Foreign Exchange Working Group Outlines Standards for Forex Market Participants

A group of central bank representatives and private sector market participants known as the Foreign Exchange Working Group (“FXWG”) released a new version of the “FX Global Code,” a set of conduct standards and principles for foreign exchange (“forex”) market participants. The FXWG was formulated in 2015 in order to “promote a robust, fair, liquid, open, and appropriately transparent market.”

The new version of the FX Global Code expands the topics covered by Phase One of the Code (ethics, information sharing, certain aspects of trade execution, and trade confirmation and settlement) published on May 26, 2016 (see Cadwalader Clients & Friends Memorandum, June 1, 2016). The new version includes: aspects of execution on e-trading and platforms, prime brokerage, governance, and risk management and compliance. Other important topics covered in the new version of the FX Global Code include “pre-hedging” and last-look practices.

As a whole, the FX Global Code covers six broad areas:

  • ethics;
  • governance;
  • execution;
  • information sharing and confidentiality;
  • risk management and compliance; and
  • transaction confirmation and settlement.

Lofchie Comment: The appropriate standards of conduct in the forex market have long been ambiguous, given (1) the absence (until Dodd-Frank) of much of a statutory/regulatory framework, (2) the fact that it is largely a principal market, (3) the limited involvement of lawyers and compliance personnel who might have served as “gatekeepers,” and (4) limited trade reporting information that might have served as a check on misconduct. That period of ambiguity is ending. While the FX Global Code may not have the force of law, regulators and private litigants are likely to point to it as establishing the required standard of conduct.

Many of the principles established in the FX Global Code are basic; e.g., one should strive to do the right thing, firms should manage risk appropriately, and trade disputes should be promptly resolved. Other standards, particularly those related to executing and information walls, will need to be carefully considered as to how they are implemented. Firms should review (or establish) compliance procedures for their FX desks and should compare those procedures to those governing other similar but perhaps more regulated markets.

CFTC “Modernizes” Recordkeeping Requirements

The CFTC amended its rules to modify the methods by which records must be kept. Under Rule 1.31, firms will no longer be required to (i) retain electronic records in their original format, (ii) keep records in a “non-rewritable, non-erasable format,” or (iii) employ a third-party technical consultant for certain filing requirements. The adopted amendments, including corresponding technical changes regarding recordkeeping, will become effective 90 days after publication in the Federal Register (see also, previous coverage).

Lofchie Comment: Will the CFTC rule changes cause the SEC to revisit its own rules? It would seem to be the right thing to do.

Historical Balance Sheets of U.S. Central Banking

Balance sheet data on two episodes of U.S. central banking are now available in spreadsheet form for the first time. Adil Javat has written a paper that digitizes data on the First Bank of the United States. The bank, established in 1791, was federally chartered and partly owned by the federal government. It was the only bank to have a nationwide branch network because states did not allow banks they chartered to branch across state lines, or in many cases even within them. The bank’s unusual attributes made in in effect a quasi central bank. The Democratic Party objected to it for that reason, and denied the bank an extension when its federal charter expired in 1811. The following year the United States became embroiled in the War of 1812 and missed the services that the Bank of the United States had provided. The U.S. Congress chartered a second Bank of the United States that began operations in 1817. It in turn was denied an extension of its charter by the Democratic Party in 1836. A fire at the U.S. Department of the Treasury in 1833 destroyed many records of the First Bank of the United States, so what remains is fragmentary, and is the fruit of searches of various archives by the 20th century historian James Wettereau. Perhaps more records are still out there, gathering dust somewhere?

Justin Chen and Andrew Gibson have written a paper that digitizes the weekly balance sheet of the Federal Reserve System (now called the H.4.1 release) from the Fed’s opening in 1914 to 1941. Their data will be of interest to anyone interested in the Fed’s behavior during the tumultuous period that included World War I, the sharp but short postwar depression of 1920-21, and the Great Depression. Previously — and surprisingly, given how much has been written about the early years of the Fed — digitized data were only available at monthly frequency. Weekly data should offer finer insights into the Fed’s behavior during episodes in which events were moving fast.

Javat, Chen, and Gibson are all students of CFS Senior Counselor Steve Hanke, and wrote their papers in a research course Hanke teaches for undergraduates at Johns Hopkins University. I read and commented on drafts of the papers.

(For the spreadsheets, see this page. There is a link underneath each paper to its accompanying workbook.)

SEC Acting Chair Piwowar Emphasizes Disclosure in Regulation of Capital Markets

Before an audience of foreign regulators at the SEC’s 27th Annual International Institute for Securities Market Growth and Development, SEC Acting Chair Michael Piwowar addressed best practices for the regulation of capital formation. He emphasized the importance of disclosure for lowering the cost of capital and for protecting investors, and asserted that a guiding principle for regulators must be to determine whether the government is facilitating or interfering with the progress of capital markets.

Acting Chair Piwowar focused on the value of the disclosure regime. He said that prudential regulation in capital markets is a “misplaced idea,” and added that “while banks are in the business of minimizing risk, the capital markets are in the business of allocating risk.” He argued that disclosure is the most effective tool for allocating capital to the most efficient industries, and suggested that a disclosure regime for banks (which he called “market-based prudential regulation”) could also benefit investors.

In addition, he stressed that a regulatory agency should not “substitute its judgment for that of the market.”

Acting Chair Piwowar also touched on the subjects of enforcement, international cooperation, and emerging issues in FinTech.

Lofchie Comment: During his interim tenure, Acting Chair Piwowar is making significant efforts to return the SEC to its historical mission of enabling investors to make investment decisions on the basis of good corporate disclosure regarding facts of economic significance. These are necessary corrections to the course of an agency that had been used since the adoption of Dodd-Frank as an instrumentality of political partisanship without regard to the economic costs or the benefits of its rulemakings.

 

Financial Services Committee Chair Prepares “Views and Estimates” Document for Markup

Financial Services Committee Chair Jeb Hensarling circulated to Members of the Committee on Financial Services a “Views and Estimates” document for markup. Once adopted by the full committee, the document will be transmitted to the Budget Committee “to be set forth in the concurrent resolution on the budget for fiscal year 2018.”

The document is required by section 301(d) of the Congressional Budget Act which requires “each standing committee to submit to the Committee on the Budget, not later than six weeks after the President submits his budget or upon the request of the Budget Committee: (i) its views and estimates with respect to all matters to be set forth in the concurrent resolution on the budget for the ensuing fiscal year that are within its jurisdiction or function; and (ii) an estimate of the total amounts of new budget authority and budget outlays to be provided or authorized in all bills and resolutions within its jurisdiction that it intends to be effective during that fiscal year.”

The document includes the following recommendations:

  • “replace the failed aspects of the Dodd-Frank Act with free-market alternatives”;
  • “place the non-monetary policy activities of the independent agencies within the Committee’s jurisdiction on the appropriations process”;
  • “replac[e] the Orderly Liquidation Authority with established bankruptcy procedures, wherein shareholder and creditor claims are resolved pursuant to the rule of law rather than the arbitrary discretion of regulator”;
  • eliminate the Office of Financial Research, as proposed by the Financial CHOICE Act;
  • “enhance accountability and lead to greater transparency” at the Consumer Financial Protection Bureau (“CFPB”) by reforming the CFPB’s “operations and unconstitutional structure, including by subjecting the CFPB to Congressional appropriations process, and by reforming the CFPB’s statutory mandate to ensure that it takes into account, and seeks to promote, robust market competition”;
  • “modernize the SEC’s operations and structure to eliminate inefficiencies”; and
  • “promote greater accountability at the Federal Reserve by advancing legislation to fund the non-monetary activities of the Federal Reserve’s Board of 33 Governors and 12 regional banks through the Congressional appropriations process.”

Lofchie Comment: If there is an overriding theme in the initiatives contained in the Visions and Estimates document, it is that Congress chooses to assert its authority over the so-called “regulatory state,” or the unofficial fourth branch of the government. Most significantly, Congress is exercising that authority by asserting its funding power over the various regulatory agencies – particularly, the CFPB. Undoubtedly, many of these measures will be seen as reasons for Democrats and Republicans to fight, but that should not be the case with the exercise of the funding powers. The issue raised by these measures is not whether elected Democrats or Republicans are in the right concerning any particular policy decision, but whether regulatory agencies should be able to operate free of the political control of whichever party is in power.

The Visions and Estimates document provides an example of this in a section that examines the funding of the CFPB. Assuming that current CFPB Director Richard Cordray serves out his term, Mr. Cordray will remain in power until some point in 2018; he will keep his position for a substantial part of President Trump’s four-year term. President Trump then will be able to appoint a new CFPB director who could undo much of the previous director’s work and will serve well into the term of the next elected President, who easily could be a Democrat. In short, we could have a situation in which the unelected head of the CFPB is not financially accountable to Congress and acts in opposition to whoever happens to be President at a given time, whether Republican or Democrat. This is no way to structure a regulatory agency. Both Democrats and Republicans ought to prefer the CFPB to be funded by Congress and held accountable by elected political officials.

Federal Register: CFTC Requests Comments on Proposal to “Modernize” Recordkeeping Requirements

The CFTC requested comment on a proposal to modernize certain recordkeeping obligations. The proposal would remove a requirement that electronic records be kept in their original format, and would allow recordkeepers to reduce costs associated with paper records through the utilization of “advances in information technology.” The request for comments was published in the Federal Register.

Comments on the proposed amendments must be submitted by March 20, 2017.

Lofchie Comment: The rule proposal would provide welcome updates to the requirements for the storage of electronic records under CFTC Rule 1.31. Significantly, the proposal would eliminate many of the prescriptive requirements of the current rule, including the need for firms to use outdated “write once, read many” (or “WORM”) storage media. Instead, the proposed new rule would adopt a technology-neutral requirement that electronic records be maintained in ways that preserved their “authenticity and reliability.” In addition, the proposal would eliminate the need for firms that store records electronically to (i) appoint a “technical consultant” that agrees to provide the records to the CFTC, and (ii) file a notice with the CFTC regarding compliance with Rule 1.31. However, the proposal also would require firms to implement written policies to assure compliance with the new requirements, including policies for training personnel, and for regular compliance monitoring.

The CFTC’s recent move to a more principles-based approach presents an interesting question: will the SEC follow the CFTC’s lead and modernize SEC Rule 17a-4 along similar lines?

 

CFTC Proposes Capital, Liquidity and Related Requirements for Swap Dealers

The CFTC approved proposed rules establishing minimum capital, liquidity, financial reporting and related requirements for CFTC-registered swap dealers (“SDs”) and major swap participants (“MSPs”). The proposed rules are a reproposal of rules previously proposed in 2011.

The proposed rules cover the follow areas related to SDs and MSPs:

  • capital requirements;
  • liquidity requirements;
  • financial recordkeeping and financial reporting;
  • obligation to notify regulators if a firm’s capital drops below certain levels; and
  • limitations on the withdrawal of capital and liquid assets.

The CFTC identified three approaches to allow firms to meet capital requirements:

  • an approach based on bank capital requirements that would be available to SDs that are subsidiaries of a bank holding company and thus subject to BHC capital requirements;
  • an approach modeled after the SEC’s capital requirements; and
  • a “tangible” net capital approach intended for a commercial enterprise, but that is also required to register as a swap dealer with the CFTC.

The proposal would establish certain liquidity, reporting and notification requirements, and would obligate entities covered by the proposal to keep current books and records in accordance with U.S. Generally Accepted Accounting Principles. Firms would be able to use models, although the models would have to be approved by the regulators. In addition, the rules provide for a “comparability” determination that will allow non-U.S. swap dealers that are not subject to regulation by the Federal Reserve Board to be subject to their home country capital rules.

There are currently 104 provisionally-registered swaps dealers (no registered major swap participants). Of those, 51 are not subject to the CFTC’s capital requirements because they are subject to U.S. bank requirements (including 36 which are non-U.S. banks having branches in the United States). Eight of the remaining swap dealers are already capital-regulated by the CFTC because they are FCMs, some of which are also SEC-registered broker-dealers. Of the remaining firms, some are subsidiaries of U.S. or non-U.S. bank holding companies or other entities subject to Basel-capital requirements that have sufficient capital to sustain their activities. Currently, there are no registered major swap participant and there is only one primarily commercial firm (Cargill) provisionally registered as a swap dealer with the CFTC.

In statements issued in connection with the reproposal, Chair Timothy Massad emphasized that the proposed requirements should avoid requiring all such firms to follow one approach. “Requiring all firms to follow one approach could favor one business model over another, and cause even greater concentration in the industry,” he said.

Commissioner J. Christopher Giancarlo expressed concerns regarding (i) the rule’s effect on smaller swap dealers and how much additional capital they may have to raise; (ii) the especially broad scope of the proposal; and (iii) the proposed capital model review and approval process.

Lofchie Comment: In terms of the substance of the rule requirements, the CFTC largely punted responsibility (and appropriately so) either to the banking regulators or to the SEC, both of which have significantly more expertise and staff to deal with these matters. It would have been messy for the CFTC and the SEC to take different approaches to capital requirements. Firms subject to regulation by both regulators would have been forced to comply with the more conservative set of rules in any case. In terms of process, the CFTC will wait and see what capital rules are eventually adopted by the SEC and then piggyback on them. For the CFTC, this is an entirely sensible way to go.  For firms that have an interest in the CFTC Rules, and will be subject to the “SEC version of the SEC rules, this means that they should concentrate on commenting on the actual SEC Rules, as the CFTC will likely follow along with whatever the SEC does.

In the Appendix, the CFTC reports the number of registered swap dealers and major swap participants. The numbers are revealing.

  • The CFTC stated that it had expected 300 swap dealers to register. Only 104 firms have done so. The costs associated with registration have likely caused numerous firms either to abandon dealing in swaps or to reduce their level of business below the de minimis level so as to not become subject to registration. Put differently, the regulations have led to a significant increase in the concentration of the swaps-dealing business. If the CFTC determines to reduce the level of business at which swap dealers are required to register, virtually all of the small unregistered swap dealers will further reduce their level of business or drop out of swaps dealing entirely. In short, Dodd-Frank has led to a significant accelerated concentration of swaps exposure.
  • There are no firms registered as a major swap participant. Not one. The registration requirements, applicable to large users of swaps that are not dealers, are absurd; it would be impossible for any non-dealer to comply with them. These provisions should be dropped from Dodd-Frank and the regulators should no longer waste time coming up with rules for registration categories that will apply to no one.
  • Congress gave no instruction as to how capital requirements could possibly be applied to a commercial entity that is a swap dealer. It simply does not work to have regulatory capital requirements (which largely require that a firm hold liquid financial assets) for commercial enterprises that own oil wells, related buildings and refineries. After years of struggling with how to make this round peg fit into a square hole, the CFTC essentially gave up (which was the rational thing to do). It set a low tangible capital requirement, which serves as an irrelevant fig leaf: a rule that the CFTC proposed merely because Congress required it to do so.

Currently, the CFTC does not have the expertise to supervise a models-based capital regime. Greater consideration should be given as to how this will work in practice.

Investor Advocate Rick Fleming Describes Progress on SEC Disclosure Effectiveness Initiative

SEC Investor Advocate Rick Fleming described continuing progress on the SEC Disclosure Effectiveness Initiative, an effort intended to review and modernize public company reporting requirements in Regulation S-K and Regulation S-X. In an address given at a NASAA Corporation Finance Training event in Texas, Mr. Fleming emphasized that meeting the informational needs of investors should be the guiding principle of the Initiative moving forward. He added that the methods for determining those needs are “as outdated as some of the disclosure rules.”

Mr. Fleming noted that the initiative is responsive to congressional mandates found in the JOBS Act and the FAST Act, but is broader in its objectives and scope than the mandates require (as is outlined in an SEC concept release dated April 2016). To the degree to which the FAST Act addresses “duplicative, overlapping, or outdated” provisions, Mr. Fleming stated, it reflects the fair criticism that the SEC has not done a “very good job of updating or streamlining its rules.”

Even so, he argued, the disclosure requirements serve as a crucial foundation upon which businesses raise capital. He stated that the success of the requirements should be measured primarily in terms of the “enhanced utility of corporate disclosures for the investing public.” Mr. Fleming stressed the importance of maintaining fairness in the evolving markets:

“[W]e are in the midst of a generational shift that will change the securities marketplace. But one thing will not change – investors will still count on those markets being fair. The challenge, particularly for regulators, will be to simultaneously think bigger and more creatively while exercising an appropriate level of caution to protect investors in an evolving world.”

Lofchie Comment: It is notable that Mr. Fleming did not focus on disclosures of political and political-interest issues, such as those favored by Senator Elizabeth Warren (D-MA). Instead, Mr. Fleming concentrated on disclosures that facilitate investment decisions.

SEC Officials Describe the Potential for Data Analytics to Improve Disclosure and Research

In separate speeches, SEC Investor Advocate Rick A. Fleming and Division of Economic and Risk Analysis Deputy Director and Deputy Chief Economist Scott W. Bauguess described how the SEC might employ data analytics to improve disclosure and the value of research using big data.

Mr. Fleming identified “wish list” priorities for the SEC: (i) “embrace the Legal Entity Identifier with the goal of making public company disclosure to the SEC interoperable with disclosure to other reporting regimes,” (ii) require the block-tagging of narrative text disclosures, and (iii) “require detail-tagging within narrative text disclosures.” Mr. Fleming stated: “by prioritizing structured data, and particularly the tagging of text . . . the [SEC] could drive even greater innovation in cost-effective enhancements to the packaging and delivery of information.” Mr. Fleming delivered his speech at the XBRL US Investor Forum 2016: “Finding Value with Smart Data.”

Mr. Bauguess described the consequences of the “proliferation of analytical methods enabled by big data.” He asserted that the rise of big data resulted in, among other things: (i) fewer limitations in the scope of potential empirical studies by researchers who have access to extensive computer resources; and (ii) an increase in the capacity to focus on assessing the robustness of the empirical methods that underlie the conclusions of studies. Despite these advances, Mr. Bauguess observed, human judgment “remains essential in making the output of [SEC] analytical models and methods actionable.” Mr. Bauguess delivered his speech at the Midwest Regional Meeting of the American Accounting Association.

SEC Commissioner Champions High-Quality Economic Analysis as “Essential Part of Regulatory Processes”

SEC Commissioner Michael S. Piwowar remarked that “high-quality economic analysis is an essential part of regulatory processes” for the Public Company Accounting Oversight Board (“PCAOB”). At the PCAOB 2016 Conference on Auditing and Capital Markets, the Commissioner described “common myths and misconceptions about the process.”

Commissioner Piwowar emphasized that high-quality economic analysis: (i) serves as the cornerstone not only for individual rulemakings but for setting the rulemaking agenda as well; and (ii) is necessary not only for the [PCAOB] to satisfy its statutory obligations to find that a proposed rule serves the public interest and protects investors but also as a prerequisite for the Commission to satisfy its own oversight obligations. He stated that the PCAOB’s guidance on rulemaking recognizes “four main elements: (1) the need for the rule, (2) the baseline for measuring the rule impacts, (3) the alternatives considered, and (4) the economic impacts of the rule and alternatives.”

In discussing myths and misconceptions of the regulatory process, Commissioner Piwowar stated that economic analysis:

  • is not interchangeable with cost-benefit analysis – economic analysis is “much broader” and “complements cost-benefit analysis, because it provides a more complete view of the trade-offs and consequences of alternative approaches, thereby providing the tools for ‘thinking through’ the cost-benefit analysis”;
  • does not slow down the rulemaking process, it “actually speeds up the rulemaking process,” by easing compliance burdens;
  • is not a partisan political issue – “[s]olid economic analysis is . . . something that both political parties can agree upon”;
  • is relevant not only to rulemaking but also to other activities such as SEC examinations and investigations; and
  • is not “a fad that will disappear” – it “has become part of the SEC’s DNA . . . [and] will become part of the PCAOB’s DNA, too.”

Commissioner Piwowar commended the PCAOB for “including, as part of its strategic plan, the use of economic analysis tools in conducting post-implementation review of new standards.” He concluded that:

I hope the [PCAOB] is more effective at post-implementation review than the [SEC]. In fact, I hope the Board is so successful in its post-implementation review efforts that the Commission can learn from them.

Lofchie Comment: It is almost certainly not the case that economic analysis is something that both political parties can agree upon. To the extent that either party seeks to use financial regulation as a device for political gain, economic analysis will always run a distant second in importance to polling.