The SEC is proposing two alternatives for amending rules that govern money market mutual funds pursuant to Rule 2a-7 under the Investment Company Act. The release provides a substantial discussion of the role of money market funds in the 2008 financial crisis, as well as some discussion of prior and subsequent valuation and liquidity problems experienced by money market funds.   According to the SEC, the two alternatives proposed by the SEC are designed to address money market funds’ susceptibility to heavy redemptions, improve their ability to manage and mitigate potential contagion from such redemptions, and increase the transparency of their risks, while preserving their benefits.

• Alternative One: Floating NAV – This proposed alternative would require that all institutional prime money market funds operate with a floating net asset value (“NAV”). This approach would preserve the stable value fund product for those retail investors who have found it to be convenient and beneficial.
• Alternative Two: Liquidity Fees and Redemption Gates – This proposed alternative seeks to directly counter potentially harmful redemption behavior during times of stress. Under this model, a non-government money market fund would impose a two percent liquidity fee (the SEC requested comment on the size of the fee) if the fund’s level of weekly liquid assets fell below 15 percent of its total assets unless the fund’s board determined that the fee was not in the best interests of the fund.  Additionally, redemption gates could be imposed.  In effect, an investor that wanted to obtain immediate liquidity in a period of market crisis would be assessed a substantial penalty on redemption, if it were able to redeem at all. 

The SEC could adopt either alternative by itself or a combination of the two alternatives. The SEC also is proposing additional amendments that are designed to make money market funds more resilient by increasing the diversification of their portfolios, enhancing their stress testing, and increasing transparency by requiring money market funds to provide additional information to the SEC and to investors. The proposal also includes amendments requiring the investment advisers to certain unregistered liquidity funds, which can resemble money market funds, to provide additional information about those funds to the SEC.

Government security money market funds and “retail” money money market funds might be exempted from the alternatives.  A “retail” fund would be defined as a fund that limited redemptions by any individual investor to $1 million a day.  The release contains an extensive discussion of how this $1 million limit might be monitored where investment in a money market fund is made through an omnibus account where the actual investors are not known to the money market fund. 

The release notes that the changes made in the regulation of money market funds would have ripple effects beyond the securities laws; e.g., they would effect the tax treatment of investments in such funds and they might potentially affect the accounting treatment of such funds.  In addition, the changes could significantly affect operational processes in the securities markets; for example, an investor purchasing shares on the stock market could not be assured that the cash required to pay for those shares could be raised by redeeming the number of money market shares equal to the number of dollars of cash required to pay for the shares.

Comments Due: September 17, 2013.

Lofchie Comment:  The release states that there is currently approximately $2.9 trillion invested in money market mutual funds.  The release notes that the changes in the money market fund rules will likely have a material effect on investment patterns; i.e., on whether that $2.9 trillion stays invested in money market funds, and, even to the extent it does, that the types of funds that receive investor money will change.  In short, the rule will materially affect not only investors and financial intermediaries but also issuers raising capital.  One other consequence may be an increased demand for government securities to be held by money market funds (as money market funds will be exempt from certain of the new requirements) at the same time that Dodd-Frank regulations also require market participants to post government securities as collateral in connection with derivative transactions.  The SEC appropriately concedes that the full effect of these proposed regulatory changes is impossible to predict. 

See: 78 FR 36834.
Related News: “SEC Open Meeting: Money Market Fund Reform (with link to Delta Strategy Description of SEC Meeting)”

Chairman Gary Gensler released a paper, previously published in a French financial journal in April, that focuses on cross-border regulation of the swaps market.  According to his paper, as the financial system failed in 2008, the swaps market, which was basically not regulated in the United States, Europe, Canada or Asia, failed to meet their objectives, causing a great financial crisis.

Chairman Gensler’s paper is divided into the following areas of focus:

• New International Consensus to Reform the Swaps Market
• Transparency – Lowering Cost and Increasing Liquidity, Efficiency, and Competition
• Clearing – Lowering Risk and Democratizing the Market
• Swap Dealer Oversight – Promoting Market Integrity and Lowering Risk
• International Coordination on Swaps Market Reform
• LIBOR

Lofchie Comment:  If Chairman Gensler was trying to persuade the Europeans, who have been very blunt in their criticism of the CFTC’s go-it-alone regulation, that the CFTC has done everything possible to work with them, he failed.  Their response has been negative; see, e.g., European Commissioner’s ”Invitation” to CFTC Chairman to Extend the CFTC Exemptive Order on Cross-Border Swaps Regulation.

If Chairman Gensler was trying to persuade an American political audience of the CFTC’s efforts at cross-border cooperation, he seems not to have succeeded. Yesterday, the House of Representatives by a very substantial majority adopted a bill that would require the CFTC to provide a fuller explanation of its cross-border policies and to cooperate more closely with both the SEC and European regulators.  Even assuming that the relevant bill (the Swap Jurisdiction Certainty Act) has no chance of being adopted into law by the Senate, the fact that it was adopted by a vote of 301-124 shows that a large majority of the House is actively opposed to the Chairman.

Whatever the merits of the CFTC’s rulemaking may be, those who are subject to its rules are going to be skeptical of a paper that describes them as “common-sense rules of the road.”  A set of rules that requires a 200-page discussion of just the defined term “swap,” followed by numerous no-action letters on the same topic, may someday be regarded as brilliant, but they are not going to be thought of as “common-sense” rules.

Soon, Chairman Gensler will face a crucial decision as to whether to extend the CFTC’s existing cross-border relief or let it lapse without any rule to take its place. See, e.g.,  Commissioner O’Malia Speaks on Cross-Border, ”Made Available to Trade” and Data Management.  Most believe it would be the right and prudent course to extend the relief.  That said, I think that most non-U.S. regulators and firms might prefer the chaos which might come without a rule over the hasty adoption of a bad cross-border rule.

See: International Swaps Market Reform: Promoting Transparency and Lowering Risk.

CFTC Commissioner Bart Chilton gave a speech to the Institute of International Bankers (“IIB”) using popular movies to illustrate the benefits of government regulation in industries such as food, energy and pharmaceutical. However, Commissioner Chilton also acknowledged that government regulations are sometimes overbroad and unnecessary. He concluded by discussing how, as in life, regulations require a balance approached. To that end, he asserted the virtues of the Volcker Rule and the Cross-Border Guidance and how both proposals strike the proper balanced approach to regulation.

Lofchie Comment: In a quick scan of Commissioner Chilton’s speech, I counted references to 38 movies, including remakes and sequels.

See: “Cinema of Uncertainty.”

CFTC Commissioner Scott D. O’Malia gave the keynote address before the OpRisk European Conference. He focused on three topics.

As might be expected, given the European audience, the first topic was cross-border regulatory issues and his reasoning for seeking an extension of the July 12, 2013 deadline for the implementation of cross-border application.

The second was the CFTC’s adoption of rules governing swap execution facilities (“SEFs”) and related trade execution rules, particularly the oddly-named “Made Available to Trade Rule.”  “Made Available to Trade” really means “must be traded on a SEF.”  Commissioner O’Malia argued that the CFTC standard for when a cleared swap is required to be traded on a SEF is too low, and is allowed to be decided by an entity that is subject to a substantial conflict of interest.

Third, the Commissioner observed that, while the CFTC is collecting a good amount of data, in its haste to require the transmission of data, it has failed to adopt rules and procedures that will allow it to make use of that data.

Lofchie Comment:  As stated in a previous comment, CFTC Chairman Gensler is now in the difficult position where the most responsible course of action as to cross-border regulation is to take an action that he has previously opposed: extending the current cross-border guidance and conceding that no final rule on cross-border regulation will be reached during his term as Chairman.  See, e.g., Trade Associations Request a Six-Month Extension of the CFTC’s Cross-Border Exemptive Guidance.

As to “made available to trade,” the Commissioner points out what are significant flaws in the CFTC’s rulemaking. As discussed in the news item, CFTC Publishes Text of SEF Rules, once a swap is subject to clearing, a SEF is able, by issuing an analysis that the CFTC estimates will cost $938.40 (in other words, for a very cursory analysis), to force the entire market to trade that swap on a SEF and not in the OTC market.  Given that there is no experience with how SEFs will function, that seems an imprudently low standard of analysis. Indeed, why bother with an analysis at all, given how cursory the standard seems to be?  One might as well allow any SEF to mandate an end to OTC trading of any swap that is subject to mandatory clearing.

Commissioner O’Malia’s third comment is one that may be made as to other regulators and other rules:  the government mandates the collection of information, at great expense to market participants, that it has no means to use.

The common theme that runs through Commissioner O’Malia’s remarks is that the CFTC, in attempting to implement Dodd-Frank quickly, has acted in too-great haste.  It is now in a position where it can continue racing ahead, but it seems inevitable that if the Commission does not take a break and reevaluate the rules it has already adopted, it will soon be forced to do so in response to market disruptions that those rules have created. 

See: Taking the Time to Get It Right: The Cross-Border Regulatory Framework.

Delta Strategy Group released a very useful summary of the finalized “Made Available to Trade Rule.”  As previously explained, this is the process by which a swap execution facility (“SEF”) may require that any swap that is subject to mandatory clearing also be traded only on a regulated market.

Click here to see a summary of the “made available to trade” rule and process from Delta Strategy Group.

SIFMA, along with the ABA, ABA Securities Association, FIA, IIB, and ISDA submitted comments to the CFTC requesting a six-month extension of the Commission’s Final Exemptive Order Regarding Compliance with Certain Swap Regulations.  The associations believe an extension would be helpful for the following reasons:

• First, an extension would provide sufficient time for swap market participants and the CFTC to consider the potential implications of recent SEC proposals relating to its regulation of cross-border security-based swap activities.
• Second, failing to extend the Exemptive Order without final cross-border guidance could increase uncertainty for international market participants.
• Third, as described by the European Commission Letter, expiration of the Exemptive Order, or the premature replacement of the Exemptive Order with final cross-border guidance, might jeopardize the productive and cooperative efforts underway to meet G20 commitments on an international basis.

Lofchie Comment:  The fundamental issue is set out in CFTC Commissioner O’Malia’s speech which is linked to the following news article:  “CFTC Commissioner O’Malia on Ensuring a Backup Plan on Cross-Border Guidance to Give Markets Certainty.”

CFTC Chairman Gensler now faces a difficult choice: he must either (i) try to force through a final rule, for which he does not have a majority currently, against criticism from regulators around the globe, as well as market participants and, implicitly, the SEC, which has taken the approach of working with global regulators, (ii) concede to an extension, which means that a final rule will likely not be adopted until after his term as Chairman is finished or (iii) simply allow the existing exemptive order to expire, which Commissioner O’Malia describes as the “nuclear option” in light of the confusion that it would cause to global financial markets.

Click here to view letter in full (links externally to SIFMA website).
See also:  “SIFMA President Bentsen Takes a Side on Cross-Border Conflict“.

H.R. 1256 calls for the SEC and the CFTC to work together and harmonize their rules relating to swaps transacted between those in the U.S. and those abroad while ensuring regulators employ a thorough and deliberate process in determining when to apply U.S. swaps rules in foreign markets and to foreign firms.

Specifically, this legislation would require joint rules to address:

(1) the nature of the connections to the United States that require a non-U.S. person to register as a swap dealer, major swap participant, security-based swap dealer, or security-based swap participant under each Commission’s respective Acts and related regulations;

(2) the extent to which U.S. swaps requirements shall apply to the swap and security-based swap activities of non-U.S. persons, U.S. persons, and their branches, agencies, subsidiaries, and affiliates outside the United States; and

(3) the circumstances under which a non-U.S. person in compliance with the regulatory requirements of a foreign jurisdiction shall be exempt from U.S. swaps requirements.

YouTube Selection:  “Why Can’t We Be Friends?“.

Click here to view text of proposed legislation.
See also: House Financial Services Committee Blog Post.

The second phase of required clearing for certain credit default swaps (“CDS”) and interest rate swaps begins today. Commodity pools, private funds, and persons predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, are included within the definition of Category 2 Entities. These entities are required to begin clearing swaps executed on or after June 10, 2013.

The five swap classes that are required to be cleared subject to this timing include swaps meeting the following specifications:

With regard to the iTraxx CDS indices on European corporate names, the following compliance dates apply: Category 1 entities began clearing on April 26, 2013; Category 2 entities begin clearing on July 25, 2013; and all other entities begin clearing on October 23, 2013. The specifications for iTraxx include the following:

Click here to view CFTC Press Release in full (links externally to CFTC website).
Related News: “CFTC’s Division of Clearing and Risk Issues Time-Limited No-Action Relief to Banks Having Assets of Less than $10 Billion from the Board Approval Requirement of the CEA and the End-User Exception to the Clearing Requirement (Letter 13-26)” (June 10, 2013).

The Division of Clearing and Risk (“DCR”) of the CFTC announced the issuance of a time-limited, no-action letter, granting relief to banking institutions having assets of less than $10 billion (“Small Banks”) which are issuers of securities (or subsidiaries of such issuers), from the Board approval requirements of CEA Section 2(j) (“Committee Approval by Board of Exemption from Clearing or Trade Execution Requirements”) and CFTC Rule 50.50 (“Exceptions to the Clearing Requirement”).

The no-action letter provides that DCR will not recommend an enforcement action for a Small Bank’s election of the end-user exception from required clearing without obtaining prior approval from the Board of the Small Bank, provided that, as soon as practicable, and no later than July 10, 2013, a Small Bank obtains retroactive Board approval for entering into uncleared swaps pursuant to the end-user exception for swaps entered into on or after June 10, 2013.

Beginning on June 10, 2013, in order to elect the end-user exception to required clearing, Small Banks otherwise must be eligible to utilize CFTC Rule 50.50.

This no-action relief expires on July 10, 2013. DCR notes that all market participants electing for the end-user exception to required clearing do not have to comply with the reporting obligations contained in regulation 50.50(b) until September 9, 2013.

Lofchie Comment:  As with many other CFTC no-action letters, this one is subject to conditions that are unnecessary and problematic.  In this case, the problem is the requirement that Board approval be “retroactive.”  Essentially, the CFTC is putting the Board in a position in which it must either approve a prior action that it had not reviewed at the time the action was taken or subject the bank to the risk of a CFTC disciplinary action.

Presumably, bank boards will approve the decision not to clear in every instance, so this problem will end up being a theoretical one.  That said, the CFTC staff has put bank boards in a very awkward position given the conditions in this letter.

See: CFTC Letter 13-26.

SIFMA President, Kenneth E. Bentsen, released a statement regarding the cross-border application of the Dodd-Frank Act in which he sided with CFTC Commissioner O’Malia (and implicitly, the EU regulators and the SEC)  in the latter’s disagreement with CFTC Chairman Gensler over whether the CFTC’s current cross-border guidance should be extended past July 12, should be allowed to lapse or a final rule should be adopted. 

Lofchie Comment:  On June 6, CFTC Chairman Gensler and CFTC Commissioner O’Malia issued statements (linked below) expressing opposing views on how the CFTC should deal with the expiration of its cross-border guidance on July 12, 2013.  In his remarks, CFTC Chairman Gensler invoked the images of U.S. soldiers who “stormed the beaches of Normandy” and urged that the CFTC should not further delay the application of its cross-border rules, regardless of the fact that the CFTC was not acting in a manner that was consistent with either the SEC or global regulators, including those in the EU.  Commissioner O’Malia took the opposing viewpoint:  that swaps regulation is inherently a matter of international concern, as to which the CFTC should attempt to coordinate with our allies.  The letter from SIFMA is in support of the position advanced by Commissioner O’Malia.

With the CFTC’s temporary extraterritorial guidance expiring on July 12, the CFTC now faces a decision.  Chairman Gensler believes that the CFTC should proceed to adopt final guidance.  However, the CFTC never issued a proposed rule on cross-border issues.  Consequently, there has never been a full opportunity for other regulators or for market participants to submit comments on the CFTC’s ultimate guidance – in fact, no one really knows what any final guidance issued by the CFTC might look like.  Thus, if the CFTC were to issue final guidance that would be effective July 12, no one in the market would have had an opportunity to prepare for its requirements, and the CFTC would then have to issue yet another last-minute exemption from its supposedly final guidance.  Rather than issuing final guidance, and then delaying that guidance, it would be more prudent for CFTC Chairman Gensler to accept the suggestion of Commissioner O’Malia and the “invitation” of the European regulators (linked below) for the CFTC to coordinate its regulatory position with regulators around the world.

A third choice is that the CFTC may not agree on anything, and simply allow the current guidance to expire without replacement.  As a practical matter, the market would likely interpret such non-action as being an implicit extension of the status quo (albeit with civil litigation risk).  That course of inaction would be unfortunate. It would suggest that the CFTC as an agency cannot reach agreement internally, let alone with the SEC or global regulators. 

See: Statement.
Related News Item: Chairman Gary Gensler’s Address on the Cross-Border Application of Swaps Market Reform;
CFTC Commissioner O’Malia on Ensuring a Backup Plan on Cross-Border Guidance to Give Markets Certainty; European Commissioner’s “Invitation” to CFTC Chairman to Extend the CFTC Exemptive Order on Cross-Border Swaps Regulation