Our Take: The changing regulatory landscape

The digital asset markets have continued to face turmoil over the past two weeks, with Bitcoin falling approximately 66% from its all-time high and Ethereum falling approximately 75%. Amid this turmoil, certain crypto platforms have taken actions including announcing staff reductions and freezing withdrawals. Meanwhile, regulators and policymakers have continued their scrutiny of these markets, including:

• The New York Department of Financial Services (NYDFS) issued guidance for stablecoin issuers. The guidance provides that stablecoins must be fully backed by fiat currency - or a narrow range of assets such as certain US Treasuries and repo agreements - held in custody by a chartered depository institution or asset custodian. It also requires clear redemption policies approved in advance by NYDFS, and issuers must undergo monthly independent audits.
• Sens. Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) released the Responsible Financial Innovation Act (RFIA), a bill that would create a regulatory framework for digital assets. Key highlights of the bill include (1) giving the CFTC authority over digital asset spot markets; (2) creating a new the category of digital “ancillary assets,” defined as assets that lack debt or equity features, which would be regulated as commodities by the CFTC; (3) clarifying that stablecoins are neither commodities nor securities; (4) establishing liquidity and disclosure requirements for stablecoins; (5) requiring that the IRS define the tax treatment for digital assets; and (6) directing various agencies to conduct studies around issues such as cybersecurity, energy impact and investor protection. In an interview earlier this week, SEC Chair Gary Gensler responded to a question about the RFIA by reasserting that many forms of digital assets have features of securities and cautioned against “undermining the protections” provided by the agency.
• In the California state legislature, an Assemblymember released a bill that would require digital asset businesses operating in the state to obtain a license from the Department of Financial Protection and Innovation and adhere to disclosure and consumer protection requirements.

These events follow several stablecoins falling below the price of the dollar earlier this month, with one stablecoin fully collapsing. Regulators in the UK and Japan have released proposals to create new requirements for stablecoin issuers.

Our Take

With turmoil in the digital asset markets putting a spotlight on risks and some questionable business models within the industry, regulators and policymakers are continuing to take action. NYDFS’s guidance represents the first publicly-articulated stablecoin requirements within the US, but they will not likely be the last as federal regulators and the RFIA have them clearly in focus. The guidance is notable since NYDFS regulates a number of stablecoin issuers, generally aligns with the user agreement disclosures and practices of those stablecoin issuers, and does not conflict with the broad contours of the President’s Working Group’s (PWG) stablecoin review and the RFIA. While the RFIA does not answer the PWG’s call for Congress to require that they become insured depository institutions, it recognizes the risks that have been exposed recently - that certain stablecoins may not have sufficient reserves and investors may not be aware that they may not be fully backed with fiat currency. The bill in its current state is unlikely to pass the split Congress this year, especially considering the upcoming elections, but it will likely serve as a starting point for continued negotiations and the recent market events will increase the pressure on both sides of the aisle to get something done. In the meantime, we expect the regulators will seek to maximize their existing authority in this space, including the FDIC and other bank regulators’ abilities to audit fiat reserves held by banks. Regulators will also likely consider new requirements for financial resources supporting stablecoins, transparency around these resources, and examination protocols.

At a recent digital asset conference, many market participants expressed that the downturn will cleanse the industry of firms with questionable business models while those with better practices have an opportunity to focus on building their products and strengthening their risk management practices. Firms that take this opportunity, which includes enhancing practices around investor protection, disclosures, and liquidity management, will be well-suited to meet the inevitable upcoming increased expectations from regulators and policymakers.

On May 25th, SEC Chair Gary Gensler gave a speech on potential market structure reforms. He revisited issues he has discussed previously on several occasions such as market segmentation with different standards and concentration of order flow to a small group of wholesalers. He also referenced the “meme stock” volatility report the SEC issued last year which included four policy areas for the SEC to consider: shortening the settlement cycle, improving short sale reporting, digital engagement practices, and trading through wholesalers. Noting that the Commission has issued proposals and a request for feedback on the first three items, he outlined six policy areas concerning wholesalers:

1. Minimum pricing increment or tick size: Gensler observed that there is a disparity in tick sizes where wholesalers can fill orders at sub-penny prices while investors are only able to see prices in penny increments. Accordingly, he said he has asked SEC staff for recommendations around reducing the minimum tick size for investors and harmonizing it across different entities.
2. National Best Bid and Offer (NBBO): He then discussed several changes to the NBBO, which consolidates the best bids and offers for stocks and options across US exchanges, that the SEC adopted in 2020 but has not yet implemented. Specifically, the 2020 Market Infrastructure Rule created a new definition for round lots, or the volume of shares that have quotes on the NBBO, by allowing round lots under the current 100 share limit and included provisions to increase transparency around remaining odd lots. Gensler said he has asked staff to consider accelerating the implementation of these provisions as they could take several years under the current timeline. He also noted that he has asked for recommendations for developing an odd-lot best bid and offer.
3. Disclosure of order execution quality: Gensler also described a disparity between the order execution information provided by dark pools, wholesalers and exchanges on monthly Rule 605 reports and broker-dealers, which are not required to disclose the same data. He said he has asked staff for recommendations around updating Rule 605 to potentially expand reporting to broker-dealers and require summary statistics of execution quality (e.g, price improvement as percentage of spread).
4. Best execution: He noted that the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB) have rules requiring broker-dealers to make a reasonable effort to provide their customers with the best possible prices but the SEC does not. Accordingly, he said he has asked staff to consider whether the SEC should develop its own best execution rule.
5. Order-by-order competition: Gensler discussed various dynamics that potentially reduce order-by-order competition, such as concentration of order flow through wholesalers and segmentation of institutional and retail markets. He said he has asked staff to study auctions in the options market and whether retail investors would get better prices if their stock orders were executed in an auction market.
6. Payment for order flow, fees and rebates: The last area Gensler raised was payment for order flow (PFOF), a practice where brokers send orders to market makers in return for payment. This topic was addressed in last year’s report and Gensler has previously expressed concerns that PFOF could create incentives for brokers to act against their customers’ by encouraging them to trade more often so the firms can receive more payments from market makers. He noted that some foreign regulators have banned PFOF and has previously said this is on the table for the SEC. In this speech, however, he said he has asked staff to consider making exchange fees and rebates more transparent at time of trade execution and adjusting access fees if minimum tick size is reduced.

Our Take

Market structure reforms have been high on Gensler’s long list of priorities and this speech sends a clear signal that the SEC has set its sights on dynamics that have increased the volume of trading through wholesalers. Firms should take this seriously as Gensler has a clear pattern of following his speeches with proposals in as little as a few months. Given the transformative potential of some of these possible reforms, formal proposals may take longer and will undoubtedly attract significant debate and probable criticism from affected parties, including wholesalers. Although Gensler did not raise banning PFOF as an area for staff to consider in this speech, the combination of several of the potential reforms, such as pre-trade disclosures and auctions, could effectively make it untenable. Sub-penny pricing increments could also result in operational challenges for exchanges. We expect comments on the eventual proposals to make these points as well as to argue that the reforms could increase costs for retail investors. It is possible that Gensler is testing the waters with this speech, but he has made it abundantly clear that he intends to make a difference in the transparency and fairness of equity markets.

On June 15th, the Basel Committee for Banking Supervision (BCBS) issued a set of principles for the effective management and supervision of climate-related financial risks. The 18 high-level principles are largely unchanged from the consultation issued last November with 12 targeted to bank management of climate-related risks and five focused on supervision. The first two principles include an expectation for banks to account for physical and transition risks in their business strategies with the board and senior management “involved in all relevant stages of the process,” including by assigning roles and responsibilities across the organization. The final principles add that the board and senior management should consider whether the incorporation of climate-related risks warrant changes to compensation policies and that they should ensure that their banks’ internal strategies reflect public commitments.

The principles then turn to expectations for banks to implement climate risk management policies, procedures and controls across the three lines of defense. One addition relative to the draft consultation calls for the first line of defense to consider undertaking climate-related risk assessments in new product or business approval processes. The next several principles cover integration of climate risk into capital and liquidity adequacy assessment procedures and comprehensive risk identification, monitoring and management across financial, credit, market and operational risk. The final principle on capital and liquidity adequacy suggests that banks consider incorporating material physical and transition risks into their stress testing programs to evaluate the potential impact on their financial position. The most detailed principle for banks concerns scenario analysis, stating that banks should use it to assess the resilience of their business models to a range of climate scenarios covering physical and transition impacts.

For supervisors, the consultation calls for the implementation of expectations in line with BCBS’ principles for banks as well as the development of capabilities and capacity to assess banks’ compliance with these expectations. The final principle for supervisors is also for them to consider conducting scenario analysis and publicly releasing the results.

Also on June 15th, the Glasgow Financial Alliance for Net Zero (GFANZ), a global coalition of over 500 financial firms, released a draft Net-zero Transition Plan (NZTP) for public comment. The plan outlines recommendations and guidance for financial institutions to transition their financing activities to meet net-zero greenhouse gas targets, including: changes to products, services and business activities; engagement with clients, other industry members and public sector representatives; defining targets and metrics to assess progress; and creating governance structures to oversee the transition. Comments will be accepted until July 27th.

Our Take

The BCBS principles represent a growing consensus around expectations for comprehensive climate risk identification and monitoring, development of scenario analysis capabilities, and strong oversight by the board and senior management. The most substantial additions to the consultation concern governance expectations, calling for the board and senior management to consider their compensation policies and the alignment of internal policies with public commitments. This addition likely reflects the increasing number of banks committing to reduce their own emissions as well as those of their financing activities. Accordingly, banks’ boards and senior management should be closely scrutinizing their public commitments and asking for regular updates on policy changes and progress toward those goals. The GFANZ draft NZTP provides a useful starting point for bank leadership to compare against their existing transition strategies and identify where enhancements should be made.

Beyond governance expectations, the BCBS principles provide a view into the climate risk management capabilities that both financial institutions and supervisors should develop over the next several years. While they discuss scenario analysis in some detail and even suggest incorporating climate risks into capital and liquidity stress testing, they seem to recognize that such capabilities are relatively nascent and may not be possible or appropriate for all institutions. The areas covered by the principles can also provide some insight into ongoing efforts from US regulators, such as the Fed’s scenario analysis development and the high-level risk management guidance expected from the OCC and FDIC. These regulators are closely following each other’s approaches and collaborating through organizations such as the Financial Stability Board and the Network for Greening the Financial System, so it will not be surprising to see similarities with the BCBS principles but we would not expect US regulators to suggest incorporating climate into stress testing anytime soon.

These notable developments hit our radar this week:

• SEC request for information on information providers. On Wednesday, the SEC released a request for information on whether, and under which circumstances, index providers, model portfolio providers, and pricing services act as “investment advisors.” Acting as an investment advisor would subject such businesses to registration requirements and a suite of enhanced regulatory expectations.
• CFPB scrutinizes bank customer service. On Tuesday, the CFPB issued a request for information around customer service practices, including customers’ ability to receive account information, in-branch and phone wait times, and complaint handling.
• Gruenberg speaks on CRA: On Monday, FDIC Acting Chair Martin Gruenberg gave a speech highlighting key provisions of the agency’s joint Community Reinvestment Act (CRA) reform proposal with the Fed and OCC. Specifically, he highlighted the proposed expansion of assessment areas to include communities where a bank may have significant business activity but no physical branches, a new metrics-based approach to evaluations that would provide greater transparency, and tailoring of requirements to bank size and complexity.
• CCAR results coming next week. The Fed announced that results from its annual Dodd-Frank Act Stress Tests (DFAST) and Comprehensive Capital Analysis and Review (CCAR) for 34 participating banks will be released on June 23rd at 4:30 PM EDT.
• Fed and SEC nominees advance from committee. Last Wednesday, the Senate Banking Committee voted to advance the nominations of Michael Barr to be Fed Vice Chair for Supervision (VCS) and SEC nominees Jaime Lizarraga and Mark Uyeda. They will now face a full Senate vote on their confirmation.