SEC to Examine Operations of Certain Mutual and Exchange-Traded Funds

In a Risk Alert, the SEC Office of Compliance Inspections and Examinations (“OCIE”) provided information on a series of examination initiatives being conducted on industry practices and regulatory compliance of mutual funds and exchange-traded funds (“ETFs”) (collectively, the “funds”). The OCIE is interested in how the operation of these funds may impact retail investors.

The OCIE said it is investigating the following funds and advisers:

  • index funds that track custom-built indexes;
  • smaller ETFs and/or ETFs with little secondary market trading volume;
  • mutual funds with higher allocations to certain securitized assets;
  • funds with aberrational underperformance relative to their peer groups;
  • advisers who are relatively new to managing mutual funds; and
  • advisers who provide advice both to mutual funds and to private funds that (i) have similar strategies or (ii) are managed by the same portfolio managers.

The OCIE stated that it is evaluating whether the advisers’ and funds’ policies and procedures are designed to address risk and conflicts. The OCIE said it will examine disclosures and how the funds assess portfolio management compliance, and fund governance.

Lofchie Comment: It should be expected that the SEC will look closely at any situation where a public fund underperformed a private fund or managed account with a generally similar strategy. Any adviser who is managing clients that fit that description should carefully consider the reasons for the difference in performance.

CFTC Commissioner Advocates for International Regulatory Cooperation

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

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

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

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

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

Senate Banking Committee Member Introduces “Pro-Growth” Legislation

Senate Committee on Banking, Housing and Urban Affairs member Mike Rounds (R-SD) introduced six bills intended to reduce regulatory burdens for investors and small businesses attempting to raise capital.

Lofchie Comment: As to the proposed Improving Investment Research for Small and Emerging Issuers Act, the SEC must find a way to allow broker-dealers to make money by publishing research. If the SEC ever thought that broker-dealers will continue to publish research on small companies even though there is no financial benefit in doing so, experience should have taught otherwise.

CFS Financial Crisis Timeline

As the 10-year anniversary of the global financial crisis approaches, assessment of key events before, during, and since is essential for understanding varying dimensions of the crisis.

The CFS Financial Timeline, created and managed by senior fellow Yubo Wang, seamlessly links financial markets, financial institutions, and public policies. It:

  • Covers more than 1,100 international events from early 2007 to the present.
  • Provides an actively maintained, free, and easy-to-use resource to help track developments in markets, the financial system, and forces that impact financial stability.
  • Curates essential inputs on a real time basis from established public sources.

Since 2010, the Timeline has become an integral part of the work done by scholars, students, government officials, and market analysts. View the Timeline.

We hope you find it of use and interest.

International Regulatory Groups Analyze “Interconnectedness” between CCPs and Clearing Members

In a new report on interconnectedness and systemic risk, IOSCO, the Financial Stability Board, the Committee on Payments and Market Infrastructures and the Basel Committee on Banking Supervision (collectively, “international standard-setting bodies”) mapped the network of relationships between central counterparties and their clearing members. This report is the second issued by the international standard-setting bodies on central clearing interdependencies. (The first is available here.)

The regulators found, among other things:

  • “prefunded financial resources are concentrated at a small number of CCPs” (e.g., the two largest cross-border central counterparties (“CCPs”) account for roughly 40% of total prefunded financial resources);
  • CCP exposure is concentrated, with the 11 largest clearing members connected to 16-25 CCPs;
  • the network of relationships between CCPs and other financial institutions is characterized “by a core of highly connected CCPs and entities and a periphery of less highly connected CCPs and entities”;
  • only a small number of entities control the provision of each of the critical services required by CCPs; and
  • clearing members and their affiliates are also providers of critical services required by CCPs, such as being custodians or liquidity providers, so that if a significant clearing member were to default, it is very possible that the same entity could also be a vital service provider to the CCP.

The regulators cautioned that they did not assess potential “feedback mechanisms” that could amplify any initial stress. Further, they noted, the study was not intended to address the risk of central clearing, but rather to evaluate levels of interconnectedness. The regulators noted that central clearing is “intended to reduce the risk of contagion in financial markets, but it does not eliminate it”.

Lofchie Comment: Has mandated central clearing exacerbated interconnected risk and too big to fail? If so, would further mandates make it worse? Are the results of mandated central clearing playing out the way in which the regulators expected, particularly in terms of the very great concentration of risk in a very small number of firms and the very small number of firms able to provide broad access to CCPs?

Treasury Department Researchers Analyze Form PF Data

Researchers at the U.S. Treasury Department’s Office of Financial Research (“OFR”) analyzed information gathered from Form PF and described trends in the activities of private equity funds and their controlled portfolio companies (“CPCs”). As stated in a recent SEC comment request, “Form PF is designed to facilitate the Financial Stability Oversight Council’s (“FSOC”) monitoring of systemic risk in the private fund industry and to assist FSOC in determining whether and how to deploy its regulatory tools with respect to nonbank financial companies.” Investment advisers with greater than $150 million in private fund assets under management are required to provide information on Form PF, such as (i) the funds they advise, (ii) private fund assets under management, (iii) fund performance and (iv) the use of leverage.

The OFR researchers found:

  • borrowing and leverage increased among certain CPCs from 2013 to 2016, which could signal a greater likelihood of default;
  • some CPCs had significant short-term debt exposures, which “should continue to be monitored”; and
  • investment in financial CPCs has shifted toward non-bank entities.

The analysis, published in the OFR Brief Series, stated that the views and opinions of the authors do not necessarily represent the views of the OFR or the U.S. Department of the Treasury.

Lofchie Comment: The report concludes as follows:

“Form PF is not a perfect tool for monitoring trends in the private equity industry. The data collection lacks a long history, and reporting errors persist. Still, the analysis in this brief illustrates that Form PF data can be useful for monitoring basic fund characteristics. . . .”

There is only so much that analysts can do with data that is both limited and flawed. The report itself contains some moderately informative background as to the state of the private equity industry. However, observations such as “if a company borrows more money, then it is more likely to default” do not really add much to the government’s ability to understand financial markets or systemic risk.

The government would be better off scrapping Form PF and trying to understand why the process of creating it went so wrong. This is not intended as a criticism of the report’s authors. It is just the reality of so-so in, so-so out.

CFTC Chair Unveils New Measure of Swaps Market Size and Risk

CFTC Chair J. Christopher Giancarlo introduced a new measure for the size of the rates segment of the swaps markets and called for a new “paradigm” in describing that market.

In remarks delivered at Derivcon 2018 in New York, Mr. Giancarlo characterized notional value as a highly flawed metric for the size and risk of the swap market, and emphasized that reliance on the metric for regulatory purposes leads to poor allocation of public resources. In particular, he noted that the common use of notional amounts in public discourse without normalizing for duration or offsetting positions creates an impression that the market is much larger than it is in actual risk terms, and has led to misguided policy decisions.

Mr. Giancarlo unveiled a new metric for measuring the size of the rate swap markets developed by CFTC Chief Economist Bruce Tuckman. This measure would evaluate market size based on entity-netted notionals (“ENNs”), which are produced by converting notional amounts for rate swaps of all durations into five-year risk equivalents, and then netting long and short exposures in the same currency between pairs of market participants. Mr. Giancarlo explained that ENNs are designed to describe the amount of market risk transfer in the interest rate swaps markets. Using this method of calculating risk, the aggregate risk transfer amount is sized much more consistently with other major markets, such as the debt market, and can be evaluated accordingly.

Mr. Giancarlo encouraged consideration of the ENN including its potential uses for regulation, but noted that his intention was not to come up with a specific alternative to the current swap dealer de minimis calculation methodology. He also emphasized that ENNs are not intended to quantify credit or operational risk.

Lofchie Comment: Query whether the new measure will be adopted by those who believe that there is a political advantage in exaggerating the size of the swaps market? It sounds a lot more ominous to describe a swap as having a billion dollar notional than it does to describe it as having a four dollars and thirty-seven cents market value.

 

SEC Requests Comments on Form PF

The SEC is requesting comment on the collection of information on Form PF (“Reporting Form for Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors”). All private fund advisers with at least $150 million in private assets under management are required to complete Form PF. The form is intended to aid the Financial Stability Oversight Council in monitoring systemic risk, and in allocating its regulatory tools for nonbank financial companies.

The SEC is requesting comments on (i) the necessity of information collection, (ii) the accuracy of the SEC’s reporting burden estimates, (iii) how to enhance the quality, utility and clarity of information requested, and (iv) how to minimize the burden of information collection.

Comments must be submitted by March 11, 2017.

Lofchie Comment: Form PF is fundamentally useless. (See, OFR Researchers Question the Utility of SEC Form PF as a Risk Management Tool.) The financial industry spent hundreds of millions of dollars developing systems to answer questions that were poorly considered and written. Anyone familiar with the relevant area of law could see that the questions posed on the form could not possibly generate useful or consistent results. Leaving aside the time and money wasted, if one believes that the information properly collected might have been useful to the regulators, then the waste was even greater, because an opportunity to acquire useful information was squandered. The real question for regulators now is how can they improve their procedures so as not to make a similar mistake or squander additional resources.

Global Markets into 2018

The Center for Financial Stability (CFS) hosted a small private workshop for leaders in finance to delve into issues that will shape the future of asset values and investment management on December 6.

CFS Special Counselor Jack Malvey set the stage with an essay “Toward the Mid-21 st Century Global Financial System” –
www.CenterforFinancialStability.org/research/MalveyGlobal_Dec_2017.pdf

Workshop topics included:

– Geopolitics and Big Picture Challenges through 2020 – AI, cyber, etc;
– Global Macro, Quantitative Tightening, and Financial Stability;
– Financial Industry Transitions – Active versus Passive Management, etc; and
– Opportunities and Risks (a selection follows).

OPPORTUNITIES

– Buy cash today – the rate of return will be extraordinarily high.
– Central banks will more actively incorporate financial stability into actions and mandates.
– Emerging markets will outperform.
– The Fed desires to move further away from the zero lower bound.
– NPLs in China are overstated / bank earnings mitigate and neutralize risks.
– Global macro investment opportunities via uneven tightening.

RISKS

– I will buy cash – but tomorrow.
– Bitcoin correction.
– Limited attractive equity names based on valuation / similar to Tokyo in 1989.
– Geopolitical tensions will increase with North Korea, China, Russia, and Saudi Arabia.
– Inflation surprise / data may be misread.
– Artificial intelligence channeled for ill.

Best wishes into the Holiday Season and 2018!

OCC Releases Semiannual Risk Report

The Office of the Comptroller of the Currency (“OCC”) described the principal risks facing national banks and federal savings associations in its Semiannual Risk Perspective for Spring 2017 (the “Report”).

In the Report, the OCC identified the following key risk themes:

  • strategic risk due to a changing regulatory climate, low interest rates and competition from nonfinancial firms, including fintech companies;
  • increased credit risk and relaxed underwriting standards due to strong risk appetite and competitive pressures;
  • elevated operational risk as a result of increased reliance on third-party service providers and attendant cybersecurity risks; and
  • high compliance risk as banks navigate money laundering risks and new consumer protection requirements.

OCC supervisory priorities for the next 12 months will remain broadly the same as in 2016 and will include the objective of identifying and assigning regulatory ratings and risk assessments. The OCC also pledged a continued commitment to monitoring and evaluating risks presented by third-party service providers.

In remarks on the Report, Acting Comptroller of the Currency Keith A. Noreika stated:

“The OCC employs a risk-focused approach to supervision, and tailors examination strategies to the individual risks of each of its supervised institutions and will pay close attention to these key risk areas over the next six months.”

 

Lofchie Comment: A material portion of the “risk” that banks face, according to the report, is regulatory risk. The Comptroller’s remark that “[m]ultiple new or amended regulations are posing challenges” to banks and the financial system also echoes the comment made by the SEC’s Investor Advocate in his recent report to Congress that he would “encourage Congress to consider giving the [SEC] a respite from statutory mandates” (at 3). It is clear that the very rate and extent of regulatory change has itself become a threat to the financial system.