SEC Chair Addresses Dynamic Regulation and Market Modernization

SEC Chair Gary Gensler urged regulators to update policy and monitor economic changes as part of a dynamic approach to regulation.

In prepared remarks before the Exchequer Club of Washington, D.C., Mr. Gensler highlighted two principles important to dynamic regulation: efficiency in capital markets and rules modernization.

On capital markets efficiency, Mr. Gensler noted the SEC’s role in promoting fair markets by lowering the costs of financial intermediation. He encouraged greater competition and transparency as key pillars of efficiency, and directed SEC staff to foster competition and transparency throughout the financial sector. Mr. Gensler hoped this focus on transparency and competition would help both issuers and investors.

With regard to modernization, Mr. Gensler described the SEC’s history of adapting to emergent technologies and emphasized the need for more dynamic regulation. While acknowledging cryptocurrency as one area of technological advancement, Mr. Gensler focused on artificial intelligence and predictive data analytics as potentially revolutionary developments for the SEC to watch closely in the coming decade. He also pointed to non-technological developments, such as special-purpose acquisition companies and direct listings, as important areas for the SEC’s consideration.

Mr. Gensler addressed public speculation on the timeline of new SEC rules publication by focusing on flexibility and “getting proposals right” rather than trying to prioritize any one area over another.

LOFCHIE COMMENTARY

Commissioner Gensler reports that in 1963, financial services accounted for 3.5% of the U.S. economy, while today it accounts for about 8%. He also cites to a 2014 study, which he describes as reporting that the “costs of financial intermediation . . . were as high in 2014 as they were in 1900.” The message behind these numbers is that financial services are too great a part of the economy with the implicit assumption that costs of financial services are effectively a tax or a drag on the U.S. economy. Mr. Gensler suggests that better (more?) dynamic regulation would serve to increase competition and drive down costs.

A different view on the role of financial services in the U.S. economy can be found on the U.S. government website, SelectUSA. According to that website, the financial services industry generated an export-import trade surplus of over $40 billion dollars and employed more than 6.3 million people. Further, the government site indicates that financial services also play a significant role in supporting the export of U.S. manufactured and agricultural products.

As to the costs of financial intermediation, without being able to access the 2014 article to which Mr. Gensler cites, it is common knowledge that the costs of trading U.S.-listed securities have dropped dramatically. New financial technologies, such as robo-advice and payment through the use of digital assets, may also substantially reduce the costs of financial transactions.

In short, a very high-level view of the numbers may not actually tell very much about the role that financial services should play in the economy, or as to whether that role is now too large, or could even be increased, given America’s position as banker to the world. While regulators should certainly be mindful of the costs of financial services and whether those costs are artificially high, it should be as important for regulators to be mindful of the costs and the impact of the regulations that they impose.

To take one example of the potential impact of regulatory costs, it is useful to take a look at another number: the number of futures commission merchants (“FCMs”) in the United States pre- and post-Dodd Frank. In January 2008, the CFTC shows that 151 firms filed financial reports as FCMs. In January 2021, the CFTC shows that 65 firms filed reports. This suggests some correlation between increasing regulation and a decrease in the number of competitor firms.

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Primary Sources

  1. SEC Chair Gary Gensler, Prepared Remarks: “Dynamic Regulation for a Dynamic Society” before the Exchequer Club of Washington, D.C.

SEC Proposes Amendments to Money Market Fund Rules

The SEC proposed amendments to the requirements applicable to money market funds pursuant to ICA Rule 2a-7 (“Money Market Funds”) under the Investment Company Act that are generally aimed at preventing a run on money market funds during a time of financial crisis. The amendments were proposed in light of the significant redemptions experienced by money market funds at the start of the COVID-19 pandemic.

Regulatory Changes
The proposed amendments include:

increasing the amount of assets with daily liquidity that a money market fund must hold from 10 percent to 25 percent of its assets; and increasing the amount of assets with weekly liquidity that a money market fund must hold from 30 percent of its assets to 50 percent; funds would be required to institute stress tests to determine their minimum level of desired liquidity; the SEC asks for comment as to what requirements should be imposed on a fund that fails to maintain its required liquidity level;

removing from the existing money market funds rule the authority of funds to impose either gates on redemption or to impose liquidity fees on redeeming investors (the SEC said that such authority was counterproductive encouraging investors to redeem before the gates or fees could be imposed);

requiring institutional prime and institutional tax-exempt money market funds to implement swing pricing, which would permit adjustments to current net asset value per share when the fund has net redemptions (and result in redeeming investors bearing liquidity costs);

modifying certain reporting requirements on Forms N-MFP and N-CR to improve the availability of money market fund information, and making conforming changes to Form N-1A to reflect proposed changes to the regulatory framework for these funds;

adding provisions to address how money market funds with stable net asset values should handle a negative interest rate environment;

adding provisions that specify how funds must calculate weighted average maturity and weighted average life; and

imposing additional reporting requirements on money market funds, including that a fund must file a report when it falls below a specified liquidity threshold.

Comments on the proposal are due within 45 days after its publication in the Federal Register.

Commissioner Statements
SEC Chair Gary Gensler supported the proposal, saying the reforms will help maintain “fair, orderly, and efficient markets.” SEC Commissioner Allison Herren Lee called the proposal a “necessary continuation of our focus on addressing weaknesses of these funds.” She added that, with respect to the public comment period, she would like to better understand the “foreseeable impacts of swing pricing” and how it might impact investor choice. SEC Commissioner Caroline A. Crenshaw stated that both the SEC and investors would be better positioned to “monitor funds’ activities and evaluate the impact of market stress on those funds.”

SEC Commissioner Hester M. Peirce opposed the proposal, saying that, as in the existing rule, there is “too much regulatory prescription and too little room for experimentation by funds.” Ms. Peirce said the proposal could “undermine the objective of making money market funds more resilient” and would “continue the trend of driving more money into government funds.” Ms. Peirce said, such an outcome would leave investors, issuers and markets worse off. Ms. Peirce was supportive of the reform to eliminate the connection between liquidity thresholds and fees and gates.

SEC Commissioner Elad L. Roisman supported some elements of the proposal, including the effort to explore several measures that could reduce run risk for money market funds. However, he dissented and expressed “strong reservations” about the requirement that a “uniform approach to charge fees to redeeming investors” would be applied to all institutional non-government money market funds (emphasis in original). Further, he found the timing of the comment period to be a “major shortcoming,” saying that he did not have confidence that market participants will be able to provide meaningful feedback over a comment period that aligns with several holidays and five other proposed rulemakings.

LOFCHIE COMMENTARY

There may be no area in securities law that is so conceptually difficult to create sound regulation as with respect to money market funds.  The central question is: how does one create a fund that maintains a fixed share value of $1, notwithstanding fluctuation in the value of the fund’s asset, and yet avoid having investors redeem when they believe that the true value of the fund is less than $1?  So far, mission not accomplished.  

Given the difficulty of the problem, Commissioner Peirce’s suggestion that the SEC should be less prescriptive and let different funds approach the problem differently makes sense.  After all, as the SEC concedes, the regulatory imposition of gates did not work.  Perhaps the SEC would do better to let the market experiment with solutions.

FRB Governor Randal Quarles Offers Parting Thoughts

Commentary by Steven Lofchie

Former Vice Chair for Supervision Randal K. Quarles covered a broad range of topics in his farewell remarks. He celebrated the overall strength of the banking system and suggested areas where there is latitude for regulatory change or recalibration.

“But I did at the time, and still do, have concerns about the possible precedents that have been created by the novel [credit] facilities that we [the Federal Reserve] created [as a reaction to the pandemic].”

Federal Reserve Board Vice Chair for Supervision Randal K. Quarles

Read his remarks, Between the Hither and the Farther Shore: Thoughts on Unfinished Business.

New Giancarlo Crypto book

J. Christopher Giancarlo – America’s leading authority on Cryptocurrency and the coming digital economy – has just released his new book, CryptoDad: The Fight for the Future of Money (https://www.amzn.com/111985508X/). 

CryptoDad is engaging and destined to have great impact. Even the footnotes are superb! The book adds depth to the many vectors influencing the future of cryptocurrencies and regulation.

Chris Giancarlo is the former Chairman of the CFTC – first nominated as a CFTC Commissioner by President Barack Obama and subsequently nominated as Chair by President Donald Trump.  He is the founder of the new Digital Dollar Project (https://digitaldollarproject.org/), which is committed to advancing the exploration of a United States Central Bank Digital Currency (CBDC).  Over the years, he has done pathbreaking work at the intersection of regulation and financial innovation.

IMF Senior Executives Warn of Financial Stability Risks Posed by “Crypto Boom”

In an International Monetary Fund (“IMF”) blog post, IMF senior executives warned of the risks to financial stability from “cryptoization.”

The executives reported that the value of the crypto asset market increased tenfold from early 2020 to September 2021, even though many of the industry’s intermediary entities (e.g., miners and exchanges) lack “strong operational, governance, and risk practices.” They noted the substantial disruptions experienced by crypto exchanges during times of market turmoil, as well as a number of “high-profile” hacking incidents that resulted in stolen customer funds. While such incidents have not significantly affected financial stability, they argued, the crypto industry’s growth poses significant consumer protection risks.

In addition, the executives noted the money laundering, tax evasion and terrorist financing risks arising from the data gaps associated with the “(pseudo) anonymity” of crypto products. They stated that international regulatory collaboration is critical to crypto market regulation because the majority of crypto exchange transactions take place “through entities that operate primarily in offshore financial centers.” They also expressed concern regarding the risks to implementing monetary policy effectively that may result from the widespread use of cryptocurrencies.

To address issues arising from rapid crypto industry developments, the executives recommended that regulators (i) promptly take action to reduce data gaps, (ii) improve cross-border collaboration to reduce the risk of “regulatory arbitrage” and maximize supervision and enforcement efforts, (iii) implement current international standards that are applicable to crypto assets, including with respect to securities regulation, (iv) assess the benefits of adopting a central bank digital currency and (v) prioritize making cross-border payments more economical, efficient, transparent and widely available through the G20 Cross-Border Payments Roadmap.

LOFCHIE COMMENTARY

For all of the concerns that the U.S. and global regulators have expressed regarding digital assets, there has been disappointingly little focus on distinguishing among the different types of digital assets. A “trust” currency such as Bitcoin raises very different issues from a stablecoin that is fully supported by U.S. dollars in a U.S. bank (assuming, of course, that the dollars are there). These assets are different from digital assets that represent ownership of a company and likewise different from utility tokens. The resort to proclaiming that all of these assets should be regulated as securities has the benefit of simplicity, but it is not correct (at least under U.S. law), and it will make impossible a good number of the legal uses for which digital assets are well suited.

Senate Subcommittee Considers Benefits of a Central Bank Digital Currency

The U.S. Senate Banking Subcommittee on Economic Policy considered testimony on the benefits of issuing a central bank digital currency (“CBDC”).

Subcommittee Chair Senator Elizabeth Warren (D-MA) expressed support for a “well-designed” and “efficiently executed” CBDC because of its potential to “drive out bogus digital private money while improving financial inclusion, efficiency, and the safety of our financial system.” By contrast, Ms. Warren criticized cryptocurrencies, calling them a “fourth-rate alternative to real currency” and asserting that they are:

  • a “lousy” means of transacting, since their value substantially fluctuates as a result of speculative day trading;
  • a poor investment, given that there are currently no consumer protections for crypto investors, and pump-and-dump schemes “have become routine in crypto trading”;
  • substantial facilitators of illegal activity, as the secrecy component of cryptocurrencies has enabled criminals to more easily move money; and
  • “staggering” consumers of energy; she pointed to (i) the amount of energy required in “proof-of-work” mining for new cryptocurrency tokens, and (ii) the fact that Bitcoin-related energy consumption is higher than the yearly energy consumption of the Netherlands.

The Subcommittee heard testimony from the following individuals:

  • Dr. Neha Narula, MIT Digital Currency Initiative Director. Ms. Narula testified that a CBDC is not the only method for addressing the issues associated with underbanking in the traditional financial system, noting that a requirement on banks to provide free, no-minimum accounts to users might address the issue. Considering that the U.S. dollar plays a significant role in the global economy, Ms. Narula cautioned against too quickly adopting a U.S. CBDC without thoroughly determining (i) how it should be accessed and managed, and (ii) what data it makes visible, to whom and under what circumstances.
  • Lev Menand, Columbia Law School Academic Fellow and Lecturer in Law. Mr. Menand described shortcomings of the current U.S. banking system, including: (i) inaccessibility for certain U.S. households, (ii) the high cost of overdraft, deposit and minimum balance fees, (iii) slow processing times for check deposits, wire transfers and credit card payments, and (iv) complexity with respect to differing bank ledgers. Mr. Menand stated that the advent of a CBDC could address these shortcomings by, among other things, (i) expanding mainstream banking eligibility, (ii) decreasing the clearing time for payments, (iii) reducing the fees associated with banking, (iv) enhancing financial stability for businesses and institutions, and (v) decreasing regulatory complexity, considering that many of the regulations promulgated following the 2008 financial crisis were aimed at deposit substitutes.
  • Dr. Darrell Duffie, Stanford University Graduate School of Business Professor of Management and Finance. Mr. Duffie urged the United States to invest in the development of a CBDC, considering the progress that has been made internationally in similar ventures, particularly that of China’s eCNY. Mr. Duffie recommended that the United States (i) “take a leadership position” in international conversations regarding the cross-border use of CBDCs, and (ii) enhance the competitiveness and efficiency of the existing U.S. payment system.
  • J. Christopher Giancarlo, Willkie Farr & Gallagher Senior Counsel. Mr. Giancarlo promoted the Digital Dollar Project’s “champion model” proposal for a CBDC, which would involve the Federal Reserve issuing “Digital Dollars” to regulated banking entities. The former CFTC Commissioner stated that the champion model would enable the continuation of the two-tiered commercial bank and regulated money transmitter model through its deployment and recording of the Digital Dollar transition on a “new transactional infrastructure informed by distributed ledger technology.” Mr. Giancarlo asserted that the Digital Dollar would be “far superior” to Bitcoin with respect to environmental sustainability because it would not have to be mined. Rather, the Digital Dollar would be created by the Federal Reserve cryptographically and distributed electronically. Additionally, Mr. Giancarlo contended that the existence of a Digital Dollar during the earlier stages of the COVID-19 crisis would have provided a means of instant monetary relief to targeted beneficiaries. Mr. Giancarlo also noted that a Digital Dollar could be superior to competing financial instruments of foreign jurisdictions, particularly those with anti-democratic regimes that could use those instruments for surveillance purposes. He explained that it would be “in the best national interest of the United States and . . . in the interest of the world economy” to create a well-designed U.S. CBDC. One challenge, Mr. Giancarlo observed, is the ability of the United States to take a leadership role in the innovation of a CBDC, considering that “this global wave of digital currency innovation is quickly gaining momentum.”

LOFCHIE COMMENT

A U.S. dollar CBDC seems inevitable. When Senator Warren and former CFTC Chair Giancarlo agree on something, on anything, it is probably time to act. At what point does continuing to conduct studies create delays that may weaken the competitive position of the dollar in the global economy (or at least fail to capitalize on its strengths)?

PRIMARY SOURCES

  1. U.S. Senate Financial Services Subcommittee Hearing: Building a Stronger Financial System – Opportunities of a Central Bank Digital Currency
  2. Senator Elizabeth Warren Testimony: Building a Stronger Financial System – Opportunities of a Central Bank Digital Currency
  3. Neha Narula, MIT Digital Currency Initiative Testimony: Building a Stronger Financial System – Opportunities of a Central Bank Digital Currency
  4. Lev Menand, Columbia Law School Testimony: Building a Stronger Financial System – Opportunities of a Central Bank Digital Currency
  5. Darrell Duffie, Stanford Business School Testimony: Building a Stronger Financial System – Opportunities of a Central Bank Digital Currency
  6. J. Christopher Giancarlo, Willkie Farr & Gallagher Testimony: Building a Stronger Financial System – Opportunities of a Central Bank Digital Currency

Inflation Fears Offers the Fed a Chance to Modernize with Money

Investors and the public are right to worry about inflation. Yet, measures to predict the impact of Fed policies on inflation, the economy, and financial stability are of deteriorating quality and being disregarded.

Market participants and especially officials must recognize that quantities of money matter now more than ever. Gyrations of the Fed’s balance sheet are at heights not witnessed in over 100 years.

Here, the Fed is moving in the opposite direction of its Congressional mandate (Section 2A) by increasing the money supply far in excess of long-run growth.

Since 2012, the Center for Financial Stability (CFS) has offered the public alternative monetary measures – pioneered by Professor William A. Barnett.

From this work, we now know that measuring activity in the financial system better predicts both inflation as well as financial instability risks.

We look forward to any comments you might have.

To view the full article:
http://www.centerforfinancialstability.org/research/Modernize_Money_042621.pdf

House Passes Bill to Establish CFTC-SEC Digital Assets Working Group

The U.S. House of Representatives passed a bill that would direct the CFTC and SEC to jointly create a digital assets working group.

The bill would require that the working group include at least one individual representing each of the following groups: (i) financial technology firms providing digital assets products or services; (ii) financial firms within the jurisdiction of the SEC or the CFTC; (iii) institutions or organizations conducting academic research or engaging in advocacy efforts concerning the use of digital assets; (iv) small businesses using financial technology; (v) organizations concerned with investor protection; and (vi) institutions and organizations advocating for investment in historically underserved businesses.

Additionally, the bill would require that, within a year of its enactment, the working group must submit a report to the SEC, the CFTC and “relevant committees” that includes, among other things, an analysis of:

  • the United States’ legal and regulatory framework concerning digital assets, including the effect of (i) the ambiguity of the framework on primary and secondary digital assets markets, and (ii) domestic legal and regulatory digital assets regimes on the “competitive position of the United States”;
  • recommendations regarding (i) the implementation, maintenance and enhancement of primary and secondary digital assets markets, including the improvement of “fairness, orderliness, integrity, efficiency, transparency, availability and efficacy” of those markets, and (ii) standards for custody, private key management, cybersecurity and business continuity as it pertains to digital asset intermediaries; and
  • best practices to (i) decrease the prevalence of digital assets fraud and manipulation in cash, leveraged and derivatives markets, (ii) enhance investor protections for participants in such markets and (iii) aid in compliance with the Bank Secrecy Act’s AML anti-terrorism financing provisions.

LOFCHIE COMMENT

Why is it necessary to have the SEC and CFTC conduct a joint study, with each naming the same number of members? Would it not make more sense to empower one agency (generally the SEC) and direct it to consult with other agencies, including the CFTC and, for example, FinCEN, if AML is a topic of concern?

Second, explicit directions as to the members of the joint study detract from the efficacy of the study. Do the legislators believe that because one financial firm – subject to the regulation of the SEC – is included in the study, that firm can speak on behalf of all the other regulated financial firms?

Third, the topics seem to be a grab bag of wholly unrelated issues: is there some link between digital custody and historically underserved businesses where the same committee members will bring value to both discussions? If so, it is not obvious. If Congress wants both issues (or any of these issues) studied, it should direct the SEC to conduct the studies, and let the SEC figure out how to do so.

Primary Sources

  1. H.R. 1602: The “Eliminate Barriers to Innovation Act of 2021”

CRS Reviews Role of “Payment for Order Flow” in Debate over “Zero Commissions”

The Congressional Research Service (“CRS”) reviewed the role that “payment for order flow” (“PFOF”) plays in the “surge in retail investor securities trading at major discount broker-dealers.”

In its report, CRS described PFOF as a controversial rebate subsidizing the “non-existent commissions.” CRS stated that when broker-dealers do not pass the PFOF rebates onto clients, the economic incentives to send retail orders to rebating market-makers create potential conflicts of interest. CRS noted that this argument is why the United Kingdom has “effectively banned” PFOF.

Advocates for PFOF argue that investors benefit from the subsidized low or zero commission rates. Critics argue that PFOF raises conflicts-of-interest concerns over a brokers’ duty of best execution.

LOFCHIE COMMENT

While payment for order flow is a legitimate area for discussion, the more significant issue is why customers don’t use full-service brokers that provide them with some level of guidance. Congress and the SEC should consider whether over-regulation and the threat of enforcement actions are killing the business of full-service brokerage, leaving retail customers essentially on their own.

Unfortunately, asking the question as to whether regulation may be excessive or have unintended consequences is not a current priority. Rather, the tendency in response to any unusual event is to seek to adopt more regulations, as if more rules are always the panacea. Whether or not payment for order flow survives, the more significant reality is that retail investors are now effectively pushed to obtain their investment advice not from a regulated institution, but from a subreddit. See generally GameStop: Regulators Should Focus Less on “Solving the Problem”; More on “Improving the Situation.”

Harvard Law School Forum publishes CFS analysis of Robinhood and GameStop

The Harvard Law School Forum on Corporate Governance published CFS analysis of Robinhood and GameStop.

Events surrounding GameStop and Robinhood signal future issues that financial market participants are destined to confront and regulators are eager to confront.

Steven Lofchie, Robin L. Lumsdaine, John D. Feldmann, Diane Glossman, Jack Malvey, Yubo Wang, and I,

1) examine essential issues as well as
2) propose next steps.

As these are complex and multipronged issues, we look forward to any comments you might have.

To view the full article:
https://corpgov.law.harvard.edu/2021/02/23/robinhood-and-gamestop-essential-issues-and-next-steps-for-regulators-and-investors/