Banking Agencies Propose Updating Calculation of Derivative Contract Exposure Amounts

The Comptroller of the Currency, the Federal Reserve Board and the Federal Deposit Insurance Corporation proposed allowing “advanced-approaches” banking organizations (i.e., those with $250 billion or more in total consolidated assets, or $10 billion or more in on-balance sheet foreign exposure) to use an alternative approach for calculating derivative exposures under regulatory capital rules.

The proposed approach – the standardized approach for counterparty credit risk (“SA-CCR”) – would replace the current exposure methodology (“CEM”). If adopted, the proposal would (i) require advanced-approaches banking organizations to use SA-CCR to calculate their standardized total risk-weighted assets by July 1, 2020 and (ii) allow non-advanced-approaches banking organizations to use either CEM or SA-CCR when calculating standardized total risk-weighted assets.

In addition, the proposal would require advanced-approaches banking organizations to use SA-CCR to determine the exposure amount of derivative contracts for calculating total leverage exposure and would amend the cleared transactions framework to include SA-CCR.

Comments on the proposal must be submitted within 60 days from the date of publication in the Federal Register.

SEC Commissioner Offers Recommendations on Implementing G20 Swaps Reforms

SEC Commissioner Hester M. Peirce offered recommendations to regulators on implementing G20 swaps reforms. Ms. Peirce said that the G20 reforms were not foolproof and encouraged regulators to exercise “healthy skepticism” when implementing them.

In remarks before the International Regulators Conference, Ms. Peirce said that “poorly designed regulations” played a role in the 2007-2009 financial crisis. She cited the “favorable regulatory treatment given to highly rated securitization tranches.” She stated that, among other things:

  • “central clearing is not a panacea” and brings its own risks;
  • regulators should attend to market feedback and market professionals’ knowledge when considering rulemaking; and
  • regulators must consider more flexible regulation rather than a one-size-fits-all approach.

In implementing the regulatory framework for security-based swaps, Ms. Peirce advised, the SEC should:

  • reexamine proposed and final regulations to ensure that the regulatory framework serves its intended purpose;
  • devise clear rules and provide guidance instead of relying on staff no-action letters;
  • streamline regulatory processes so that the agency can promptly respond when implementation issues arise;
  • ensure that the compliance periods for rules provide the market with sufficient time to prepare for and then comply with requirements; and
  • provide that multiple rule sets do not overly burden market participants.

In addition, Ms. Peirce advocated for regulatory cross-border deference as international regulators develop their framework for security-based swaps. According to Ms. Peirce, regulatory cross-border deference will ensure that the global over-the-counter derivatives market can serve the risk management needs of companies throughout economies.

Lofchie Comment: Commissioner Peirce’s call for the regulators to be self-critical is welcome. Likewise are her suggestions that both the causes of the financial crisis and the regulatory responses to it be critically re-examined.

There are, however, important challenges to her stated goals. Is it possible to have multiple regulators both be open to ongoing regulatory review and revision and, at the same time, to conform their own rules? It is certainly good news that the CFTC and the SEC are cooperating now; but will the agencies be able to sustain such cooperation over the long term?

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.

Treasury Proposes Regulations on Opportunity Zones

The U.S. Treasury Department (“Treasury”) proposed regulations relating to the new Opportunity Zone tax incentive. The tax incentive is intended to encourage investments in economically distressed communities by allowing taxpayers to defer capital gains tax if they reinvest within 180 days in “qualified opportunity funds” (“QOFs”), which are generally required to maintain at least 90 percent of their assets in “qualifying opportunity zone property.” In addition, an investor who holds a QOF investment for at least 10 years may qualify to increase its basis to the fair market value of the investment on the date it is sold.

The proposed regulations address, among other things, (i) the type of gains that may be deferred by investors (capital gains), (ii) investments in QOFs by pass-through entities, such as partnerships, (iii) guidance as to what constitutes opportunity zone property and what entities are eligible to be QOFs, and (iv) timing and election mechanics. In addition to the proposed regulations, the Treasury and the IRS issued Rev. Rul. 2018-29, which provides guidance for taxpayers on the “original use” requirement for land purchased after 2017 in qualified opportunity zones. The Treasury and IRS also released Form 8996, which investment vehicles will use to self-certify as QOFs.

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.

SEC Commissioner Urges Agency to Facilitate Competition in Capital Markets

SEC Commissioner Robert J. Jackson, Jr. called upon the agency to focus on the “forgotten fourth pillar” of its mission: facilitating competition in capital markets.

In a speech to a Washington D.C. think tank, Mr. Jackson highlighted the current lack of competition across financial markets and urged the SEC to address this problem through rulemaking and oversight. According to Mr. Jackson, the concentration of power in a few players across capital markets has worsened over the decades. Among other issues, Mr. Jackson noted (i) the lack of competition in public stock exchanges and national credit rating agencies and (ii) the decrease in IPOs among smaller companies due to the seven percent IPO tax. To reduce the concentration of power among these players, Mr. Jackson advised the SEC to:

  • review the current state of competition in financial markets, not just the effect proposed rulemaking may have on it;
  • more formally incorporate competition economics into the agency’s work;
  • collaborate with the Federal Trade Commission; and
  • be more vigilant in oversight, not less.

Lofchie Comment: There is no doubt that competition is a powerful force and should be encouraged to the extent possible. That said, there is only so much that the SEC can do to encourage competition, without going into business for itself, while there is a great deal that the SEC, along with other regulators, can do to discourage competition.

Let’s start with the destruction of firms through over-harsh enforcement actions. Exhibit No. 1 would be Salomon Brothers, a great firm largely destroyed by a combined federal, 50-state enforcement barrage in response to limited misconduct by a very small number of individuals. Arguably, Kidder Peabody suffered the same fate. Further, it was a Department of Justice enforcement action that likely resulted in the destruction of the Arthur Anderson accounting firm; although the DOJ’s victory in court was reversed by the Supreme Court, the accounting firm was already dead at that point.

Since Dodd-Frank was adopted, the number of operating futures commission merchants has been cut in about half. See generally, CFTC Commissioner Giancarlo Warns of Threat Posed by “Increasing Ill-Conceived Regulatory Burdens.” Virtually no new banks are being created; in good part due to increased regulatory burdens. The SEC’s recently proposed fiduciary rule raises a similar concern, that “full service” brokers may be driven out of service. See Choose One: Best Interest or Full Service.

These examples stand in contrast to Mr. Jackson’s view that it is some SEC inertia that has resulted in the decrease of IPOs, see SEC Commissioner Faults Regulatory Policies for Downward Trend in IPOs.

Of course, blame should not be confined to the federal government. In fact, New York State is likely the country’s leader in adopting financial regulations that sound nice on the airwaves but set impossible standards on the ground. See, e.g., NY Financial Services Department Adopts Final Revisions to Cybersecurity Requirements.

In short, there is only so much that the government can really do to force competition, but there is a great deal that it can do to kill competition.

FRB Governor Says FinTech Innovation Offers Solutions for Financial Inclusion

Federal Reserve Board (“FRB”) Governor Lael Brainard argued that more needs to be done to encourage financial inclusion and to improve access to credit for underserved families and small businesses. She stated that FinTech developments “may be combined in powerful ways to bring end-to-end solutions to financial inclusion.”

In a speech at the FinTech, Financial Inclusion Conference, Ms. Brainard stated that while access to accounts and credit are lowering transaction costs, such developments are not sufficient. She argued that continued progress toward financial inclusion is likely to require solutions that are designed with an understanding of issues that the underserved face (e.g., many unbanked or underbanked people in the U.S. are deliberately choosing not to maintain a bank account). According to Ms. Brainard, access to credit is important in mitigating financial vulnerability.

Ms. Brainard said that policymakers and financial services providers are assessing “financial inclusion” in a more holistic and nuanced manner, with a greater emphasis on “financial health.” In particular, she said that innovative platforms, such as faster payment services, can be combined with other technological developments (e.g., cheap access to cloud computing) to establish a more robust solution to fostering financial inclusion. Ms. Brainard said that the FRB has “a role and, potentially, a responsibility” to help build an “infrastructure that facilitates safe, innovative, and ubiquitous faster payment services.” For those who are struggling financially, she observed, the “difference between waiting for a payment to clear and receiving a payment in real time is not merely an inconvenience; it could tip the balance toward overdraft fees, bounced checks, or collection fees.”


CFS Monetary Measures for September 2018

Today we release CFS monetary and financial measures for September 2018. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.2% in September 2018 on a year-over-year basis versus 4.7% in August.

For Monetary and Financial Data Release Report:

For more information about the CFS Divisia indices and the data in Excel:

Bloomberg terminal users can access our monetary and financial statistics by any of the four options:

3) {ECST} –> ‘Monetary Sector’ –> ‘Money Supply’ –> Change Source in top right to ‘Center for Financial Stability’
4) {ECST S US MONEY SUPPLY} –> From source list on left, select ‘Center for Financial Stability’

Senate Banking Committee Considers State of Cryptocurrency and Blockchain

The U.S. Senate Committee on Banking, Housing and Community Affairs held a hearing on the state of cryptocurrency and blockchain. The two invited witnesses were Coin Center Director of Research Peter Van Valkenburgh and NYU Professor of Economics Nouriel Roubini.

Mr. Van Valkenburgh lauded the benefits of decentralized computing (i.e., blockchain) but criticized the surrounding “hype.” According to Mr. Van Valkenburgh, the terminology used to describe blockchain is often “vague and undefined,” leading to an overall lack of public understanding. In particular, he criticized the public perception that blockchain is the “solution to any number of social, economic, organizational, or cybersecurity problems.” However, Mr. Van Valkenburgh advocated for the continued exploration of decentralized computing, and advised regulators to take a “light-touch approach” in order to allow the technology to develop “unfettered.”

Conversely, Dr. Roubini criticized cryptocurrencies as the “mother of all bubbles,” and called the underlying blockchain technology the “most over-hyped – and least useful – technology in human history . . . nothing more than a glorified spreadsheet or database.”

In a statement given at the hearing, Senator Sherrod Brown (D-OH) expressed concern about the potential for fraudulent activity in cryptocurrencies and said that the malign effects of blockchain on our society are currently more prominent than the benefits. Senator Mike Crapo (R-ID) said that the “regulatory and oversight questions still remain,” but added that he wanted to better understand the opportunities and challenges regarding blockchain in order to regulate more effectively.


SEC Commissioner Advocates for Letting Investors Make Their Own Decisions

SEC Commissioner Hester M. Peirce advocated for a flexible regulatory approach that allows firms to experiment with new technologies and provides investors with a wider selection of investment choices.

In a speech at the Financial Planning Association 2018 Major Firms Symposium, Ms. Peirce expanded on her recent remarks discussing ways in which the SEC can “facilitate fund adaption of technological and other innovations” for the benefit of investors. To achieve this, Ms. Peirce stated, the SEC must change its approach to individual products and practices by giving firms the flexibility to utilize new technologies, products, fee structures and methods for disclosure. Such an approach, Ms. Peirce argued, would allow investors to make more informed decisions about whether and how to invest. As to the issue of the SEC deciding for investors, or depriving investors of the opportunity to decide for themselves, she chided the SEC again for its refusal to allow exchanges to list products based on bitcoin, saying that it should be up to investors (not the SEC) to decide whether such investments were good deals.

Ms. Peirce stated that, in order to permit investors to be sufficiently capable of assessing new technological innovations, the SEC must ensure that disclosures are written clearly. According to Ms. Peirce, changes to fund disclosure requirements in the last decade have not always factored in investors’ ability to understand the information. Fund disclosure forms are still “predominately paper-based,” “voluminous and . . . overwhelm[ing],” and “riddled with legalese and technical terms.” Ms. Peirce urged the SEC to consider “shorter document[ation] that contains only key information,” such as is required by the 2009 mutual fund summary prospectus.

Lofchie Comment: Commissioner Peirce’s arrival at the SEC is genuinely exciting to those who care about financial regulation, both its implementation and philosophy. She is not just staking out positive positions, which is obviously a nice-to-have; she is establishing the intellectual underpinning of those positions, which is an essential-to-have if the positions are to be enduring and to establish a framework for approaching issues on an ongoing basis. By conceding that there are limits to the knowledge of regulators, and by conceding that investors left to their own may make bad decisions, she acknowledges the possibility of failure – which is essential if we are to take risks.

While in the current regulatory environment, Commissioner Peirce’s views may seem radical, they would in fact return the SEC to its historical role as a regulator whose primary purpose is to mandate good disclosure, and then to step aside and let investors decide how to invest.