Thursday, May 30, 2013

Bi-partisan House Legislation Would Expand Tick Sizes in Wake of Decimalization


Rep. David Schweikert (R-AZ), a primary author of the JOBS Act  has introduced the Spread Pricing Liquidity Act, HR 1952, to give small companies with limited market capitalization greater access to public equity.  According to Rep. Schweikert, the bill responds to overwhelming evidence that wider ticks for small-cap companies will stimulate liquidity, encourage capital formation, and grow jobs. The  Congressman said that  the SEC has been inactive on this issue. He also noted that since the introduction of decimalization the number of public companies has decreased by one-third.

The introduction of decimalization a decade ago changed all stock quotes to a penny. This penny quoting is widely believed to be the direct cause of the erosion of the economic infrastructure required to support small-cap stocks, said Rep, Schweikert. He added that such narrow spreads create a disincentive to provide liquidity at the best price, which results in smaller quoted sizes and thinner markets. In addition, narrow tick sizes also create inefficiencies and detrimentally affect the price discovery process.

He believes that wider tick sizes will increase investor confidence by reducing the number of price points at which stocks are traded and by limiting computer trading behaviors. Wider ticks favor long-term investors and stock pickers over short-term traders. In addition, they will lead to investment in the securities ecosystem necessary to provide visibility to companies going public and support them in the aftermarket.

The Spread Pricing Liquidity Act allows companies with public float of less than $500 million and average daily trading volume under 500,000 shares to select to have their securities quoted at increments of either 5 or 10 cents, while maintaining trading between the quoted ticks.

The bill includes a multi-tiered phase-in, with the change occurring for companies with public float of less than $100 million and average daily trading volume under 100,000 shares at inception. After three months, that threshold will rise to include companies with public float of less than $250 million and average daily trading volume under 250,000 shares. After a further three months, the threshold will rise again to the stated public float of less than $500 million and average daily trading volume under 500,000 shares.

The Act includes an opt-out for companies after six months, and a re-opt in a full year later, and provides a three month grace period for companies cresting through either the float or volume thresholds before they revert to trading at traditional increments.

The bill disallows exchanges from charging maker/taker fees, and requires the SEC to report to Congress on the effectiveness of wider ticks for small-cap companies nine months after implementation.

Tuesday, May 28, 2013

PCAOB Frames Audit Quality Issues

One of the greatest concerns facing the PCAOB, and indeed more broadly the SEC and the financial markets, is that the external audit report has essentially become a pass/fail exercise replete with meaningless boilerplate of litte value to investors and other users of financial statements. A PCAOB staff memo recently framed the discussion of audit quality indicators for the Standing Advisory Group, which the staff defines as measures that provide insight into financial statement audit quality. In November 2012, the Board identified a project to develop audit quality measures as a priority project for 2013, with a longer-term goal of tracking such measures with respect to domestic global network firms and reporting collective measures over time.

The staff’s initial thinking is that an audit quality definition, framework, and related audit quality indicators are an integrated construct.

Over the years, many organizations have sought to define audit quality, with little consensus. While the Board’s  initial purpose is to seek SAG member input on possible audit quality indicators, the Board recognizes the need to ground discussion with the working definition of audit quality developed by the staff. For purposes of the discussion, staff defines audit quality as meeting investors’ needs for independent and reliable audits and robust audit committee communications on financial statements, including related disclosures; assurance about internal control; and going concern warnings.

It is axiomatic that any definition of  audit quality must be based on concepts that are already widely accepted, rather than trying to break new conceptual ground. At  the most basic level, the audit quality framework includes three segments: audit inputs, processes, and results. The staff views these segments as intuitive and conceptually aligned with much of the existing work on audit quality completed by other organizations.

Sunday, May 26, 2013

E.U. Mandates Rotation of Credit Rating Agencies for Structured Financial Products

As the SEC considers the best approach to assuring conflict of interest free credit rating agencies, the Council of the European Union has adopted a Directive and a Regulation mandating the rotation of credit rating agencies for the rating of structured financial products. The adoption of the legislation follows agreement reached with the European Parliament.

The Directive and Regulation amend existing legislation on credit rating agencies in order to reduce investors' over-reliance on external credit ratings, mitigate the risk of conflicts of interest in credit rating activities and increase transparency and competition in the sector. Specifically, the Directive amends current Directives on the activities and supervision of financial institutions for occupational retirement provisions, on undertakings of collective investment in transferable securities (UCITS) and on hedge funds and other alternative investment fund managers (AIFM) in order to reduce the financial institutions' reliance on external credit ratings when assessing the creditworthiness of their assets.

The Regulation introduces a mandatory rotation rule obliging issuers of structured finance products with underlying re-securitized assets who pay credit rating agencies for their ratings (the issuer pays model) to switch to a different agency every four years. An outgoing rating agency will not be allowed to rate re-securitized products of the same issuer for a period equal to the duration of the expired contract, though not exceeding four years.

Mandatory rotation will not apply to small credit rating agencies, or to issuers employing at least four credit rating agencies, each rating more than 10 percent of the total number of outstanding rated structured finance instruments.

A review clause provides the possibility for mandatory rotation to be extended to other instruments in the future. Mandatory rotation is not a requirement for endorsement by the E.U. of U.S. or other third country credit rating agencies. Due to the complexity of structured finance instruments and their role in contributing to the financial crisis, the Regulation also requires issuers to engage at least two different credit rating agencies for the rating of structured finance instruments.

To mitigate the risk of conflicts of interest, the Regulation also requires CRAs to disclose

publicly if a shareholder with 5 percent or more of the capital or voting rights holds 5 percent or more of a rated entity. And to ensure the diversity and independence of credit ratings and opinions, the regulation prohibits ownership of 5 percent or more of the capital or the voting rights in more than one CRA, unless the agencies concerned belong to the same group.

Senator Warren Asks SEC for Data on Settlement of Enforcement Actions

In a letter to SEC Chair Mary Jo White, Senator Elizabeth Warren (D-MA), a key member of the Senate Banking Committee, asked for an analysis and/or internal research the Commission has done on trade-offs to the public between settling an enforcement action without admission of guilt and going forward with litigation necessary to obtaining such an admission.

In an earlier letter to U.S. Attorney General Eric Holder, Senators Mark Warner (D-VA) and Robert Corker (R-TN), also key members of the Banking Committee, voiced their concern that the DOJ is restricting its enforcement actions based on the size of the culpable financial institution, that is to say that DOJ is indicating that large, complex financial institutions will escape prosecution because their size indicates that an enforcement action against them will negatively impact the U.S. economy. The Senators ask if it is the position of the DOJ that some financial institutions are large enough that their management is above prosecution in the case of a serious crime.

Friday, May 24, 2013

U.S. and Global Hedge Fund Groups Seek Guidance on German High Frequency Trading Legislation

In a letter to the German Federal Financial Supervisory Authority (BaFin), U.S. and global hedge fund associations asked the regulator to issue guidance under the High Frequency Trading Act to clarify that where an investment management firm trades on a German organized market or multi-lateral trading facility on behalf of funds that it manages, neither the investment management firm nor the funds on whose behalf it trades are dealing for their own account, meaning that they are therefore not subject to the definition of the Act and the associated licensing regime.

In their joint letter, the U.S. Managed Funds Association and the London-based Alternative Investment Funds Association explained that an investment manager, a distinct legal entity, is a fiduciary responsible for implementing a hedge fund’s investment strategy and trading securities on a fund’s behalf. The investment manager trades securities as a customer of an intermediary; accordingly, the investment manager is the indirect member of a trading venue. 

 

Wednesday, May 22, 2013

Senators Thune and Toomey Urge SEC to Promptly Implement JOBS Act Elimination of Ban on General Solicitation

In a letter to SEC Chair Mary Jo White, Senators John Thune (R-SD) and Pat Toomey (R-PA) urged the SEC to promptly implement Section 201 of the JOBS Act, which ends the ban on general solicitation in private offerings. The Senators were encouraged by the commitment that Chairman White demonstrated during her Senate confirmation process to see that the Commission completes these important rulemakings. The Commission should act expeditiously, they said. The letter was also signed by Rep. Patrick McHenry  (D-NC), Chair of the House Oversight Subcommittee of the Financial Services Committee.

The overall purpose of the JOBS Act was to facilitate capital formation to help small businesses and entrepreneurs invest, expand and create jobs. As proponents of the JOBS Act, the Senators and Chairman McHenry believe that the regulation proposed by the Commission last August accomplishes this goal. The proposal properly implements Congress’ intent to remove the general solicitation ban in a consistent manner for all types of issuers conducting private offerings under Rule 506.

Paragraph (b) of Section 201 clearly effectuates this by providing that all issuers subject to other federal securities laws will be able to conduct private offerings pursuant to amended Rule 506. The proposed rule ensures that all purchasers of securities under Rule 506 are accredited investors, they noted, and follows Congress’ policy objectives to require that issuers take reasonable steps to verify that the purchasers are accredited investors. The Senators and Chairman McHenry emphasized that additional or more prescriptive requirements would overturn Congress’ intent and they strongly urged the Commission not to do so.

Tuesday, May 21, 2013

Obama Administration Opposes SEC Regulatory Accountability Act


While reaffirming its commitment to smart and effective regulations and the value of cost-benefit analysis, the Obama Administration opposes passage of the SEC Accountability Act, H.R. 1062, because its burdensome and disruptive new procedures would impede the ability of the SEC to protect investors, maintain orderly and efficient markets, and facilitate capital formation. In a Statement of Policy, the Administration said that H.R. 1062  would add onerous procedures that would threaten the implementation of key reforms related to financial stability and investor protection.

H.R. 1062 would direct the SEC to conduct time resource intensive assessments after it adopts or amends major regulations before the impacts of the regulations may have occurred or be known. According to the Administration, the bill would add analytical requirements that could result in unnecessary delays in the rulemaking process, thereby undermining the ability of the SEC to effectively execute its statutory mandates.

The Administration is committed to a regulatory system that is informed by science, cost-justified, and consistent with economic growth. Through efforts including Executive Order 13579,  the Administration is taking important steps to encourage independent agencies to follow cost-saving and burden-reducing principles in their reviews of new regulations, and to examine their existing rules to identify those that should be modified, streamlined, or repealed.

By a vote of 235 to 161 the House of Representatives passed the SEC Regulatory Accountability Act, H.R. 1062. Seventeen Democrats voted to pass the bill. Rep. Scott Garrett (R-NJ), Chairman of the Financial Services Subcommittee on Capital Markets, introduced the SEC Regulatory Accountability Act, which would require the SEC to conduct robust cost-benefit analysis on each new rulemaking to ensure that its costs do not outweigh its benefits, and would make certain that all new and existing regulations are accessible, consistent, written in plain language, and easy to understand.

Executive Orders. The legislation is designed to essentially codify Executive Orders issued by President Obama reforming the regulatory process.  Chairman Jeb Hensarling (R-TX) of the Financial Services Committee said that in many respects the Act carries out Executive Order 13563.
President Obama issued two Executive Orders during his first term on the reform of the federal regulatory process. Executive Order No. 13563 set out general requirements directed to executive agencies concerning public participation, integration and innovation, flexible approaches, and science. It also reaffirmed that executive agencies should conduct a cost-benefit analysis of regulations. Executive Order No.13579 states that independent regulatory agencies, such as the SEC, should follow EO No. 13563. To facilitate the periodic review of existing significant regulations, EO No. 13579 said that independent regulatory agencies should consider how best to promote retrospective analysis of rules that may be outmoded, ineffective, insufficient, or excessively burdensome, and to modify, streamline, expand, or repeal them in accordance with what has been learned.

There is a debate over whether EO No. 13579 directed independent regulatory agencies to conduct a cost-benefit analysis of regulations. The use of the word “should’’ in the Executive Order has led some to conclude that it is not mandatory. Thus, as an independent agency, the SEC is not clearly required to follow Executive Orders No. 13563 and 13579, but former SEC Chairman Mary Schapiro indicated that the Commission would abide by the Executive Orders  and in Senate confirmation hearings testimony SEC Chair–Designate Mary Jo White acknowledged that the SEC should seek to assess the economic impacts of its contemplated rulemaking.

Sunday, May 19, 2013

UK FRC Proposes Guidance on Financial Instruments for Outside Auditors of Company Financial Statements


In light of the financial crisis and changes to international auditing and accounting standards, the UK Financial Reporting Council proposed revisions to its guidance for outside auditors of company financial statements on financial instruments. Generally, the auditor must obtain an understanding of how the firm manages and controls its exposure to financial instruments, including how the firm ensures that all instruments are accurately recorded, that the valuations are accurate and reviewed, that risk limits are applied, and that duties are segregated between those transacting, settling and accounting for financial instruments. Risk management and professional skepticism are important components of the revised guidance.
           
For firms transacting financial instruments, an understanding of the firm’s related risk management processes and risk appetite may identify risks of material misstatement. It is not the job of the auditor to determine the amount of risk a firm should take or how it should monitor and manage risk, said the FRC, but it is important for the auditor to consider and develop a point of view on this because poor risk management processes can affect the audit in a number of indirect ways by, for example, exposing  a firm to levels of risk that breach legal or regulatory restrictions. Importantly, poor risk management can make it more difficult to obtain an understanding of the impact of financial instruments on the firm as a whole. And, in extreme circumstances, inadequate risk management can increase the risk of a going concern problem. For example, financial instruments losing value or becoming illiquid can threaten the ability of the entity to continue as a going concern.

The guidance posits that professional skepticism is necessary to the critical assessment of audit evidence and assists the auditor in remaining alert for possible indications of management bias. Professional skepticism can include questioning contradictory audit evidence and the reliability of documents, as well as questioning responses to inquiries and other information obtained from management and those charged with governance. It also includes being alert to conditions that may indicate possible misstatement due to error or fraud and considering the sufficiency and appropriateness of audit evidence obtained in light of the circumstances.

The proposed guidance states that maintaining professional skepticism throughout the audit is necessary if the auditor is to reduce the risks of overlooking unusual circumstances, over generalizing when drawing conclusions from audit observations, or using inappropriate assumptions in determining the nature, timing, and extent of the audit procedures and evaluating the results thereof.

In addition, evaluating audit evidence for assertions about financial instruments requires
considerable judgment because the assertions, especially those about valuation, may be based on highly subjective assumptions or be particularly sensitive to changes in the underlying assumptions. For example, valuation assertions on financial instruments may be based on assumptions about the occurrence of future events for which expectations are difficult to develop or about conditions expected to exist a long time. Thus, competent persons could reach different conclusions about valuation estimates or estimates of valuation ranges. Considerable judgment also may be required in evaluating audit evidence for assertions based on features of the financial instrument and applicable accounting principles, including underlying criteria, that are both extremely complex.

The need for professional skepticism increases with the complexity of financial instruments, said the FRC, for example, with regard to evaluating whether sufficient appropriate audit evidence has been obtained, which can be particularly challenging when models are used or in determining if markets are inactive. Professional skepticism also ratchets up with evaluating management’s judgments, and the potential for management bias, in applying the firm’s applicable financial reporting framework, in particular management’s choice of valuation techniques, use of assumptions in valuation techniques, and addressing circumstances in which the auditor’s judgments and management’s judgments differ. Moreover, a good dose of professional skepticism is needed in drawing conclusions based on the audit evidence obtained, for example assessing the reasonableness of valuations prepared by management experts and evaluating whether disclosures in the financial statements achieve fair presentation.

In planning the audit, the auditor must focus on understanding the accounting and disclosure requirements and understanding the financial instruments to which the firm is exposed, and their
purpose and risks. The auditor must determine whether specialized skills and knowledge are needed in the audit and also evaluate the system of internal control in light of the firm’s financial instrument transactions and the information systems that fall within the scope of the audit.

More specifically, the auditor must understand the nature, role and activities of the internal audit function and management’s process for valuing financial instruments, including whether management has used an expert or a service organization.

Determining materiality involves both quantitative and qualitative considerations. When
planning the audit, materiality may be difficult to assess for a firm using particular financial instruments given some of their characteristics. In particular, some financial instruments can be assets or liabilities depending on their valuation and this may change over the course of the audit.

Under the guidance, a firm’s policies for accounting for financial instruments must take into account the different purposes for which they can be transacted, such as trading or hedging. Relevant accounting standards may be under review and firms need to monitor developments to ensure the correct accounting requirements, including possible transitional arrangements, are complied with. Having regard to disclosure requirements is important as they can play a key role in making transparent the levels of holdings of financial instruments, as well as their purpose and the underlying risk profile.

The FRC posits that it may be appropriate for the auditor’s understanding of relevant industry and regulatory factors to include inquiry of management as to whether there have been discussions with regulators during the year about their policies in respect of financial instruments, and whether management has reviewed its processes in the light of those discussions. For example the regulator may have expressed a view that the entity’s valuations appear out of line with those of other entities or are not sufficiently prudent. The auditor can review relevant correspondence, if any, with regulators.

For a regulated firm in the financial sector, it may be appropriate for the auditor to
discuss matters related to the firm’s use and disclosure of financial instruments directly
with the regulator in bilateral and/or trilateral meetings. In May 2011, the FSA published a Code of Practice for the relationship between the external auditor and the regulator. The Code of Practice sets out principles that establish, in the context of a particular regulated firm, the nature of the relationship between the regulator and the auditor.

While intended to mitigate risk, inappropriate hedge transactions can cause significant financial loss if the risks are not properly identified or managed. A simple example might be the hedging of baskets of bonds or shares with an index, if the basket does not match the index closely, price movements may not offset each other, therefore increasing risk not reducing it. Another example might be hedging of possible future price movements. For example, an airline that purchases all its future fuel needs for the next two years at forward prices, will suffer if the price then falls over the next two years, because unhedged competitors will benefit from a cost advantage.

Thus, auditing financial instruments may require the involvement of one or more experts or specialists, for example, in the areas of understanding the operating characteristics and risk profile of the industry in which the company operates and understanding the business rationale for the particular financial instruments used, the related risks and how they are managed. The involvement of experts or specialists may be needed especially when the financial instruments are complex or the firm is engaged in the active trading of complex financial instruments.

Saturday, May 18, 2013

House Passes SEC Regulatory Accountability Act


By a vote of 235 to 161 the House of Representatives passed the SEC Regulatory Accountability Act, H.R. 1062. Seventeen Democrats voted to pass the bill. Rep. Scott Garrett (R-NJ), Chairman of the Financial Services Subcommittee on Capital Markets, introduced the SEC Regulatory Accountability Act, which would require the SEC to conduct robust cost-benefit analysis on each new rulemaking to ensure that its costs do not outweigh its benefits, and would make certain that all new and existing regulations are accessible, consistent, written in plain language, and easy to understand.

Executive Orders. The legislation is designed to essentially codify Executive Orders issued by President Obama reforming the regulatory process.  Chairman Jeb Hensarling (R-TX) of the Financial Services Committee said that in many respects the Act carries out Executive Order 13563.

President Obama issued two Executive Orders during his first term on the reform of the federal regulatory process. Executive Order No. 13563 set out general requirements directed to executive agencies concerning public participation, integration and innovation, flexible approaches, and science. It also reaffirmed that executive agencies should conduct a cost-benefit analysis of regulations. Executive Order No.13579 states that independent regulatory agencies, such as the SEC, should follow EO No. 13563. To facilitate the periodic review of existing significant regulations, EO No. 13579 said that independent regulatory agencies should consider how best to promote retrospective analysis of rules that may be outmoded, ineffective, insufficient, or excessively burdensome, and to modify, streamline, expand, or repeal them in accordance with what has been learned.

There is a debate over whether EO No. 13579 directed independent regulatory agencies to conduct a cost-benefit analysis of regulations. The use of the word “should’’ in the Executive Order has led some to conclude that it is not mandatory. According to Chairman Sessions, this fuels the need for federal legislation to codify that independent regulatory agencies, such as the SEC, must conduct a cost-benefit analysis of regulations as executive agencies must do.Thus, as an independent agency, the SEC is not clearly required to follow Executive Orders No. 13563 and 13579. 
Cost-benefit analysis. Specifically, the SEC Regulatory Accountability Act would direct the SEC before issuing a regulation under the securities laws to identify the nature and source of the problem that the proposed regulation is designed to address in order to assess whether any new regulation is warranted and to use the SEC Chief Economist to assess the costs and benefits of the intended regulation and adopt it only upon a reasoned determination that its benefits justify the costs.
Alternatives. The SEC would also have to identify and assess available alternatives that were considered and ensure that any regulation is accessible, consistent, written in plain language, and easy to understand. Under a modified comply-or-explain provision in the bill, the SEC would be required to explain why the regulation meets the regulatory objectives more effectively than the alternatives.
Other considerations. In addition, H.R. 1062 would require the SEC to consider whether the rulemaking will promote efficiency, competition, and capital formation and the impact of the regulation on investor choice, market liquidity, and small business. The Commission must also evaluate whether the regulation is consistent with, incompatible with, or duplicative of other federal regulations.
Comments. The Commission must also explain in its final rule the nature of comments received concerning the proposed rule or rule change and respond to those comments, explaining any changes made in response, and the reasons that it did not incorporate industry group concerns regarding potential costs or benefits.
Review of existing regulations. Further, within one year of enactment and every five years thereafter, the SEC must review its existing regulations to determine if they are outmoded, ineffective, insufficient, or excessively burdensome and must modify, streamline, expand, or repeal them in accordance with such reviews.
Major rule. Whenever it adopts or amends a major rule, the SEC must state in the adopting release the purposes and intended consequences of the regulation, the post-implementation quantitative and qualitative metrics to measure the economic impact of the regulation and the extent to which it has accomplished the stated purposes, the assessment plan that will be used under the supervision of the Chief Economist to assess whether the regulation has achieved those purposes, and any foreseeable unintended or negative consequences.
For purposes of the Act, Title 5, U.S. Code, Section 804(2) defines three alternative ways a regulation can become a major rule under H.R. 1062: It is likely to result in: (1) an annual effect on the economy of $100 million or more; (2) a major increase in costs or prices for consumers, individual industries, federal, state, or local government agencies, or geographic regions; or (3) significant adverse effects on competition, employment, investment, productivity, innovation, or the ability of U.S.-based enterprises to compete with foreign-based enterprises.
Assessment plan. The assessment plan for a major rule must consider the costs, benefits, and intended and unintended consequences of the regulation and specify the data to be collected, the methods for its collection and analysis, and an assessment completion date.

In any event, the SEC Chief Economist must submit the completed assessment report to the Commission no later than two years after the publication of the adopting release, unless the Commission, at the request of the Chief Economist, has published at least 90 days before such date a notice in the Federal Register extending the date and providing specific reasons why an extension is necessary.
Within seven days after the final assessment report is submitted to the Commission, it must be published in the Federal Register for notice and comment. Any material modification of the plan, as necessary to assess unforeseen aspects or consequences of the regulation, must be promptly published in the Federal Register for notice and comment.

Within 180 days of publication of the assessment report in the Federal Register, the SEC must issue for notice and comment a proposal to amend or rescind the regulation, or publish a notice that the Commission has determined that no action will be taken on the regulation. Such a notice will be deemed a final agency action.

Thursday, May 16, 2013

House Panel Approves Legislation Directing FSOC Study on Derivatives Credit Valuation Adjustment


The House Financial Services Committee approved legislation requiring the Financial Stability Oversight Council (FSOC) to conduct a study and report to Congress on the likely effects that differences between the U.S. and other jurisdictions in implementing the derivatives credit valuation adjustment capital requirement would have on United States financial institutions that conduct derivatives transactions and participate in derivatives markets. The study would also be required to examine the impact on end users of derivatives and on the international derivatives markets. According to Rep. Stephen Fincher (R-Tenn), the sponsor of the bill, the Financial Competitive Act, H.R. 1341, is needed because of the potential negative impact of Basel III on the U.S. economy.

FSOC study. Specifically, H.R. 1341 requires that the FSOC study include an assessment of the extent to which there are differences in the approaches that the United States and other jurisdictions are taking regarding implementation of the derivatives credit valuation adjustment capital requirement, and the nature of the differences and the impact that the differences would have on U.S. financial institutions that conduct derivatives transactions and participate in derivatives markets, including their ability to serve end users of derivatives.

The study must examine pricing and other costs of, and services available to, end users of derivatives in the United States and other jurisdictions, as well as the competitiveness of U.S. financial institutions and derivatives markets, including the extent to which differences in the credit valuation adjustment capital requirement could shift derivatives business among jurisdictions. The study must also explore the interaction between differing credit valuation adjustment capital requirements and margin rules.

The FSOC study must recommend steps that Congress and the federal financial regulatory agencies that compose FSOC, including the SEC and CFTC, should take to minimize any expected negative effects on U.S. financial institutions, derivatives markets, and end users. The study must also make recommendations encouraging greater global consistency in the implementation of internationally agreed upon capital, liquidity, and other prudential standards.

Rep. David Scott (D-Ga), a co-sponsor of the legislation, noted that certainty and uniformity are needed on the calculation of the derivatives credit valuation adjustment as it relates to Basel III capital requirements. Ranking Member Maxine Waters (D-Cal), in supporting H.R. 1341, observed that regulators must ensure that the calculation of the derivatives credit valuation adjustment is uniform and does not disadvantage U.S. financial institutions.

The Committee approved an amendment sponsored by Rep. Joyce Beatty (D-Ohio) that clarifies that the study must also indentify any risks and threats to financial stability, thereby recognizing FSOC’s mandate to maintain oversight of financial stability. The FSOC study must consider the cost of failing to take regulatory action as well as the cost of taking regulatory action. According to Ranking Member Waters, the amendment requires the FSOC study to report on the impact not just on derivatives markets but also on the wider markets as well.

E.U. Directive. The European Union is currently finalizing its implementation of Basel III, known as the Capital Requirements Directive IV (CRD IV). As drafted, CRD IV would exempt E.U. supervised swap dealers from certain Basel III capital mandates, specifically the credit valuation adjustment, when doing business with non-financial end users, pension funds, and sovereign entities. The securities industry finds the CRD IV exemption troubling in that it is a diversion from a uniform application of capital standards and will result in an unlevel playing field for U.S. and other non-E.U. dealers.

Thus, the securities industry supports H.R. 1341 as part of an effort to promote consistent international standards that provide a level playing field, while avoiding market distortions.
Rep. Fincher noted that Canada recently announced a one-year delay of the derivatives credit valuation adjustment, despite having finalized the rest of Basel III, citing the uncertainty around the provision’s global implementation and its effect on non-financial entities.

A Committee staff memorandum issued in connection with the markup noted that the E.U. exemption for derivatives transactions with sovereign, pension fund, and corporate counterparties has raised concerns that derivatives transactions will be subject to different capital requirements and that the credit valuation adjustment could distort the pricing of trades and limit the amount of liquidity available for non-financial U.S. derivatives end-users, as their transactions would not receive the exemption.

The FSOC study is due within 90 days of enactment to the Chairman and Ranking Members of the Committees on Agriculture and Financial Services of the House of Representatives, as well as the Chairman and Ranking Members of the Senate Committees on Agriculture and Banking.

House FSC Approves Extending SEC Registration Thresholds to Thrifts

The House Financial Services Committee approved legislation to extend to savings and loan institutions the JOBS Act shareholder thresholds for SEC registration and deregistration. Introduced by Rep. Steve Womack (R-Ark), the Holding Company Registration Threshold Equalization Act, H.R. 801, corrects the inadvertent omission of thrifts from the new shareholder thresholds contained in the JOBS Act and thereby effects Congressional intent.

Currently, Section 601 of the JOBS Act raises the number of shareholders permitted to invest in a community bank before triggering SEC reporting and registration from 499 to 1999. It also requires termination of a security registration in the case of a bank or bank holding company if the number of holders of a class of security drops below 1200. H.R. 801 would extend these shareholder thresholds to savings and loan associations.

Rep. Ann Wagner (R-Mo), a co-sponsor of the legislation, noted that these JOBS Act provisions lift outdated burdens off of small lenders and help increase capital raising. She noted that many community banks have already taken advantage of the new shareholder threshold provisions. Thrifts were intended to be included in the new thresholds, she said, since they are regulated like banks and are subject to the same reporting requirements.

Committee Ranking Member Maxine Waters (D-Cal) expressed strong support for H.R. 801, noting that it corrects an inadvertent omission in the JOBS Act. Congress neglected to include thrifts in the JOBS Act, she noted, adding that thrifts are subject to mandatory public reporting requirements.
LegislativeActivity: JOBSAct

Sunday, May 12, 2013

House FSC Chairman Emeritus Bachus Fears Regulatory Arbitrage with Financial Reform Regulations

Chairman Emeritus of the House Financial Services Spencer Bachus (R-AL) is very concerned with regulatory arbitrage in the implementation of financial services legislation globally, which is to say that he is concerned that the SEC and CFTC regulations implementing the Dodd-Frank Act will not be equivalent with regulations implementing various pieces of E.U. financial reform regulation, which ultimately is to say he fears that U.s. financial firms may be globally disadvantaged.

Make no mistake, the title of Chairman Emeritus is not just an honarary one. Rep. Bachus is a full voting member of the Committee and serves on two of its most important subcommittees. He attends hearings and questions witnesses before the Committee. Those questions have increasingly focused on the need for regulators to harmonize financial regulations both domestically and globally. At a recent hearing, he expressed frustration with the ability of the Financial Stability Oversight Council to coordinate SEC and CFTC regulations implementing the derivatives provisions of Dodd-Frank, let alone globally. He asked Treasury to provide the Committee with a memo detailing what legislation may be needed to empower FSOC to mandate harmonizatio of financial reform regulations. The Secretary of the Treasury is the permanent chair of FSOC.  The Chairman Emeritus is not alone in these concerns. Last December, before the Bipartisan Policy Center, Senator Mark Warner (D-VA), a key member of the Banking Committee, expressed frustration with FSOC's inability to foster converged finanicial regulations and said he would entertain a legislative fix. Calling FSOC an imperfect creation, Senator said that it has not become the arbiter of conflicting regulations that he had envisioned.

Friday, May 10, 2013

House Panel Approves SEC Regulatory Accountability Act, Full House Vote Expected This Month

The House Financial Services Committee has approved, by a 31-28 vote, legislation directing the SEC to conduct a thorough cost-benefit analyses of its regulations and proposed regulations. Under the SEC Regulatory Accountability Act, H.R. 1062, the SEC must ensure that the benefits of its regulations outweigh the costs. The legislation was introduced by Rep. Scott Garrett (R-NJ), Chair of the Subcommittee on Capital Markets, with ten original cosponsors. The legislation also expresses the sense of Congress that other regulators and self-regulatory bodies, including the PCAOB and the MSRB, and any national securities association registered under the Exchange Act, should also follow the requirements set forth by H.R. 1062. House Majority Leader Eric Cantor (R-VA) has indicated that H.R. 1062 is currently scheduled for full consideration sometime in May.

FSC Chair Jeb Hensarling (R-TX) described H.R. 1062 as common sense legislation that requires the SEC to consider the impact of regulations on jobs and the economy. This is simply codifying what then SEC Chair Mary Schapiro said that the Commission intended to do, he noted, adding that this is a minimal expectation from federal financial regulators.

Ranking Member Maxine Waters (D-CA) opposes H.R. 1062 because it would add a number of additional factors to the cost-benefit analysis that the SEC would have to do and, among other things, impede the Commission’s implementation of the Dodd-Frank Act.

Similarly, in a letter to Chairman Hensarling and Ranking Member Waters, state securities administrators said that H.R. 1062 would require the SEC to conduct new and unreasonably extensive analyses prior to issuing a regulation. The SEC would be permitted to adopt a rule only upon a reasoned determination that the rule’s benefits justify its costs. The SEC must determine, and measure, the effectiveness of a rule even prior to its adoption, said NASAA, and without assessing its ultimate impact on investor protection. Ranking Member Waters had mentioned that the phrase investor protection is absent from the legislation. According to NASAA, the bill also requires the SEC to consider an unduly broad range of considerations before issuing a rule that are much more expansive, and in certain cases, more vague than what is currently required.

Cost-Benefit Analysis. Specifically, the SEC Regulatory Accountability Act would direct the SEC before issuing a regulation under the securities laws to identify the nature and source of the problem that the proposed regulation is designed to address in order to assess whether any new regulation is warranted and to use the SEC Chief Economist to assess the costs and benefits of the intended regulation and adopt it only upon a reasoned determination that its benefits justify the costs.

The SEC would also have to identify and assess available alternatives that were considered; and ensure that any regulation is accessible, consistent, written in plain language, and easy to understand. Under a modified comply or explain provision in the bill, the SEC would be required to explain why the regulation meets the regulatory objectives more effectively than the alternatives.

In addition, H.R. 1062 would require the SEC to consider whether the rulemaking will promote efficiency, competition, and capital formation and the impact of the regulation on investor choice, market liquidity, and small business. The Commission must also evaluate whether the regulation is consistent, incompatible or duplicative of other federal regulations.

The Commission must also explain in its final rule the nature of comments received concerning the proposed rule or rule change and respond to those comments, explaining any changes made in response, and the reasons that it did not incorporate industry group concerns regarding potential costs or benefits.

Review of Existing Regulations. Further, within one year of enactment and every five years thereafter, the SEC must review its existing regulations to determine if they are outmoded, ineffective, insufficient, or excessively burdensome; and modify, streamline, expand, or repeal them in accordance with such reviews.

Major Rule. Whenever it adopts or amends a major rule, the SEC must state in the adopting release the purposes and intended consequences of the regulation, the post-implementation quantitative and qualitative metrics to measure the economic impact of the regulation and the extent to which it has accomplished the stated purposes, the assessment plan that will be used under the supervision of the Chief Economist to assess whether the regulation has achieved those purposes, and any foreseeable unintended or negative consequences.

For purposes of the Act, Title 5, U.S. Code, Section 804(2) defines three alternative ways a regulation can become a major rule under H.R. 1062: It is likely to result in: 1) an annual effect on the economy of $100 million or more; 2) a major increase in costs or prices for consumers, individual industries, Federal, State, or local government agencies, or geographic regions; 3) significant adverse effects on competition, employment, investment, productivity, innovation, or on the ability of U.S.-based enterprises to compete with foreign-based enterprises.

Assessment Plan. The assessment plan for a major rule must consider the costs, benefits, and intended and unintended consequences of the regulation; and specify the data to be collected, the methods for its collection and analysis, and an assessment completion date.

Thursday, May 09, 2013

``Act of Congress'' Recounts Fascinating Inside Story on How Dodd-Frank Was Enacted

A book entitled ``Act of Congress: How America's Essential Institution Works and How It Doesn't,'' by Robert G. Kaiser of the Washington Post, provides an excellent and definitive study of how the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted into law. The book reveals the inside and as yet untold story of how Congress came to pass this monumental, landmark and complicated piece of legislation. The book relates the intense and ultimately unavailing effort of Senator Christopher Dodd (D-Conn) to report a bi-partisan financial regulatory reform bill out of the Senate Banking Committee. The book recounts the lengthy and tortuous negotiations between Chairman Dodd and Senator Richard Shelby (R-Ala), the Committee's Ranking Member, to reach an agreement on a bi-partisan piece of legislation. The author had extraordinary access to the main congressional players and their staffs and relates a detailed and fascinating story. The book also faithfully recounts the efforts of Rep. Barney Frank (D-Mass), Chair of the Financial Services Committee to get the bill passed in the House.


U.K. Financial Conduct Authority Charts New Path of Securities Regulation

On April 1, 2013, the U.K. embarked on the twin peaks model of financial regulation, with the Financial Conduct Authority regulating the securities industry and professionals and the Prudential Regulation Authority regulating the banking industry and financial institutions. In remarks at the London School of Economics, FCA Chief Executive CEO Martin Wheatley indicated that the Authority will employ behavioral economics in its regulatory tool kit. He noted that one of the most significant challenges for modern financial regulators is to recognize that they operate within a very human environment in a fallible world governed and directed by psychology.

Despite this human element, one of the features of regulation historically was that it was all about compliance. In his view, financial regulation had become a robotic exercise focusing on whether a particular set of rules were followed and a particular set of boxes ticked. The question was whether a firm could demonstrate and document that it had followed those rules to the letter. If companies were able to tick those boxes and confidently hold up their product’s terms and conditions in court, he noted, they were assumed safe from regulatory scrutiny.

But in many cases, said the FCA head, this reliance on rules, processes and disclosure simply encouraged firms to hand over more information to customers who were already confused. It resulted in more text, more figures, and more legalese.

The FCA rejects the idea that risk should squarely sit with the consumer. This is the buyer beware or caveat emptor approach that says poor decision making by customers is not the responsibility of businesses. While noting that consumers should take personal responsibility for decisions, the FCA CEO said that buyer beware becomes hard to defend when customers are buying seriously complicated derivatives and other complex financial products.

The senior official said that the FCA will not be afraid to shine a light on the murkier psychological enticements and entrapments that exist in financial services. The pushes and pulls, the frames and biases that are sometimes used to entice customers to buy financial products they may not need or that might be wholly unsuitable for them.

The FCA will be looking across markets to see where and how behavioral economics might support its regulatory activity, such as areas like information disclosure and product complexity. For example, the FCA could use behavioral economics to understand why some consumers do not switch from one savings product to another after a teaser rate expires.

Behavioral economics could also be used to weed out products that are too complex for their target market, and may even be specifically designed to benefit from consumer mistakes. Many structured products fall into this category, noted Mr. Wheatley, products with too many moving parts; products that are almost impossible to take a rational decision on.

Wednesday, May 08, 2013

Bi-Partisan Senate Legislation Would Delink Federally Insured Banks from Derivatives Dealers and Other Non-Bank Subsidiaries as Part of TBTF

Bi-partisan legislation introduced by Senators Sherrod Brown (D-OH) and David Vitter (R-LA) seeks to end too big to fail and protect federally insured financial institutions from being linked to securities underwriters and derivatives dealers. The Terminating Bailouts for Taxpayer Fairness (TBTF) Act would also require federal regulators to walk away from Basel III and create a new capital regime based on two comment letters sent by Senators Brown and Vitter. Regulators would institute new capital rules that do not rely on risk weights and are simple, easy to understand, and easy to comply with. However, regulators would still be able to use risk-based capital as a supplement for banks over $20 billion, if their supervisory authority proves insufficient to prevent institutions from over-investing in risky assets.

The Senators noted that risk-weighting can obscure banks’ true capital situations, distorting the views of markets and regulators, and undermining investor confidence. They said that Basel II relied on a risk-weighting system that inaccurately assigned safe ratings to mortgage-backed security collateralized debt obligations and credit default swaps that actually amplified risk instead of mitigating it.

Under the legislation, bank holding companies will be restricted in their ability to move assets or liabilities from non-banking affiliates to a banking affiliate within the bank holding company structure. This will ensure that the government safety net begins and ends at the commercial bank and other subsidiaries, such as insurance, securities underwriters, and derivatives dealers must fend for themselves. Similarly, the Federal Reserve and other banking regulators will be prohibited from allowing non-depositories access to Federal Reserve discount window lending, deposit insurance, and other federal support programs. According to the Senators, this will help reduce market expectations of financial assistance for large, complex financial institutions.

The legislation would ensure that financial companies operating under one holding company would be adequately capitalized, as would be required if they were stand-alone companies. The Senators said that the legislation would ensure that highly-leveraged lines of business do not threaten the well being of other affiliates or the entire enterprise. The Senators noted that former FDIC Chair Sheila Bair has said that creating stand-alone subsidiaries will make large, complex financial institutions easier to put into resolution if they run into trouble.

Tuesday, May 07, 2013

Consumer Groups and Former Comm. Wallman Urge SEC to Incorporate IAC Recommendations in Re-Proposal of JOBS Act General Solicitation Regulation


In a letter to SEC Chair Mary Jo White, consumer groups and former SEC Commissioner Steven M.H. Wallman urged the Commission to re-propose the regulation implementing the JOBS Act provision eliminating the ban on general solicitation so that the recommendations of the SEC Investor Advisory Committee can be incorporated into the final regulation. The groups believe that the re-proposal of a rule that includes the IAC recommendations for appropriate investor protections and that complies with the Commission’s guidelines for economic analysis is the best way to assure that any final rule adopted in this area can be speedily adopted, is legally defensible and enjoys the broad support of the issuer and investor communities. In addition to former Commissioner Wallman, the letter was signed by Barbara Roper, Director of Investor Protection at the Consumer Federation of America.


Title II of the JOBS Act allows private issuers to market their securities through general solicitations and advertising under exemptions to the registration requirements of the Securities Act. The JOBS Act required the SEC to revise its rules to remove the prohibition against general solicitations and advertising in these exemptions within 90 days of its enactment. The deadline for the SEC to revise Rules 506 and 144A was July 4, 2012. The SEC proposed regulations on August 29, 2012, but has not yet adopted the regulations.

The consumer groups and former Commissioner Wallman believe that the Investor Advisory Committee has issued reasonable proposals that will enhance investor confidence in this market without unduly impeding legitimate offerings. Moreover, given the volume of comment the Commission has already received on these issues,  the consumer groups and Commissioner Wallman believe that the SEC staff should be able to quickly craft a rule proposal that can move very expeditiously,  possibly with the minimum comment period,  through the notice and comment process to final adoption.

The letter notes that the recommendations of the IAC include provisions designed to ensure that the Commission receives the information necessary to provide effective oversight of the Rule 506 offering market, that these private offerings are sold only to those who are appropriately qualified to make such investments, that any performance claims made in such offerings are based on reliable standards, and that bad actors will not be allowed to participate in such offerings.

Specifically, the IAC recommendations would require all issuers intending to rely on the new JOBS Act general solicitation exemption to file with the Commission either a new Form GS or a revised version of Form D. They would also require that all solicitation material prepared or disseminated by or on behalf of the issuer that is being disseminated to the public through a general solicitation or advertising campaign in reliance on the new exemption be furnished to the Commission.

The IAC also recommends the adoption of a safe harbor providing clear and enforceable standards for verification, as opposed to reasonable belief, of accredited investor status, including standards to promote reliance on reliable third parties, such as broker-dealers, banks, and licensed accountants.

Saturday, May 04, 2013

Quoting Chairman Volcker, Sen. Wirth Was Prescient in Senate Report on Proxmire Financial Modernization Act

The Proxmire Financial Modernization Act of 1988, which passed the Senate but was never enacted, came to fruition with the passage of the Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act. The Proxmire bill would have repealed Glass-Stegall and allowed a bank holding company to operate a securities affiliate under Fed and SEC regulation. Just as with Gramm-Leach-Bliley, the Proxmire bill embodied the now largely discredited principle of functional regulation.

In Senate Banking Committee Report No. 100-305, accompanying the Proxmire bill, Senator Tim Wirth (D-CO) noted that there are good reasons to support a cautious approach to new securities activities for bank holding companies. Senator Wirth noted that former Fed Chair Paul Volcker expressed reservations that a bank can ever e truly shielded from its securities affiliates.

This Volcker position in 1988, as reported by Senator Wirth, is not too far from Chairman Volcker’s current skepticism of the U.K. Vickers Commission proposal to allow commercial and investment banking activities within the same holding company, with the investment bank permitted to conduct proprietary securities trading.

In recent testimony before the U.K. Parliamentary Commission on Banking Standards, Chairman Volcker said that the ring-fencing of retail from commercial banking within the same bank holding company would inevitably break down. Mr. Volcker called for institutional separation of retail banking and proprietary trading and sponsoring hedge funds.

When the U.K. Government drafted legislation to implement the Vickers Commission recommendation to ring fence retail banks from investment banks engaged in proprietary trading and sponsoring hedge funds, Parliament took the unprecedented step of creating its own inquiry into banking standards and taking evidence on the draft legislation. The Commission on Banking Standards has heard testimony from eminent authorities, including Chairman Paul Volcker and Martin Wheatley, head of the new Financial Conduct Authority. Recently, the Commission decided to take further evidence in 2013 on whether the full separation of proprietary trading, something akin to a Volcker Rule for the UK, may be appropriate.

Friday, May 03, 2013

House Panel Considers Dodd-Frank Derivatives Correction Legislation

The House Capital Markets Subcommittee held a hearing to consider a number of pieces of legislation to amend the derivatives provisions in Title VII of the Dodd-Frank Act, as well as legislation requiring the Financial Stability Oversight Council to study the competitive impact on U.S. financial institutions of an E.U. exemption from Basel III rules for European financial institutions.

Subcommittee Chair Scott Garrett (R-NJ) described the pieces of legislation amending the derivatives provisions of the Dodd-Frank Act as bi-partisan and common sense bills. He particularly praised the Swap Jurisdiction Certainty Act, H.R. 1256, which would require the SEC and CFTC to have identical cross-border regulations for derivatives regulation. The legislation will limit regulatory arbitrage by ensuring identical standards for all types of swap markets. Limiting regulatory arbitrage is a top priority for Congress, emphasized Chairman Garrett. The legislation would also require that cross-border regulation of OTC derivatives must be effected through rulemaking, not guidance. Noting that the CFTC has issued proposed guidance on cross-border swaps, Chairman Garrett said that the CFTC’s use of guidance has questionable legal authority. Some entities may ignore the guidance.

Rep. David Scott (D-GA) said that, after close and careful examination, he supports the majority of the bills before the Subcommittee. The legislation is not a radical departure from the reforms effected by the Dodd-Frank Act, and will not ``blow a hole in the bottom of Dodd-Frank.’’ They are corrections to Title VII provisions that are not going to work, said Rep. Scott, and have unintended consequences. Importantly, he noted that Dodd-Frank and Basel III must not be allowed to put U.S. financial institutions at a competitive disadvantage. Further, Rep. Scott does not believe that the bills will undermine transparency by lessening the disclosure of trading data. Importantly, Rep. Scott noted that Dodd-Frank and Basel III must not be allowed to put U.S. financial institutions at a competitive disadvantage.

Former Rep. Ken Bentsen, and current SIFMA CEO, testified that the securities industry supports the Swap Jurisdiction Certainty Act, H.R. 1256, because it would harmonize the cross-border approaches to derivatives regulation by requiring the CFTC and SEC to jointly issue a regulation related to the cross-border application of the Dodd Frank Act within 180 days. This joint rule would have to be in accordance with the Administrative Procedures Act. The measure would also ensure that foreign countries with broadly equivalent regimes for swaps would not be subject to U.S. derivatives regulations H.R. 1256 would also require the Commissions to jointly provide a report to Congress if they determine that a foreign regulatory regime is not broadly equivalent to United States swap requirements. On March 20, 2013, H.R. 1256 was approved by voice vote by the House Agriculture Committee to be recommended favorably to the House.

Implementation of the Basel III capital standards accord is an area of great interest and concern for the securities industry and indeed the financial services industry as a whole. Mr. Bentsen testified that the industry strongly supports efforts to promote consistent international standards that provide a level playing field, while avoiding competitiveness issues and market distortions that impact the real economy.

The European Union is currently finalizing its implementation of Basel III, known as the Capital Requirements Directive IV (CRD IV). As drafted, CRD IV would exempt EU supervised swap dealers from certain Basel III capital mandates, specifically the credit valuation adjustment, when doing business with non-financial end-users, pension funds and sovereign entities. SIFMA finds the CRD IV exemption troubling in that it is a diversion from a uniform application of capital standards and will result in an un-level playing field for U.S. and other non-EU dealers.

Thus, the industry supports the Financial Competitive Act, H.R. 1341, authored by Rep. Stephen Fincher (R-TN), and co-sponsored by Rep. Scott, that would direct the Financial Stability Oversight Council to examine differences in the implementation of derivatives capital requirements and the credit valuation adjustment. Further, the bill would require FSOC to assess the effects on the U.S. financial system and to make recommendation to minimize any negative impact on U.S. financial firms and end-users. Rep. Fincher noted that Canada recently announced a one-year delay of the credit valuation adjustment, despite finalizing the rest of Basel III, citing the uncertainty around the provision's global implementation and its effects on non-financial entities.

DTCC Data Repository strongly supports the Swap Data Repository and Clearinghouse Indemnification Correction Act, H.R. 742, a bipartisan bill co-sponsored by Representatives Bill Huizenga (R-MI), Gwen Moore (D-WI), Rick Crawford (R-AR), and Sean Patrick Maloney (D-NY). The legislation was reported out of the House Agriculture Committee on March 20, 2013 with bipartisan support. H.R. 742 will resolve issues surrounding Dodd-Frank’s indemnification provisions and confidentiality requirements.

Testifying on behalf of DTCC, CEO Christopher Childs cautioned that the Dodd-Frank indemnification provision will fragment swap data, and that such fragmentation will hinder regulators’ efforts to oversee a global market. Also, indemnification risks will negate the existing global data sharing framework Sections 728 and 763 of Dodd-Frank apply to swap data repositories registered with the CFTC and SEC. Prior to sharing information with U.S. prudential regulators, the Financial Stability Oversight Council, the Department of Justice, foreign financial authorities, foreign central banks, or foreign ministries, Dodd-Frank requires the swap data repositories to receive a written agreement from each entity stating that the entity must abide by certain confidentiality requirements relating to the information on swap transactions that is provided and each entity must agree to indemnify the swap data repository and the CFTC or the SEC for any expenses arising from litigation relating to the information provided. In practice, said Mr. Childs, these provisions have proven to be unworkable.

Mr. Childs noted that indemnification is a common law concept with its origin in tort law. Many countries and their legal systems do not recognize indemnification, he said, and many foreign governments cannot or will not agree to indemnify foreign, private third parties, such as U.S. registered swap date repositories.

Moreover, the continued presence of the indemnification requirement is a significant barrier to the ability of regulators globally to effectively utilize the transparency offered by a trade repository registered in the U.S. Without a Dodd-Frank compliant indemnity agreement, he observed, U.S.-registered swap data repositories may be legally precluded from providing regulators market data on transactions that are subject to their jurisdiction. In order to access the swap transaction information necessary to regulate market participants in their jurisdiction, global supervisors will be forced to establish local repositories to avoid indemnification.

In turn, the creation of multiple swap data repositories will fragment the current consolidated information by geographic boundaries. While each jurisdiction would have a swap data repository for its local information, noted Mr. Childs, it would be far less efficient, more expensive, and prone to error when compared with the current global information sharing arrangement in place today. Further, he raised the specter that a proliferation of local trade repositories would undermine the ability of regulators to obtain a timely, consolidated, and accurate view of the global derivatives marketplace.

The Dodd-Frank indemnification requirement has not been copied by Asian and European regulators. In fact, he noted that the European Market Infrastructure Regulation (EMIR) considered and rejected an indemnification requirement. H.R. 992, the Swaps Regulatory Improvement Act, introduced by Reps. Randy Hultgren (R-IL), James Himes D-CT), Richard Hudson (R-NC) and Sean Patrick Maloney (D-NY), would repeal most of Section 716 of the Dodd-Frank Act. Section 716 prohibits federal assistance, defined as “the use of any advances from any Federal Reserve credit facility or discount window or FDIC insurance, to swaps entities, which include swap dealers and major swap participants, securities and futures exchanges, swap-execution facilities, and clearing organizations. In effect, Section 716, commonly known as the swap desk “push out” or “spin off” provision, forces financial institutions that have swap desks to move them into an affiliate to preserve their access to Federal Reserve credit facilities and federal deposit insurance. Although the provision allows banks to continue dealing in swaps related to interest rates, foreign currency, and swaps permitted under the National Bank Act, they are prohibited from engaging in swaps related to commodities, equities, and credit.

Rep. Himes called Section 716, ``problematic,’’ adding that interest rate swaps get to remain in banks, while more dangerous swaps, such as those around structured finance, are pushed out. Rep. Hultgren said that H.R. 992 would allow depository institutions to provide a spectrum of services and products. Currently, since foreign jurisdictions are not enacting similar provisions, Section 716 imposes a unilateral prohibition on U.S. financial institutions.

Former Rep. Bentsen, and current SIFMA CEO, said that the securities industry supports H.R. 992, which would modify the push-out provision in the Dodd-Frank Act, Section 716, to ensure that federally insured financial institutions can continue to conduct risk-mitigation efforts for clients like farmers and manufacturers that use swaps to insure against price fluctuations. In addition, the bill would fix a drafting error acknowledged by the Swap Push-Out Rule’s authors, under which the limited exceptions to the rule that apply to insured depositing institutions appear not to include U.S. uninsured branches or agencies of foreign banks.

The Swap Push Out Rule was added to the Dodd-Frank Act at a late stage in the Senate and was not debated or considered in the House of Representatives. It would force banks to push out certain swap activities into separately capitalized affiliates or subsidiaries by providing that a bank that engages in such swap activity would forfeit its right to the Federal Reserve discount window or FDIC insurance. In addition to the increase in risk that would be caused by the Swaps Push-Out Rule, contended SIFMA, the limitations will significantly increase the cost to banks of providing customers with swap products as a result of the need to fragment related activities across different legal entities. As a result, U.S. corporate end users and farmers will face higher prices for the instruments they need to hedge the risks of the items they produce.

He noted that the Swap Push-Out Rule has been opposed by senior prudential regulators from the time it was first considered. Ben Bernanke, Chair of the Federal Reserve, stated in a letter to Congress that forcing these activities out of insured depository institutions would weaken both financial stability and strong prudential regulation of derivative activities. Sheila Bair, former FDIC Chair, said that by concentrating the activity in an affiliate of the insured bank, the U.S could end up with less and lower quality capital, less information and oversight for the FDIC, and potentially less support for the insured bank in a time of crisis, further adding that one unintended outcome of this provision would be weakened, not strengthened, protection of the insured bank and the Deposit Insurance Fund.

The Dodd-Frank Act is silent on the application of swap rules to swaps entered into between affiliates. Inter-affiliate swaps are swaps executed between entities under common corporate ownership. Inter-affiliate swaps allow a corporate group with subsidiaries and affiliates to better manage risk by transferring the risk of its affiliates to a single affiliate and then executing swaps through that affiliate.

In the view of SIFMA, inter-affiliate swaps provide important benefits to corporate groups by enabling centralized management of market, liquidity, capital and other risks inherent in their businesses and allowing these groups to realize hedging efficiencies. Since the swaps are between affiliates, rather than with external counterparties, they pose no systemic risk and therefore there are no significant gains to be achieved by requiring them to be cleared or subjecting them to margin posting requirements. In addition, these swaps are not market transactions and, as a result, requiring market participants to report them or trade them on an exchange or swap execution facility provides no transparency benefits to the market.

Thus, SIFMA urges Congress to enact H.R. 677, the InterAffiliate Swap Clarification Act, which would exempt certain inter-affiliate transactions from the margin, clearing, and reporting requirements under Title VII. On March 20, 2013, H.R. 677 was approved by voice vote by the House Agriculture Committee to be recommended favorably to the House.

The Business Risk Mitigation and Price Stability Act, H.R. 634, introduced by Reps. Michael Grimm (R-NY), Gary Peters (D-MI), Austin Scott (R-GA) and Mike McIntyre (R-NC), would exempt end-users from the margin and capital requirements of Title VII of the Dodd-Frank Act (P.L. 111-203). During consideration of the Dodd-Frank Act, a colloquy among the chairs of the four committees with primary jurisdiction over Title VII (Senators Dodd and Lincoln and Representatives Frank and Peterson) clarified Congress’s intent that the Dodd-Frank Act did not grant regulators the authority to impose margin requirements for end-user transactions. Notwithstanding this expression of Congressional intent, some regulators have interpreted Title VII as granting them the authority to impose margin requirements on end-users merely because they are counterparties to swaps with a regulated entity, such as a swap dealer or financial institution.

Rep. Peters noted that H.R. 634 allows companies to manage risk and clarifies that non-financial end-users are exempt from Dodd-Frank margin rules. Rep. Grimm noted that legislation identical to H.R, 634 passed the House last year, H.R. 2682, adding that the legislation ensures that the working capital of non-financial end users is not diverted to margin accounts.

Wednesday, May 01, 2013

In Letter to Treasury, Global Finance Ministers Urge Consistent Cross-Border Regulation of Derivatives under Substituted Compliance or Equivalence

In a letter to U.S. Treasury Secretary Jack Lew, with copies to the Chairs of the SEC and CFTC, global Finance Ministers expressed their concern at the lack of progress in developing workable cross-border regulations as part of reforms of the OTC derivatives market. The ministers, joined by E.U. Internal Market Commissioner Michel Barnier, said that they are already starting to see evidence of fragmentation in this vitally important financial market as a result of a lack of regulatory coordination. Without clear direction from global policymakers and regulators, they cautioned, the derivatives markets will recede into localized and less efficient structures, impairing the ability of global business to manage risk. In turn, this will dampen liquidity, investment and growth. The letter was signed by, among others, U.K. Chancellor of the Exchequer George Osborne, German Finance Minister Wolfgang Schäuble, and Japanese Finance Minister Taro Aso.

The ministers said that they share a common commitment with respect to OTC derivatives reform, and are implementing regulations across very different markets with different characteristics and different risk profiles, to support this global initiative. They warned that an approach in which jurisdictions require that their own domestic regulations be applied to their firms’ derivatives transactions taking place in broadly equivalent regulatory regimes abroad is simply not sustainable. Market places where firms from all respective jurisdictions can come together and do business will not be able to function under such burdensome regulatory conditions.

A coherent collective solution is therefore needed for cross-border derivatives, said the Finance Ministers, and regulators must work together to avoid outright conflicts in regulation and minimize overlaps as far as possible. In this regard, mutual recognition, substituted compliance, exemptions, or a combination of these would all be a valid approach, and careful consideration should be given with respect to registration requirements for firms operating across borders. Recent experience shows that these discussions can only proceed if they are based on a shared understanding of the overall outcome being sought.

The senior officials emphasized that the basic principles on which cross-border derivatives regulations should be based are clear and widely shared. They urged the SEC, CFTC and other regulators to carefully consider the principles to avoid cross-border conflicts.