Washington regulatory update
March 14, 2011
"Most economic fallacies derive from the tendency to assume that there is a fixed pie that one party can gain only at the expense of another." Milton Friedman
"Economics is extremely useful as a form of employment for economists." John Kenneth Galbraith
The Financial Stability Board: Focus on SIFIs
In a recent speech, Mario Draghi, Chairman of the Financial Stability Board (FSB), indicated that the FSB is concentrating on the "moral hazard problem" posed by systemically important financial institutions (SIFIs) that in the latest crisis and earlier ones were considered too large or too complex and interconnected, to be allowed to fail. During 2011, the FSB will publish the essential features of national rules for the winding up of SIFIs, "a framework for the restructuring and winding up plans that every SIFI must prepare," and a preliminary analysis of the questions involved in the international coordination of laws on this matter. By the middle of 2011, the FSB plans to have established the parameters for identifying "global SIFIs, to which to start applying more rigorous prudential rules". The criteria will include not only the size of intermediaries but also the extent to which they are interconnected with others and their importance in specific segments of the financial market.
Chairman Draghi emphasized that SIFIs’ ability to absorb losses needs to be improved in order to minimize the probability and systemic impact of a crisis; the measures to this end include capital requirements additional to those laid down by Basel III. He noted that there are various possible techniques to achieve this: higher ordinary capital ratios, the participation of some creditors in losses (bail-in) and debt instruments that convert into common equity on the occurrence of specific events (contingent capital).
Another field for action by the FSB concerns the shadow banking system. The FSB is preparing a map of the non-bank activities and intermediaries that, insofar as they create credit and transform maturities, "need rules and supervision similar to those of the regulated banking system."
The Chairman noted that the new European supervisory bodies are now operational. The first task, in which the European Banking Authority will be primarily engaged, is to carry out stress tests on the leading banks. The tests will have to satisfy four requirements: very severe scenarios; strict assessment of the results using a common methodology and backed by thorough peer review; complete transparency; and prompt identification of the remedial measures. Harmonization of the prudential rules is the other urgent object to achieve for the FSB. A set of common rules – the single rulebook – will help to prevent less strict supervisory rules and practices in one country from jeopardizing the stability of the European financial system, having repercussions on the economies of other countries and distorting competition. A first test will be the implementation in Europe of the Basel III rules. He noted that all the countries of Europe have pledged to transpose those rules into law.
SEC Management Study and Response
Section 967 of Dodd-Frank directed the SEC to engage an independent consultant "to examine the internal operations, structure and the need for reform at the SEC." The SEC retained the Boston Consulting Group (BCG) which delivered its report to Congress on March 10, 2011.
The BCG stated its work led it to two key conclusions. First the SEC has significant opportunity to further optimize its available resources through implementing a number of initiatives recommended in the report. including reprioritizing regulatory activities, reshaping the organization, investing in enabling infrastructure, enhancing the SRO engagement model and adopting an implementation plan. Second, Congress "should reflect on" whether this optimization meets its expectations. If not, the Congress should either relax SEC funding constraints or change the SEC's role to fit available funding.
Chairman Schapiro welcomed the Report which she said "confirms the concerns I have been expressing that the SEC does not have the resources to perform all the activities expected of us." In testimony before Congress, Chairman Schapiro described a large number of changes that have been made at the SEC over the past two years, including new leadership of its five largest operating units; the hiring of its first COO; the creation of the new Division of Risk, Strategy and Financial Innovation; enforcement division reforms; examination program reforms; data standardization efforts; and other changes and improvements. In discussing its budget request, the Chairman noted under Dodd-Frank, beginning with the FY 2012, the SEC is required to adjust fee rates on securities transactions so that the amount collected matches the amount appropriated by Congress. The SEC has requested funding for 780 new positions, 60% of which are related to implementing Dodd-Frank.
Congress Holds Multiple Hearings on Derivatives Implementation
Four Congressional committees with jurisdiction over derivatives held hearings in the past few weeks to examine the speed and impact of proposed derivatives regulations issued by the CFTC and SEC. The Senate Banking, House Financial Services, Senate Agriculture and House Agriculture Committees all received testimony from CFTC Chairman Gary Gensler, SEC Chairman Mary Schapiro and, in certain cases, the Federal Reserve, regarding derivatives reform regulation. Various representatives from the commercial and financial services industry, and their trade groups also appeared.
The hearings did not indicate whether additional legislation might appear to correct many perceived problems in the Dodd-Frank derivatives provisions. Concerns regarding statutory deadlines for regulations and effective dates dominated many discussions, although the CFTC assured Congress that it can write regulations within the prescribed deadlines and provide phased in compliance to ease the burden. The SEC, in contrast, stated that certain rulemakings would be delayed due to inadequate funding and tight deadlines; although it did not suggest that any security-based swap regulations might be in this group. Both the CFTC and SEC were criticized for not issuing identical regulations where joint regulations are required, and for the delay in issuing joint regulations regarding the definition of swaps, and capital and margin requirements.
Committee members and the regulators broadly agreed that commercial end-users that trade derivatives to hedge underlying commercial risk should enjoy minimal regulation under Dodd-Frank. The CFTC stated categorically, in several hearings, that commercial hedgers would not face margin requirements. The SEC expressed doubt that security-based swaps would serve an underlying hedging purpose and was more ambiguous about granting blanket exemptions from margin.
U.S. Regulators Encourage Comments on the CPSS-IOSCO Consultative Report on the Principles for Financial Market Infrastructures
The Basel Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) have released for comment a consultative report on the Principles for Financial Market Infrastructures. The CPSS and IOSCO expect these principles to play an important role in the "future regulation of financial market infrastructures around the world." The Federal Reserve, a member of the CPSS, and the SEC and CFTC, members of the Technical Committee of IOSCO, "encourage interested persons to review and comment on the consultative report." The deadline for submitting comments on the Principles for Financial Market Infrastructure (FMIs) is July 29, 2011.
The report contains updated and new proposed international principles for "systemically important" payment systems, central securities depositories (CSDs), securities settlement systems (SSS), central counterparties (CCP), and trade repositories. The 24 proposed principles would replace existing CPSS and CPSS-IOSCO standards for payment, clearing, and settlement systems previously published in the Core Principles for Systemically Important Payment Systems, Recommendations for Securities Settlement Systems, and Recommendations for Central Counterparties
and introduce principles for trade repositories for the first time.
Comments are requested on a number of issues that may be reflected in the risk management and related rules to be proposed by the Fed for Financial Market Utility SIFIs under Dodd-Frank. Of particular interest and relevance to the CPSS-IOSCO are those principles dealing with credit and liquidity risk.
The proposed credit risk principle requires a payment system that is systemically important, a CSD or a SSS to cover its current credit exposures
and, where they exist, potential future credit exposures
participant fully with a high degree of confidence "using collateral and other equivalent financial resources." It also requires a CCP to cover its current credit exposures and its potential future credit exposures to each participant fully with a high degree of confidence using margin and other financial resources. A CCP is also required to maintain additional financial resources sufficient to cover a wide range of potential stress scenarios identified in regular and rigorous stress testing.
With respect to the particular stress scenarios for which CCPs should hold additional
financial resources, the CPSS and IOSCO are considering, and requesting comment on, the establishment of a minimum credit requirement that (1) all CCPs should include the default of the one participant and its affiliates that, in the aggregate, would potentially cause the largest credit exposure in extreme but plausible market conditions (that is, a cover one
minimum requirement); (2) all CCPs should include in their stress scenarios the default of the two participants and their affiliates that, in the aggregate, would potentially cause the largest credit exposure in extreme, but plausible market conditions (that is, a cover two
minimum requirement); or (3) a CCP should be subject to either the cover one or the cover two minimum requirement, depending on the particular risk and other characteristics of the products it clears, the markets it serves and the number and type of participants it has.
The liquidity risk principle requires an FMI to maintain sufficient liquid resources to effect same-day and, where appropriate, intraday settlement of payment obligations with a high degree of confidence under a wide range of potential stress scenarios. The CPSS and IOSCO are considering and seeking comment on the establishment of a minimum liquidity requirement for systemically significant CSD and SSS that (1) would require such FMIs to include in their stress scenarios the inability of the one participant and its affiliates with the largest aggregate payment obligation to settle that obligation (that is, a cover one minimum requirement); (2) all such FMIs should include in their stress scenarios the inability of the two participants and their affiliates with the largest aggregate payment obligations to settle those obligations (that is, a cover two minimum requirement); or (3) such an FMI should be subject to either the cover one or the “cover two” minimum requirement, depending on the particular risk and other characteristics of the payment obligations it settles.
With respect to the particular stress scenarios for which a CCP should hold sufficient liquid resources, the CPSS and IOSCO are considering and seeking comment on the establishment of a minimum liquidity requirement that (1) all CCPs should have sufficient liquid resources to meet the required margin payments and to effect the same-day close out or hedging of the one participant and its affiliates with the largest potential open positions in extreme but plausible market conditions (that is, a cover one minimum requirement); (2) all CCPs should have sufficient liquid resources to meet the required margin payments and to effect the same-day close out or hedging of the two participants and their affiliates with the largest potential open positions in extreme but plausible market conditions (that is, a cover two minimum requirement); or (3) a CCP should be subject to either the cover one or the cover two minimum requirement, depending on the particular risk and other characteristics of the products that it clears, the markets it serves and the number and type of participants it has.
Comments are also requested on principles pertaining to segregation and portability, general business risk, and access and interoperability.
Anti-Disruptive Trading Practices Interpretation Proposed by CFTC
The CFTC has proposed an interpretive order to clarify aspects of three new disruptive trading prohibitions that will apply to the swaps markets under Dodd-Frank. In order to preserve "fair and equitable trading", the Act makes it unlawful for any person to engage in the following three practices on or subject to the rules of a registered entity: (1) Violate bids or offers; (2) Demonstrate intentional or reckless disregard for the orderly execution of transactions during the closing period; or (3) Engage in spoofing
(bidding or offering with the intent to cancel the bid or offer before execution). The disruptive trade practice prohibition would not apply to block trades or "exchanges for related positions" under exchange rules, or to bilaterally negotiated swaps. The bid/offer violation standard would prohibit persons from buying a contract for more than the lowest offer, or selling for less than the highest available market price, unless this is impossible because trades are electronic. Disorderly execution during the closing period would require intent and the closing period occurs when daily settlement price is determined under facility rules. Spoofing would target aggressive trading patterns that disrupt markets and would require intent to cancel bid or offer before execution. Reckless trading is not spoofing and partial fill orders are permissible, but the CFTC will watch for context to see if these become disruptive practices. Acting in good faith would be a defense to allegations of disruptive trading stemming from disorderly execution or spoofing.
Registration of Intermediaries Rule Proposed by CFTC
On March 9, 2011, the CFTC proposed changes to its existing rules regarding the registration of futures intermediaries to reflect the addition of swaps and regulated swaps entities by the Act. The proposed exemptions would shelter (i) Associated Persons from registering as swap dealers or MSPs, (ii) foreign banks that make a capital contribution in the form of subordinated debt to a registrant from being listed as a "principal", and (iii) foreign brokers and other foreign intermediaries that execute commodity interest transactions on SEFs for non-U.S. persons from having to register as a futures commission merchant. These exemptions seek to create uniformity in the treatment of previously regulated and newly regulated commodity interest transactions. Comments are due on this proposal by May 9, 2011.
Processing, Clearing and Transfer of Customer Positions Rule Proposed by CFTC
On February 24, 2011, the CFTC approved a proposed rule that would set the required time frame for a swap dealer, major swap participant (MSP), futures commission merchant (FCM), swap execution facility (SEF), and designated contract market (DCM) to submit contracts, agreements, or transactions to a derivatives clearing organization (DCO) for clearing. The proposed rule would require an SD or MSP to submit swaps that must be cleared "as soon as technologically practicable" following execution, but not later than the close of business on the day of execution. If a counterparty elects
to clear a swap that does not require clearing, that swap must be submitted for clearing not later than the next business day after execution of the swap or the agreement to clear, if later than execution.
The CFTC also proposed new regulations regarding the transfer of open positions and treatment of customer funds by a DCO. Upon request of the customer, and with the consent of the receiving clearing member, a DCO would have to promptly transfer all or a portion of a customer’s portfolio of positions and related funds from the carrying clearing member to another clearing member, without requiring the close-out and rebooking of the positions prior to the requested transfer. Requiring close-out and rebooking would create "unnecessary delay and market disruption" according to the CFTC.
Comments are due on the proposed rule within 60 days of publication in the Federal Register, which is pending.
Security-Based Swap Clearing Agencies Rule proposed by SEC
On March, 2, 2011, the SEC proposed rules regarding the registration, operation and governance of security-based (SB) swap clearing agencies. This comprehensive release contains several new SEC rules that would govern (i) minimum standards for clearing agencies, (ii) require dissemination of pricing and valuation information by SB swap clearing agencies that provide central counterparty services, (iii) require safeguards to protect confidential trading information of clearing agency participants, (iv) exempt certain SB swap dealers and SB swap execution facilities from the definition of clearing agency, (v) provide for registration of SB swap clearing agencies in existing rules, and (vi) mandate conflict of interest procedures, corporate governance standards and a chief compliance officer for clearing agencies.
This release also notes that the standards for SB swap clearing agencies reflect requirements in Title VIII of the Dodd-Frank Act, which creates an enhanced supervisory and risk control system for systemically important clearing agencies and other financial market utilities (the majority of SB swaps provisions appear in Title VII of Dodd-Frank). Title VIII permits the SEC to impose risk management standards, for any clearing entities it regulations. It recognizes that the operation of multilateral payment, clearing or settlement activities may reduce risks for clearing participants in the financial system, but requires that such systems be well-designed and operated in a safe and sound manner. This feeds into the general mandate that requires clearing systems to "facilitate prompt and accurate clearance and settlement, safeguard securities and funds and protect investors" set forth in the Securities Exchange Act.
The comment period ends on April 29, 2011.
SEC Extends Comment Period for Proposed Ownership and Governance Requirements for Security-Based Swap Clearing Agencies, SEFs and National Exchanges
On March 8, 2011, the SEC reopened the comment period for proposed Regulation MC on ownership and governance of security-based swap execution, clearing and exchange facilities. Regulation MC is intended to mitigate potential conflicts of interest at SB swap clearing agencies and execution facilities (SEFs) and in national securities exchanges that post SB swaps or make them available for trading. The SEC reopened the comment period in light of its proposed rulemakings issued on February 2, 2011, and on March 2, 2011, regarding the registration of SB SEFs and SB clearing agencies, respectively. The SB SEF proposal seeks comments on whether it "appropriately" addresses conflict of interest concerns." The clearing agency proposal includes rules regarding conflicts of interest and would require membership access to non-dealers and persons that have capital of at least $50 million, among other changes designed to increase access and participation in clearing agencies. The reopened comment period seeks to allow the public to comment on the interaction between these three proposed regulations.
The original comment period for proposed Regulation MC expired on November 26, 2010, and has been reopened through April 29, 2011.