Congrats Randal Quarles on Fed Appointment…

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Congratulations to Randy Quarles for his appointment and confirmation to serve as the Vice Chairman of the Federal Reserve Board.

CFS is thankful for Randy’s early and constant support of our organization. As an Advisory Board Member and Trustee, he has been a source of wisdom on a wide range of topics. In particular, his involvement in “Bretton Woods: The Founders and Future” was especially productive and meaningful. The inspiration and encouragement from Randy will continue to guide CFS especially as we plan to honor the 75th anniversary of the birth of the international financial system and think strategically about the future.

See “Summary and Next Steps  – Bretton Woods: The Founders and Future.”

Randy is uniquely experienced, remarkably learned, and thoughtful on virtually any monetary, regulatory, or related legal topic. Likewise, few to none are more honorable in character.

We wish him the best at the Fed.

CFTC and UK Financial Conduct Authority Sign FinTech Collaboration Arrangement

The CFTC and the UK Financial Conduct Authority (“FCA”) signed an agreement to facilitate collaboration, share information and support each other’s FinTech initiatives. This is the first FinTech arrangement for the CFTC with a non-U.S. counterpart.

The “Cooperation Arrangement” is primarily focused on the agencies’ respective FinTech initiatives, specifically the CFTC’s “LabCFTC” and the FCA’s “Innovate” programs. The regulators agreed to a framework for the exchange of information on businesses who participate in the programs, trends and developments in FinTech, regulatory issues surrounding FinTech development, best practices for engaging with innovators, and the activities of organizations that promote innovation. The regulators further committed to referring FinTech businesses to each other when such businesses are interested in operating in the other regulator’s jurisdiction. They also agreed to a variety of other measures intended to foster their mutual understanding of technology. The FCA and CFTC will host a joint event in London to facilitate FinTech firms’ engagement with both regulators.

CFTC Chair J. Christopher Giancarlo spoke of the groundbreaking nature of the arrangement: “This is the first FinTech innovation arrangement for the CFTC with a non-U.S. counterpart. We believe that by collaborating with the best-in-class FCA FinTech team, the CFTC can contribute to the growing awareness of the critical role of regulators in 21st century digital markets.” FCA Chief Executive Andrew Bailey agreed, saying, “As our first agreement of this kind with a U.S. regulator, we look forward to working with LabCFTC in assisting firms, both here in the UK and in the U.S., who want to scale and expand internationally in our respective markets.”

Lofchie Comment: Regulators cooperating with each other to better understand markets and products and to prepare for change is a far better approach than fighting over jurisdiction or shutting down change.

CFS Monetary Measures for January 2018

Today we release CFS monetary and financial measures for January 2018. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.8% in January 2018 on a year-over-year basis, maintaining the same growth rate as in December.

For Monetary and Financial Data Release Report:
http://www.centerforfinancialstability.org/amfm/Divisia_Jan18.pdf

For more information about the CFS Divisia indices and the data in Excel:
http://www.centerforfinancialstability.org/amfm_data.php

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

1) {ALLX DIVM }
2) {ECST T DIVMM4IY}
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’

CFTC Advisory Committee Examines Emerging Technology

The CFTC Technology Advisory Committee (“TAC”) considered challenges posed by new technologies. Officials from both inside and outside the CFTC and non-government financial and technology executives discussed (i) blockchain and the potential application of distributed ledger technology to the derivatives markets; (ii) virtual currencies and related futures products; (iii) the future of machine learning, artificial intelligence and computing power; (iv) developments in automated trading technologies; and (v) cybersecurity developments and best practices.

CFTC Commissioner Brian Quintenz, the sponsor of TAC, commented that while there is a need to rationalize the current regulatory framework for virtual currencies, there should be further investigation before adopting any new regulation. He described the potential application of distributed ledger technology (“DLT”) in the derivatives markets and the benefits exhibited by a trial version. Noting the challenges posed by DLT – including scalability issues, the digitalization of derivatives contracts, and DLT’s compatibility with existing CFTC regulations – he urged further discussion before taking any action. He cautioned that the CFTC “should not attempt to make value judgments about which new products are worthwhile,” and urged the cryptocurrency sector to set up a self-regulatory organization to set standards for its activities.

CFTC Commissioner Rostin Behnam recommended the CFTC take more immediate steps. While applauding TAC’s plans to reintroduce some of the Regulation Automated Trading (“Reg. AT”), he urged the CFTC to take immediate action “before an automated trading system run amok causes harm to market participants.” He asserted that “the question of a market event, flash crash or otherwise, is not if, but when.” Mr. Quintenz, speaking separately on the matter, encouraged the Committee to discuss and identify the specific risks associated with automated trading, how those risks are being addressed through the market’s incentive structure, and then to determine if regulation can effectively alleviate those risks.

CFTC Chair J. Christopher Giancarlo stated the CFTC’s first duty was to learn everything about the emerging FinTech industry before adopting regulations. LabCFTC, according to Mr. Giancarlo, will lead their efforts to learn and communicate with those in the technology industries. Since its launch, LabCFTC has conducted over 150 meetings with relevant entities and plans to continue fostering open communication.

Lofchie Comment: Mr. Behnam is right, of course, in predicting that something bad will eventually happen. More difficult is predicting what specific bad thing might happen and proposing rules that are reasonably tailored to prevent or deal with it. The alternative is to propose rules that don’t prevent problems, to have problems in spite of those ineffectual rules, and then to “find” that government wasn’t “tough enough” and so to adopt more expensive and futile rules. Put differently, the question is not, should there be rules; the question is whether there are specific rules that can forestall reasonably likely specific problems at a reasonable expense.

New Fed Chair Vows Vigilance in Preserving Financial Stability

Chair of the Board of Governors of the Federal Reserve System (“FRB”) Jerome H. Powell pledged to preserve the “essential” financial regulatory gains made since the financial crisis and to remain vigilant to risks to financial stability. In remarks delivered at his ceremonial swearing in, Mr. Powell emphasized the importance of transparency in the FRB, and vowed a commitment to fulfilling the goals of stable prices and maximum employment. He said that the FRB is “in the process of gradually normalizing both interest rate policy and [the Federal Reserve] balance sheet,” with the intention of “extending the recovery.”

D.C. Court of Appeals Decides to Exempt CLOs from Dodd-Frank Risk Retention Rules

A three-judge panel of the U.S. Court of Appeals for the D.C. Circuit ruled in favor of the Loan Syndications and Trading Association (“LSTA”) in its litigation against the SEC and Board of Governors of the Federal Reserve System (“FRB”) over the application of risk retention rules to managers of collateralized loan obligations (“CLOs”).

The Court concluded that “open-market CLO managers” are not subject to the credit risk retention rules mandated under the Dodd-Frank Act, which require firms to hold 5% of their fund. The Court explained that because CLO managers are not “securitizers” under Dodd-Frank Section 941, managers have no requirement to retain any credit risk.

The LSTA, which represents participants in the syndicated corporate loan market, first sued the SEC and FRB in 2014. On December 22, 2016, the United States District Court for D.C. ruled against LSTA. In overturning that ruling, the Court of Appeals agreed with LSTA’s primary contention that “given the nature of the transactions performed by CLO managers, the language of the statute invoked by the agencies does not encompass their activities.”

If the decision stands, (i) managers of open market CLOs will no longer be required to comply with the U.S. Risk Retention Rules, (ii) there may be no “sponsor” of this type of securitization transaction needed, and (iii) no party may be required to acquire and retain an economic interest in the credit risk of the securitized assets of such a transaction.

Implementation of the decision reached by the Panel could be delayed, modified, or reversed if the SEC and FRB seek rehearing in the Appellate Court or petition the United States Supreme Court to accept the case.

 

Senate Banking Committee Approves Three Trump Nominees

In executive session, the Senate Committee on Banking, Housing, and Urban Affairs considered the following nominations: Ms. Jelena McWilliams to be Chairperson and a Member of the Board of Directors of the Federal Deposit Insurance Corporation, Dr. Marvin Goodfriend to be a Member of the Board of Governors of the Federal Reserve System, and Mr. Thomas E. Workman to be a Member of the Financial Stability Oversight Council. All three nominees were approved. The nominations will now be advanced to the Senate floor for confirmation.

FINRA Calls Attention to Customer Recovery Issues

In a newly published paper, FINRA examined the issue of unpaid arbitration awards in the financial services industry and explored ways to improve outcomes for the FINRA arbitration forum.

Historically, FINRA has addressed unpaid arbitration awards through, among other actions, the suspension of member firms and individuals for non-payment. In this paper, FINRA identified additional steps that could be taken that would require action by the SEC or Congress. Those steps include:

  • SEC rulemaking to require firms to maintain additional capital;
  • Congressional legislation that would expand the scope of the Securities Investor Protection Corporation (“SIPC”) to include unpaid customer arbitration awards;
  • Legislation or rulemaking that would obligate firms to carry insurance to cover unpaid awards;
  • Legislation or rulemaking that would establish a second brokerage industry fund (distinct from SIPC);
  • An amended SEC Form BD that would require firms to disclose unpaid awards;
  • Legislation to amend the statutory disqualification definition under the Securities Exchange Act; and
  • Legislation to amend the Bankruptcy Code to prevent arbitration awards from being discharged in bankruptcy.

FINRA also made public certain data on unpaid customer arbitration awards from the past five years, and discussed plans to collaborate with other regulators on alternative approaches.

Separately, FINRA proposed amendments to its Membership Application Program rules to improve the timely payment of arbitration awards (see related coverage).

Lofchie Comment: FINRA should not address the issue of unpaid arbitration awards through an expansion of SIPC insurance. That fund is intended solely to remediate custodial claims. If it is turned into a general antifraud insurance fund, not only will the costs of maintaining the fund balloon, but those costs will be borne by firms and their customers who have nothing to do with generating them and exert no control over them.

 

SEC and CFTC Leaders Vow to Cooperate on Virtual Currency Regulation

Chair of the SEC Jay Clayton and Chair of the CFTC J. Christopher Giancarlo described their agencies’ approaches to the regulation of virtual currency and pledged to collaborate to provide investor protection.

In testimony before the U.S. Senate Banking Committee, Mr. Giancarlo noted that some observers tout the transformative potential of distributed ledger technology, while others characterize it as overblown hype with no real utility. He emphasized the importance of perspective, saying that virtual currencies receive media attention that is disproportionate to their small market size. The novel nature of virtual currencies presents a unique set of challenges for regulators, he said. With regard to CFTC authority and oversight, Mr. Giancarlo said that the CFTC does not have regulatory jurisdiction over cash or spot transactions in virtual currency, but does have regulatory jurisdiction over derivatives on virtual currencies. He highlighted several recent efforts by the CFTC to communicate its authority over virtual currencies and enforce federal commodities regulations against bad actors in the virtual currency markets.

Mr. Giancarlo also stressed the importance of perspective when considering the impact of the exchange trading of Bitcoin futures, again emphasizing the small size of the market. He addressed concerns about the self-certification process employed by exchanges to list virtual currency futures products, and reiterated that the CFTC has developed a heightened review process to ensure that virtual currency futures were not susceptible to manipulation. In the interest of facilitating transparency, he stated, the CFTC is requesting that exchanges disclose to the CFTC which steps were taken to solicit public input with regard to particular virtual currency product listings.

Mr. Giancarlo asserted that broadening CFTC authority to include virtual currency spot markets would represent a “dramatic expansion of the CFTC’s regulatory mission.” Considering the retail investor-oriented nature of virtual currencies, he said that they may require closer regulatory oversight, and encouraged Congressional consideration of exploring policy solutions to facilitate more effective federal regulation of virtual currencies. He acknowledged the many potential benefits of virtual currencies and distributed ledger technology, and encouraged a “proper balance of sound policy, regulatory oversight, and private sector innovation.”

SEC Chair Clayton emphasized that initial coin offerings (“ICOs”) often contain the hallmarks of securities and should be subject to federal securities laws. As the virtual currency and ICO markets experience exponential growth, Mr. Clayton expressed optimism for the potential financial benefits, but stressed that retail investors deserve an appropriate degree of investor protection. He pointed to the global nature of the product, the widespread lack of regulation, and cybersecurity deficiencies as significant red flags surrounding many ICOs, and said that no ICO has registered with the SEC. Mr. Clayton underscored the risks associated with ICOs, and warned that naming conventions do not absolve ICO issuers of their SEC-registration obligations.

Mr. Clayton further stated that the SEC has not approved any exchange-trade products holding virtual currencies, and also expressed concern about trading platforms that are not federally regulated and may not afford investors with an appropriate level of protection. He emphasized that the SEC does not have direct oversight over currency or commodity transactions, including trading platforms. He highlighted SEC enforcement efforts in the virtual currency space, and vowed to take a collaborative approach with the CFTC and other regulators to oversee the virtual currency markets.

New FINRA Rules to Protect Senior Investors Take Effect

Two FINRA rule changes designed to prevent the exploitation of seniors and other vulnerable adults took effect on February 5th.

The changes amended FINRA Rule 4512 (“Customer Account Information”) and created new FINRA Rule 2165 (“Financial Exploitation of Specified Adults”). Accordingly, firms are now (i) required to make reasonable efforts to obtain the name of a trusted contact person for a senior or other vulnerable customer with an account, and (ii) permitted to place temporary holds on disbursements of funds or securities from the accounts of certain customers when the firm has a reasonable suspicion that these customers are being financially exploited. FINRA also published responses to Frequently Asked Questions to help firms prepare for and adjust to the changes.

The rule changes were approved by the SEC in March 2017.

Lofchie Comment: The protection of seniors is an issue of large and increasing social importance. However, it would be better if this issue were addressed by federal or state law, rather than by SRO regulation.  The FINRA rule “permitting” broker-dealers to put a hold on disbursements is complicated in cases where such a hold would not be sanctioned by state law. Conversely, the failure of a firm to exercise its “authority,” however questionable, may put the firm at risk from FINRA or an investor.

In light of the above conflicting considerations, firms need to think carefully about the procedures they put in place with respect to new Rule 2165.  Firms should give particular care as to how decisions are documented.

CFTC Chair Unveils New Measure of Swaps Market Size and Risk

CFTC Chair J. Christopher Giancarlo introduced a new measure for the size of the rates segment of the swaps markets and called for a new “paradigm” in describing that market.

In remarks delivered at Derivcon 2018 in New York, Mr. Giancarlo characterized notional value as a highly flawed metric for the size and risk of the swap market, and emphasized that reliance on the metric for regulatory purposes leads to poor allocation of public resources. In particular, he noted that the common use of notional amounts in public discourse without normalizing for duration or offsetting positions creates an impression that the market is much larger than it is in actual risk terms, and has led to misguided policy decisions.

Mr. Giancarlo unveiled a new metric for measuring the size of the rate swap markets developed by CFTC Chief Economist Bruce Tuckman. This measure would evaluate market size based on entity-netted notionals (“ENNs”), which are produced by converting notional amounts for rate swaps of all durations into five-year risk equivalents, and then netting long and short exposures in the same currency between pairs of market participants. Mr. Giancarlo explained that ENNs are designed to describe the amount of market risk transfer in the interest rate swaps markets. Using this method of calculating risk, the aggregate risk transfer amount is sized much more consistently with other major markets, such as the debt market, and can be evaluated accordingly.

Mr. Giancarlo encouraged consideration of the ENN including its potential uses for regulation, but noted that his intention was not to come up with a specific alternative to the current swap dealer de minimis calculation methodology. He also emphasized that ENNs are not intended to quantify credit or operational risk.

Lofchie Comment: Query whether the new measure will be adopted by those who believe that there is a political advantage in exaggerating the size of the swaps market? It sounds a lot more ominous to describe a swap as having a billion dollar notional than it does to describe it as having a four dollars and thirty-seven cents market value.