US Regulatory Update
Fiscal Year 2019 Budget Requests Released
On 12 February, the Office of Management and Budget (“OMB”) published the Presidential Budget for fiscal year (“FY”) 2019. Among other things, the budget: (i) requested $4.4 trillion for the U.S. Government for FY 2019; and (ii) proposes to subject all Financial Stability Oversight Council (“FSOC”) and Office of Financial Research (“OFR”) activities to the normal appropriations process.
The same day, the SEC announced its budget request of $1.658 billion for FY 2019, a 3.5 percent increase over the FY 2018 budget of $1.602 billion. The request proposes to “restore” 100 positions that the agency lost as a result of its self-imposed FY 2017 hiring freeze in order to “address critical priority areas and enhance the agency’s expertise in key areas,” including, among others: (i) 4 cybersecurity staff positions; (ii) a “new chief risk officer position to oversee the agency’s enterprise risk program”; (iii) 17 positions in the Division of Enforcement; (iv) 24 positions in the National Examination Program; (v) 7 positions in the Division of Investment Management; and (vi) 16 positions in the Division of Trading and Markets.
Also on February 12, the CFTC announced its budget request of $281.5 million for FY 2019, a $31.5 million increase over the FY 2017 budget and the same as the budget requested for FY 2018. The CFTC requested that Congress enact legislation permitting the CFTC to collect fees to pay for the increased budget. The CFTC indicated that in FY 2019 it will focus on, among other things: (i) enhancing “its capacity to develop economic modeling and econometric capabilities aimed at boosting the CFTC’s analytical expertise and monitoring of systemic risk in the derivatives markets, in particular with regard to central counterparty clearinghouses”; (ii) strengthening its “examinations capability to enable it to keep pace with the growth in the amount and value of swaps cleared by [derivatives clearing organizations] pursuant to global regulatory reform implementation”; and (iii) addressing “market enhancing innovation through financial technology (FinTech).”
U.S. Court of Appeals for the D.C. Circuit Exempts Managers of Collateralized Loan Obligations from Risk Retention Rules
On 9 February, the U.S. Court of Appeals for the D.C. Circuit issued a decision in a lawsuit against the SEC and the Federal Reserve Board holding that managers of collateralized loan obligations (“CLOs”) are exempted from risk retention rules under the Dodd-Frank Act’s Credit Risk Retention Rule. The Court held that “CLO managers do not hold the securitized loans at any point [because a CLO manager only] meets with potential investors and agrees to the terms of its performance as well as the risk profiles and tranche structures the CLO will ultimately take,” and thus can neither retain nor transfer any economic interest in the credit risk for any assets.
o On 12 February, American Banker reported that the SEC and Federal Reserve Board are unlikely to appeal the decision, particularly since the Department of Treasury recommended in its report setting forth “Core Principles” for U.S. financial regulation that “rulemaking agencies introduce a broad qualified exemption for CLO risk retention.”
SIFI AND FINANCIAL STABILITY
U.S. House Committee on Financial Services Hearing Entitled “The Annual Report of the Financial Stability Oversight Council”
On 6 February, the House Committee on Financial Services held a hearing entitled “The Annual Report of the Financial Stability Oversight Council.” Department of Treasury Secretary Steven Mnuchin testified on a number of issues, including, among others: (i) the designations non-bank systemically important financial institutions (“SIFIs”); (ii) cybersecurity; and (iii) the Consolidated Audit Trail (“CAT”).
o SIFI Designation: When questioned on the SIFI designation process, Treasury Secretary Mnuchin stated that: (i) the FSOC intends to re-revaluate Prudential Financial’s SIFI designation “in the near future, this year”; (ii) the FSOC will be working with the Committee to issue “revised guidelines for designations” of non-bank institutions; and (iii) the FSOC intends to increase transparency in the designation process, to focus on an activities-based approach for determining whether an entity poses systemic risk, and to provide an “off-ramp” for de-designation. When questioned by Rep. Bruce Poliquin (R-ME) as to whether bank-like stress tests for non-bank financial institutions should be eliminated, Treasury Secretary Mnuchin stated that such stress tests should be eliminated.
o Cybersecurity: When questioned on the FSOC’s work on cybersecurity, Treasury Secretary Mnuchin stated that he is “very much focused on” cybersecurity and that FSOC currently has two related priorities: (i) ensuring that various regulators are “working together, that they are pooling resources to focus on this issue”; and (ii) developing the “proper public-private partnerships to be able to exchange information and best practices.”
o CAT: Rep. Warren Davidson (R-OH) expressed concern that the CAT would become operational without a Chief Information Security Officer and questioned what plans the Department of Treasury had to coordinate the “functional areas” it oversees to address cybersecurity. Treasury Secretary Mnuchin stated that Treasury is coordinating with other independent agencies to ensure that such agencies are “following the administration’s priorities on cybersecurity.”
SEC & SECURITIES
U.S. House of Representatives Passes Bill to Require SEC Subpoena for Algorithmic Trading Source Code
On 14 February, the U.S. House of Representatives passed, by a vote of 271-145, H.R. 3978. Title II of the bill would, among other things, prohibit the SEC from “compel[ling] . . . a person to produce or furnish source code, including algorithmic trading source code or similar intellectual property that forms the basis for design of the source code, to the Commission unless the Commission first issues a subpoena.’’
SEC Office of Compliance Inspections and Examinations Announces 2018 Examination Priorities
On 7 February, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) announced its Examination Priorities for 2018. The priorities are separated into five categories relating to: (i) “retail investors, including seniors and those saving for retirement”; (ii) “compliance and risks in critical market infrastructure”; (iii) FINRA and Municipal Securities Rulemaking Board; (iv) cybersecurity; and (v) anti-money laundering programs.
o Retail Investors: Examination priorities include: (i) fee disclosures; (ii) advisers that provide “investment advice through automated or digital platforms,” such as robo-advisers; (iii) wrap fee programs; (iv) “never-before-examined investment advisers”; (v) “senior investors and retirement accounts and products”; (vi) mutual funds and exchange traded funds (“ETFs”) that have experienced relative poor performance or liquidity, are managed by advisers with little experience, or hold securities that may become difficult to value during periods of market stress; (vii) ETFs that “have little secondary market trading volume and that face the risk of being delisted from an exchange and having to liquidate assets”; and (viii) cryptocurrency, so-called initial coin offerings, related secondary market trading, and blockchain.
o Critical Market Infrastructure: Examination priorities will focus on: (i) clearing agencies, including compliance with the SEC’s Standards for Covered Clearing Agencies and whether timely corrective action has been taken in response to examinations; (ii) national securities exchanges, with respect to the “internal audits conducted by the exchanges,” the “fees paid under Exchange Act Section 31,” and the “governance and operation of certain National Market System . . . plans”; and (iii) Regulation Systems Compliance and Integrity (“SCI”) Entities, with respect to “whether they have effectively implemented [their] written policies and procedures.”
o Cybersecurity: Examination priorities will focus on, among other things; (i) governance and risk assessment; (ii) access rights and controls; (iii) data loss prevention; (iv) vendor management; (v) training; and (vi) incident response.
CFTC & DERIVATIVES
U.S. Senate Committee on Agriculture Hearing Entitled “State of the CFTC: Examining Pending Rules, Cryptocurrency Regulation, and Cross-Border Agreements”
On 15 February, the Senate Committee on Agriculture, Nutrition, and Forestry held a hearing entitled “State of the CFTC: Examining Pending Rules, Cryptocurrency Regulation, and Cross-Border Agreements.” CFTC Chairman J. Christopher Giancarlo testified on a number of issues, including: (i) cross-border regulation; (ii) virtual currencies; (iii) the CFTC’s enforcement activity; (iv) the CFTC’s current agenda; and (v) the CFTC’s cybersecurity protections.
o CFTC Enforcement Activity: When questioned by Ranking Member Stabenow regarding what the CFTC has done to strengthen its oversight program and whether its lack of staffing has impacted its ability to provide adequate oversight, CFTC Chairman Giancarlo stated that he would “never let [the CFTC’s] oversight capabilities suffer any deterioration in its effectiveness” and that if necessary the CFTC would prioritize its oversight functions over other functional areas such as training or producing publications. Committee Chairman Roberts expressed his opposition to the FY 2019 CFTC budget’s inclusion of derivatives user fees as a funding mechanism, noting that such user fees would “likely reduce liquidity, have increased volatility, and less efficient use of [the] futures markets.” He is a member of the Senate Appropriations Committee and he explained that the Appropriations Committee is working to address the issue of funding.
o CFTC Agenda: When questioned by Ranking Member Stabenow whether the CFTC intends to complete the rulemaking mandated by the Dodd-Frank Act, CFTC Chairman Giancarlo stated that: (i) he intends to complete the swap dealer de minimis threshold rulemaking in the first half of 2018 and that meetings have been scheduled over the “next several months" to present the CFTC Commissioners with data through the end of 2017 in order to facilitate action on this issue; and (ii) with regards to the position limits rulemaking, he intends to present “something” to his fellow CFTC Commissioners “by the beginning of the second half of this year,” but noted that because this is a complicated issue, the issue “should be considered by a Commission of five as intended.”
U.S. House Committee on Financial Services Hearing Entitled “Legislative Proposals Regarding Derivatives”
On 14 February, the U.S. House Committee on Financial Services Subcommittee on Capital Markets, Securities, and Investment held a hearing titled “Legislative Proposals Regarding Derivatives.” The individuals who testified at the hearing were: Kenneth Bentsen, Jr. President and CEO of the Securities Industry and Financial Market Association (“SIFMA”); Thomas Deas, testifying on behalf of the Coalition for Derivatives End-Users; Andrew Green, Managing Director of Economic Policy at the Center for American Progress; and Scott O’Malia, Chief Executive Officer of the International Swaps and Derivatives Association (“ISDA”). The hearing focused on the review of the post-crisis derivatives regulatory regime and considered 11 derivatives related legislative proposals for discussion.
o CFTC Fees: Subcommittee Chairman Bill Huizenga (R-MI) asked Mr. O’Malia and Mr. Bentsen as to whether the CFTC should be granted the authority to impose fees on users of derivatives products, a funding assumption contained within the CFTC’s FY 2019 budget, which reflects the FY 2019 White House budget request. Mr. O’Malia noted that such a proposal has been made and rejected many times because “it adds to the cost of risk management” and stated that ISDA does not support this proposal. Chairman Huizenga noted that CFTC Chairman Giancarlo has opposed the imposition of such user fees, as did Mr. Bentsen, who also added that the CFTC should be cautious in in implementing such a proposal as there could be instances where the fee “exceeds the spread on a product.”
o Amending Dodd-Frank Act Rules: Ranking Member Carolyn Maloney (D-NY) said there needs to be “a real concrete problem that is both significant and unintended” identified before she supports a bill that would amend Dodd-Frank Act derivatives rules. She questioned Mr. Green as to whether he believes any of the 11 derivatives-related bills that were the focus of the hearing met this standard or addressed problems that were “significant enough to warrant legislative action.” Mr. Green answered no.
o De Minimis Threshold: Rep. Randy Hultgren (R-IL) quoted CFTC Commissioner Brain Quintenz’s speech before the Smart Financial Regulation Roundtable hosted by the Mercatus Center and Institute for Financial Markets, in which he stated that the swap dealer de minimis threshold’s “reduction to three billion would create a black hole sucking in community banks and end-users who pose zero systemic risk [and] at the center of that black hole lies an enormous set of costs” and questioned whether Mr. Bentsen believes that legislation proposing to exclude all hedging from the de minimis threshold would provide relief to smaller swaps dealers. Mr. Benston responded that “we really need more data to see [which institutions are] subject to the de minimis threshold” and that while smaller dealers do not pose any systemic risk, they might not be “willing to stay in business” if they become subject to the swap dealer regulatory regime, which will lead to higher market concentration and less competition in the market. He added that the CFTC needs to thoroughly review the data it has acquired to determine the best course of action going forward.
o Client Margin: Rep. David Scott (D-GA) questioned whether removing initial client margin for cleared derivatives from the supplemental leverage ratio (“SLR”) calculations would incentivize more companies to clear derivatives, as proposed in the bipartisan H.R. 4659, and whether this legislative proposal could increase risk in the financial system. Mr. Bentsen stated that the bill would address one of the “problems in the construct of the SLR” that incentivizes firms to not clear derivatives. Mr. O’Malia stated that ISDA supports the bill because it is “prudent” and “recognizes that clearing has put [initial margin] aside and that’s a very important risk reducing measure and to add an SLR component on it . . . just makes it more costly.”
CFTC Technology Advisory Committee meeting
On 14 February, the CFTC Technology Advisory Committee hosted a meeting that included panels on the following topics: (i) blockchain and the potential application to derivatives markets of distributed ledger technology (“DLT”); (ii) “market and regulatory developments with virtual currencies and related futures products”; and (iii) “developments and challenges with automated trading technologies.” Remarks were given by CFTC Chairman J. Christopher Giancarlo and CFTC Commissioners Brian D. Quintenz and Rostin Behnam. Lead participants included representatives from the CFTC’s Division of Market Oversight, the Depository Trust and Clearing Corporation (“DTCC”), the Coin Center, and various industry actors. During the meeting, the Committee voted to create two new subcommittees: one focused on cryptocurrencies and the other focused on the broad application of DLT in the financial sector.
o Chairman Giancarlo’s remarks: Chairman Giancarlo noted that the Commission’s LabCFTC initiative, launched in May 2017, “is the focal point of the CFTC’s efforts to facilitate market-enhancing innovation and fair competition for the benefit of the American public.” He emphasized the importance of housing LabCFTC within the CFTC’s Office of the General Counsel, as doing so allows LabCFTC to “leverage the expertise of the CFTC’s legal team to manage the interface between technological innovation, regulatory modernization, and existing rules and regulations.”
o Developments and challenges with automated trading technologies: Commissioner Behnam noted that he is “pleased that the TAC plans to resuscitate at least some of Regulation AT” (“Reg AT”) and that he believes “it is vitally important that the Commission take immediate action on Reg AT before an automated trading system runs amok causes harm to market participants.” Conversely, Commissioner Quintenz referred to Reg AT as a “missed opportunity” and that the CFTC “should only pursue additional regulation in [the automated trading] space after it has identified specific risks associated with automated trading, examined how those risks are being addressed through the market’s incentive structure, and then determined if regulation can play a proper role in alleviating those risks.” In his presentation, Vanderbilt Law professor Yesha Yadav stated that regulatory mechanisms to constrain automated markets are weak because “intent-based liability for manipulation and fraud has been notoriously difficult to establish.” While his presentation argued that Reg AT has made the task easier as regulators can now more easily use data, it noted that challenges surrounding data collection and interpretation “may push regulators to focus on more self-evident types of deception like fairly clear spoofing activity.”
CFTC Market Risk Advisory Committee Meeting
On 31 January, the CFTC’s Market Risk Advisory Committee (“MRAC”) held a meeting to discuss the “statutory and regulatory process for the listing of new and novel products on CFTC-regulated designated contract markets (DCMs) and swap execution facilities (SEFs) through self-certification.” As explained in the meeting agenda, participants discussed topics related to: (i) the “overview of self-certification for products”; (ii) “new products from a risk perspective”; (iii) “futures exchanges and new products”; and (iv) “policy [and] regulatory approach for novel products.” In his opening remarks, CFTC Chairman J. Christopher Giancarlo stated that he is “neither an apologist nor an opponent of the current process of self-certification” and explained that while some market participants raised concerns that the CFTC did not hold any hearings prior to the self-certification of Bitcoin futures, there is currently “no avenue for public input” in the self-certification process under the Commodity Exchange Act or the CFTC’s rules. Chairman Giancarlo also stated that he has asked CFTC staff to include an “additional element to its Review and Compliance Checklist for virtual currency product self-certification . . . requiring DCMs and SEFs to disclose to CFTC staff what steps they have taken in their capacity as self-regulatory organizations to gather and accommodate appropriate input from concerned parties.” He also noted that he has asked CFTC staff to “take a close look at DCO governance around the clearing of new virtual currency products and formulate recommendations for possible further action.”
CFTC Office of the Chief Economist Publishes New Metric in Measuring the Size of Interest Rate Swaps Markets
On 1 February, the CFTC’s Chief Economist Bruce Tuckerman, Supervisory Economist Richard Haynes, Senior Economist John Roberts, and Economist Rajiv Sharma co-published a paper introducing Entity-Netted Notionals (“ENNs”) as a potential metric for measuring the size of the interest rate swaps (“IRS”) market. The paper introduces the ENN as a potential replacement or supplement of notional value, which the paper argues does not accurately measure of the size of the IRS market. Instead, the paper argues that the netting of counterparty risk under the ENN would “capture the market risk transfer in IRS markets much more accurately than notional amounts” and could be used “instead of or in addition to notional amounts to set regulatory thresholds.” The paper notes, however, that ENNs “are not intended to measure counterparty credit risk,” which may be better measured by “net market value,” “gross credit exposure,” or “net credit exposure” and not intended to measure operational risk, which may be better measured by notional value.
o CFTC Chairman J. Christopher Giancarlo delivered accompanying remarks before the DerivCon 2018 conference on the ENN. In his remarks, he clarified that while the ENN “may be worth academic consideration, it was not [his] intention . . . to come up with a specific alternative to the CFTC’s current swap dealer de minimis calculation methodology,” but rather “to bring greater clarity to the public understanding of the global derivatives markets.”
Remarks of Commissioner Brian Quintenz before the DerivCon 2018 Conference
On 1 February, CFTC Commissioner Brian Quintenz delivered remarks before the DerivCon 2018 conference on improvements to the swaps data reporting regime. Commissioner Quintenz stated while “significant improvements” have been made to improve transparency in the swaps market, there is still “a long way to go.” For example, he noted that while mandatory swaps reporting to swaps data repositories (“SDRs”) and the anonymous dissemination of that information to the public have improved transparency in the swaps market, the data reported was “frequently . . . incomplete or incorrect.” In looking at ways to improve swaps data reporting, he referenced a review by the CFTC’s Division of Market Oversight of the CFTC’s reporting regulations. He stated that: (i) the reporting counterparty should be the counterparty that confirms the accuracy of the trade reports with SDRs; (ii) “SDRs should automatically reject trade reports with missing or invalid fields”; (iii) the CFTC should “establish clear standards for what minimum set of fields must be reported in order for a trade report to be considered complete by an SDR”; and (iv) the CFTC should “lengthen reporting deadlines,” such as moving to a T+1 deadline. In addition, he supported the CFTC having data fields that match those established in guidance by the CPMI and IOSCO for real-time and regulatory reporting, which will be finalized during the first or second quarter of 2018.
Remarks of CFTC Chief of Staff Michael Gill before the CFTC KISS Policy Forum
On 12 February, CFTC Chief of Staff Michael Gill delivered remarks at the National Press Club providing updates on the CFTC’s Keep it Simple, Stupid (“KISS”) initiative to simplify CFTC regulations and update outdated rules. Mr. Gill noted that on 3 May 2017 the CFTC requested public comments on ways to simplify and modernize the CFTC’s rules and outlined a number of recommendations the CFTC has taken under consideration based on the feedback received.
o Division of Clearing and Risk (“DCR”): Mr. Gill stated that the DCR is considering: (i) “recommending a proposed change to codify in regulation the process the Commission has followed in granting exemptions from DCO registration”; (ii) amending a number of DCO related regulations to clarify “certain requirements for DCOs that may have caused confusion in the industry, and streamlining the process for comingling futures and swaps in customer accounts”; (iii) “codify[ing] existing no-action relief through amendments to the Commission’s required clearing rules for certain [financial institutions] to qualify for an exemption to the clearing requirement”; (iv) “codify[ing] existing no-action relief relating to an exemption for swaps between affiliates”; and (v) “recommending extensive proposed amendments to current Part 190 regulations [that] would revise and reorganize provisions that pertain to FCM liquidation, add explicit provisions that pertain to a DCO liquidation, clarify general provisions, and simplify standard forms.”
o Division of Market Oversight (“DMO”): Mr. Gill stated that the DMO is considering: (i) a proposed rule amendment that would “revisit, revise and re-propose guidance on peaking supply contracts, including to clarify that other similar customary commercial agreements are not swaps”; (ii) codifying the “no-action letter DMO issued last year with respect to notice filing requirements under the final aggregation rule for position limits [to] clarify when an entity must submit a notice filing to claim an exemption from aggregation of position limits”; (iii) “a revision to remove the applicable ‘hard coded’ reporting levels under Part 15 (Large Trader Reporting Levels) from the regulatory text and instead publish such lists on the CFTC website, allowing staff to update, as appropriate, without requiring a rulemaking”; (iv) reducing the “timeline to complete designated contract market rule enforcement reviews with an effort to streamline the process”; (v) “codify[ing] and improv[ing] several no-action letters with respect to the swap execution facility rules in Part 37 of the Commission’s regulations”; and (vi) “proposing several changes to swap data reporting rules as part of the Commission’s Roadmap to Achieve High Quality Swaps Data issued on July 10, 2017 and the CPMI-IOSCO harmonization process.”
o Division of Swap Dealer and Intermediary Oversight (“DSDIO”): Mr. Gill stated that the DSDIO is considering, among other things: (i) codifying no-action relief to “allow swap dealers to allocate disclosure obligations to other swap dealers acting as executing dealers in prime brokerage transactions”; (ii) amending “several swap dealer business conduct standard rules [to] add flexibility for different types of swap dealers and simplify and clarify requirements”; and (iii) simplifying “risk management rules . . . to allow more effective programmatic risk management rather than prescriptive policies and procedures that don’t apply for many registrants.”
UPCOMING EVENTS AND DEADLINES
o 21 February: FSOC executive session to discuss, among other things, an update on the annual re-evaluation of the designation of a nonbank financial company, reported by Reuters to be Prudential Financial.
o 26 February: comments due on the New York State Department of Financial Services’ proposed regulation to establish a “best interest” standard for entities selling life insurance and annuity products.
o 11 March: comments due on the SEC’s request for comments on the use and necessity of the information collected by Form PF.