“Clean” Holding Company Requirements Now Fully Effective

The Federal Reserve Board’s (“FRB”) “clean holding company” requirements – which apply to the eight U.S. globally systemically important banks and the U.S. intermediate holding companies of the largest foreign banks operating in the United States – became effective on January 1, 2019. The requirements are applicable only to the legal entity that is the top-tier U.S. holding company and do not apply to its affiliates or subsidiaries.

According to the final rule adopted by the FRB, covered holding companies generally are barred from:

  • issuing guarantees of a subsidiary’s liabilities with cross-default rights regarding the covered holding company’s insolvency/resolution;
  • entering into qualified financial contracts with a third party;
  • providing short-term debt instruments to a third party; and
  • participating in upstream guarantees.

The prohibitions are applicable only to instruments or arrangements issued or entered into on or after January 1, 2019.

SEC Office of Investor Advocate Reviews FY 2018 Activities

The SEC Office of the Investor Advocate (“OIA”) identified “problematic products or practices” and summarized steps the agency and self-regulatory organizations took to respond to investor concerns during the past year.

In a “Report on Activities,” the OIA Investor Advocate identified “potentially problematic products or practices during Fiscal Year 2018” as reported by the SEC, NASAA, FINRA and the MSRB. These include, among others: (i) initial coin offerings, cryptocurrency and blockchain; (ii) a variety of scams and schemes (related to, e.g., regulator impersonations, Ponzi schemes, natural disasters and investments in “unicorns,” binary options, oil and gas, marijuana, microcap stocks and real estate, among others); (iii) cybersecurity; (iv) investment fees and expenses; (v) suitability of wrap fee programs; (vi) registrations of third-party providers, marketers and gatekeepers; (vii) a variety of risks (e.g., trading on margin, data aggregation, disclosure, and use of credit cards); and (vii) other practices (e.g., pennying and prearranged trading in connection with primary offerings).

In the report, the OIE focused on five key policy areas: public company disclosure, equity market structure, municipal market reform, accounting and auditing, and fiduciary duty.

On some of the broader policy questions, the OIA:

  • approved of the SEC’s current approach to ICOs, including its emphasis on the responsibilities of gatekeepers and others under securities laws;
  • encouraged FINRA to publicize the “data sets, models, and rankings” it uses to evaluate broker risk to help retail investors;
  • urged the SEC to prioritize reforming “outdated transfer agent regulations”; and
  • supported the continuing publication of investor education materials regarding the use of margin debt, although the OIA did not recommend any immediate regulatory changes.

Investor Advocate Rick A. Fleming recounted specific steps the OIA took to address investor concerns. The OIA:

  • requested additional research on the impact of proposed amendments to modernize public company reporting requirements;
  • collaborated with SEC staff and several SROs to “encourage equity market structure reforms designed to enhance market resilience, efficiency, transparency, and fairness”;
  • reviewed rulemaking proposals to reform the regulation of the fixed income markets and municipal securities markets;
  • supported the SEC’s proposed amendments concerning enhanced municipal securities disclosure under Exchange Act Rule 15c2-12;
  • provided feedback in response to MSRB’s draft amendments to rules on primary offering practices;
  • continued monitoring accounting and auditing standard setters:
  • urged the FASB to return to its earlier proposal for harmonizing its definition of materiality with “the courts, the SEC, and the PCAOB” due to investor concerns;
  • encouraged the SEC’s attention to problems regarding non-GAAP financial measures;
  • monitored developments with respect to auditor attention requirements;
  • sought internal and external feedback on accounting and auditing issues;
  • assisted the SEC in researching how proposed Regulation Best Interest would affect investors; and
  • submitted a comment supporting FINRA’s proposal to amend Rule 2111.

Mr. Fleming also stated that budgetary constraints affected some 2018 initiatives, including the agency’s failure to “build out” the Ombudsman role and certain research functions.

Crisis Detection and Prevention

I discuss crisis detection and prevention based on experiences chairing an inter-agency crisis prevention group (while at the U.S. Treasury), working as a strategist on Wall Street, and advising a global macro hedge fund. The paper was published as a chapter in “The 10 Years After” the financial crisis volume published by the Reinventing Bretton Woods Committee.

My views differ from many recently offered.

I conclude with eight actionable ideas to improve crisis detection for investors and officials.

For full remarks:
www.CenterforFinancialStability.org/research/10YearsAfter_Goodman_Chapter.pdf

CFTC Commissioner Quintenz Supports Revised Cross-Border Swaps Framework

CFTC Commissioner Brian Quintenz expressed support for an approach toward substituted compliance determinations that distinguishes between the rules designed to address systemic risk reforms and those designed to address market activities. The approach is consistent with an alternative cross-border swaps framework espoused by CFTC Chair J. Christopher Giancarlo in a recent white paper.

In remarks at FIA Asia 2018, Mr. Quintenz disagreed with recent criticism of the white paper by CFTC Commissioner Rostin Behnam. Mr. Behnam argued that Mr. Giancarlo should have expressed his views through formal, statutory procedures, as opposed to a white paper. Mr. Quintenz stated that the majority of CFTC Commissioners will “find a consensus on restructuring the agency’s cross-border approach in the coming months.”

Among other things, Mr. Quintenz supports:

  • an approach toward substituted compliance determinations that distinguishes between the rules designed to address systemic risk reforms and those designed to address market activities;
  • expanding the use of exemptive authority for non-U.S. central counterparties (“CCPs”) that do not pose risks to the U.S. financial system, while CCPs posing a risk to the U.S. financial system should continue to be registered with the CFTC;
  • the proposition that swaps trading venues subject to comparable regulation abroad should be exempt from swap execution facility (“SEF”) registration with the CFTC;
  • the proposition that U.S. persons should be permitted to access non-U.S. platforms in non-comparable jurisdictions without SEF registration “subject to materiality threshold”; and
  • Mr. Giancarlo’s approach to which transactions count for purposes of the swap dealer thresholds, noting in particular that “foreign consolidated subsidiaries” need only count their dealing activity with U.S. and U.S.-guaranteed persons (rather than all transactions).

Mr. Quintenz also considered “arranged, negotiated and executed” (“ANE”) transactions. Mr. Quintenz said that it is a “credible proposition” that involvement of U.S. personnel in a trade should implicate some U.S.-based regulations. He urged the CFTC to consider whether its supervisory interest in a trade outweighs that of a non-U.S. regulator who has oversight of the counterparties. Mr. Quintenz advocated an ANE standard that focuses on client-facing sales and trading activity, rather than “incidental activity by U.S. personnel.” He also said that any ANE standard must provide market participants with clarity with respect to which regulations will apply to swap transactions from the outset.

Lofchie Comment: While it would be a wonderful thing if the SEC and the CFTC could reach full agreement on a (sensible) cross-border regulatory approach, there are a few issues on which such agreement is particularly important to decreasing regulatory complexity: the definition of U.S. (non-U.S.) person; the situations in which the involvement of a U.S. agent in ANE for a foreign dealer results in the imposition of U.S. legal requirements; and just what U.S. legal requirements are imposed as a result of the U.S. agent’s involvement.

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.