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Our Take: The changing regulatory landscape

Change is a constant so move with confidence by staying up to date.

Change remains a constant in FS risk & regulation. Here’s “our take” on key developments impacting the industry.

Current topics - October 22, 2021

1. FSOC releases climate risk report

Yesterday, the Financial Stability Oversight Council (FSOC) released a report outlining actions to date and recommendations for addressing climate-related risks. The report was developed in response to a May Executive Order on climate-related financial risk. FDIC Chairman Jelena McWilliams was the only member to abstain from voting to approve the report, stating her view that the FSOC has not sufficiently examined the report’s findings while acknowledging climate change as an issue for the financial system.

The majority of the report focuses on describing the current state of work to address climate-related risks, including analysis of the connections from physical and transition risks to financial risks, existing data and disclosures on these risks, and models for climate scenario analysis. The report closes with 30 recommendations across four categories:

  • Build capacity. As a necessary precursor to recommendations in other areas, the report calls on agencies to invest in their capacity to study and monitor climate-related risk through investments in staffing, training, data and technology. It also recommends that the agencies devote particular attention to the impacts of climate risk and potential policy solutions on financially vulnerable populations. In addition to recommendations for the member agencies, the report announces that the FSOC will have a new staff-level Climate-related Financial Risk Committee (CFRC) to identify priorities and facilitate coordination as well as an advisory committee made up of outside specialists from fields such as academia, finance and climate science.
  • Enhance climate-related data. Following an earlier section of the report that acknowledges a number of challenges and limitations in getting dependable data on climate risks and exposures, the second category of recommendations concerns filling those gaps. The report calls on the agencies to identify the data they need to assess their supervised institutions’ climate risk exposures, catalogue the relevant data they have available, and develop a plan to obtain the necessary data to bridge the gap between those two categories. It also recommends that they work together in addressing similar data challenges and developing uniform standards, in part through the CFRC.
  • Promote enhanced climate-related risk disclosures. The report devotes considerable attention to the value of consistent, comparable and reliable climate-related disclosures. It describes steps the SEC has taken so far by soliciting feedback and planning proposals for enhanced disclosure requirements for both public issuers and asset managers. The report endorses these efforts and encourages the other agencies to explore how they can enhance disclosure and reporting requirements for their supervised institutions.
  • Assess climate-related risks to financial stability. The final recommendation area concerns the development of analysis and supervision to understand and mitigate climate-related risks. Specifically, the report recommends that regulators pursue scenario analysis following examples from other countries and scenarios developed by international organizations. In his statement on the report, Fed Chair Jerome Powell confirmed that the Fed is developing a scenario analysis program as a tool to address climate risk. The report also recommends that regulators incorporate expectations for climate risk management into their supervision processes, an effort that it acknowledges has been started by some regulators including the Fed, OCC, and New York Department of Financial Services (NYDFS). In his response to the report, Acting Comptroller Michael Hsu said the OCC is “developing high-level climate risk management supervisory expectations for large banks and hopes to issue framework guidance in the near future.”

Our Take

With the issuance of this report, the FSOC is putting its cards on the table and presenting an (almost) unified front in what it sees as the future direction of climate-related financial risk mitigation. Although many of the regulators have independently been making progress on their climate risk priorities over the last year, this is the first official issuance to comprehensively take a view on where these efforts should go further. While the report does not set out any specific rulemaking expectations or deadlines for the agencies, it does set the stage for continued focus and accountability through two new dedicated committees and biannual progress reports to the FSOC. Based on their endorsement of this report and progress so far, we expect a number of agencies to show definitive advances towards meeting these recommendations over the next six months - specifically, the SEC to issue its first proposal on new disclosure requirements, the OCC to issue climate risk management expectations and the Fed to further develop scenario analysis.

This regulatory outlook will require firms to make their own investments to develop climate risk management, scenario analysis and disclosure capabilities. In order to do so, they will need to understand the necessary building blocks for these capabilities, such as climate expertise, reliable data sources, analysis methodologies and clearly defined metrics. In addition, they should make sure to add a strong layer of governance to any climate initiatives through informed senior management and empowered compliance staff. After thinking through what their climate risk management will look like, firms should conduct a gap analysis to determine where exactly they need to direct their investments - whether it is hiring dedicated climate experts, procuring new data sources, or any number of other necessary actions. As a number of regulators in Europe and Asia have already begun to set requirements for their supervised institutions, global firms will have a head start in meeting future US rules and guidance. Those that have not yet started should see this FSOC report as a strong forecast for heightened climate risk expectations and begin their preparations accordingly.

2. Banking supervisors issue interagency statement on LIBOR transition

On Wednesday, the Fed, joined by the CFPB, FDIC, OCC, NCUA and state banking regulators, issued an interagency statement emphasizing the importance for institutions to continue their efforts to transition away from LIBOR as reference rate. Although the most widely used tenors of USD LIBOR will continue to be published into June 2023, regulators have made it clear that they expect the issuance of new USD LIBOR based contracts to end after year end 2021 — with limited exceptions for the risk management of existing positions. The regulators clarify that any agreement creating additional LIBOR exposure or extending the term of an existing contract should be considered “new.” Drawdowns on legally enforceable committed facilities entered into prior to 2022, however, would not be included in that definition. The statement also provides considerations for evaluating the appropriateness of alternative reference rates, expectations for fallback language, and stresses the importance of communication with clients and counterparties as well as operational readiness to transact in alternative rates.

With respect to the evaluation of alternative reference rates, supervisors consider “conducting the due diligence necessary to ensure that alternative rate selections are appropriate” a part of an institution’s commitment to safe-and-sound practices. Similar expectations for the assessment of replacement rates’ suitability were also at the core of the OCC’s updates to its transition preparedness self-assessment tool, which were published earlier in the week on Monday.

Our Take

With just over 70 days to go until USD LIBOR becomes effectively unavailable for use in new products, this concerted effort to instill a sense of urgency into banks’ transition efforts comes as little surprise. The provided considerations relating to the evaluation of alternative reference rates and the definition of “new” LIBOR contracts do not address any and all eventualities in detail – supervisory guidance rarely does. But in both cases, supervisors provide banks with a clearer framework to guide their decision making as they continue on the journey to end their reliance on LIBOR.

Regulators have recently warned of the risks associated with credit sensitive rates (CSRs) proposed as additional rate options to replace USD LIBOR, primarily due to their perceived similarities to LIBOR itself. Some of those warnings have been much more direct than others. While CSRs may provide benefits to some banks in managing their funding risks, explicitly considering and demonstrating their appropriateness for the customer — as suggested by the interagency guidance — may be more challenging. With respect to the definition of “new” use of LIBOR, we expect some market participants would have preferred even more prescriptive guidance. Capital markets and the financial products within them can at times be maddeningly complex — and the provided definition cannot be easily applied to any and all situations. The principle, however, appears to be clear: Any firm that actively adds to their USD LIBOR exposures, either in terms of absolute dollars or length of exposure, can expect to face supervisory consequences.

Banks in the US have arguably been given more power in the selection of replacement rates and reduction of LIBOR exposures than their counterparts in some other jurisdictions. However, with great power comes great responsibility. There are explicit expectations on banks to clearly articulate and evidence the decisions they have made and to put in place the appropriate governance and oversight to ensure consistent behaviors. Firms should have no doubt that scrutiny will only rise as the cessation date approaches – likely with increasingly severe consequences for those that do not adequately demonstrate readiness over the next 20 months.

Subscribe to PwC’s LIBOR Transition Market Update here to read more about these and other developments.

3. SEC releases report on market volatility

On Monday, the SEC released a report analyzing market volatility that occurred earlier this year surrounding “meme stocks,” particularly that of GameStop (GME). GME’s volatility originated in an investing subforum of social media platform Reddit and later expanded to other platforms as a response to hedge funds shorting the stock. At the end of January 2021, GME peaked at $483 (after ending 2020 trading under $20) and certain platforms temporarily restricted GME purchases which led the SEC to publicly take note of the situation.

The report outlines the market structures and dynamics underlying the GME volatility, including a growing volume of retail investors trading on zero-commission platforms that use various digital engagement practices (DEPs) to reward or encourage trading. It explains that reducing commissions has led brokers to seek to increase revenue from directing orders to certain off-exchange market makers or payment for order flow (PFOF), which may have an influence on encouraging higher trading volumes. The report also discusses potential proximate influences like high levels of short positions and significant attention from social and traditional media. The report closes with four areas for the SEC to potentially study further:

  • Forces that may cause a brokerage to restrict trading. The report explains that some broker-dealers restricted GME purchases due to an inability to meet clearinghouse intraday margin calls. It suggests that further study may be warranted regarding the effects of margin calls and that shortening the settlement cycle may alleviate some risk concerns.
  • DEPs and PFOF. The report proposes further evaluation of the effects of DEPs and PFOF on increasing customer trading beyond their best interest. SEC Chair Gary Gensler has separately indicated that he has asked staff to provide recommendations regarding these issues and the Commission recently closed the comment period on a request for information on DEPs.
  • Trading in dark pools and through wholesalers. As a significant volume of GME trades were executed off-exchange and through wholesalers, which are less visible than exchanges, the report suggests that more study may be warranted about these areas of the market structure.
  • Short selling and market dynamics. The report explains that short selling was less influential on the resulting GME volatility than was suggested at the time, but it suggests that there may be a benefit to improving reporting of short sales.

Our Take

By thoroughly explaining the market dynamics and events surrounding the GME volatility, the report appears to be targeted not only to industry professionals but also the retail investors that were extensively involved in the maelstrom. This is an acknowledgement by the SEC that protecting investors in a rapidly changing social media- and digital platform-driven trading landscape will require investor education as well as potential regulatory changes. Although the report devotes relatively little attention to such regulatory solutions, it is clear from other public comments and issuances that several of these reform options are clearly on the SEC’s agenda. In particular, the studies on DEPs and PFOF appear to be well underway with indications that the Commission is sympathetic to evidence of their conflicts with investors’ best interests. Regarding DEPs, we may be more likely to see interpretative guidance or an update to Regulation Best Interest to require disclosures or investor notifications rather than a separate rulemaking. On PFOF, although Chair Gensler has suggested that an outright ban is on the table, we expect an eventual proposal to be more of a scalpel, with an emphasis on disclosures and reporting, than a cudgel.

4. Treasury revisits US sanctions policy

On Monday, the Treasury Department released a report on US sanctions policy. The report explains that sanctions have been effectively used for a number of goals including cutting off funds to terrorist groups, bringing Iran to negotiate its weapons program and dismantling drug trafficking cartels. However, it notes that the sanctions regime faced challenges posed by increasing instances of cybercrime, new strategic economic competitors, and new ways of hiding cross-border transactions. It also highlights that sanctions become less effective when countries reduce their use of the US dollar, noting that digital currencies and alternative payment platforms can provide avenues for bad actors, including those on the Specially Designated Nationals And Blocked Persons List, to evade sanctions.

To address these concerns, the report calls for modernizing and strengthening the US Sanctions Program by 1) seeking multilateral coordination with regards to sanctions policy; 2) calibrating sanctions to avoid unintended economic, political and humanitarian impact; 3) ensuring that sanctions are easily understood and enforceable; and 4) investing in modernizing Treasury’s sanctions technology, workforce and infrastructure.

The US has increasingly used sanctions in recent years to further its foreign policy goals, with total numbers of new designations and penalties reaching record highs during the Trump Administration. With the ability to impose “secondary sanctions” that block parties from the US financial system for engaging in prohibited activity, violating US sanctions could result in not only substantial fines but complete isolation from the global economy. While certain of these policies have been successful in various areas highlighted in the report (e.g., countering Hezbollah and the Cali Cartel), others have drawn criticism from 1) allies frustrated with a lack of coordination regarding sanctions policy, especially as administrations change; 2) humanitarian groups regarding sanctions’ impact on access to food, medicine and the overall well-being of the citizens of targeted countries; and 3) the business community for shutting down avenues of economic activity.

The report follows sanctions guidance for virtual currencies released by Treasury’s Office of Foreign Assets Control (OFAC) last Friday. After providing background on the existing sanctions landscape, the guidance advises, consistent with recent enforcement actions, that firms implement geolocation tools to identify and prevent transacting with prohibited entities, developing strong know-your-customer and customer due diligence programs, implementing transaction monitoring programs to prevent transfers to addresses associated with sanctioned entities, and conducting risk assessments.

Our Take

This report seeks to address the concerns shared by US allies, humanitarian groups and others highlighted above while sharpening the effectiveness of sanctions that the US chooses to impose. As such, we expect that new designations will slow down, Treasury will increase its use of humanitarian waivers, and the Biden Administration may potentially revisit existing policies toward Cuba and Iran. However, this change in policy direction should not be interpreted as the sanctions regime becoming weaker or slowing to a halt. Instead, new designations will likely be closely coordinated with US allies and come with a strong focus on enforcement. As evidenced by OFAC’s guidance, it will also likely turn toward addressing emerging challenges such as those posed by digital currency and ransomware. Recently, the US and its allies have pledged to work together to combat ransomware and Treasury sanctioned a digital currency exchange for facilitating ransom payments. The report’s call for modernizing sanctions technology continues this push, acknowledging that a coordinated effort to combat these new challenges will require leadership that understands the threats and can assist allies with defending against them. This technology push will not be easy for many institutions as it calls for finding and leveraging new and large data sets and implementing analytics technologies.

5. Regulators continue crypto focus as Bitcoin futures ETFs debut

This week saw the following notable actions related to digital currency:

  • Bitcoin futures ETFs launch without SEC objection. This week, two Bitcoin futures exchange-traded funds (ETFs) launched on the New York Stock Exchange, debuting as the first such products to receive the green light from the SEC. While the agency did not formally approve the funds’ applications, by not objecting as it has done for previous digital currency-related fund applications, its silence is considered to be an implied approval. In an interview, SEC Chair Gary Gensler explained that part of the calculation for not objecting to the funds’ launch was the acknowledgment that the underlying Bitcoin futures have been regulated for four years by the CFTC. The first ETF to launch received over $1b in trading volume in its first day, making it the second-most heavily traded ETF debut. The price of Bitcoin also reached an all-time high this week of $66,975.
  • NY Attorney General steps in. On Monday, New York Attorney General (NY AG) Letitia James announced that she has sent cease and desist letters to two crypto lending platforms, ordering them to discontinue operating in New York State. She also sent three other platforms requests for information regarding their activities and business practices. Among other questions, the letters ask for details around the platforms’ know-your-customer programs, risk disclosures and licensing in other jurisdictions.
  • FSOC receives stablecoin update. After the FSOC discussed its climate report (see point 1 above) yesterday, it heard from Treasury staff on the stablecoin report that is being developed by the President’s Working Group on Financial Markets. No details around the closed meeting were released, but the readout notes that the Council discussed the risks, benefits and regulatory considerations related to stablecoins.

Crypto advocates have paid close attention to Chair Gensler’s actions for hints as to what the future of digital asset regulation might look like. At times, they have been optimistic considering his background teaching the subject at MIT, and at others they have braced for strict limitations as Gensler decried the frauds, scams and abuse prevalent in the market. This week’s implied approval of two Bitcoin futures ETFs is evidence that Gensler is neither a crypto hawk nor a dove but is instead - to use his own words - “technology neutral but not policy neutral.” In other words, his policy stance is not so much focused on the technology behind digital assets as it is ensuring that it contains sufficient protections against investor harm, illicit activity and financial stability risks. In addition to the CFTC regulating the ETFs’ underlying derivatives, the fact that they do not actually possess Bitcoin and therefore do not have the same custody and cybersecurity risks as the spot market likely contributed to the SEC’s decision that they contain enough protections to be allowed to launch. Considering nearly record-breaking trading volume, we expect to see increased competition and consumer interest - as well as continued scrutiny from the SEC to ensure that these funds’ disclosures and consumer protections are in order.

Our Take

As the SEC and other federal regulators take time to develop their crypto approaches, states have stepped in to regulate and monitor crypto activity within their jurisdictions - particularly NYDFS, which has required since 2015 that certain platforms register under the state’s BitLicense. However, as virtual currency lending platforms are not covered under the scope of the BitLicense, the NY AG has now interpreted certain digital assets as securities and used its authority over securities markets to make it clear that these platforms are still in regulatory focus in New York. To be sure, the regulatory classification of digital assets remains a work in progress, and the definition of which types of digital assets constitute “securities” is nearly certain to face challenges and litigation as both state and federal regulators continue to assert their authority over the market. One thing is less open to debate, however: with New York State elections for both Governor (who appoints the NYDFS Superintendent) and AG coming up next year, we expect to see more assertion of state authority in the digital asset space as potential candidates build their cases.

6. On our radar

These notable developments hit our radar this week:

  • OCC releases bank supervision operating plan. Last Friday, the OCC released its bank supervision operating plan for the fiscal year 2022. Among other areas, the plan explains that supervisors will focus on credit risk management, cybersecurity, operational resilience, third party oversight, anti-money laundering compliance management, fair lending risk, Community Reinvestment Act Performance, fintech partnerships for potential cryptocurrency-related activities and other services, and climate change risk management.
  • OCC publishes report on payment practices. Yesterday, the OCC published a report providing an overview of payment systems, associated risks and risk management practices. The report includes the concept of digital ledger technology as a payments option.
  • CFPB orders big techs to provide payment plan information. Yesterday, the CFPB issued a series of orders to large technology companies that operate payment systems collecting information on their business practices. The orders specifically request information around 1) data harvesting and monetization; 2) access restrictions and user choice; and 3) other consumer protections. These orders come as one of the first actions under newly-confirmed CFPB Director Rohit Chopra, who explained in a statement that there is a current gap in understanding of how big techs will “exploit their payments platforms,” raising issues around data privacy, use of scale to extract rents and processes to address consumer complaints.
  • Fed announces new trading ethics rules. Yesterday, the Fed announced new rules prohibiting its policymakers and senior staff from purchasing individual securities, holding investments in individual bonds, holding investments in agency securities, or entering into derivatives. Policymakers and staff will also need to provide 45 days notice before the purchase or sale of any securities and obtain approval before completing the transaction. They will then need to hold any investments for at least a year and not be able to transact during periods of heightened market stress.
  • Behnam hearing scheduled. The Senate Agriculture Committee has announced that it will hold a confirmation hearing on October 27 for acting CFTC Chair Rostin Behnam to lead the agency on a permanent basis.
  • IRS account reporting proposal scaled back. This week, Congressional Democrats scaled back the provision of their reconciliation bill that would require banks to report to the IRS the total amount of funds deposited and withdrawn from an account over the course of a year if the total is over $10k for the year. The change resulted from lobbying from banks and other groups that the previous proposal’s reporting threshold of $600 was too low. Republicans are still strongly against the provision, with many in the Senate co-signing a bill to prohibit reporting of account inflows and outflows to the IRS. Treasury Secretary Yellen has endorsed the reporting proposal as an important tool in targeting tax evasion.



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