Monthly Archives: May 2013

Timeline for Implementation of SEF Trade Execution Requirements (Prepared by Delta Strategy Group)

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The attached document, prepared by the Delta Strategy Group, shows an estimated timeline for the implementation of the “SEF” requirements; i.e., (i) the ability for certain swap execution facilities (“SEFs”) to register with the CFTC, (ii) the implementation of the requirement that certain swaps be traded on a SEF or on a fully regulated futures exchange and (iii) the process for determining the “block” size at which certain trading information would not be immediately publicly disseminated. 

Click here to see the draft timeline prepared by Delta Strategy Group.

Bloomberg News Breach

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My fascination with the information available on Bloomberg began in January 1999, the first time I had ever seen a Bloomberg terminal (also my first day on a trading floor). I remember someone running over to tell us the Brazilian real was depreciating and typing something on the computer keyboard (BRL <Crncy> GIP, I later learned). And I remember being captivated as I watched the axes of the intraday graph recalibrate in real-time as the currency went into freefall.

Thus began my interest in the role the media plays in shaping financial market perception. In the interest of full disclosure, I have an unpublished working paper, “What the Market Watched: Bloomberg News Stories and Bank Returns as the Financial Crisis Unfolded,” that considers whether it was possible to glean information about market participants’ perceptions using Bloomberg’s readership statistics. So I was naturally drawn to recent stories (e.g., like this Washington Post article) on the access Bloomberg reporters had to information on subscribers’ activity and how that information was used.

Firms using customers’ information to benefit/enhance/promote their business is nothing new; on the contrary it is something we regularly agree to whenever we check that “I have read and agree to the Terms and Conditions” box on virtually everything we sign up for. The concept of targeted marketing is based on this practice. Sure there are differences between activity monitored via computer algorithm versus via actual person. But the fact is (and I am hardly the first to point it out) that we have become rather lax about our privacy…in a wide variety of contexts. Yet whenever a story hits about a firm using information they collect for specific business purposes (see, for example, this CNN article on retailers’ use of price discrimination), some amount of outrage often ensues.

Concerns over a firms’ ability to track and use information about online activity arise with any browser or website. And while a browser enables identification of an organization’s use (via the IP address), any site requiring a login potentially enables identification of a specific user.

This is not just about ethics but about cybersecurity. While some work is being done to strengthen disclosures regarding what firms do with information they collect and how it might be shared outside the firm, there is comparatively little effort spent on who inside a firm has access, how the information is stored, and what the shelf-life of such information might be. And the more these incidents are viewed as isolated to a specific “rogue” individual or groups of individuals at the organization, rather than a systemic reflection of the strength of a firm’s information security protocols, the greater the operational risk.

Outrage is a natural reaction to some of the more egregious uses of information. But until we become more proactive rather than reactive about safeguarding information, the risk that such information will be used inappropriately remains.

CFTC Commissioner O’Malia Gets Frank on Dodd-Frank Regulatory Framework

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CFTC Commissioner Scott D. O’Malia delivered a keynote address at Energy Risk USA 2013, in which he (i) criticized the Dodd-Frank rulemaking process, (ii) asserted that a significant number of unknowns had been created by Dodd-Frank and the implementing rules, (iii) wondered whether Dodd-Frank had not made the markets worse for end users and (iv) questioned whether Dodd-Frank had not made the markets even riskier by centralizing risk in a very limited number of clearing corporations. 

As to the rulemaking process, Commissioner O’Malia said that, in its “rush to implement all the rules,” the CFTC had chosen to adopt rules in some cases that are “either unworkable or simply make no sense.”  He then went on to say that, rather than attempting to fix its rules, the CFTC dealt with the problem temporarily by issuing “an unprecedented number of no-action letters and exemptions” providing “indefinite relief” in a “process . . . at odds with the basic principles of the Administrative Procedure Act.”  According to Commissioner O’Malia, the CFTC’s flawed rulemaking process had led to litigation against the CFTC, and the “shortcuts and inconsistencies” in the process will make the litigation difficult for the CFTC to defend.  

As to the CFTC’s cross-border regulatory proposal, he describes them as “over-reaching and overly prescriptive.”

In terms of wildcards and the future shape of the market, he pointed to the process of futurization (as market participants are driven out of swaps by “vague and complex” rules), the rules for the operation of SEFs, and Volcker. 

As to end users, Commissioner O’Malia indicated that they will have to pay a high price to obtain hedge customization. 

He wondered whether clearinghouses will reduce systemic risk given the massive amounts of credit that are being centralized there. 

Lofchie Comment:  Commissioner O’Malia’s view of Title VII and the related rulemaking process is bleak.   He indicates there is one bright spot in the CFTC’s rulemaking process:  “market participants are now familiar with the Commission’s definition of a swap.”  Alas, in this the Commissioner is wrong. According to a recent count, in the adopting release for the definition of a swap, the CFTC and the SEC used the phrase “facts and circumstances” (or something similar) in providing guidance as to what constitutes a swap 278 times.  In other words, the definition of a swap may be a “final rule,” but, to use the language of the Commissioner’s speech, it is a “known unknown.”   As more final rules come into force, it will become clearer just how problematic the ambiguous and overbroad definition of a swap is. 

As to the CFTC’s adopted rules, virtually everyone who is participating in the market shares the Commissioner’s view that they are, in many cases, “unworkable or simply make no sense.”  The danger for our economy is that this is perceived in the press as a partisan truth, so that it becomes impossible to hear criticisms and thus to make corrections.

See: Dodd-Frank Regulatory Framework: What Questions Remain Unanswered?

Remarks by Chairman Mary Jo White and Commissioner Luis Aguilar at SEC Roundtable on How to Change the Current Credit Ratings System

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At the SEC roundtable on credit ratings, Chairman Mary Jo White delivered opening remarks emphasizing the critical “gatekeeper” role played in the debt market by NRSROs and the impact of credit ratings on the economy.  Commissioner Aguilar discussed the importance of improving the credit ratings system. 

Chairman White reiterated that the roundtable is dedicated to allowing all sides to discuss possible regulatory or statutory changes to the current model subsequent to the SEC requesting public comment on the issue.

In his remarks, Commissioner Aguilar went on to discuss studies which have found that inflated credit ratings, among other factors, contributed to the financial crisis by masking the true risk of many mortgage-related securities.  One of the key concerns he discussed was the issue of conflicts of interest associated with the “issuer-pays” model, which encourages ratings shopping and places undue pressure on NRSROs to give favorable ratings.  He urged the establishment of transparent and orderly processes to ensure that a product will receive the appropriate rating level commensurate with its risk.

See: Chairman White’s Remarks and Commissioner Aguilar’s Remarks.

Comparison of Simple Sum and Divisia Monetary Aggregates in GDP Forecasting

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We recently added to our Advances in Monetary and Financial Measurement library a study comparing the simple sum and Divisia monetary aggregates in GDP forecasting. The authors are Periklis Gogas, Theophilos Papadimitriou, and Elvira Takli from the Democritus University of Thrace, Greece. Following is the abstract:

Abstract
In this study we compare the forecasting ability of the simple sum and Divisia monetary aggregates with respect to U.S. gross domestic product. We use two alternative Divisia aggregates, the series produced by the Center for Financial Stability (CFS Divisia) and the ones produced by the Federal Reserve Bank of St. Louis (MSI Divisia). The empirical analysis is done within a machine learning framework employing a Support Vector Regression (SVR) model equipped with two kernels: the linear and the radial basis function kernel. Our training data span the period from 1967Q1 to 2007Q4 and the out-of-sample forecasts are performed on a one quarter ahead forecasting horizon on the period 2008Q1 to 2011Q4. Our tests show that the Divisia monetary aggregates are superior to the simple sum monetary aggregates in terms of standard forecast evaluation statistics.

The study is forthcoming in Economics Bulletin. The full study can be accessed via our library by clicking here.

Bernanke on Monitoring the Financial System

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Federal Reserve Chairman Ben Bernanke gave a speech discussing the Federal Reserve’s ongoing monitoring of the financial system, and how such monitoring efforts have changed in response to the financial crisis.  In particular, Chairman Bernanke stated that the Federal Reserve has both increased the resources it devotes to monitoring as well as shifted its approach: in addition to monitoring individual financial systems, as it traditionally has, the Federal Reserve has begun emphasizing a more systemic approach that pays attention to the vulnerabilities of the financial system as a whole.  Chairman Bernanke went on to highlight the four components of the financial system that the Federal Reserve now follows most closely:  systemically important financial institutions, shadow banking, asset markets, and the nonfinancial sector.

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

Eurex Publishes Report In Praise of High-Frequency Trading

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Eurex published the attached report on High-Frequency Trading (HFT).  In the report, Eurex asserts that HFT is a “natural reflection of competition between market participants using the advances in computer technology.”  The report discusses background, issues, and regulation of HFT using the following outline.

  • How do you define high-frequency trading (HFT)?
  • What are the most common HFT strategies?
  • Why is the speed so important?
  • What is the impact of HFT on market quality?
  • Do HFT users cause volatility?
  • Why are there critical voices on HFT from institutional investors?
  • How do HFT firms (re-)act in critical times?
  • How do regulators deal with HFTs?
  • What impact does the German HFT Bill have for HFTs?

Click here to view report in full (links externally to Eurex website).

SEC Commissioner Aguilar’s Speech on the Need for Robust Oversight of SROs

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In a speech at the SEC, Commissioner Aguilar stated that an SRO Outreach Conference will soon be held to address the need for robust SEC oversight over and collaboration with the securities industry self-regulatory organizations (“SROs”). 

Aguilar further remarked that the SROs are faced with increased competition from electronic communications networks and foreign trading markets. Due to the fact that SROs must attract order flows to stay in business, this may, he suggested, lead them to be less inclined to enforce rules vigorously against members, issuers, and shareholders. Aguilar went on to state that SROs have in the past favored one member or customer over another, creating a conflict of interest.  He asserted that “over the years, there have been a growing number of enforcement actions by the Commission against SROs, who failed to meet their legal and regulatory obligations under the law.”  In this regard, he listed seven significant cases that the SEC had brought in the past fourteen years.  He stated that new competitive challenges and continued conflicts of interest require a closer working relationship between SROs and the SEC.

Lofchie Comment:  Recently, the SEC proposed new Regulation SCI, which would impose substantial additional compliance responsibilities on SROs, and also make it much easier for the SEC to sanction an SRO whose technology failed.  So, clearly part of the message is that SROs are increasingly under the microscope and in danger of becoming the subject of enforcement actions.

Suggestion that things are getting more evil in the financial industry is troubling; i.e., the Commissioner’s statement that “over the years, there have been a growing number of enforcement actions. . . . ” There has always been a certain amount of misconduct in the financial industry, just as in every other industry. It may be simply that enforcement is tougher today than ever before. The ongoing depiction of the financial industry – worse than ever, and worse than others – does not seem fair. Worse, it encourages a spiral of hypercriticism of the industry that may be overdone.

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

House Financial Services Committee Passes Various Proposed Amendments to Dodd-Frank and JOBS Act

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The House Financial Services Committee passed bipartisan bills to amend the derivatives provisions in the Dodd-Frank Act, to require cost-benefit analyses to be done at the SEC, and to require faster implementation of the JOBS Act.

The following is a summary of the legislation that the committee passed today including the vote count.

H.R. 634 (59-0): The Business Risk Mitigation and Price Stabilization Act of 2013 introduced by Reps. Michael Grimm (R-NY), Gary Peters (D-MI), Austin Scott (R-GA) and Mike McIntyre (D-NY), would exempt end users from the margin and capital requirements of Dodd-Frank Title VII (“Wall Street Transparency and Accountability”).

H.R. 677 (50-10): The Inter-Affiliate Swap Clarification Act, introduced by Reps. Steve Stivers (R-OH), Marcia Fudge (D-OH), Chris Gibson (R-NY) and Gwen Moore (D-WI), would exempt inter-affiliate trades from the Dodd-Frank Act’s margin, clearing, and reporting requirements.

H.R. 701 (passed by voice vote): To amend a provision of the Securities Act of 1933 directing the SEC to add a particular class of securities to those exempted under such Act to provide a deadline for such action, introduced by Reps. Patrick McHenry (R-NC), Anna Eshoo (D-CA), David Scott (D-GA), David Schweikert (R-AZ), and Scott Garrett (R-NJ). H.R. 701 would require the SEC to finalize the rules to implement JOBS Act Title IV also known as “Regulation A+” by October 31, 2013.

H.R. 742 (52-0): The Swap Data Repository and Clearinghouse Indemnification Act of 2013, introduced by Reps. Rick Crawford (R-AR), Sean Patrick Maloney (D-NY), Bill Huizenga (R-MI) and Gwen Moore (D-WI), would remove an indemnification requirement imposed on foreign regulators by the Dodd-Frank Act as a condition of obtaining access to data repositories.

H.R. 801 (passed by voice vote): The Holding Company Registration Threshold Equalization Act of 2013, introduced by Reps. Steve Womack (R-AR), James Himes (D-CT), and Ann Wagner (R-MO). H.R. 801 would amend JOBS Act Title VI (“Capital Expansion”).

H.R. 992 (53-6): The Swaps Regulatory Improvement Act, introduced by Reps. Randy Hultgren (R-IL), James Himes (D-CT), Richard Hudson (R-NC) and Sean Patrick Maloney (D-NY), would repeal most of Dodd-Frank Section 716 (“Prohibition against Federal Government bailouts of swaps entities”).

H.R. 1062 (31-28): The SEC Regulatory Accountability Act, introduced by Capital Markets Subcommittee Chairman Scott Garrett (R-NJ), would direct the SEC to follow President Obama’s Executive Order No. 13563, which requires government agencies to conduct cost-benefit analyses to ensure that the benefits of any rulemaking outweigh the costs. The Executive Order also requires that regulations be accessible, consistent, written in plain language, and easy to understand. Because the SEC is an independent agency, it is not required to follow the Executive Order. Former SEC Chairman Mary Schapiro indicated that the SEC will abide by the Executive Order. This bill codifies the Executive Order. 

H.R. 1256 (48-11): The Swap Jurisdiction Certainty Act, introduced by Reps. Garrett (R-NJ), John Carney (D-DE), Michael Conaway (R-TX) and David Scott (D-GA), would require the SEC and CFTC to jointly issue rules relating to swaps transacted between U.S. persons and non-U.S. persons. H.R. 1256 would also exempt a non-U.S. person in compliance with the swaps regulatory requirements of a G20 member nation from U.S. swaps requirements unless the SEC and CFTC jointly determine that the regulatory requirements are not “broadly equivalent” to U.S. swaps requirements.

H.R. 1341 (59-0): The Financial Competitive Act of 2013, introduced by Rep. Stephen Fincher (R-TN), requires the Financial Stability Oversight Council (“FSOC”) to study the likely effects of the differences between the U.S. and other jurisdictions in implementing the derivatives credit valuation adjustment (“CVA”) capital requirement.

Lofchie Comment:  We also summarized these bills in yesterday’s news.  Link here.  Some press reports have described these bills as deregulatory.  With the arguable exception of H.R. 1062 (which requires cost-benefit analyses), that really is not a fair description for the reasons set out yesterday.  Further,  H.R. 634 and H.R. 992 fix what everyone, including supporters, has agreed were mistakes in the legislation.  It’s hard for someone who does not live in Washington, D.C., to understand why these mistakes cannot be fixed.

Click here to learn more (links externally to House Financial Services website).
See also: SIFMA Statement of Support.

FRB Governor Tarullo Remarks on ”Evaluating Progress in Regulatory Reforms to Promote Financial Stability”

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Federal Reserve Governor Daniel K. Tarullo gave a speech discussing regulatory efforts to promote financial stability, including efforts to address the “too-big-to-fail” problem and systemic risk generally. Governor Tarullo noted that the existing regulatory response has been extensive, citing ongoing efforts such as the Basel III rulemaking, the Section 165 prudential regulation of large bank holding companies, and the implementation of Title VII of the Dodd-Frank Act as examples. Nevertheless, Governor Tarullo stated that current efforts do not adequately address all of the vulnerabilities that developed in the U.S. financial system in the years preceding the financial crisis. Most important, Governor Tarullo stated, is that relatively little has been done to change the structure of wholesale funding markets to make them less susceptible to damaging runs, especially with respect to security financing transactions. While Governor Tarullo acknowledged that there is no existing blueprint for addressing the basic vulnerabilities in short-term wholesale funding markets, he cautioned that a more comprehensive set of regulatory measures is necessary.

With respect to the too-big-to-fail problem, Governor Tarullo asserted that the “regularization and refinement” of stress testing may be the most important supervisory improvement to strengthen the resilience of large institutions. Additionally, although finalizing the Basel III rulemaking should be a priority, Governor Tarullo stated his belief that such measures do not go as far as he would like. He went on to discuss several additional potential regulatory reforms, including the possibility of imposing higher liquidity and capital standards, as well as that of tying liquidity and capital standards together by requiring higher levels of capital for large firms unless their liquidity positions are substantially stronger than minimum requirements.

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