CFTC, EU Make Comparability Determinations on Margin Requirements for Uncleared Swaps

The CFTC approved a comparability determination that European Union (“EU”) margin requirements for uncleared swaps are comparable in outcome to relevant CFTC Regulations. The European Commission announced a similar equivalence decision that the CFTC uncleared margin rules are comparable to the EU’s requirements.

The CFTC determination generally allows swap dealers that comply with the EU margin requirements, in circumstances enumerated in the CFTC Regulation 23.160, to be deemed to be in compliance with CFTC requirements. Such swap dealers would remain subject to CFTC examination and enforcement authority. CFTC Letter 17-22, which extended exemptive relief to certain swap dealers that are subject to both U.S. and European margin requirements for uncleared swaps, is no longer applicable.

In addition, the CFTC announced that the CFTC and the EC have agreed to a “common approach” for certain authorized trading venues. Under the common approach, the CFTC plans to grant relief to certain EU trading venues from the swap execution facility (“SEF”) registration requirement, provided they satisfy the “comparable and comprehensive” standard for exemptive relief under CEA Section 5h(g). The EU would propose a corresponding equivalence decision recognizing CFTC-authorized SEFs and designated contract markets as eligible venues.

CFTC Chair J. Christopher Giancarlo characterized the cooperative efforts as an important step in cross-border harmonization:

“These cross-border measures will provide certainty to market participants. It will ensure that our global markets are not stifled by fragmentation, inefficiencies, and higher costs. Indeed these measures are critical to maintaining the integrity of our swaps markets.”


Lofchie Comment: This is a significant step by the CFTC both in improving relationships with the Europeans and in accomplishing Chair Giancarlo’s goals of facilitating the ability of firms to transact globally and undoing the geographic market fragmentation that had resulted from the post Dodd-Frank regulatory regime.  One can guess that the Chair will next turn attention to improving the rules for trading on U.S. swap execution facilities, which will benefit the competitiveness of the United States as a financial center.

SEC Names Chief of Office of International Corporate Finance

The SEC named Robert Evans III as Chief of the Office of International Corporate Finance. The office operates within the SEC Division of Corporation Finance and is responsible for “outreach to non-U.S. issuers that access the U.S. capital markets.”

Prior to the appointment, Mr. Evans was Deputy Director of the Division of Corporation Finance. Before that, worked as a partner in the capital markets practice at Shearman & Sterling LLP.

SEC Chair Jay Clayton Updates House Finance Committee on EDGAR System Breach

SEC Chair Jay Clayton testified before the U.S. House Financial Services Committee providing an update on the EDGAR system cybersecurity breach (see previous coverage). He also outlined the SEC’s regulatory agenda reiterating previous testimony provided to the Senate Banking Committee (see previous coverage). His principal priorities include the facilitation of capital formation and encouraging initial public offerings.

SEC Clarifies Intent of Amendments to “Fully Paid Securities” Definition

In a letter to FINRA, the SEC clarified that an amendment to the definition of “fully paid securities” in Exchange Act Rule 15c3-3 (“Customer Protection – Reserves and Custody of Securities”) was not intended to expand the scope of securities that cannot be rehypothecated by the broker-dealer. Rather, the SEC said that the technical amendment was merely meant to “amend out-of-date” citations and “remove text that the Commission believed to be superfluous or redundant.”

Lofchie Comment: In a somewhat cryptically worded letter, the SEC staff clarified that securities that have no lending value for purposes of the broker-dealer margin regulations, but that serve to collateralize a margin loan, may be rehypothecated by a broker-dealer. Any such rehypothecation would of course remain subject to the limits set out in Rule 15c3-3, which are intended to ensure that even an insolvent broker-dealer be able to make its custodial customers whole.

President Trump Signs FSOC Bill Assuring Insurance Regulator Continuity

President Donald J. Trump signed into law the Financial Stability Oversight Council Insurance Member Continuity Act (H.R. 3110) on September 27, 2017.

The bill, introduced by Representatives Randy Hultgren (R-IL) and Maxine Waters (D-CA), permits an FSOC independent member with insurance expertise to remain past his or her term for the earlier of (i) 18 months or (ii) when a successor is confirmed.

Representative Hultgren explained the importance of the bipartisan bill:

“[I]t is now extremely important that we have someone with a deep understanding of our insurance markets, and how they interact with our entire financial system, to continue serving as a voting member of FSOC. The Financial Stability Oversight Council Insurance Member Continuity Act ensures that this key regulatory body is able to benefit from the perspective of a voting member with insurance expertise without any unnecessary lapses.”


Lofchie Comment: The realization of the “importance” of industry participation in the FSOC designation process is welcome. When FSOC designated MetLife as being systemically important, it generally ignored the views of the FSOC member with insurance industry experience. See FSOC Proposes Preliminary Designation of MetLife as a Non-Bank Systematically Important Financial Institution (with Lofchie Comment).  See also D.C. District Court Calls FSOC’s Review of MetLife’s Status “Fatally Flawed”.

MSRB Advises Dealers on Compliance Risks

The MSRB issued a Compliance Advisory to aid municipal securities dealers, brokers and dealers (collectively, “dealers”) in addressing compliance risks and in supplementing evaluations of existing compliance programs and controls.

In the Advisory, the MSRB highlighted several factors (as summarized below) for dealers to consider when evaluating compliance:

  • Standards of Professional Qualification (Rules G-2, G-3, A-12): Firms should consider how they ensure that employees perform functions only as permitted by their qualifications and whether appropriate training procedures have been implemented to train employees on the scope of their qualifications.
  • Best Execution and Fair Pricing Standards (Rules G-18, G-30): Firms should evaluate whether they have policies and procedures that take into account the entire “market” when making best execution determinations, and cover how and when retail customer orders are exposed to multiple bids, in addition to considering whether they are periodically evaluating processes for determining whether aggregate prices charged to customers are fair and reasonable.
  • Standards of Conduct in the Performance of Financial Advisory Activities (Rule G-23): Firms should assess whether they have procedures to notify issuers of their role in a particular transaction and to consider factors that necessitate classification (and possible registration) as a “municipal advisor.”
  • Fair Dealing with All Persons in the Conduct of Municipal Securities Activity (Rule G-17): Firms should consider employee training on standards of fair dealing, procedures for determining the best account structure for particular customers, and processes for evaluating disclosures and representations made by underwriters.
  • Pay-to-Play Restrictions (Rule G-37): Firms should evaluate current training available to make employees aware of reporting requirements for certain political contributions, assess processes for monitoring for such contributions for two-year look-back periods, and ensure that firms are meeting all reporting and disclosure requirements.
  • Time of Trade Disclosures to Customers (Rule G-47): Firms should examine their procedures to determine whether they have a process for ensuring they are using established industry sources of information relating to municipal securities transactions (particularly as new sources become available and are more generally used by dealers). Firms should also examine whether they have procedures to ensure that all material information about municipal securities transactions is properly disseminated to registered representatives engaged in sales to and purchases from a customer.
  • Supervisory Controls (Rule G-27) and Books and Records (Rules G-8G-9): Firms should assess all of their supervisory controls to ensure that they are properly monitoring regulatory developments, maintaining written procedures and accurately documenting the nature and function of particular securities accounts.

Lofchie Comment: The MSRB’s statement provides a useful outline for firms to undertake a general review of their compliance procedures in this space. There is nothing like a priority risk list from the regulators to focus one’s attention.

CFTC Enforcement Director Offers Incentives for Cooperation and Self-Reporting

On September 25, 2017, CFTC Director of Enforcement James McDonald described an enforcement approach that emphasizes self-reporting and cooperation by regulated financial institutions.

In remarks before the New York University Institute for Corporate Governance & Finance, Mr. McDonald described a continuing dedication to vigorous prosecution combined with a new emphasis on cooperation and self-reporting in order to best achieve the mission of the CFTC to “foster open, transparent, competitive and financially sound markets.” In addition to pursuing enforcement actions, Mr. McDonald stressed the importance of receiving buy-in from the companies regulated by the CFTC in order to safeguard these markets and achieve meaningful deterrence. The CFTC self-reporting and cooperation program, Mr. McDonald explained, is intended to incentivize companies to report violations and cooperate in CFTC investigations by making clear the “substantial” benefits of cooperation, such as “significantly” reduced monetary penalties. Mr. McDonald also emphasized the commitment of the CFTC to working with industry members to facilitate voluntary compliance and contribute to a cooperative business environment.

Mr. McDonald outlined the kind of cooperation that might lead to CFTC special consideration and reduced penalties:

  • Voluntarily self-reporting of wrongdoing to the CFTC Division of Enforcement. This includes disclosure of all relevant facts within a reasonably prompt time.
  • Full cooperation throughout the CFTC investigation. This involves proactive disclosure of all relevant facts and participating individuals as a company becomes aware of them. The CFTC focus on individuals reaches not only traders, but also the supervisors who directed or made decisions underlying a violation.
  • Remedial measures to prevent future misconduct. This includes fixing problems with compliance and internal programs that led to the misconduct in question.

In return, Mr. McDonald stated that the Division of Enforcement will clearly communicate all expectations, facilitate and help the self-reporting company with remediation efforts, and offer concrete benefits. Mr. McDonald explained that if a company complies with all three criteria, the Division of Enforcement will recommend a substantial reduction in penalties, and, in extraordinary circumstances, may decline to prosecute a case. Cooperation in the absence of a self-report may also warrant a lower penalty, albeit one that involves a significantly smaller reduction.

Mr. McDonald said that his remarks reflected his “own views and not necessarily those of the Commission or its staff” and should not be interpreted as a softening in the CFTC stance on the enforcement or prosecution of corporate misconduct. He indicated that the CFTC will continue to aggressively pursue bad actors. The Director expressed hope that the CFTC’s commitment to encouraging self-reporting will add another layer of deterrence to misconduct by market participants and help to prevent future misconduct.

Lofchie Comment: There are few policy decisions that are as significant for a regulatory agency as determining how to handle firms and individuals that come forward with admissions of their own legal violations. It often seems to outside observers that the desire of regulators to chalk up an easy win, or to be acclaimed for collecting a fine, overwhelms any inklings of common sense (or compassion). This is unfortunate because when a firm comes forward, particularly with information as to unintended violations, it often provides notice to other market participants of areas where they may need to shore up their own compliance procedures or, very significantly, their technology. In any case, the proof of the CFTC’s word will be in the pudding (or in the Cabinet news) and, as enforcement actions are reported, individual firms will continue to make their own assessment of whether to come forward.

SEC Provides Guidance on Compliance with Pay Ratio Disclosure Requirements

The SEC released interpretive guidance on compliance with the pay ratio disclosure rule, which mandates that companies begin filing reports in early 2018 (for fiscal year 2017). Under the pay ratio disclosure rule, a public company is obligated to disclose (i) the median of the annual total compensation of all its employees, except that of the CEO, (ii) the annual total compensation of its CEO, and (iii) the ratio of those two amounts.

As explained in the guidance, a company has “significant flexibility” in determining the appropriate methodology to identify its median employee. The SEC acknowledged that industry members expressed concerns about compliance and liability due to the imprecision that could arise from estimation. The guidance states that “if a registrant uses reasonable estimates, assumptions or methodologies, the pay ratio and related disclosure that results from such use would not provide the basis for Commission enforcement action unless the disclosure was made or reaffirmed without a reasonable basis or was provided other than in good faith.”

The guidance also details how a company is permitted to use payroll or tax records to (i) identify a median employee and (ii) make a determination about the inclusion of non-U.S. employees. Under the rule, non-U.S. employees representing up to 5% of the company’s total personnel generally are exempted from calculations.

In separate staff guidance, SEC Division of Corporation Finance Staff outlined important information regarding reasonable methodologies for calculations as required by the pay ratio disclosure rule.

Lofchie Comment: Given the absence of any specific requirements as to how the compensation calculation should be made and the complete absence of any reasonable policy rationale for this rule (after all, the CEO’s salary is disclosed), issuers have significant flexibility as to how to comply with this rule. Don’t waste resources overthinking the reporting methodology. The important compliance rules are (i) choose a methodology (doesn’t really matter what it is), (ii) fully document it, and (iii) stick to it rigidly.

SEC Committee on Small and Emerging Companies Makes Final Recommendations

The SEC Advisory Committee on Small and Emerging Companies (the “Committee”) met to review the Final Report of the Committee. The report included recommendations for future areas of focus including (i) capital raising by “emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization,” (ii) trading securities of these companies, and (iii) public reporting and corporate governance requirements for them. The Committee also reviewed the auditor attestation report under Section 404(b) of the Sarbanes-Oxley Act and the registration exemption under Securities Act Rule 701.

The Committee recommended that the SEC focus on facilitating exempt offerings for privately held small companies, asserting that legal costs and associated risks have made such offerings less attractive to broker-dealers, which in turn makes it difficult for small companies to find investors.

Specifically, the Committee noted that (i) non-registered entities are hesitant to take part in exempt offerings because there is significant uncertainty in the market about what activities require broker-dealer registration under the current definition of “broker” and (ii) companies seeking to comply with the rules find it difficult to determine when they can engage a “finder” or online platform that is not registered as a broker-dealer. As a remedy, the Committee encouraged the SEC to provide regulatory clarity in this area and to create a less burdensome avenue for small businesses to engage potential investors.

The Committee also proposed that the SEC should revisit the definition of “accredited investor” under Rule 506 of Regulation D, and to avoid raising the threshold to qualify as an accredited investor. The Committee supported potential revisions that would take into account the “sophistication” of investors, but cautioned against revisions on the basis of net worth or income.

With respect to reporting and corporate governance requirements, the Committee urged the SEC to finalize a rule that would expand the number of small businesses that qualify for “scaled disclosure requirements.” The Committee explained that, since the implementation of the JOBS Act, 87% of initial public offerings (“IPOs”) have qualified as emerging growth companies (“EGCs”) (companies with less than $1,070,000,0000 in gross revenue during its most recently completed fiscal year), and that IPOs have declined significantly in recent years. This decline was described as being a result of the high costs of compliance and disclosure requirements that impose undue burdens on small companies. The Committee expressed support for the rule that would allow smaller reporting companies to qualify for the same disclosure and reporting requirements as EGCs. Furthermore, the Committee suggested amendments to the “accelerated filer” definition to exempt certain smaller companies from Section 404(b) auditor attestation requirements.

The meeting also included a presentation by executives from Orrick and Warby Parker regarding amendments to Securities Act Rule 701. The executives recommended (i) removal of the “hard cap limit” that restricts the value of securities sold in reliance on Rule 701, (ii) increase of the “soft cap limit” from $5 million to at least $10 million, and (iii) exclusion of material amendments from calculation of either limit. The executives asserted that equity compensation is a crucial aspect of facilitating success for small businesses, and said that it can be “critical to recruit talent” for companies that are not able to offer competitive cash compensation.

Finally, the Committee made recommendations for facilitating secondary market liquidity through preemption of certain state registration requirements, continued monitoring of the tick-size pilot program and less strict listing requirements for smaller companies.

This was the final meeting of the current Committee, as the two-year term expires on September 24, 2017.

Lofchie Comment: New SEC Chair Clayton has pledged to focus on improving the ability of companies to raise money in the public markets at a reasonable cost. This is an important change to the persistent governmental mindset of “ever more regulation.” After almost a decade of regulatory explosion that has shaped the norms and expectations of government behavior, any real reduction in regulation seems extraordinary.

One aspect of the recommendations was odd: the notion that it is not clear who must register as a “broker.” Under the law, it’s actually pretty clear: just about anyone who touches a securities transaction must register as a broker. Legal clarity isn’t really the issue; the issue is whether there should be a real exemption from registration for private placement brokers or else a form of much lighter registration/regulation that looks more like the regulatory scheme that applies to investment advisers (which may not be light, but it is much lighter than the broker-dealer scheme).

Sargen: The Fed Begins to Shrink Its Balance Sheet


  • The Federal Reserve is expected to announce it will begin to shrink its balance sheet over the next few years at this month’s FOMC meeting.  Investors are pondering how smoothly the process will go.
  • Opinions on this matter are divided.  Some observers are concerned it could disrupt financial markets, but the prevailing view is it will not.
  • Another issue is whether monetary policy will ever be as it was before the 2008 Global Financial Crisis (GFC).  Our take is it has been permanently altered, because the transmission mechanism increasingly works through capital markets.
  • We believe the Fed will aim for the funds rate to reach 2% and will then pause.  The changing composition of the Board of Governors, however, adds an element of uncertainty in 2018.

The Controversy Surrounding Quantitative Easing

During the GFC the Federal Reserve engaged in unorthodox policies that were intended to stabilize the financial system and to encourage investors to add to holdings of risk assets.  The Fed did so by purchasing massive amounts of government securities and residential mortgage-backed securities (RMBS) that increased its balance sheet four-fold (Figure 1).  The initial round of quantitative easing (QE) is widely credited by economists as having stabilized the financial system and thereby averted an even worse outcome.  However, subsequent rounds were viewed more skeptically, as they occurred when the economy and markets had stabilized.

Figure 1:  Assets of the Federal Reserve ($ billions)

Source: Bloomberg and Federal Reserve.

The Fed’s intent was to encourage investors to add to risk assets such as corporate stocks and bonds, which would bolster the economy by creating a positive wealth effect and ease borrowing conditions for consumers and corporations.  From the Fed’s perspective, it was worth doing so in order to reduce the unemployment rate, which fell from a peak of 10% to below 4.5% recently.  One of the main criticisms, however, is that its actions also distorted capital market prices and thereby may contribute to another asset bubble.  Previously, the Fed primarily influenced short-term interest rates rather than the entire term structure and risk assets, so it would not distort capital markets.

Normalizing Monetary Policy

The ultimate test of the QE experiment is the Fed’s ability to develop a successful exit strategy.  The Fed’s staff has been working on a game-plan since the early part of this decade.  One of the first actions was the decision to pay interest on bank reserves.  By doing so, the Fed created an additional means to control bank reserves and thereby lessen the risk that the money supply would expand unduly once bank lending expanded materially.  Officials were also cognizant of mistakes their predecessors made during the Great Depression, when the Fed doubled reserve requirements and banks responded by reducing loans outstanding considerably.

One of the key differences today is that monetary policy works through capital markets, as well as through the banking system.  Therefore, the Fed ultimately must influence investors’ expectations by communicating its intentions clearly.  Policymakers learned this lesson all too well during the so-called “taper tantrum” in mid-2013, when Ben Bernanke mentioned in Congressional testimony that the Fed was considering winding down its purchases of securities in 2014.  Much to the Fed’s chagrin, bond yield surged by a full percentage point during the remainder of 2013 as investors believed the Fed was about to tighten monetary policy.

In light of this experience, some observers are concerned that a similar outcome could occur as the Fed pares its holdings of securities.  The prevailing view, however, is that this news already is priced into markets, and a spike in rates is only likely if there are surprise developments. Recognizing this, Fed officials have gone out of their way to reassure investors that it will shrink its balance sheet very gradually: It has stated that it will not sell securities outright, but will allow a portion to roll off its books as bonds mature.

The Fed also indicated at the June FOMC meeting that its balance sheet would eventually decline by $50 billion on a monthly basis ($600 billion annually) until it chooses to halt or reverse the process.  At this pace, the monetary base would revert to its pre-crisis growth trend by 2021. However, Fed watchers do not expect it to get there: Estimates vary, but the general consensus is the terminal size of the balance sheet the Fed range is around $2.5 trillion, or roughly one half of the current level.  The Fed has indicated that the balance sheet will be no larger than necessary to manage monetary policy in the current framework, which requires more reserves than pre-crisis policy.

Challenges Confronting Policymakers

It remains to be seen how well the transition to policy normalization will go.  Although the initial process has been smooth, the Fed nonetheless faces formidable challenges ahead.  One is to ascertain the natural rate of unemployment, commonly referred to as NAIRU, below which inflation rises.  This is important because the Fed utilizes econometric models that assume the Phillips curve relationship between wage increases and unemployment holds.  The relationship, however, is far from stable: Previously, wage pressures would typically be evident when the unemployment rate is below 5%, but this has not happened currently.  The reason is unclear to policymakers and market participants, but one reason may be is that there is a large pool of workers who are currently working part time that are seeking full time jobs.

Meanwhile, the core rate of inflation has drifted below the Fed’s 2% target.  This has increased uncertainty about whether it will raise the funds rate at the end of this year, as it did in 2015 and 2016.  Nonetheless, while the timing of rate increases is uncertain, we believe the Fed is aiming for a funds rate of 2.0% and will then pause.  This is well below the average rate of 4%, which is typical for an economy growing at 2% and inflation close to that pace.

Will Monetary Policy Ever Return to Normal?

This begs the question of whether monetary policy will eventually revert to the way it was conducted before the GFC, when it mainly influenced the volume of bank reserves by purchasing or selling treasuries to influence the funds rate.

Our assessment is that the conduct of monetary policy has been altered permanently, as the transmission mechanism increasingly occurs through capital markets.  If so, investors need a guide to assess whether policy conditions are becoming easier or tighter.  The standard procedure today is to look at a variety of financial market indicators — such as short term and long term treasury yields, credit spreads, the stock market, and the trade weighted dollar – to compute a financial conditions index.  Thus, based on the latest readings, financial conditions have actually eased despite the increases in the funds rate, because equities have risen while credit spreads and the trade-weighted dollar have declined (Figure 2).

Figure 2: Financial Conditions Have Eased Recently

Source: Bloomberg and Goldman Sachs.

Finally, it remains to be seen how monetary policy may shift as the composition of the Board of Governors changes.  By next year, for example, there could be a new Fed Chair, along with a new Vice Chair and three new governors.  It is too early to speculate about what is in store. Nonetheless, investors will be keen to assess whether monetary policy will remain highly discretionary and consensual, as it was during the Bernanke-Yellen era, or whether it will become more rules based, as some Fed critics have argued.  In this respect, the changing of the guard will become a focus for market participants in the coming year.