.S. Regulators’ Refusal to Delay Swaps Margin Rules

CFTC Commissioner J. Christopher Giancarlo reprimanded U.S. prudential regulators and the CFTC for ordering swap dealers to meet a contested September 1 deadline for the implementation of certain margin requirements that are applicable to uncleared swaps.

In March 2015, IOSCO and the Basel Committee on Banking Supervision published a final policy framework establishing (i) standards for margin requirements for uncleared swaps, and (ii) a phased-in implementation period for the requirements with an initial implementation date of September 1, 2016. Last week, regulators in Australia, Hong Kong and Singapore announced that their implementation of the requirements would be delayed, which followed the pattern of a similar announcement by the European Commission several months before. Notwithstanding these announced delays, the CFTC and U.S. prudential regulators decided to proceed with the original implementation date.

Commissioner Giancarlo called that decision a “failure of U.S. trade negotiation,” and cited it as “yet another example of the failure of U.S. policymakers to negotiate harmonization in regulations . . . in a manner that does not place American markets at a competitive disadvantage.”

In his statement, Commissioner Giancarlo stated he was astonished at regulators’ “blindness to commercial reality,” and noted that American markets now will have a higher margin structure, which he emphasized will give a competitive advantage to major overseas derivatives markets. He also emphasized ramifications of the decision that could prove dangerous to the economy:

Even from a practical standpoint, the coming days will be enormously challenging for U.S. market participants as dealers are still working to finalize account documentation. Some observers warn of a liquidity crunch because certain dealers will not be ready to trade with other dealers. Unfortunately, U.S. regulators appear more concerned with sticking to an arbitrary deadline than the health of American markets and American market participants.

Commissioner Giancarlo warned that the United States will lose its negotiating leverage in the event of further delays.

Lofchie Comment: Kudos to Commissioner Giancarlo for prioritizing commercial realities. When Dodd-Frank first was adopted, certain U.S. regulators asserted that the rest of the world would follow their example whether or not the rules made any sense. That assertion has proved to be incorrect. In many cases, the Europeans have gone their own way (sometimes adopting more sensible rules, sometimes adopting rules that seem even less sensible), but they have not adhered to the strictures of U.S. regulators. Knowing now that the Europeans will follow their own path, U.S. regulators should not place U.S. firms at a material competitive disadvantage.