FINRA Conducts Review of Firm’s “Zero Commissions”

In a targeted examination, FINRA is seeking information on the practices of firms that charge zero commission on client trades and “the impact that not charging commissions has or will have on the Firm’s order routing.”

In this latest targeted exam, also referred to as a “sweep,” FINRA’s Market Regulation Department’s Trading & Financial Compliance Examinations Department issued a sample exam letter of the information requested. The letter is intended to elicit information about the scope of the trades on which no commission is charged, as well as information concerning how the firm makes money, whether clients understand how the firm makes money, and whether the firm’s revenue practices may be detrimental to customers; e.g., whether the firm is less focused on obtaining best execution for customers because it is more dependent on obtaining revenue through trade rebates or payments for order flow arrangements.

LOFCHIE COMMENTARY

This is actually quite a significant targeted exam letter. It has relevance well beyond those firms that have a zero commission offering. FINRA is asking very detailed questions about how the firm makes money, and how the firm’s revenue stream affects the manner in which the firm does business and treats customers.

The type of information that the letter is intended to elicit includes information that would be relevant to the completion of Form CRS that is to be provided to clients.

In short, all firms, not only those that are potential recipients of the letter, should give careful consideration to how they would answer the questions raised, and as to how those answers would look to the regulators and their customers.

CFS Interviews John Williamson on the Washington Consensus, Exchange Rates, and More

The CFS is delighted to present an interview with the eminent international economist John Williamson, reviewing his more than five decades of work in the field.

Williamson is best known for coining the term “Washington Consensus” in 1989 as a summary of the policy reforms and structural adjustment measures that the International Monetary Fund, World Bank, and U.S. Treasury advocated for emerging market economies. The term quickly gained resonance and continues to be widely used today, both as the description Williamson initially presented it as and as a prescription of what good policies should be (see the appendix to the interview).

He also worked for much of his career on “intermediate” exchange rates between the extremes of fixed and floating. The late Rüdiger Dornbusch of MIT summarized Williamson’s proposals as “BBC” – band, basket and crawl. In support of them, Williamson devised the influential concept of the “fundamental equilibrium exchange rate” (FEER).

In 2012 Williamson retired from the Peterson Institute of International Economics, where he had been a senior fellow for more than 20 years. His previous appointments included professorships in his native England, the United States, and Brazil; an advisory post at the British Treasury; and staff or management positions at the International Monetary Fund, World Bank, and United Nations.

Besides covering the major ideas of Williamson’s career as an economist, the interview offers a few glimpses into other areas of his life and reminds us of how much economic conditions have changed. He was born at home, common in his generation but now rare in rich countries. Despite being the son of a successful English businessman, he went abroad only once before adulthood, on a one-week school trip to Paris. The UK had extensive exchange controls back then, and allowances for tourism were notoriously stingy. He served his compulsory national service, another now-bygone institution, working on a nuclear attack scenario for the Royal Air Force that has a bit of a darkly comic Dr. Strangelove feel.

I interviewed Williamson with CFS research associate Robert Yee. John’s daughter Theresa gave us considerable help, for which we are grateful.

House Urges Supreme Court to Uphold Constitutionality of CFPB

The House of Representatives filed an amicus curiae brief urging the Supreme Court to reject a challenge to the constitutionality of the CFPB. The CFPB is an independent agency within the Federal Reserve System created by Title X of the Dodd-Frank Act. The Supreme Court scheduled the matter for oral argument on March 3, 2020.

The House brief argued that the Court should affirm the Ninth Circuit’s ruling in Seila Law LLC v. Consumer Financial Protection Bureau, 923 F.3d 680 (9th Cir. 2019), which upheld the CFPB’s constitutionality following the refusal of Seila Law LLC (“Seila”), a debt-collection firm, to comply with a civil investigative demand (“CID”) issued by that agency. In its petition to the Supreme Court, Seila argued that the CID is unlawful because the CFPB is unconstitutionally structured. In particular, Seila maintained that CFPB’s regulatory structure violates the Constitution’s separation of powers because it is an independent agency headed by a single Director who exercises substantial executive power but can be removed by the President only for cause.

The House brief addressed two questions: (i) whether the CFPB Director’s removal protection violates the separation of powers and (ii) whether a constitutional flaw in the CFPB Director’s removal protection entitles Seila to relief from the civil investigative demand, and requires invalidation of Title X of the Dodd-Frank Act, the statutory provision creating the CFPB.

In its brief, the House urged the Supreme Court to avoid ruling on the constitutionality of the CFPB Director’s removal protection, arguing that the Court should rule that the CID would be enforceable even if the removal protection is invalid. Second, the House contended that if the Court does reach the constitutional question, it should uphold the CFPB Director’s removal protection, arguing that such protection “is exactly the same as” that provided members of other independent agencies such as the FTC, and that the CFPB’s single-director structure enhances, rather than diminishes, the agency’s accountability to the President. Finally, the House argued that the constitutionality of the removal protection should not affect Title X and, therefore, the legal viability of the CFPB, pointing to the severability provision within the Dodd-Frank Act, which states that if “any provision” of the statute “is held to be unconstitutional, the remainder of th[e] Act . . . shall not be affected thereby.”

Amici curiae briefs from New York and 23 other state attorneys general, the National Consumer Law Center, and several other consumer-advocacy organizations echoed similar arguments in support of preserving the CFPB’s structure. Click here to see all amici briefs submitted on the constitutionality of the CFPB.

LOFCHIE COMMENTARY

Leaving aside the big picture question of the constitutionality of the CFPB structure, the CFPB structure makes for bad public policy. It represents an immense amount of power concentrated in the hands of a single individual, who does not report to any branch of Congress. There is simply no good reason why the CFPB should not be reorganized following the same basic structure as the other independent regulatory agencies, with representation from both political parties on the Commission, and the leader of the Commission being appointed by the current President, of whichever party that might be.

FRBNY Assesses Potential Impact of Cyberattacks on Payment Systems

The Federal Reserve Bank of New York (“FRBNY”) analyzed the potential impact of a cyberattack transmitted through a payment system against a (i) single large bank, (ii) group of smaller banks and (iii) common service provider.

In a report entitled “Cyber Risk and U.S. Financial System: A Pre-Mortem Analysis,” the FRBNY warned that an attack on a bank’s ability to send payments “would likely be amplified to affect the liquidity of many other banks in the system.” According to the FRBNY, the U.S. financial system would be impaired by such an attack on (i) any one of the five most active U.S. banks, (ii) several small to midsize banks that are associated through a shared vulnerability or (iii) a bank with a small number of total assets but a heavy payment flow.

Additionally, the FRBNY:

– compared cyber risk against the “broader theoretical literature on bank runs,” such as cyber and other shocks modeled in the theoretical literature;

– investigated the quantitative impact that a cyberattack can have on the financial system by studying the impairments of a cyberattack on a set of banks’ payment activities in Fedwire Funds Service;

– conducted a baseline scenario to highlight the high concentration of payments between large institutions within the wholesale payment network, and the great imbalance in liquidity that follows if a large institution does not remit payments to its counterparties; and

– considered scenarios involving multiple institutions that would be directly affected due to technological or other commonalities.

LOFCHIE COMMENTARY

Presumably, the bad guys know how to do this anyways, and the issues raised will focus the good guys on the risks.

FINRA Identifies 2020 Risk Monitoring and Examination Priorities

In its Risk Monitoring and Examination Priorities Letter (the “2020 Letter”), FINRA identified several areas of focus for 2020, including:

– Sales Practice and Supervision. FINRA will assess firms’ compliance with Regulation Best Interest (“Reg. BI”) and Form CRS. In addition, FINRA will focus on (i) communications to retail investors regarding private placements, (ii) use of different electronic communication channels (e.g., texting and social media), (iii) cash management and bank sweep programs, (iv) sales of IPO shares and (v) trading authorizations.

– Market Integrity. FINRA will monitor firms for compliance with current Order Audit Trail System (“OATS”) requirements, and implementation of Consolidated Audit Trail (“CAT”) reporting requirements. In addition, FINRA will address firms’ compliance with (i) direct market access requirements under Exchange Act Rule 15c3-5, (ii) best execution requirements under FINRA Rule 5310, and (iii) the requirements of Rule 603 (the “Vendor Display Rule”) and Rule 606 (“Disclosure of order routing information”) of Regulation NMS.

– Financial Management. FINRA will focus on (i) clearance and custody of digital asset transactions, (ii) liquidity management, (iii) compliance with net capital requirements in connection with underwriting commitments and (iv) the steps firms are taking to transition away from LIBOR.

– Firm Operations. FINRA will focus on (i) cybersecurity, (ii) technology governance programs and (iii) supervisory controls relating to customer confirmation and AML requirements.

Lofchie Commentary

Several of the financial management areas of focus are as to issues where there is not actually a rule in place; e.g., liquidity management and transition from LIBOR. That does not make them any less significant. Firms may want to consider how they institute operational procedures to deal with regulatory expectations where there is not a specific rule that drives the firm’s conduct.

WSJ: Positive Revival of Agency that Aids Exporters (Exim)

The Wall Street Journal reports this morning on the reauthorization of the Export-Import Bank of the United States (EXIM) for seven years.

– The move represents a positive step forward to enhance economic growth, financial stability, and national security.

– Exim’s educational opportunities and finance unleash meaningful network effects. Once small and medium sized companies overcome obstacles to exporting, new markets open.

– Conservative critics are justifiably worried about heavy-handed “industrial policy.” Yet, Exim activities fall far short of a well-intention public sector misallocating resources.

Congratulations to Chairman Kimberly Reed and Exim for the hard work and reforms needed to safeguard US financial and strategic interests!

SEC Commissioner Hester Peirce Questions Current Data Collection Practices

SEC Commissioner Hester M. Peirce questioned the agency’s current data collection process and analysis.

In a speech before the National Economists Club, Ms. Peirce expressed concern that regulators’ data collection requirements are too far-reaching. According to Ms. Peirce, regulators are increasingly expanding data requirements without adequately considering (i) the underlying costs to regulators, market participants and investors, (ii) the usefulness of the information, and (iii) the potential cybersecurity risks. She:

  • questioned whether the information collected by Form PF is useful enough to outweigh the burden of compliance on hedge funds and other private funds; and
  • expressed concern that the Consolidated Audit Trail (or “CAT”) – which will collect data from broker-dealers across the county – is costly and a significant cybersecurity liability.

Ms. Peirce urged the SEC to invite academics and market participants to analyze the data collected, raise questions and suggest regulatory solutions. She stated that oftentimes market participants are better at “identifying problems and generating solutions” than the regulators. To encourage independent assistance, Ms. Peirce advised the SEC to make it easier for market participants to access the available data.

Ms. Peirce also addressed recent feedback calling on regulators to foster “sustainable finance,” (a/k/a “building a financial system that fosters a better, more sustainable society”). She stated that such a system should be formed by the free market, and should not be “dictated by a few powerful financial regulators.”

LOFCHIE COMMENTARY

In a world where every website is under potential attack from hostile nation states and from criminal organizations, why would one take the risk of gathering so much financial information in one place? The U.S. government has been successfully hacked; very sophisticated data companies have been successfully hacked; large financial institutions have been successfully hacked. There appears no obvious justification for accumulating so much financial information in a single location, as there can be no assurance that it can be kept safe for all time. Put another way, if the regulators cannot attest that, even if the site is hacked, the benefit of collecting and aggregating the financial information will nonetheless outweigh the harm, then it seems imprudent to proceed.

Form PF, as previously described, is “fundamentally useless.” See, e.g.SEC Requests Comments on Form PF. Anyone with knowledge of the relevant subject areas can look at the questions and see that they will not generate meaningful data; it’s not even necessary to look at the responses to see that the entire data collection effort has been a 99% waste.

Facebook CEO Mark Zuckerberg Defends Libra

In testimony before the House Financial Services Committee, Facebook CEO Mark Zuckerberg defended his company’s proposed virtual currency, “Libra.” The Committee also considered several bills related to technology and the financial services industry.

Mr. Zuckerberg emphasized that Facebook would not launch the Libra payment system until it has the support of U.S. regulators. He warned that, while these issues are being “debate[d],” China and other countries are working to launch similar payment systems. He argued that since Libra would be backed by U.S. dollars, it would “extend” U.S. financial leadership. He also addressed several concerns, assuring the legislators that:

– a recent white paper co-authored by Facebook (see previous coverage) was intended to start a dialogue with financial experts and regulators, rather than serve as the “final word”;

– Facebook does not intend to “circumvent” regulators; and

– the intended purpose of Libra is to provide for the transfer of money through an online payment system, not to be a replacement for sovereign currency.

Mr. Zuckerberg also affirmed Facebook’s commitment to preventing discrimination among Facebook’s advertisers. To “combat[]” discrimination, he stated, Facebook has made specific changes to policies in order to prevent discriminatory advertisement targeting. For example, Facebook banned the use of age, gender or zip codes in housing and credit advertisements.

Committee members at the hearing discussed several bills concerning technology and finance related to issues raised by the testimony. These included:

H.R. Draft “Keep Big Tech Out of Finance Act” would prohibit large platform utilities (i.e., Facebook) from (i) being authorized as, or affiliating with, a U.S. financial institution or (ii) operating a digital asset that is intended to be “widely used” as a method for exchange, pursuant to the Federal Reserve.

H.R. Draft “Stablecoins Are Securities Act of 2019” would make clear that a managed stablecoin is subject to the same securities laws’ requirements as other securities that are meant to protect investors, such as disclosure, antifraud and conflicts of interest.

H.R. Draft “Bill to Prohibit the Listing of Certain Securities” would limit issuers of stablecoins access to capital markets prohibiting certain trading on U.S. national securities exchanges.

H.R. Draft “Designing Accounting Safeguards to Help Broaden Oversight and Regulations on Data” would create more “transparency” on how consumer data is collected by requiring commercial data operators to disclose (i) the type of user data collected, (ii) an examination of how valuable the user data is and (iii) third-party contracts involving the collection of the data.

H.R. Draft “Diverse Asset Managers Act” would require SEC registrants to (i) consider at least one “diverse” asset manager when seeking asset management services and (ii) report to the SEC the extent to which diverse asset managers are used.

LOFCHIE COMMENTARY

Facebook’s attempted entry into the digital currency market accelerated the inevitable: Congress and the financial regulators are more closely scrutinizing the entry of technology firms into the financial markets. What was not inevitable was Congressional overreaction. While it now seems universal practice to refer to Libra as a Stablecoin, it is not: it is an asset-backed coin (try “ABCoin”). Because the managers of Libra would have had the ability to shift the assets supporting Libra, Libra is not stable. Because of the management of the underlying assets backing the product, Libra almost certainly would have been a “security,” at least in the absence of an exemption, and therefore, it is not necessary to amend the securities laws to that end.

A true Stablecoin, whether backed by the dollar or another currency (or even a pool of currencies) may be issued as a custodial receipt that is not a security, and need not be regulated as a security. It would thus be a shame if such Stablecoins, which may very well provide an attractive alternative to other payment methods, were made impossible because of an overbroad reaction to Libra.

Mr. Zuckerberg is absolutely correct that the United States benefits if a global stablecoin backed by the dollar were to emerge. Facebook’s principal mistake, which arguably reflects a certain lack of sophisticated understanding of financial regulation, was to go forward with a managed ABCoin, rather than a true Stablecoin.

IRS to Ask Taxpayers about Virtual Currency Transactions

The IRS proposed an amended draft of the 2019 Form 1040 that includes a question about taxpayer virtual currency transactions.

As previously covered, the IRS provided updated guidance in the form of a revenue ruling and an FAQ on the tax treatment of virtual currency transactions. The FAQ addressed (i) when a cryptocurrency on a distributed ledger undergoes a protocol change that permanently divides the legacy from the existing distributed ledger (i.e., a “hard fork”) and (ii) when units of a cryptocurrency are delivered to the distributed ledger addresses of multiple taxpayers (i.e., an “airdrop”), typically following a hard fork.

The IRS proposed adding the following question to the 2019 Form 1040: “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”

Comments on the revised draft must be submitted to the IRS within 30 days after October 11, 2019.

FRB Vice Chair Randal Quarles Reviews FSB Activity

Federal Reserve Board Vice Chair Randal K. Quarles reviewed Financial Stability Board (“FSB”) activity and raised issues that continue to affect the global financial system. In a speech at the European Banking Federation’s European Banking Summit, Mr. Quarles highlighted the following:

OTC Derivatives. The FSB focused on the following issues as to OTC derivatives: (i) central clearing of standardized OTC derivatives, (ii) trading standardized OTC derivatives on an exchange or through an electronic trading platform, (iii) “reporting to trade repositories” and (iv) capital and margin requirements.

Prudential Bank Standards. Mr. Quarles addressed the work done by the Basel Committee to improve prudential standards for internationally active banking organizations (a/k/a “Basel III”). Mr. Quarles said that each of the 24 FSB jurisdictions have implemented the fundamentals of Basel III to incorporate risk-based capital and liquidity measures.

Key Attributes for Effective Resolution. As a solution to the “too-big-to-fail” dilemma, the FSB published “Key Attributes for Effective Resolution.” Mr. Quarles explained that the guidance offered procedures for national resolution regimes to follow if an important financial institution is failing.

Nonbank Financial Intermediation (“NBFI”). To better understand NBFI, the FSB conducted a “global monitoring exercise” and concluded that the overall size of NBFI to the global economy was $184 trillion. The FSB report also contained categories of NBFI activity and identified potential vulnerabilities.

Mr. Quarles also emphasized two issues the FSB is monitoring concerning the future of the global financial system.

– Financial Innovation. Mr. Quarles said that in response to an “explosion of financial innovation” in recent years, the FSB published a report on the potential implications and benefits of FinTech for the global financial system. Mr. Quarles highlighted multiple regulatory issues, such as (i) operational risks from third-party service providers, (ii) cyber risks and (iii) macrofinancial risks that may arise from FinTech activity.

– Market Fragmentation. While noting that market fragmentation will never “disappear,” Mr. Quarles explained that since the financial crisis, there have been growing concerns that globalization in the markets is slowing down. Mr. Quarles said that the FSB is working to assess the possible implications of market fragmentation, such as (i) the potential for regulatory “arbitrage” and (ii) an increased regulatory burden on firms.