The IOSCO has published a final report on Global Developments in Securitisation Regulation, which proposes a series of recommendations aimed at ensuring securitisation markets, including cross-border markets, develop on what IOSCO views as a sound and sustainable basis.  In addition to making the recommendations summarized below, the report provides a very broad overview of the state of the securitization markets around the world.  (It is fairly remarkable how substantially these markets have shrunk in size.)

The primary recommendations, which start on page 48, relate to risk retention and standarization of disclosures.  The other recommendations relate to the following topics:  prudential treament; standardization of products to encourage secondary market trading, sound underwriting practices, guidance on cross-border issues and accounting. 

Lofchie Comment:  The report provides a lot of interesting information as to the state of the market, and particularly as to how much the market has reduced in size.  From an academic standpoint, if I can presume to have such a standpoint, one thing I found disappointing was that the report seemed to take it as a given that risk retention was a good idea and further that it was important that each jurisdiction develop fairly standardized rules as to risk retention.  Neither assumption seems obvious to me; even assuming that it is a good idea, I don’t know why different jurisdictions should not adopt different approaches to this topic.

View report in full here (links externally to IOSCO website).
See also: Press Release.

CFTC will move forward with an appeal of a federal district court’s decision vacating the position limits rule.  The Commission approved the appeal on a 3-2 vote.

In explaining the CFTC’s decision, CFTC Chairman Gensler said, “As part of the Dodd-Frank Act, Congress directed the Commission to limit promptly speculative positions in physical commodity futures and options contracts and economically equivalent swaps. The rule addresses Congress’ concern that that no single trader be permitted to obtain too large a share of the market, and that derivatives markets remain fair and competitive. I believe it is critically important that these position limits be established as Congress required. I support the Commission’s continued efforts to put in place position limits on speculative positions by appealing the September ruling.”

In dissent, CFTC Commissioner O’Malia said, ” To save the Commission’s time and resources, it would be much more logical for the Commission to go back to the drawing board now to study the markets and to determine whether new position limits are in fact necessary, and only if so then to decide on the most cost-effective way of establishing such limits.  Ideally, it would make sense for Congress to act and clarify the statute in order to end any further debate about its meaning.”

View press release in full here (links externally to CFTC website).
See also: O’Malia Dissenting Statement

The Financial Stability Oversight Council issued a significant report, including three major (and non-exclusive) recommendations for material changes in the manner in which money market funds (“MMFs”) operate, all with the intended purpose of forestalling a run on MMFs of a type that may trigger a market crash.  FSOC’s summary of the three proposals is as follows:

Alternative One: Floating Net Asset Value. Require MMFs to have a floating net asset value (“NAV”) per share by removing the special exemption that currently allows MMFs to utilize amortized cost accounting and / or penny rounding to maintain a stable NAV. The value of MMFs’ shares would not be fixed at $1.00 and would reflect the actual market value of the underlying portfolio holdings, consistent with the requirements that apply to all other mutual funds.

Alternative Two: Stable NAV with NAV Buffer and “Minimum Balance at Risk.” Require MMFs to have an NAV buffer with a tailored amount of assets of up to 1 percent to absorb day-to-day fluctuations in the value of the funds’ portfolio securities and allow the funds to maintain a stable NAV. The NAV buffer would have an appropriate transition period and could be raised through various methods. The NAV buffer would be paired with a requirement that 3 percent of a shareholder’s highest account value in excess of $100,000 during the previous 30 days – a minimum balance at risk (MBR) – be made available for redemption on a delayed basis. Most redemptions would be unaffected by this requirement, but redemptions of an investor’s MBR itself would be delayed for 30 days. In the event that an MMF suffers losses that exceed its NAV buffer, the losses would be borne first by the MBRs of shareholders who have recently redeemed, creating a disincentive to redeem and providing protection for shareholders who remain in the fund. These requirements would not apply to Treasury MMFs, and the MBR requirement would not apply to investors with account balances below $100,000.

Alternative Three: Stable NAV with NAV Buffer and Other Measures. Require MMFs to have a risk-based NAV buffer of 3 percent to provide explicit loss-absorption capacity that could be combined with other measures to enhance the effectiveness of the buffer and potentially increase the resiliency of MMFs. Other measures could include more stringent investment diversification requirements, increased minimum liquidity levels, and more robust disclosure requirements. The NAV buffer would have an appropriate transition period and could be raised through various methods. To the extent that it can be adequately demonstrated that more stringent investment diversification requirements, alone or in combination with other measures, complement the NAV buffer and further reduce the vulnerabilities of MMFs, the Council could include these measures in its final recommendation and would reduce the size of the NAV buffer required under this alternative accordingly.

In addition to providing the above recommendations, the report provides (i) an overview of the regulations that apply to MMFs, (ii) a summary of the recent changes that have been made to those regulations and (iii) a discussion of the role that MMFs played in triggering the financial crisis.

Lofchie Comment:  The issuance of the FSOC recommendations follows disagreement among the SEC Commissioners, that came to a head this summer as to whether the SEC should issue a rule proposal regarding the operation of MMFs.  At that time a majority of the SEC Commissioners took the view that more study was needed before rule proposals were issued.  The issuance of this report will obviously put significant pressure on the SEC to act with respect to them. 

All three of the proposals really work major changes in the operation of MMFs.  The first proposal is the simplest: it arguably does away with the notion of a MMF and says that the NAV of a MMF shall rise and fall each day with its underlying assets, just as is the case for every other type of mutual fund.  The second alternative exposes large investors in money market funds  to limits on their ability to withdraw their assets and in fact provides a disincentive to withdraw money by imposing losses first on those who withdrew their money recently.  (One negative reaction that I have to this proposal is that it punishes those investors who are alert to a problem by creating a disincentive to monitor the safety of their investments.)  An example of how this proposal would work is on page 42 of the report.  The third alternative essentially creates a level of quasi-equity that would be at risk of loss in the event of a run on the MMF. (In some sense, one might think of this making a MMF more like a bank; the ordinary investors in the MMF are more akin to depositors, and there is level of risk absorbtion below the depositors.  The level of capital required would be less than is required of a bank, but the allowed investments of the MMF would be more limited than those permitted to a bank.)

It would seem inevitable that there be a major change in the way that MMFs are regulated, given wide acknowledgment of the role that such funds played in the financial crisis.  What is odd, and disappointing, is that so much regulatory energy has been diverted to the creation of rules regarding matters that had pretty much nothing to do with the financial crisis.  That said, notwithstanding the amount of time that has passed since the financial crisis, I wonder how much “macro” level consideration has been given to the effect of these proposals (for better or worse) on the financial markets.  To take two open questions: (i) will these proposals draw money out of MMFs and into banks? (ii) will those proposals draw money out of public MMFs subject to such regulations and into private or non-U.S. MMFs?  In any case, the report does ask for comments on many questions.

Anyways, as far as the way the markets work and the economy functions, this report is big stuff.

Link here to the press release announcing the report.
Link here to FSOC’s Proposed Reccomendations Regarding Money Market Funds.  
Link here to FSOC’s 2012 Annual Report, which contains extensive discussion of Money Market Funds.

The CFTC is proposing to adopt new regulations and amend existing regulations to require enhanced customer protections, risk management programs, internal monitoring and controls, capital and liquidity standards, customer disclosures, and auditing and examination programs for futures commission merchants (FCMs).  The proposal also addresses certain related issues concerning derivatives clearing organizations (DCOs) and chief compliance officers (CCOs).  The CFTC’s summary of the high points of the rule changes are listed below:

• Amending Part 30 of the regulations to require FCMs to hold sufficient funds in secured accounts to meet their total obligations to both U.S.-domiciled and foreign-domiciled customers trading on foreign contract markets, computed under the net liquidating equity method;
• Prohibiting FCMs from holding any positions in a Part 30 secured account other than customers’ foreign futures and option positions and associated margin collateral;
• Requiring FCMs to hold sufficient proprietary funds in segregated accounts and Part 30 secured accounts to reasonably ensure that the firms are properly segregated and secured at all times, and to cover margin deficiencies in customers’ trading accounts;
• Requiring FCMs to maintain written policies and procedures governing the maintenance of excess funds in customer segregated and Part 30 secured accounts, and requiring FCMs to obtain the pre-approval of management prior to the withdrawal of 25 percent or more of the excess funds held in segregated or secured accounts if the withdrawals were not for the benefit of the FCMs’ customers;
• Requiring FCMs to provide the Commission and their respective designated self-regulatory organizations with daily reporting of the segregation and Part 30 secured amount computations, and semi-monthly reporting of the location of customer funds and how such funds are invested under Regulation 1.25;
• Requiring FCMs and DCOs to provide the Commission and designated self-regulatory organizations, as applicable, with read-only direct electronic access to bank and custodial accounts holding customer funds;
• Requiring FCMs to adopt policies and procedures on supervision and risk management of customer funds;
• Requiring FCMs to provide potential customers with additional disclosures addressing firm specific risks; and
• Enhancing the standards for the self-regulatory organizations’ examinations of member FCMs.

Comments Due: January 14, 2013.

Cross-References: CFTC Rules Parts 1 (General Regulations), 3 (Registration), 22 (Cleared Swaps), 30 (Foreign Futures and Foreign Swaps), and 140 (Organization, Functions, and Procedures of the Commission).

Lofchie Comment:  This is a very extensive set of rule changes (the Release runs over 400 pages) that will require close review by FCMs. 

On the one hand, it was inevitable that there would be significant additional custody and related requirements imposed on firms following the failures of Peregrine and MF Global.   (Many of the requirements, such as the required procedures around the handling of customer funds, are a direct function of the specific events leading to the failure of those two firms.  In fact, one might trace the changes to the part 30 rules and to the supervision of customer funds largely to MF Global.)  On the other hand, these changes are not necessitated directly by Dodd-Frank, but lie on top of all that is required under Dodd-Frank.  At some point, one wonders just how many rule changes, even rule improvements, the financial system can tolerate in a short period of time.

One interesting aspect of the rule changes is the increased responsibility put on futures SROs for the supervision of FCMs.  Given the tremendous scope of the new Dodd-Frank responsibilities assumed by the CFTC, it would seem likely that we will see a greater imposition of regulatory responsiblities on the SROs.  This would be consistent with the historical direction of the regulation of broker-dealers.

View release here: 77 FR 67865.
See also: Press Release; Chairman Gensler Statement of Support; Commissioner Sommers Statement; O’Malia Statement.

In a speech at George Mason University, CFTC Commissioner Scott O’Malia suggested that the CFTC rethink Dodd-Frank implementation within a framework of good governance, highlighted several places where the CFTC has failed (including the position limits rule), and urged the Commission to “scrap” its entire cross-border guidance, stating that he “cannot support a Commission proposal that puts U.S. firms at a competitive disadvantage to foreign banks”. 

In terms of following a platform of good governance in implementing Dodd-Frank, O’Malia suggests the following three guiding principles:

1. For rules that have already been finalized, provide transparent implementation guidance that is consistent with the final rules;
2. Be aware of the consequences of CFTC regulations on market activity; and
3. Maintain the flexibility to reassess and revise such regulations where appropriate.

In terms of content, O’Malia focused on three Dodd-Frank rulemaking areas:

1. The October 12 effective date for swap regulations and the resulting ‘futurization’ of the swaps world, with a resulting reduction in the availability of tailored products;
2. The CFTC’s final rules for swap execution facilities (SEFs); and
3. The CFTC’s guidance on cross-border issues.

O’Malia’s most detailed criticisms addressed cross-border rulemaking.  In this he suggested that the CFTC “review the comparability of non-U.S. regulations with Commission rules… [which] should be a broad, big-picture assessment of comparability, not a rule-by-rule analysis.”  He further urged the Commission to engage more actively and meaningfully with foreign regulators to “develop a more harmonized approach in order to eliminate redundancy and inconsistency among the respective regulatory regimes.”

Lofchie Comment:  In a news letter from last week, we published a news item linking to a speech by Commissioner Chilton in which he took the view that the CFTC’s swap implementation rules were ready to go; today, a speech by fellow Commissioner O’Malia in which he takes an equally negative view of the rule making process.  My own views are, as is reasonably known, more akin to that of Commissioner O’Malia, but I leave it to readers in the financial industry to judge which speech strikes them as closer to their personal experiences. 
       I did say in a prior comment that I believed that the CFTC would have to retreat on its rule making, and withdraw from many of its majority positions.  There was, in my view, simply too much criticism of the CFTC’s rule making by non-U.S. regulators for the CFTC to go straight forward.  But there is implicit in Commission O’Malia’s remarks a more significant criticism of the CFTC’s rulemaking: the rules simply make it too expensive to enter into swaps.  This may seem a good result to those who believe “swaps bad,” but given the broad usage of swaps by commercial users, governmental entities and pension plans, the market generally believes “swaps pretty good.”  Thus, a regulatory regime that makes U.S. financial institutions noncompetitive with non-U.S. institutions is bad, but a regulatory regime that makes swaps needlessly expensive, to the point of unavailability, to commercial users, is even more problematic.   In any case, it seems even clearer now than it did when I first predicted that the CFTC will have to rethink its approach to cross-border regulation.  That leaves open the question implicit in Commissioner O’Malia’s remarks as to whether it will rethink its approach to purely domestic regulation.

Click here to view speech in full (links externally to CFTC website).

The High Court in London has ruled that the appointment of administrators to oversee MF Global’s UK operations did not automatically trigger an event of default under a repurchase agreement entered into with US affiliate MF Global Inc., as it was not equivalent to the appointment of a liquidator for the purposes of the agreement.  The effect of the ruling would allow MFG UK, rather than MF Global US, to be the non-defaulting party under the GMRA between the parties, and thus to be the party which has the right under the GMRA to determine how much it owes or is owed by its affiliate.  Since the sides are apart by a considerable sum in their valuations under the agreement (MF Global Inc. has suggested that it is owed more than £286 million under the arrangements, whereas the UK administrators maintain that the sum outstanding should only amount to around £37 million), the ability to value the claim under the GMRA appears to have considerable worth.

Lofchie Comment:  As if the unwind of Lehman were not proof enough, this case is indicative of how much potential benefit there would be to the U.S. and the U.K. devising some common approach to the liquidation of affiliates in the two jurisdictions in the case of an insolvent financial institution.   Beyond that, it seems rather remarkable, and not in a good way, that the right to determine valuations under the GMRA, in a transaction between two affiliates both of whom were going to fail regardless of who failed first, should be worth approximately  £250 million to the winning party.