CFTC COMMISSIONER O'MALIA ON STATE OF COMMODITY FUTURES INDUSTRY

FROM:  COMMODITY FUTURES TRADING COMMISSION 
Keynote Address by Commissioner Scott D. O’Malia, State of the Industry 2014 Conference, Commodity Markets Council

We Can Do Better: It’s Time to Review Our Rules and Make Necessary Changes

January 27, 2014

Thank you very much for the kind introduction and for inviting me to speak here today.

While it is an honor to be offered a speaking spot, I am also very interested in participating in this conference to learn more about changes that are in store for the commodity merchant businesses. Recent headlines herald the exit of banks from this business. The landscape is changing since the Volcker rule now limits proprietary trading by banks and the Federal Reserve may start assessing new capital charges on bank commodity activities.

Let’s not forget the change that has already come to the commodity space as a result of Dodd-Frank, including the swap dealer definition rule, the position limits final rule and re-proposal, the evolving hedge definitions and the futurization of swaps.

Considering these changes, it is amazing you have let me within a mile of this place, let alone offered me a speaking slot.

Today, I will address three areas where the Commission must make changes. First, I will discuss positive developments in meeting the Commission’s data challenges and our much needed investment in technology. Next, I will discuss challenges in swap trade execution. Finally, I will talk about solutions and possible reforms to rules that negatively impact end-users.

In my opinion, the Commission must make the necessary adjustment to improve our rules when we encounter unexpected outcomes of our rulemakings. In fact, it would be irresponsible of the Commission to ignore problems and to continue implementing its unworkable regulations. The topics I will discuss today are candidates for rule revisions. In the case of data and end users, we will need significant changes. Swap trade execution, on the other hand, requires more targeted reforms.

1. The Commission’s Progress on the Data Front

First, I’d like to address the Commission’s ability to receive and utilize data. I am pleased to announce that the Commission is making progress towards improving the quality of its data. On January 21, the Commission announced that it will establish a cross-divisional team to identify data utilization problems faced by each division and to recommend appropriate solutions.

Until now, nobody has taken ownership to fix our data problems. At last, this will change. In March, the Commission will provide a comment period for market participants to offer suggestions to improve reporting. Based on the comments and its own self-evaluation, the data team will make recommendations to the Commission in June.

I can’t emphasize enough how important it is for the Commission to improve our data quality so it can have an accurate and complete picture of the swaps market. Our ability to perform risk assessments and market oversight will hinge on the quality of our data.

In this regard, I would also like to emphasize the importance of harmonizing the Commission reporting rules with the reporting rules of foreign jurisdictions.

I hope the Commission will reengage with the various jurisdictions that have trade repositories to come up with a global solution to data reporting. As you may know, the European Union reporting rules will be effective on Feb 12, 2014.

By recognizing E.U. trade repositories, we would eliminate the need for dual reporting by U.S. persons trading in Europe and non-U.S. persons trading in the United States. Both regimes can work together to agree on a data standard and taxonomy that can be readily used for identifying risk and performing market surveillance.

Speaking of market surveillance, the Commission’s major oversight functions will be severely impaired if we do not invest in new technology. Investing in technology must be the Commission’s top investment priority.

While on the subject of the Commission’s investment priorities, I would like to note that I appreciate Congressional efforts to provide the Commission with an appropriation of $215 million, a modest increase in current spending levels. It is quite clear from this funding level that the Commission will need to pick its funding priorities carefully.

Tony Blair once said, “It is not an arrogant government that choses priorities, it is an irresponsible government that fails to choose.” I look forward to working with my fellow Commissioners and staff to develop a responsible spending plan with clear deliverable goals that makes technology investment our top priority.

I realize that technology doesn’t run itself, but we must acknowledge we live in a digital age where over 90 percent of markets trade electronically. The future of our compliance and oversight mission must be electronic and data driven. In other words, this agency needs to become a 21st century regulator. So far, we have not articulated our mission and technology priorities, but I believe we can do better.

To ensure that we continue to identify the appropriate corrections, I have included a panel on data at the upcoming February 10 Technology Advisory Committee (TAC) meeting, which I chair. At the TAC meeting, the pertinent Commission Division Directors will share their challenges in utilizing our swaps data.

2. Swap Trade Execution–Positive Progress Report

Now let’s turn to my second topic: swap trade execution.

Although it has been off to a rocky start, we now have twenty-one temporarily registered and operational swap execution facilities (SEFs). I am excited about the opportunity for SEFs to bring transparency to the swaps market.

Still unknown is whether SEFs will become a spitting image of a designated contract market (DCM) or whether they open the door for competition, innovation and transparency in the derivatives markets. As the Commission progresses to the permanent registration phase, it is important to remember that Dodd-Frank did not intend SEFs to look like DCMs. SEFs’ trading protocols must reflect the diversity of market participants and diversity of products traded on these platforms. The Commission must resist the temptation to impose a one-size-fits-all approach to SEF platforms.

Unfortunately, we have already started seeing the results of the Commission’s overly prescriptive regulatory approach when Commission staff deemed certified Javelin and TrueEx’s made available to trade (MAT) requests for standard interest rate benchmark swaps. Staff also noted that any packaged transactions involving these mandatorily traded swaps are subject to the mandatory trade execution requirements. However, in the same breath, staff is now contemplating some relief from the mandatory trade execution requirement for packaged transactions.

In my view, the real break down in the MAT certifications process occurred when the Commission gave up its authority to review these first-of-a-kind products. The Commission and not staff should be making these decisions.

Today, the market trades multi-leg butterfly and curve trades as well as combinations of swaps and Treasury bonds that are subject to Securities and Exchange Commission (SEC) jurisdiction. I understand it is more cost-effective to trade these products as a package. Unfortunately, the SEF rules have not caught up to the realities of today’s market. This is another area where we can do better.

I hope the Commission will identify the critical components of a solution that involves trading, clearing, and reporting of these packaged trades. The Commission must encourage trading on SEF platforms, while, at the same time, protecting the efficiency of trading various combination products. It is also important to recognize that the energy markets utilize packaged transactions. The solutions we develop today will likely impact energy market swaps trading in the future.

The TAC meeting will also address SEF trading to better understand the challenges and opportunities for SEF traded packaged transactions. In my view, Commission staff should have held a MAT roundtable prior to the effective date of the first MAT self-certification. But at least, we will discuss the available options at the TAC meeting before February 17, the mandatory trade execution deadline.

3. Let’s Help End-Users–We Must Do Better

Now, let me turn to my third topic, helping end-users. Yesterday, you heard from former Senator Chris Dodd, whose name appears on the landmark Dodd-Frank legislation. Senator Dodd was quite clear during the legislative debate about the importance of protecting end-users. And, in their letter to the House, both Senators Dodd and Lincoln emphasized the importance of allowing end-users to continue to hedge commercial risk and ensuring that Dodd-Frank regulatory reform does not make this legitimate activity prohibitively expensive.

Regrettably, it has been an uphill battle to get the Commission to follow the express directive from Congress to protect end-users from the reach of Dodd-Frank. As the Commission moves into the rule implementation phase, the impact of our regulations on end-users is becoming more visible. End-users must spend far too much time and resources in order to get the necessary reassurance from the Commission that they are in fact entitled to the protection that Congress afforded them in Dodd-Frank.

It is troubling that our rules require end-users to file numerous forms, filings and reports to validate their commercial behavior, only to be later second-guessed by the Commission regarding what is and what is not a legitimate commercial risk mitigating behavior.

The Swap Dealer Rule Should be Amended to Better Protect End-Users

One rule that must be revisited to provide end-users greater certainty is the swap dealer rule. 1 The rule broadly applies the swap dealer definition to all market participants and then allows for some limited conditional relief, but only if those end-users manage to navigate the market-making definition and do not fall into the trap of the de minimis threshold. To escape entanglement in this regulatory web, it is better to focus on the characteristics of entities rather than their activities.

To give end-users greater certainty, I propose a modest fix that would exclude all cleared trades from the calculation toward any de minimis threshold. This safe harbor would encourage end-users to clear their trades and would provide an additional buffer from being captured in this regulatory mesh. The swap dealer definition was meant to capture entities engaging in dealing activities that could become systemic to their counterparties.2 To the extent that end-users utilize clearing, they should never have been caught up in the de minimis calculation.

Another element of the swap dealer rule that must be corrected is the Special Entity definition. Under this rule, when dealing with Special Entities, such as state, city and county municipal utilities, the $8 billion threshold drops to $25 million. The reasoning behind this distinction was to afford Special Entities special protections, because any loss incurred by a Special Entity would result in members of the public bearing the brunt of the damage.3

That sounds like a noble intention. But, by reducing the threshold, the Commission has limited the number of swap counterparties to the Wall Street dealer banks. In a quick fix, the Commission has since raised the $25million de minimis threshold to $800 million, but this has done nothing to attract commercial participants. These municipal energy firms are large and savvy market participants and should be treated like any other commercial entity. The Commission must fix the paradoxical result of this rule so that commercial counterparties will come back to the market to do business with Special Entities, and Special Entities are not forced to trade exclusively with dealer firms.

Forward Contracts with Volumetric Optionality are Not Swaps

In addition, end-users have been struggling to decipher the Commission swap definition rules4 to determine whether and under what conditions a forward contract with embedded volumetric optionality falls within the forward exclusion.5 To determine whether a volumetric option is a forward or a swap, the rule applies a seven-part test. However, under the seventh factor, contracts with embedded volumetric optionality may qualify for the forward contract exclusion only if exercise of the optionality is based on physical factors that are outside the control of the parties.

This is in complete contradiction as to how volumetric options have been traditionally used by market participants. We need to fix the definition and create reliable and well-defined safe harbors. I also note that both Senators Lincoln and Dodd believe these contracts should not be captured by the swap definition.

Commission Rule 1.35 is Burdensome on Smaller Institutions

There are a handful of rules where the Commission has failed to carefully consider the impact to end-users due to the lack of appropriate cost-benefit analysis. Let’s take Rule 1.35 as an example. 6

This rule requires futures commission merchants (FCMs) and introducing brokers (IBs) to record all electronic communications as part of a trade record, including preliminary conversations that may occur over cell phones if they relate to trading or if they start a conversation that may lead to execution of orders.

In essence, the rule requires the use of hindsight to know if a certain personal conversation led to a trade further down the road, and then it requires that this conversation is recorded in a searchable format. To comply with this rule, FCMs and IBs will need to purchase expensive recording technology.

While large banking institutions will have the means to find a compliance solution, smaller institutions will take the heavy brunt of regulatory compliance. To avoid this situation, the Commission should have performed the necessary analysis beforehand to determine whether the cost, especially to small market participants, outweighed the benefits of this requirement.

The Commission Position Limits Re-proposal Does Not Reflect Commercial Realities

The Commission position limits re-proposal is yet another example of a rule that ignores the realities of end-users’ commercial and risk mitigation operations. For some reason, in the new and supposedly “improved” position limits re-proposal, the Commission has decided to scale back the bona fide hedging exemption.

To put things in perspective, a broader bona fide hedging definition has been in effect since the 1970s. To my knowledge, the previous hedging exemption worked well in the market and the Commission did not encounter any serious regulatory abuses or violations. More importantly, the hedging exemption did not contribute to the financial crisis.

With the passage of Dodd-Frank, Congress gave the Commission a difficult job in setting position limits. On one hand, the Commission is supposed to stop excessive speculation and manipulation, but on the other hand, the Commission must protect the essential price discovery and hedging function of the futures and swaps markets. This is not an easy line to walk.

The Commission must take caution before it prohibits these longstanding and legitimate hedging activities. Unfortunately, this is just another example of where end-users might feel they are on the short end of the stick when it comes to Commission rulemaking, especially when the statute specifically authorizes such activity.7

Again, I have just scratched the surface of some of the issues where the Commission has failed to heed Congressional mandates to protect end-users. Instead, it has imposed massive new documentation and compliance requirements that force end-users to justify their commercial and business operations. These entities did not contribute to the financial crisis, but they will spend an enormous amount of time, money, and effort navigating the new regulatory order.

I believe we can do better. When the Commission spots a rule that imposes unnecessary or undue burdens—or doesn’t have the data to validate the position—the Commission must consider revising the rule to offer cost-effective alternatives, not another barrage of reflexive no-action letters.

Conclusion

The Commission has an express directive from Congress to accomplish two competing objectives: reduce systemic risk in the derivatives markets and protect end-users. In a rush to reduce systemic risk, the Commission has neglected to safeguard end-users from costly compliance with our regulations. It is the Commission’s responsibility to provide the necessary relief to end-users.

I have shared with you three broad areas where I believe the Commission should reconsider its rules to make critical and necessary modifications to take into account commercial interests of end-users.

Finally, I am pleased that we are making the initial strides to improve data quality. But we cannot continue to ignore the technology needs of this Commission. It’s time to focus on technology. The Commission must make the investment that drives its mission. This will certainly make us better.

I look forward to working with the new Commission to address these issues.

1 Further Definition of ‘‘Swap Dealer,’’ ‘‘Security-Based Swap Dealer,’’ ‘‘Major Swap Participant,’’ ‘‘Major Security- Based Swap Participant’’ and ‘‘Eligible Contract Participant,” 77 Fed. Reg. 30595 (May 23, 2012).

2 Id. at 30744.

3 Id. at 30628, referring to documented cases of municipalities losing millions of dollars on swaps transactions because they did not fully understand the underlying risks of the instrument.

4 See Further Definition of ‘‘Swap,’ ’‘‘Security-Based Swap,’’ and ‘‘Security-Based Swap Agreement,’’ Mixed Swaps; Security-Based Swap, Agreement Recordkeeping, 77 FR 48208 (Aug. 13, 2012).

5 The seventh criterion states that the exclusion applies only when “[t]he exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors, or regulatory requirements, that are outside the control of the parties and influencing demand for, or supply of the nonfinancial commodity.” Id. at 48238 n. 341.

6 17 C.F.R. § 1.35.

7 7 U.S.C. § 6a.

SEC COMMISSIONER GALLAGHER SPEECH: PERSPECTIVE ON SEC PRIORITIES

FROM:  SECURITIES AND EXCHANGE COMMISSION 
A Renewed Perspective on SEC Priorities
 Commissioner Daniel M. Gallagher
Forum for Corporate Directors, Orange County, California

Jan. 24, 2014

Thank you, Chris [Cox], for your generous introduction and your invitation to address this truly distinguished gathering.  I was honored that Chris asked me to speak here today.  But it was an even bigger honor to work for Chris when he was Chairman, both as his Counsel and as Deputy Director of the Division of Trading and Markets.  Chris’s incredible intellect and leadership tremendously benefitted the agency during the worst of the financial crisis.  I know I can speak for my colleagues who, like me, toiled in the trenches alongside Chris when I say that Chris was an island of calm in a sea of misguided government intervention.

* * *

This morning, I’d like to discuss two issues that, along with a holistic review of equity market structure, should be at the very top of the SEC’s agenda.  The first is the revamping of our corporate disclosure system, and the other is a set of much needed reforms for the proxy advisory industry.  Each of these issues demands our close attention despite the fact that – at the risk of sounding subversive – neither issue was the subject of a congressional mandate to the Commission.  So while these issues are not among the fashionable diversions of the moment, addressing them would be consistent with what I like to call the Commission’s basic “blocking and tackling” mandates.  We have spent far too little time on such core responsibilities over the last four years, and the neglect is evident.

* * *

Let’s begin with disclosure reform.  The SEC is, first and foremost, a disclosure agency.  Our bedrock premise is that public companies should be required to disclose publicly and in a timely fashion the information a person would need in order to make a rational and informed investment decision.  That is the foundation of our securities law regime and the core principle by which we administer those laws.  We can’t protect investors and foster capital formation in fair and efficient capital markets unless critically important information about public companies is routinely and reliably made available to the public.

At the same time, we need to take seriously the question of whether there can be too much disclosure.  Justice Louis Brandeis famously called sunlight the best disinfectant.[1]  No doubt – but, as my friend and former colleague Troy Paredes pointed out some years ago, investors can be “blinded by the light” of information overload.[2]  From an investor’s standpoint, excessive illumination by too much disclosure can have the same effect as inundation and obfuscation — it becomes difficult or impossible to discern what really matters.  More disclosure, in short, may not always yield better disclosure.

* * *

Investors often say that disclosure documents are lengthy, turgid, and internally repetitive.  Today’s mandated disclosure documents are no longer efficient mechanisms for clearly conveying material information to investors, particularly ordinary, individual investors – myself included.  A recent House of Representatives Appropriations Committee report put it like this:

“Voluminous, overly-complex, legalistic and immaterial corporate disclosures both increase investor confusion and discourage shareholder participation in important corporate governance matters.”[3]

The complexity of today’s disclosure requirements give the Commission cause for self-examination.  SEC rules that require periodic corporate reporting, the detailed instructions that implement them, as well as pertinent staff interpretations and guidance, have been the principal forces shaping modern corporate disclosure.  External forces, too, have played a role, most notably the risk of litigation – much of it absolutely frivolous and solely for the benefit of plaintiffs’ lawyers.  When failing to make an anticipatory disclosure can prompt a shareholder lawsuit, it is rational for those who prepare corporate disclosure documents to prepare for the worst.  The result is a perverse incentive to create prolix disclosure documents that are designed primarily to anticipate and defend against shareholder lawsuits rather than to provide intelligible and pertinent information to the average investor.

* * *

So what should we do?  Should we jump in with both feet to begin a comprehensive review and overhaul of SEC-imposed disclosure requirements under the securities laws?  Or should we take a more targeted approach, favoring smaller steps towards our ultimate reforming goals?  Ordinarily, I would argue for a comprehensive approach to solving almost any problem in securities regulation, since actions in one area frequently have unforeseen and unintended effects in others.

Where disclosure reform is concerned, though, I would prefer to address discrete issues now rather than risk spending years preparing an offensive so massive that it may never be launched.  I’ve been gratified to see that Chair White, too, has expressed an interest in disclosure reform,[4] so I hope and expect that, under her stewardship, the Commission can make real headway on this important issue.

Although the Dodd-Frank Act did not mandate disclosure reform, the JOBS Act required the SEC to study Regulation S-K, our fundamental regulation governing non-financial statement corporate disclosure, to determine where its requirements could be updated “to modernize and simplify the registration process and reduce the costs and other burdens associated with” it for emerging growth companies.[5]  The resulting Commission staff report to Congress called for a reevaluation of the Commission’s disclosure requirements “in order to ensure that existing security holders, potential investors and the marketplace are provided with meaningful and … non-duplicative information upon which to base investment and voting decisions, that the information required to be disclosed by reporting companies continues to be material and that the disclosure requirements are flexible enough to adapt to dynamic circumstances.”[6]

The staff report further emphasized that “economic analysis must … inform any reevaluation of disclosure requirements.”[7]  It’s hard to disagree with any of those conclusions.

* * *

So, notwithstanding the approximately sixty – yes, sixty - Dodd-Frank-mandated rules we have yet to complete, it’s my strong belief that it’s time to get started on disclosure reform.  I’d like to share, based in large part on what I’ve heard from market participants, a few examples of some good, practical issues on which the Commission should focus.

One such issue is “layering disclosure” based on the recognition that some information is inherently material, such as a company’s financial statements, while some is not – for example, the pay-ratio calculation required by Dodd-Frank.[8]

Another issue is the need to streamline Form 8-K disclosure.  Does each of the categories of information now required to be disclosed on Form 8-K really require almost immediate disclosure when a change occurs?

I also believe that we should make a targeted effort to reduce redundancy in filings by providing authoritative guidance explicitly telling issuers where they must disclose and where, by contrast, they need not disclose particular types of information. This would enable those looking for that information, including professional analysts and advisers, to find it or identify its absence easily.

Also in the name of reducing redundancy, it’s high time that we gave priority to streamlining proxy statements and registration statements.  Permitting some of the required financial information to be included in an appendix to the proxy, for example all financial tables other than the summary compensation table, would aid both investors and issuers.  As for registration statements, we could permit forward incorporation by reference in Form S-1 registration statements. That would permit a registrant automatically to incorporate reports filed pursuant to the Exchange Act subsequent to the effectiveness of the registration statement.

We also need to renew our focus on the potential of technology to improve corporate disclosure, acknowledging that our present requirements are almost certainly not those we would have devised for today’s technology-enabled world.[9]  Here, I would be remiss if I did not cite data tagging as an investor-empowering analytic tool for ensuring that information is disclosed and presented in a manner that promotes ease of comparison and analysis.  The SEC’s move to data tagging is an innovation for which Chairman Cox deserves the lion’s share of the credit, and it took vision and persistence, not to mention one heck of a terrific staff.  But make no mistake:  we have not come anywhere close to realizing the potential technology holds for improving our disclosure system.

One small way to further integrate technology into our disclosure regime would be to test a standardized, online disclosure system that requires one-time online disclosure of basic corporate information, mandating that it be updated as necessary with changes tracked, rather than rotely repeated each year in annual disclosure documents.

In addition, we could increase the reliability and authoritativeness of SEC disclosure guidance by issuing significant guidance only with the explicit endorsement of the Commission, rather than as staff guidance.  Guidance issued under a Commission imprimatur would allow registrants to feel more confident in relying on it – especially, I’d note, from a litigation standpoint.

We must also recognize politically-motivated disclosure mandates as the ill-advised anomalies they are and, as an independent, bipartisan agency, express our opposition to the use of the securities disclosure regime to advance policy objectives unrelated to providing investors with information material to investment decisions.  Our new Form SD, adopted to implement a pair of wholly social policy mandates,[10] serves as an example of such policy-driven forays.

These are just examples, and I’m sure that all of you could supplement this short list.

* * *

But we can’t stop there.  No discussion of disclosure reform would be complete without addressing the issue of corporate governance – and no discussion of corporate governance would be complete without considering the role of the proxy advisory industry.  I have spoken about this issue repeatedly, and I’ve been glad to see that the subject of proxy advisor reform has, over the past twelve months, been the subject of a Congressional hearing, academic articles, media reports, rulemaking petitions and even, I’m especially happy to say, a recent SEC roundtable.

Proxy advisory firms have gained an outsized role in corporate governance, both in the United States and abroad.  In the United States, I am sorry to say this is largely a result of the unintended consequences of SEC action.  In 2003, the SEC adopted new rules and rule amendments that required an investment adviser exercising voting authority over its clients’ proxies to adopt policies and procedures reasonably designed to ensure that it votes those proxies in the best interests of its clients.[11]  By adopting this rule, the Commission sought to address, among other goals, an investment adviser’s potential conflicts of interest when voting a client’s securities on matters that affected its own interests.  The Commission’s adopting release noted that “an adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendations of an independent third party.”[12]

Proxy advisory firms realized the potential windfall offered by these new rules, and sought guidance from the SEC staff accordingly.  The result was the issuance of two staff no-action letters that effectively blessed the practice of investment advisers rotely voting the recommendations of proxy advisors.[13]  I have spoken frequently and at length about the perceived safe harbor that these letters created and the fiduciary and other concerns they raise, and I have called for prompt Commission action to address the harm they have done.[14]

In a 2010 concept release often called the “proxy plumbing release,” the Commission revisited the question of proxy advisory firms by highlighting several issues, including conflicts of interest and the lack of accuracy and transparency in formulating voting recommendations.[15]  Attention to proxy advisory firms has, since then, increased both in the United States and abroad.[16]  

Last month’s Commission roundtable on the issue brought together a distinguished and diverse group of participants to discuss the role of proxy advisory firms and the services they provide.  Participants included representatives from proxy advisory firms, institutional shareholders, pension funds, investment advisors, legal practitioners and groups representing corporate secretaries and directors.  Among the topics discussed were the influence of proxy advisers on institutional investors, the lack of competition in this market, the lack of transparency in the proxy advisory firms’ vote recommendation process and, significantly, the obvious conflicts of interest when proxy advisory firms provide advisory services to issuers while making voting recommendations to investors.[17]

The feedback we have received confirms that the roundtable was an important first step towards proxy advisory reform.  While not everyone agrees on what the next steps should be, I see a common thread: there is a clear need for reform and sustained SEC attention.  The spirited, in depth discussions that took place at the roundtable and a burgeoning proxy advisory services comment file are evidence enough.[18]  In that vein, I want to take this opportunity to ask each of you to join in thinking about the influence of proxy advisory firms and I encourage you to provide your views to the Commission.  Start by asking yourselves whether the current role of proxy advisory firms and rote reliance on them by institutional investors advances the best interests of shareholders.  I think the answer is obvious, but the Commission can benefit from your views on which reforms would be most impactful.

* * *

In conclusion, I very much hope you will engage vigorously in the conversation regarding reforms to both our corporate disclosure system and the proxy advisory industry.  We need to hear directly from those of you who are daily and directly affected by the status quo.  As helpful as they have been, we don’t need any more concept releases or roundtables.  In both of these priority areas, we have a good idea of the problems and what needs to be done to fix them – and even where to begin, which is often the hardest part of enacting reforms.  There is no reason for further delay.  We have an opportunity to make good, incremental progress in this area.  We should not let a fixation on the perfect put at risk, or even delay getting started making such progress.

I appreciate the opportunity to share these thoughts with you this morning and look forward to your engagement – as well as your questions.

[1]   Louis D. Brandeis, Other People’s Money at 92 (1914).

[2]   Troy A. Paredes, “Blinded by the Light: Information Overload and Its Consequences for Securities Regulation,” 81 Wash. U. L. Q. 417 (2003). Available at:   http://digitalcommons.law.wustl.edu/lawreview/vol81/iss2/7 .

[3]   House Rep’t 113-172, Financial Services and General Government Appropriations Bill, 2014, at 71.

[4]   M. J. White, “The Path Forward on Disclosure,” speech to the National Association of Corporate Directors — Leadership Conference 2013 (Oct. 15, 2013). Available at: http://www.sec.gov/News/Speech/Detail/Speech/1370539878806.

[5]   JOBS Act, sec. 108(a).  The SEC Staff’s report was issued on December 20, 2013.  See, “Report on Review of Disclosure Requirements in Regulation S-K” (Dec. 2013) (“S-K Report”), available at http://www.sec.gov/news/studies/2013/reg-sk-disclosure-requirements-review.pdf.

[6]   S-K Report at 93.

[7]   Id. at 94.

[8]   Section 953(b).

[9]   Professor (and former SEC Commissioner) Joe Grundfest and former SEC Director of Corporation Finance Alan Beller made this point in their 2008 paper, “Reinventing the Securities Disclosure Regime: Online Questionnaires as Substitutes for Form-Based Filings,” Rock Center for Corporate Governance, Stanford University, Working Paper Series No. 2 (Aug. 4, 2008). Available at: http://ssrn.com/abstract=1235082.

[10]   The Commission adopted Form SD (17 CFR 249.448), in conjunction with adopting its rule to implement Section 1502 of the Dodd-Frank Act (“Conflict Minerals”) (Rel. No. 34-67716 (Aug. 22, 2012)). That same day, the Commission also adopted a rule to implement Section 1504 (“Disclosure of Payments by Resource Extraction Issuers”) of that Dodd-Frank Act, to which Form SD would also apply (Rel. No. 34-67717 (Aug. 22, 2012)). Both rules were subsequently challenged in court. The district court upheld the conflict minerals rule; its decision was appealed and argued in the D.C. Circuit on January 7, 2014.  The resource extraction rule was vacated and remanded to the Commission.

[11]   Final Rule: Proxy Voting by Investment Advisers, 68 FR 6585, available at http://www.sec.gov/rules/final/ia-2106.htm.

[12]   Id. Emphasis added.

[13]   See “Investment Advisers Act of 1940—Rule 206(4)-6: Institutional Shareholder Services, Inc.” SEC letter to Mari Anne Pisarri, September 15, 2004, http://www.sec.gov/divisions/investment/noaction/iss091504.htm and “Investment Advisers Act of 1940—Rule 206(4)-6: Egan-Jones Proxy Services,” SEC letter to Kent S. Hughes, May 27, 2004, http://www.sec.gov/divisions/investment/noaction/egan052704.htm.

[14]   See Commissioner Daniel M. Gallagher, “Remarks before the Corporate Directors Forum,” January 29, 2013 available at http://www.sec.gov/News/Speech/Detail/Speech/1365171492142#.UpENB3cgqSo; See Commissioner Daniel M. Gallagher, “Remarks at 12th European Corporate Governance & Company Law Conference,” May 17, 2013 available at http://www.sec.gov/News/Speech/Detail/Speech/1365171515712#.UpEMtXcgqSo; See Commissioner Daniel M. Gallagher, “Remarks at Society of Corporate Secretaries & Governance Professionals,” July 11, 2013 available at http://www.sec.gov/News/Speech/Detail/Speech/1370539700301#.UpEMPHcgqSo; See Commissioner Daniel M. Gallagher, “Remarks at Georgetown University’s Center for Financial Markets and Policy Event,” October 30, 2013 available at http://www.sec.gov/News/Speech/Detail/Speech/1370540197480#.UpEL9HcgqSo.

[15]   See Concept Release on the U.S. Proxy System, July 14, 2010, available at http://www.sec.gov/rules/concept/2010/34-62495.pdf.

[16]   See Commissioner Daniel M. Gallagher, “Remarks at Transatlantic Corporate Governance Dialogue Conference: The Realities of Stewardship for Institutional Owners, Activist Investors and Proxy Advisors,” December 3, 2013 available at http://www.sec.gov/News/Speech/Detail/Speech/1370540436067#.UtVfr3f3Jn8.

[17]   See SEC’s Proxy Advisory Services Roundtable Webpage available at
http://www.sec.gov/spotlight/proxy-advisory-services.shtml.

[18]   See Comments on Proxy Advisory Firm Roundtable available at http://www.sec.gov/comments/4-670/4-670.shtml.

CAPITAL REQUIREMENT PHILOSOPHIES BY SEC COMMISSIONER GALLAGHER

FROM:  SECURITIES AND EXCHANGE COMMISSION 
The Philosophies of Capital Requirements
 Commissioner Daniel M. Gallagher
Washington, DC
Jan. 15, 2014

Thank you, Sarah [Kelsey, Exchequer Club Secretary], for that introduction.  I’m very pleased to be here this afternoon.

Today, I’d like to talk about regulatory capital.  Given the usual reaction I get when I raise this subject, just to be safe, I’ve barred the exits!

In all seriousness, though, there’s been a great deal of attention paid to regulatory capital recently, including new Dodd-Frank requirements, Basel III implementation (or non-implementation) issues, and even bipartisan Congressional efforts to raise capital requirements for large banks.[1]  Almost all of that attention has naturally centered on the question of how much capital a financial institution should be required to hold.  What’s missing from the conversation, however – and what I’d like to focus on today – is a proper understanding of the theories behind capital requirements, both for banks and for non-bank financial institutions.

You may have noticed my reference to the theories behind capital requirements, rather than a single theory.  If so, you’re one step ahead of many policymakers both here and abroad, who often implicitly or explicitly advance a single, one-size-fits-all approach to capital.  As I’ll explain, this is a mistaken view that has the potential to impact the U.S. economy.

Understanding capital requirements begins with addressing the fundamental question of why financial institutions need minimum capital levels.  In the banking sector, where the regulated entities operate in a principal capacity and are leveraged institutions, capital requirements are rightly designed with the paramount goal of enhancing safety and soundness, both for individual banks and for the banking system as a whole.  Bank capital requirements serve as an important cushion against unexpected losses.  They incentivize banks to operate in a prudent manner by placing the bank owners’ equity at risk in the event of a failure.  They serve, in short, to reduce risk and protect against failure, and they reduce the potential that taxpayers would be required to backstop the bank in a time of stress.

Capital requirements for broker-dealers, however, serve a different purpose.  In the capital markets, we want investors and institutions to take risks – informed risks that they freely choose in pursuit of a return on their investments.  Eliminate the risk of an investment, and you eliminate the opportunity for a return as well.  Capital markets, in short, are predicated on risk.

Whereas bank capital requirements are based on the avoidance of failure, broker-dealer capital requirements are designed to manage failure by providing enough of a cushion to ensure that a failed broker-dealer can liquidate in an orderly manner, allowing for the orderly transfer of customer assets to another broker-dealer.

These two models of capital requirements, in other words, differ in fundamental ways - it’s certainly not a matter of comparing apples to apples.  Applying bank-based capital requirements to non-bank financial entities, in fact, is rather like trying to manage an orange grove using apple orchard techniques – it’s the equivalent of trying to determine how best to grow oranges to be used in orange pie, orangesauce, and, as a special treat, delicious caramel oranges on a stick.  If you think that metaphor is a bit strained, well, it is – but nowhere near as strained as imposing a bank capital regime on broker-dealers.

In order to fully understand the danger of imposing bank capital requirements on non-bank institutions, it’s helpful to take a bit of a detour to review the actions of the Federal Reserve during the height of the financial crisis, which leads us to that dreaded word: bailouts.

The word “bailout,” of course, has come to stand for everything wrong with the federal government’s response to the financial crisis.  As with, I imagine, everyone except for bailout recipients themselves, I find the idea of using taxpayer money to prop up insolvent financial institutions repugnant.  There’s a basic ant-and-grasshopper dynamic to bailouts: we naturally recoil from the idea of using the resources of prudent taxpayers to rescue institutions felled by their lack of prudence.  So let’s be absolutely clear: I hate bailouts.  We should all hate bailouts.  Case closed.

But…what, exactly, is a bailout?  Notwithstanding the risk of being misunderstood on an incredibly sensitive topic, I believe it is critically important to understand what is, and what is not, a bailout.  And here we come to the concept of the Federal Reserve as the lender of last resort and the crucial difference between insolvency and illiquidity for financial institutions.

The Federal Reserve Act of 1913 established the Fed, through its use of the discount window, as the nation’s lender of last resort.  The best starting point for understanding the concept of a lender of last resort remains Walter Bagehot’s seminal work Lombard Street.  Writing in 1873, Bagehot, who may be familiar to you from his work as editor-in-chief of The Economist or his treatise on the English constitution, set forth what is sometimes referred to as “Bagehot’s Dictum.”  My friend Paul Tucker, former Deputy Governor of the Bank of England, succinctly summarized Bagehot’s Dictum as follows: “to avert panic, central banks should lend early and freely…to solvent firms, against good collateral, and at ‘high rates.’”[2]

As you may recall me noting, I’m starkly against bailouts.  But offering access to the discount window to illiquid, but not insolvent, banks against good collateral comports with the traditional role of a central bank as the lender of last resort and falls outside even an expansive definition of the dreaded concept of a bailout.  Indeed, it falls squarely within the traditional understanding of a central bank’s paramount purpose.

In 2008, however, the Fed went well beyond offering access to the discount window to depository institutions in its capacity as the lender of last resort.  Instead, what happened in 2008 was that the Fed became the investor of last resort, a tremendously different concept which does indeed lend itself to the terrible title of “bailout.”  The acquisition of almost 80 percent of AIG in exchange for an $85 billion loan, for example, as well as the ownership of $29 billion in former Bear Stearns assets, marked a fundamental departure from the Fed’s traditional role.  As explained by Professor Allan Meltzer, author of a history of the Federal Reserve, “This is unique, and the Fed has never done something like this before.  If you go all the way back to 1921, when farms were failing and Congress was leaning on the Fed to bail them out, the Fed always said, ‘It's not our business.’ It never regarded itself as an all-purpose agency.” [3] One reporter aptly deemed the Fed’s actions in the financial crisis as a transformation into “The Fed Inc.”[4]

As the Fed explains on its web page detailing its “Mission,”[5] in an amusingly understated manner, “Over the years, its role in banking and the economy has expanded.”[6]  The Fed describes its current duties as conducting the nation's monetary policy, supervising and regulating banking institutions, maintaining the stability of the financial system and providing financial services to depository institutions, the U.S. government, and foreign official institutions.[7]  Notwithstanding the breadth of this mandate and the full plate of work you’d expect it to engender, the Fed has also taken steps to extend its regulatory paradigm – designed, once again, to prevent bank failures - to non-bank institutions as well.  Such institutions include broker-dealers, which, as I noted earlier, have their own regulatory capital regime that is designed to manage, rather than prevent, failure in order to ensure the return of customer assets. In addition, Title II of Dodd-Frank was explicitly designed not to prevent failure, but instead to manage the liquidation of large, complex financial institutions close to failure – indeed, the very name of the Title is “Orderly Liquidation Authority.”

In light of this, a more cynical person might suggest that the Fed’s efforts to extend the failure-prevention paradigm of bank capital regulation to financial entities that are already subject to failure-management regulatory schemes implies an institutionalization of the concept of too-big-to-fail.  Good thing I’m not a cynical guy.

I digress, but it is important to remember that the Fed’s lender of last resort activity during the financial crisis came after its intervention in the Bear failure as well as its bailout of AIG.  To be fair, once the Fed resumed its traditional role as the lender, rather than investor, of last resort, it did so robustly.  By March 2009, the Fed had lent a staggering $7.7 trillion dollars to beleaguered financial institutions, including $1.2 trillion on one day alone on December 5, 2008.[8]  And you thought your holiday spending was high!

So what does all of this have to do with capital?  To answer that question requires a better understanding of the recent and disturbing fascination with imposing bank-theory capital requirements on non-bank institutions.  Here, the recent FSOC intervention in the money market mutual fund space is quite instructive.

In August 2012, a lack of consensus among the Commission on the best way to proceed with proposing reforms to our money market fund rules led to an ill-advised abdication of the issue to FSOC, which enthusiastically took up the cause, leading to an unprecedented -- albeit invited -- incursion into the regulatory purview of an independent regulator.  The result was the issuance, in November 2012, of a report entitled “Proposed Recommendations Regarding Money Market Mutual Fund Reform,” in which FSOC floated – pun intended – the concept of a “NAV buffer,” that is, a capital requirement for money market funds.[9]

As I delved into the issue of money market fund reform following my return to the SEC as a Commissioner, it quickly became apparent to me that, perhaps in the hopes of staving off more stringent regulation, the industry was coalescing behind a capital buffer requirement of approximately 50 basis points, to be phased in over a several year period.  For the largest money market funds, this would have resulted in an approximately 1 to 200 ratio – a $500 million buffer to support $100 billion in investments.  This would amount to chicken feed in any serious capital adequacy determinations.

The ostensible reasoning behind a capital buffer for money market funds is that it would serve to mitigate the risk of investor panic leading to a run on a fund.  Common sense, however, belies this notion.  Do we really believe that investor panic would be assuaged by the comforting knowledge that for every one dollar they had on deposit, the money market fund had set aside half a penny?

Common sense also leads to the conclusion that there is no reason to assume that this view of capital requirements as a panacea to mitigate run risk is limited to money market funds.  Indeed, the now notorious “Asset Management and Financial Stability” report issued by Treasury’s Office of Financial Research last September featured similar reasoning, as reflected in its implied support for “liquidity buffers” for asset managers.[10]

As I noted in my statement at last June’s open meeting at which the Commission voted to propose reforms to our money market fund rules, which by the way thankfully did not include a capital buffer, “It became clear to me early on in this process that the only real purpose for the proposed buffer was to serve as the price of entry into an emergency lending facility that the Federal Reserve could construct during any future crisis – in short, the “buffer” would provide additional collateral to facilitate a Fed bailout for troubled MMFs.”[11]

Indeed, some Fed officials and academics[12] have suggested as much.  In a speech delivered last February, New York Fed President Bill Dudley, while expressing support for the FSOC-proposed money market fund reform mechanisms of a NAV buffer and a “minimum balance at risk,” explained his concern that “even after such reforms, we would still have a system in which a very significant share of financial intermediation activity vital to the economy takes place in markets and through institutions that have no direct access to an effective lender of last resort backstop.”[13]  He went on to raise the possibility of expanding access to the lender of last resort to additional entities in exchange for “the right quid pro quo—the commensurate expansion in the scope of prudential oversight.” Arguing that “[s]ubstantial prudential regulation of entities—such as broker-dealers —that might gain access to an expanded lender of last resort would be required to mitigate moral hazard problems,” he concluded, “Extension of discount window-type access to a set of nonbank institutions would therefore have to go hand-in-hand with prudential regulation of these institutions.”[14]

Fed Governor Daniel Tarullo, on the other hand, indicated his discomfort with extending access to the discount window to non-bank entities in a speech last November, noting that he was “wary of any such extension of the government safety net.”  In the context of addressing the “vulnerabilities” of short-term wholesale funding, he stated that he “would prefer a regulatory approach that requires market actors using or extending short-term wholesale funding to internalize the social costs of those forms of funding”[15] – that is, an increased capital charge. In a different speech earlier last year, he cited the risk of “regulatory arbitrage” if increased capital charges were applied “only to some types of wholesale funding, or only to that used by prudentially regulated entities”[16] and concluded, “Ideally, the regulatory charge should apply whether the borrower is a commercial bank, broker-dealer, agency Real Estate Investment Trust (REIT), or hedge fund.”[17]

All of this adds up to a terribly muddled situation.  Is the Fed seeking to impose bank-based capital charges on non-bank entities in conjunction with granting them access to the discount window at the cost of submitting to prudential regulation, as Mr. Dudley suggests?  Or is the situation just the opposite, as Governor Tarullo implies – would those additional capital charges be intended to prevent non-prudentially regulated financial entities from ever relying upon, as Governor Tarullo puts it, an extension of the “government safety net” the discount window provides?

Put another way, is the goal to expand the Fed’s role by making it the lender of last resort to non-bank entities such as money market funds and broker dealers, or is it to use its Bank Holding Company Act authority and its role in FSOC to dictate capital requirements to non-bank entities in order to prevent those entities from ever gaining access to the discount window?

These are more than purely semantic questions, although semantics play a role: one man’s expansion of the Fed’s role as the lender of last resort is another man’s institutionalization of bailouts for failing financial institutions.

In my opinion, both Governor Tarullo and Mr. Dudley raise very good points that warrant a healthy debate.  The issues they raise, however, as well as the more general issue of how much capital is enough in the banking and capital markets, create a degree of confusion about the Fed’s role as the lender of last resort.  Should the Fed still perform that role?  If so, when and for what entities?  Does such lending, in fact, constitute a bailout?

All of these questions require answers as we debate questions of capital adequacy.  If we are to assume that the Fed will not, or cannot, expand its role as the lender of last resort to non-bank entities, including non-bank subsidiaries of bank holding companies, would it ever be possible to set capital requirements at a level that would guarantee avoidance of 2008-type scenarios?  I think not, even if we were to impose capital requirements of 100%.  To me, therefore, capital markets regulators simply cannot stray from the theory of capital as a tool to facilitate the unwinding of a failed firm with the goal of returning customer assets.

I certainly don’t want to leave the impression that I disregard the Fed’s concerns about capital requirements for bank affiliated non-bank financial institutions.  Indeed, it is my hope in the coming year to work with Commission staff and FINRA to begin an in-depth review of whether it would be appropriate to establish separate capital rules for bank-affiliated broker-dealers.  If we determine that such a bifurcated broker-dealer capital regime would be appropriate, however, any such regime would be based on the principles of our current program for broker-dealer net capital, and it would be crafted to stand on its own, without any reference to the discount window.  On this and related issues, it is far past time that the SEC play an active role in the policy debate in order to ensure the ongoing vibrancy of our capital markets.

Before I conclude, I’d like to make one final point that is obvious but still needs to be reiterated: the judgment calls regulators make in establishing capital rules incentivize regulated entities in a manner that inevitably results in unforeseen (although often quite foreseeable) externalities.  A classic example is the beneficial capital treatment provided to certain asset-back securities under what’s known as the “Recourse Rule.”[18]  The Recourse Rule, issued by the Fed, the FDIC, the OCC and OTS as a supplement to their implementation of Basel I, hugely privileged highly rated ABS as well as ABS issued or guaranteed by a GSE.  How hugely? Well, for every $100 of highly rated or GSE sponsored ABS, well-capitalized banks had to set aside $2.  This compared to a $5 set-aside for unsecuritized mortgage loans and a $10 charge for commercial loans or corporate bonds.  In other words, by holding ABS from these favored categories, banks could reduce their capital requirements by 60% compared to holding an equivalent amount of mortgage loans and by 80% compared to holding corporate loans or bonds.

I’m reminded of the ubiquitous TV commercials featuring children’s responses to simple questions: what’s better, bigger or smaller, faster or slower, more or less?  As the ads say, it’s not complicated.  Concluding that setting aside less capital was better than setting aside more capital, banks loaded up their balance sheets accordingly, and by 2008, a staggering 93 percent of all the mortgage-backed securities held by American banks were either GSE-issued or rated AAA.[19]  As noted in a 2010 report issued by the American Enterprise Institute, “If not for the recourse rule's privileging of mortgage-backed bonds, the burst housing bubble almost certainly would not have caused a banking crisis. The banking crisis, in turn, froze lending and caused the Great Recession.”[20]

As the Recourse Rule illustrates, regulatory capital requirements play a tremendous role in incentivizing financial institutions’ holdings.  All the more important, therefore, that regulators use the right tool for the right job.  We rightly take great pride in our capital markets, the deepest and safest in the world.  We’re an entrepreneurial nation, and taking risks, whether with respect to investments or otherwise, is as American as apple pie.  Superimposing upon those markets a capital regime based on the safety-and-soundness banking paradigm, on the other hand, would be as sensible as orange pie.

Thank you all for your attention this afternoon.  I’d be happy to take questions.


[1] Terminating Bailouts for Taxpayer Fairness Act of 2013, S. 798, 113th Cong. (2013).

[2] Paul Tucker, Deputy Governor, Financial Stability, Bank of England, The Repertoire of Official Sector Interventions in the Financial System: Last Resort Lending, Market-Making, and Capital (May 28, 2009), available at http://www.bankofengland.co.uk/archive/Documents/historicpubs/speeches/2009/speech390.pdf.

[3] Edmund L. Andrews, A New Role for the Fed: Investor of Last Resort, N.Y. Times, September 18, 2008, available at http://www.nytimes.com/2008/09/18/business/18fed.html?pagewanted=print.

[4] Id.

[5] http://www.federalreserve.gov/aboutthefed/mission.htm

[6] Id.

[7] Id.

[8] Bob Ivry, Bradley Keoun and Phil Kuntz, Secret Fed Loans Gave Banks $13 Billion Undisclosed to Congress, Bloomberg, November 27, 2011, available at

http://www.bloomberg.com/news/2011-11-28/secret-fed-loans-undisclosed-to-congress-gave-banks-13-billion-in-income.html. By comparison, Treasury’s much better-known TARP program entailed a mere $700 billion.

[9] Financial Stability Oversight Council, “Proposed Recommendations Regarding Money Market Mutual Fund Reform” (November 2012), available at http://www.treasury.gov/initiatives/fsoc/Documents/Proposed%20Recommendations%20Regarding%20Money%20Market%20Mutual%20Fund%20Reform%20-%20November%2013,%202012.pdf.

[10] U.S. Department of Treasury, Office of Financial Research, “Asset Management and Financial Stability,” (September 2013), available at http://www.treasury.gov/initiatives/ofr/research/Documents/OFR_AMFS_FINAL.pdf.

[11] Daniel M. Gallagher, Commissioner, Sec. & Exch. Comm’n, Statement at SEC Open Meeting – Proposed Rules Regarding Money Market Funds (June 5, 2013), available at

 http://www.sec.gov/News/Speech/Detail/Speech/1365171575594#.UsneCvRDvqN.

[12] See, e.g., Comment Letter of Jeffrey N. Gordon (File No. FSOC-2012-0003) (Feb. 28, 2013), available at http://www.regulations.gov/#!documentDetail;D=FSOC-2012-0003-0131).

[13] William C. Dudley, President and Chief Executive Officer, Federal Reserve Bank of New York, Fixing Wholesale Funding to Build a More Stable Financial System (February 1, 2013), available at      http://www.newyorkfed.org/newsevents/speeches/2013/dud130201.html.

[14] Id.

[15] Daniel K. Tarullo, Governor, Board of Governors of the Federal Reserve System, Shadow Banking and Systemic Risk Redgulation (November 22, 2013), available at http://www.federalreserve.gov/newsevents/speech/tarullo20131122a.htm.

[16] Daniel K. Tarullo, Governor, Board of Governors of the Federal Reserve System, Evaluating Progress in Regulatory Reforms to Promote Financial Stability (May 3, 2013), available at http://www.federalreserve.gov/newsevents/speech/tarullo20130503a.htm.

[17] Id.

[18] Risk-Based Capital Guidelines; Capital Adequacy Guidelines; Capital Maintenance: Capital Treatment of Recourse, Direct Credit Substitutes and Residual Interests in Asset Securitizations, 66 Fed. Reg. 59613 (November 29, 2001).

[19] Jeffrey Friedman and Wladimir Kraus, “A Silver Lining to the Financial Crisis,” American Enterprise Institute for Public Policy Research Regulation Outlook at 3 (January 2010), available at http://www.aei.org/files/2010/01/19/01-2010-Regulation-g.pdf (citing Viral V. Acharya and Matthew Richardson, “Causes of the Financial Crisis,” Critical Review 21 no. 2–3 at 195–210, table 1 (2009), available at http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/acharya_richardson_critical.pdf)). See also Jeffrey Friedman, “A Perfect Storm of Ignorance,” Cato Policy Report (January/February 2010), available at http://www.cato.org/policy-report/januaryfebruary-2010/perfect-storm-ignorance.  Note that this figure would be even higher if it included Recourse Rule-friendly AA-rated securitizations.

[20] Friedman and Kraus at 4.

FDIC ALERTS CONSUMERS TO NEW PROTECTIONS FROM RISKY LOANS

FROM:  FEDERAL DEPOSIT INSURANCE CORPORATION 
December 12, 2013

For anyone thinking about buying a home or shopping for a mortgage, the Fall 2013 issue of FDIC Consumer News features an overview of important rules taking effect soon that are intended to protect consumers from risky loans. The coverage includes practical tips when shopping for a loan and for avoiding mortgage scams. Additional articles offer suggestions on options to consider if an institution turns you down for an account based on a report of a previously closed checking or savings account, as well as information on using a financial institution's social media site to communicate or conduct business with a bank. Here's an overview of this issue, which also marks the 20th anniversary of the FDIC newsletter:

New mortgage rules: Important new rules from the Consumer Financial Protection Bureau, which will implement provisions of the 2010 Dodd-Frank financial reform law, are primarily intended to ensure that consumers are not encouraged by a lender or loan broker to take a mortgage that they don't have the ability to repay. Other provisions will help consumers do a better job of protecting themselves during the loan origination process. Most of the new rules will take effect on January 10, 2014.

Mortgage scams: FDIC Consumer News is reminding mortgage borrowers to watch out for scammers who falsely claim to be lenders, loan servicers, financial counselors, representatives of government agencies or other professionals wanting to "help" fix loan payment problems. The newsletter presents common warning signs of fraudulent offers.

If you're turned down for a checking account: Certain "consumer reporting" companies can legally collect information from financial institutions on aspects relating to a consumer's checking account, such as the reasons an account was closed. And just as a negative credit report can hurt someone's ability to borrow from a financial institution, a checking history that shows a closed account because of unpaid overdrafts or other mismanagement can hurt that person's ability to open a new account. FDIC Consumer News offers suggestions for consumers who are unable to open a new account, including the importance of reviewing a copy of the report and disputing errors.

Using financial institutions' social networking sites: Many people interact with businesses on social media sites such as Facebook, Google+ and Twitter. Banks are also using social media to advertise their products and services, obtain consumer feedback and, in some cases, provide a gateway for customers to access their accounts. There can be consumer benefits, including finding out about new products or special offers more quickly, but users also need to be careful, such as by protecting personal, confidential or account information in their posts.

SEC ANNOUNCES $14 MILLION AWARD TO WHISTLEBLOWER

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

The Securities and Exchange Commission today announced an award of more than $14 million to a whistleblower whose information led to an SEC enforcement action that recovered substantial investor funds.  Payments to whistleblowers are made from a separate fund previously established by the Dodd-Frank Act and do not come from the agency’s annual appropriations or reduce amounts paid to harmed investors.

The award is the largest made by the SEC’s whistleblower program to date.

The SEC’s Office of the Whistleblower was established in 2011 as authorized by the Dodd-Frank Act.  The whistleblower program rewards high-quality original information that results in an SEC enforcement action with sanctions exceeding $1 million, and awards can range from 10 percent to 30 percent of the money collected in a case.

“Our whistleblower program already has had a big impact on our investigations by providing us with high quality, meaningful tips,” said SEC Chair Mary Jo White.  “We hope an award like this encourages more individuals with information to come forward.”

The whistleblower, who does not wish to be identified, provided original information and assistance that allowed the SEC to investigate an enforcement matter more quickly than otherwise would have been possible.  Less than six months after receiving the whistleblower’s tip, the SEC was able to bring an enforcement action against the perpetrators and secure investor funds.

“While it is certainly gratifying to make this significant award payout, the even better news for investors is that whistleblowers are coming forward to assist us in stopping potential fraud in its tracks so that no future investors are harmed,” said Sean McKessy, chief of the SEC’s Office of the Whistleblower.  “That ultimately is what the whistleblower program is all about.”

The SEC’s first payment to a whistleblower was made in August 2012 and totaled approximately $50,000.  In August and September 2013, more than $25,000 was awarded to three whistleblowers who helped the SEC and the U.S. Department of Justice halt a sham hedge fund, and the ultimate total payout in that case once all sanctions are collected is likely to exceed $125,000.

By law, the SEC must protect the confidentiality of whistleblowers and cannot disclose any information that might directly or indirectly reveal a whistleblower’s identity.

CFTC ORDERS BAN ON TRADING FOR ONE YEAR FOR COMPANY AND PRINCIPAL IN 'SPOOFING' CASE

FROM:  COMMODITY FUTURES TRADING COMMISSION 

CFTC Orders Panther Energy Trading LLC and its Principal Michael J. Coscia to Pay $2.8 Million and Bans Them from Trading for One Year, for Spoofing in Numerous Commodity Futures Contracts

First Case under Dodd-Frank’s Prohibition of the Disruptive Practice of Spoofing by Bidding or Offering with Intent to Cancel before Execution

Washington DC – The U.S. Commodity Futures Trading Commission (CFTC) issued an Order today filing and simultaneously settling charges against Panther Energy Trading LLC of Red Bank, New Jersey, and Michael J. Coscia of Rumson, New Jersey, for engaging in the disruptive practice of “spoofing” by utilizing a computer algorithm that was designed to illegally place and quickly cancel bids and offers in futures contracts. The Order finds that this unlawful activity took place across a broad spectrum of commodities from August 8, 2011 through October 18, 2011 on CME Group’s Globex trading platform. The CFTC Order requires Panther and Coscia to pay a $1.4 million civil monetary penalty, disgorge $1.4 million in trading profits, and bans Panther and Coscia from trading on any CFTC-registered entity for one year.

According to the Order, Coscia and Panther made money by employing a computer algorithm that was designed to unlawfully place and quickly cancel orders in exchange-traded futures contracts. For example, Coscia and Panther would place a relatively small order to sell futures that they did want to execute, which they quickly followed with several large buy orders at successively higher prices that they intended to cancel. By placing the large buy orders, Coscia and Panther sought to give the market the impression that there was significant buying interest, which suggested that prices would soon rise, raising the likelihood that other market participants would buy from the small order Coscia and Panther were then offering to sell. Although Coscia and Panther wanted to give the impression of buy-side interest, they entered the large buy orders with the intent that they be canceled before these orders were actually executed. Once the small sell order was filled according to the plan, the buy orders would be cancelled, and the sequence would quickly repeat but in reverse – a small buy order followed by several large sell orders. With this back and forth, Coscia and Panther profited on the executions of the small orders many times over the period in question.

David Meister, the CFTC’s Enforcement Director, said, “While forms of algorithmic trading are of course lawful, using a computer program that is written to spoof the market is illegal and will not be tolerated.  We will use the Dodd Frank anti-disruptive practices provision against schemes like this one to protect market participants and promote market integrity, particularly in the growing world of electronic trading platforms.”

The Order finds that Panther and Coscia engaged in this unlawful activity in 18 futures contracts traded on four exchanges owned by CME Group. The activity involved a broad spectrum of commodities including energies, metals, interest rates, agricultures, stock indices, and foreign currencies. The futures contracts included the widely-traded Light Sweet Crude Oil contract as well as Natural Gas, Corn, Soybean, Soybean Oil, Soybean Meal, and Wheat contracts.

In a related matter, the United Kingdom’s Financial Conduct Authority issued a Final Notice regarding its enforcement action against Coscia relating to his market abuse activities on the ICE Futures Europe exchange, and has imposed a penalty of approximately $900,000 against him. Furthermore, the CME Group, by virtue of disciplinary actions taken by four of its exchanges, has imposed a fine of $800,000 and ordered disgorgement of approximately $1.3 million against Coscia and Panther and has issued a six-month trading ban on its exchanges against Coscia.

The CFTC’s $1.4 million disgorgement will be offset by amounts paid by Panther and Coscia to satisfy any disgorgement order in CME Group’s disciplinary action related to the spoofing charged by the CFTC. As CME Group has represented to the Commission, disgorgement paid in the CME Group’s action will be used first to offset the cost of customer protection programs, and thereafter, if the disgorged funds collected exceed the cost of those programs, the excess will be contributed to the CME Trust to be used to provide assistance to customers threatened with loss of their money or securities. The CME Trust is prohibited from utilizing any of its funds for the purpose of satisfying any legal obligation of the CME.

The CFTC thanks the Financial Conduct Authority in the United Kingdom and the CME Group for their cooperation.

Concurring Statement of Commissioner Bart Chilton in the Matter of Panther Energy Trading LLC and Michael J. Coscia

July 22, 2013
While I concur with the settlement in this matter, and agree wholeheartedly with the civil monetary penalty, disgorgement, findings of violations, undertakings, and cease and desist order imposed by the settlement, I am dissatisfied with the imposition of a one-year trading ban as to the respondents. I believe that the type of disruptive trading practice described in the Commission’s complaint is an egregious violation of the Commodity Exchange Act, and warrants the imposition of a much more significant trading ban to protect markets and consumers, and to act as a sufficient deterrent to other would-be wrongdoers.

Additionally, these types of violations of the law are becoming more common with the advent of high frequency traders (HFTs)—traders I’ve termed “cheetahs” due to their incredible speed. The cheetahs are to be commended for their innovative strategies, at the same time, when they violate the law, regulators need to be firm and resolute in our desire to deter such activities. Regulators already have a tough time keeping up with the cheetahs. Without sufficient deterrents, such as meaningful trading bans, many trading cats will simply find other ways to get back to their market hunting grounds. In years past, for example, a trader who was banned for a year from trading might as well consider it a lifetime ban. People on the trading floor would know, customers would know. People wouldn’t want to do business with the trader. In today’s cheetah trading world where identities can be cloaked behind technology, a year trading ban might simply be a nice sabbatical for a cheetah trader to work on some new algo programs to unleash after the trading ban has expired.

At the end of the day, regulators will have to work overtime to be able to keep up with the cheetahs and their superfast trading.  But like the cheetahs are a breed all their own, so are regulators.  And, we are a persistent bunch.  That’s our advantage.  We may have to work out the curve to get all the technology tools we need.  But we will be tenacious and tireless in our efforts to tract down market predators that break the rules.  And, we need those that violate, or may be thinking of violating the law to understand that regulators will always be harsh hard-hitters when the rules are broken.

SEC SAYS IT RECEIVED OVER 3000 WHISTLEBLOWER TIPS OVER THE PAST YEAR

SEC Headquarters.  Credit:  Wikimedia Commons  

FROM: U.S. SECURITIES AND EXCHANGE COMMISSION 

Washington, D.C., Nov. 15, 2012 — Over the past year, the Securities and Exchange Commission received more than 3,000 whistleblower tips from all 50 states and from 49 countries, according to the agency's 2012 Annual Report on the Dodd-Frank Whistleblower Program released today.

The report, which is required by the Dodd Frank Wall Street Reform and Consumer Protection Act, summarizes the activities of the SEC's Office of the Whistleblower.

"In just its first year, the whistleblower program already has proven to be a valuable tool in helping us ferret out financial fraud," said SEC Chairman Mary L. Schapiro. "When insiders provide us with high-quality road maps of fraudulent wrongdoing, it reduces the length of time we spend investigating and saves the agency substantial resources."

Among other things, the report notes:
The SEC made its first award under the new program to a whistleblower who helped the SEC stop an ongoing multi-million dollar fraud. The whistleblower received an award of 30 percent of the amount collected in the SEC's enforcement action, which is the maximum percentage payout allowed by law.
The SEC received 3,001 tips, complaints, and referrals from whistleblowers from individuals in all 50 states, the District of Columbia, and the U.S. territory of Puerto Rico as well as 49 countries outside of the United States.
The most common complaints related to corporate disclosures and financials (18.2 percent), offering fraud (15.5 percent), and manipulation (15.2 percent).
There were 143 enforcement judgments and orders issued during fiscal year 2012 that potentially qualify as eligible for a whistleblower award. The Office of the Whistleblower provided the public with notice of these actions because they involved sanctions exceeding the statutory threshold of more than $1 million.
Under the Dodd-Frank Act, the SEC can pay financial awards to whistleblowers who provide high-quality, original information about a possible securities law violation that leads to a successful SEC enforcement action with more than $1 million in monetary sanctions. The SEC is authorized to pay the whistleblower 10 to 30 percent of the sanctions collected. Awards are paid from the Investor Protection Fund established by Congress to fund payments.

Information on eligibility requirements, directions on how to submit a tip or complaint, instructions on how to apply for an award, and answers to frequently asked questions are available at: www.sec.gov/whistleblower.

SEC MAKES REMARKS AT CREDIT SUISSE GLOBAL EQUITY TRADING FORUM

The following excerpt is from the SEC website:

“Remarks at the Credit Suisse Global Equity Trading Forum
Commissioner Daniel M. Gallagher
Miami Beach, FL
February 17, 2012
Thank you, John [Anderson], for that very kind introduction. I am pleased to be here today.
Before I continue, I need to provide the standard disclaimer that my comments today are my own, and do not necessarily represent the positions of the Commission or my fellow Commissioners.

The broad topic of this conference is “Seeing Beyond,” and this theme is particularly relevant given the focus of my discussion this morning--Dodd-Frank, with a special emphasis on the Volcker Rule. Indeed, for the financial services industry, not just in the U.S. but worldwide, it is very difficult to “see beyond” Dodd-Frank. The largest financial reform law in 70 years has and will continue to impose massive costs on market participants, and will reconfigure the financial services industry worldwide, but the amount of these costs and the scope of this reconfiguration are still highly uncertain.

18 months on, regulators are still working to implement Dodd-Frank, and most, if not all, of the new regulatory undertakings are very much works in progress. Regulators are therefore in a difficult position, because the markets and the public need regulatory guidance and certainty, but that certainty can and should not come at the cost of hasty and ill-considered regulatory initiatives that will damage the real economy that Dodd-Frank ostensibly is designed to protect.

At the SEC, we face this tension every day. Dodd-Frank requires more than 100 rulemakings and studies from the agency. Among these rulemakings, Dodd-Frank mandates that the agency build regulatory infrastructures from scratch in several areas, including the OTC derivatives market, in conjunction with the CFTC; the registration and oversight of municipal advisors; and the registration and oversight of hedge funds and private equity funds. The sheer breadth of rulemaking for the agency argues for a general approach that is systematic yet incremental: particularly in areas where we are creating new regulatory paradigms, we should strive to build a solid foundation, and develop the regulatory regime over time as the markets and our expertise in those markets develop.

It is also important to remember, as we implement Dodd-Frank, what the law did and didn’t do, particularly as it relates to the SEC. Critically, it did notchange the fundamental mission of the agency. Our mission was and still is to protect investors, maintain fair and efficient markets, and promote capital formation. Dodd-Frank did not make us a banking or safety and soundness regulator. We still regulate markets that are risky, and where the taking of risk is critical to capital allocation and the healthy functioning of these markets and the broader economy. Moreover, in terms of the additional responsibilities given to the SEC, both in those areas we traditionally oversee and those that we don’t, Dodd-Frank reinforced Congress’s nearly 80-year commitment to a strong, vibrant, expert and independent equity markets regulator.

Which brings me to the Volcker Rule. I can think of no better topic to address today. It is not only timely--the comment period to the proposal closed this week, to great fanfare in the press--but it may, perhaps more than any other rule regulators are promulgating under Dodd-Frank, have a dramatic impact on world markets and U.S. competitiveness. Moreover, the heart of the Volcker Rule deals with a topic about which the SEC traditionally has--among all the regulators writing rules in this space--the most experience and expertise in regulating. For those reasons--because it is potentially so significant and because it implicates areas of the SEC’s core competence, it is a perfect case study for how to think about approaching Dodd-Frank rulemaking and the SEC’s role in that rulemaking. Indeed, Volcker is especially important to the major U.S. investment banks which until the financial crisis were subject primarily to SEC oversight. Now, as a result of the financial crisis, the survivors are all within bank holding companies.
I want to begin by talking a bit about the statute and the proposed rules. Section 619 of the Dodd-Frank Act,1 commonly known as the “Volcker Rule” even though it is a statutory provision, imposes two significant prohibitions on banking entities and their affiliates. First, the Rule generally prohibits banking entities that benefit from federal insurance on customer deposits or access to the discount window, as well as their affiliates, from engaging in proprietary trading. Second, the Rule prohibits those entities from sponsoring or investing in hedge funds or private equity funds. The Rule identifies certain specified “permitted activities,” including underwriting, market making, and trading in certain government obligations, that are excepted from these prohibitions but also establishes limitations on those excepted activities. The Volcker Rule defines--in expansive terms--key terms such as “proprietary trading” and “trading account” and grants the Federal Reserve Board, the FDIC, the OCC, the SEC, and the CFTC the rulemaking authority to further add to those definitions.

The statute also charges the three Federal banking agencies, the SEC, and the CFTC with adopting rules to carry out the provisions of the Volcker Rule. It requires the Federal banking agencies to issue their rules with respect to insured depositary institutions jointly and mandates that all of the affected agencies, including the Commission, “consult and coordinate” with each other in the rulemaking process. In doing so, the agencies are required to ensure that the regulations are “comparable,” that they “provide for consistent application and implementation” in order to avoid providing advantages or imposing disadvantages to affected companies, and that they protect the “safety and soundness” of banking entities and nonbank financial companies supervised by the Fed.

In October of last year, the Commission jointly proposed with the Federal banking agencies a set of implementing regulations for the Volcker Rule,2with the CFTC issuing a substantively identical set of proposals last month. The proposed rules, which were issued prior to the beginning of my tenure as a Commissioner, are designed to clarify the scope of the Volcker Rule’s prohibitions as well as certain exceptions and limitations to those exceptions as provided for in the statutory text. The proposing release includes extensive commentary designed to assist entities in distinguishing permitted trading activities from prohibited proprietary trading activities as well as in identifying permitted activities with respect to hedge funds and private equity funds. In addition, the release includes over 1,300 questions on nearly 400 topics--you can see why I and my colleague Commissioner Troy Paredes thought that commenters needed 30 extra days when the comment period extension was granted in December.

The proposed implementing rules are designed to clarify the scope of the Volcker Rule’s prohibitions on proprietary trading and hedge fund or private equity fund ownership and identify transactions and activities excepted from those prohibitions, as well as the limitations on those exceptions. For example, the proposed rules would except from the prohibition on proprietary trading transactions in certain instruments--such as U.S. government obligations--as well as certain activities, such as market making, underwriting, risk-mitigating hedging, or acting as an agent, broker, or custodian for an unaffiliated third party. The proposed rules would also establish a three-pronged definition of “trading accounts” which would include exceptions from that definition such as repurchase and reverse repurchase agreements and securities lending transactions, liquidity management positions, and certain positions of derivatives clearing organizations and clearing agencies.
The proposed rules would require a banking entity to establish an internal compliance program designed to ensure and monitor compliance with the prohibitions and restrictions of the Volcker Rule. The rules would require firms with significant trading operations to report certain quantitative measurements designed to aid regulators and the firms themselves in determining whether an activity constitutes prohibited proprietary trading or falls under an exception to that prohibition, such as the exception for market-making transactions. Finally, the proposed rules would set forth activities exempt from the general prohibition on investments in hedge funds and private equity funds: for example, organizing and offering a hedge fund or private equity fund with investments in such funds limited to a de minimis amount, making risk-mitigating hedging investments, and making investments in certain non-U.S. funds.

As I mentioned earlier, the Volcker Rule comment period ended earlier this week.
Although it would of course be premature to share my thoughts on the proposed rules today, based on just a quick review of many substantial comment letters--more than 100 of which were filed just this week--it appears that many of my fears about the effect of the proposed rules on the proper functioning of global markets and the competitiveness of the U.S. financial industry might be well-founded.
Here are a few lines from comment letters:

From a major investment bank: “The list of undesirable consequences is long and troublesome. We share the view, already noted by others, that the Proposal would reduce market liquidity, increase market volatility, impede capital formation, harm U.S. individual investors, pension funds, endowments, asset managers, corporations, governments, and other market participants, impinge on the safety and soundness of the U.S. banking system, and constrain U.S. economic growth and job creation.”3
From a major coalition of financial services trade groups: “Many commenters, including customers, buy-side market participants, industrial and manufacturing businesses, treasurers of public companies and foreign regulators--constituencies with different goals and interests--have agreed that the Proposal would significantly harm financial markets. They point to the negative impacts of decreased liquidity, higher costs for issuers, reduced returns on investments and increased risk to corporations wishing to hedge their commercial activities.”4
From a Fortune 50 corporation: “Although we appreciate the Agencies' efforts to strike the correct balance in the Proposed Rule, we are concerned that the sweeping effects of the Proposed Rule and the narrowness of the exceptions to it would have a substantial and negative impact not only on banks and the broader financial services industry, but also on industrial and other non-financial businesses, and ultimately the real economy.”5
From a large foreign bank: ”We are concerned that certain key aspects of the Proposed Rule are deficient and will lead to a significant negative impact on the efficient functioning of the U.S. and international financial systems, with a particularly disruptive effect on the capital markets.”6
And we have also received very interesting comment from our foreign regulatory counterparts from around the world. In a comment letter filed in December, the Japanese FSA and the Bank of Japan discuss “the importance of taking due account of the cross-border effect of financial regulations and the need to collaborate with the affected countries” and express their concerns over “the potentially serious negative impact on the Japanese markets and associated significant rise in the cost of related transactions for Japanese banks” that they believe would arise from the extraterritorial application of the Volcker Rule. They specifically cite the adverse impact they believe the Rule would have on Japanese Government Bonds, adding, “We could also see the same picture in sovereign bond markets worldwide at this critical juncture.” 7

Last month, British Chancellor of the Exchequer George Osborne wrote to Fed Chairman Bernanke to express his belief that the proposed rules would result in the withdrawal of market making services for non-U.S. debt, making it “more difficult and costlier” for banks to trade non-U.S. sovereign bonds on behalf of clients. Citing the harm that would arise from the potential reduction of liquidity in sovereign markets, he proposed that the U.S. and the U.K. “launch a more active dialogue” on the Rule and its potential impact on markets outside the U.S. 8

Bank of Canada Governor Mark Carney--who was recently named Chairman of the G-20’s Financial Stability Board--has stated that he and other Canadian officials have “obvious concerns” about the proposed rules. He cited the lack of clarity in the proposed rules’ definitions of “market making” versus “proprietary trade,” and the effect the rules would have on non-U.S. government bond markets. In addition, he criticized what he viewed as the Rule’s “presumption” that trades are proprietary, stating that any such presumption “should go in reverse.”9

Lastly, Michel Barnier, the European Commissioner for Internal Markets and Services, has written to Fed Chairman Bernanke and Treasury Secretary Geithner that “[t]here is a real risk that banks impacted by the rule would also significantly reduce their market-making activities, reducing liquidity in many markets both within and outside the United States.”10
To be fair, these are just a few select quotes from commenters who have provided significant and detailed comments on a variety of issues, and there is broad comment generally on the range of issues presented by the rule proposal. However, these comments are very different from the garden variety comments we usually see in our rulemaking. Those usually go something like: “We applaud the Commission’s efforts to do X. . .” I am not hearing any clapping in these quotes. And that’s because the consequences to world markets of getting it wrong are so significant.

This brings me back to thinking about the role of the SEC in this rulemaking, our role generally as a markets regulator, and how, if we at the SEC play our role properly, we can and should ensure that the Volcker Rule meets the aims of Congress without destroying critically important market activity explicitly contemplated by the statute.

In particular, although commenters have raised many concerns about the proposal, including significant issues surrounding extraterritoriality, I want to focus on the skills that the SEC can bring to bear in sorting through the difficult questions posed by distinguishing between permitted trading activities and prohibited proprietary trading activities.

In her Opening Statement introducing the joint rule proposals at an SEC Open Meeting last October, Chairman Schapiro praised the collaborative effort among the five agencies involved in the drafting process, noting that it involved “more than a year of weekly, if not more frequent, interagency staff conference calls, interagency meetings, and shared drafting.”11 It is telling, however, that in his recent testimony before a House Financial Services Subcommittee, CFTC Chairman Gensler, noting his agency’s role as a “supporting member” in the rulemaking process, stated, “The bank regulators have the lead role.”12

I think, however, that both the statute and our expertise compel the SEC to play a strong and vigorous role in the rulemaking. The Volcker Rule applies to “banking entities” and their affiliates, affecting a wide range of financial institutions regulated by the five different agencies. Regardless of the nature of the regulated activities, however, the Rule addresses a set of activities--the trading and investment practices of those entities--that fall within the core competencies of the SEC. Indeed, the Rule expressly envisions that quintessential market-making activity continue within these firms.

By taking a leadership role, the SEC can also ensure that the final rule is consistent with our core mission of protecting investors, maintaining fair and efficient markets and promoting capital formation. These considerations, coupled with the expertise that the SEC brings to the table, should ensure that the bank regulators’ focus on safety and soundness and Dodd-Frank’s overarching focus on managing systemic risk (although many have argued whether the statute will in the end reduce such risk), are balanced by legitimate considerations of investor protection and the maintenance of robust markets.
Senator Jeff Merkley, cosponsor of the Volcker Rule, wrote this week: “Put simply, the Volcker rule takes deposit-taking, loan-making banks out of the business of high-risk, conflict-ridden trading.” 13 In essence, a main goal of the Volcker Rule is a return to the Glass-Steagall division between commercial and investment banking. But, it bears mentioning that the major investment banks that became part of bank holding companies during the 2008 crisis don’t meet this profile: they are not buying lottery tickets with their depositors’ money, because their business models are not premised on taking deposits. They provide services to clients and the objective should be for them to provide the services that they have traditionally provided, that market participants count on, while fulfilling the statutory imperative to ban proprietary trading.

I want to turn to another point I made at the beginning of my remarks, but which I think is an appropriate guiding principle as we undertake not only our consideration of the Volcker Rule but also other significant rulemaking mandated under Dodd-Frank. The aggregate impact of the rulemakings we and our fellow regulators are promulgating is massive, the costs are enormous, and we are doing so at a time when our economy is still hopefully limping towards recovery. These factors all argue for an approach that is careful, systematic, but most importantly regulatorily incremental. It is important to remember that regulators’ authority and oversight responsibilities do not end when final rules are promulgated, and that continued oversight will ensure that regulators can refine and improve the rules as markets organize and develop in response to the rules we write. Importantly, we can and should recalibrate the rules as markets develop and regulators learn more and gather and analyze relevant data. We must avoid regulatory hubris and should not regulate--particularly where the changes are so novel or comprehensive--with the belief that we completely understand the consequences of the regulations we may impose. In many of these areas, including Volcker, missing the mark could have dire and perhaps irreversibly negative consequences.

Before I end, I also wanted to touch on one last regulatory issue, which is surprisingly not a Dodd-Frank rulemaking but which has received quite a bit of attention recently, and that is the possibility of a new proposal to regulate money market funds.

I say “surprisingly not in Dodd-Frank” because, in a 2350-page lawostensibly devoted to solving for systemic risk, Congress did not address money market funds and they are, according to various speeches and news articles, considered a continuing systemic risk notwithstanding significant money market reforms approved by the SEC in 2010.

Any effort to reconsider the SEC’s oversight of money market funds should be guided by the same principles outlined above. First, we should ensure that any prospective reforms in this are consistent with the core missions of the agency to protect investors, maintain fair and efficient markets and promote capital formation. Second, we should consider such proposals carefully, but ultimately we need to let empiricism and not guesswork guide our decision-making.

Last year I posed two questions: “First, for what specific problems or risks are we trying to solve? And second, do we have the necessary data that will allow us to regulate in a meaningful and effective way?” Indeed, I have further refined these simple queries to be even more straightforward: What data do we have that clearly demonstrates the need for reform above and beyond that imposed in 2010? This question has yet to be answered for me, although I understand the Staff is working on it. I anticipate working closely with the economists in the Division of Risk, Strategy and Financial Innovation as they analyze the available data. Only by continuing such a data-driven analysis can we determine if money market fund investors are exposed to unnecessary risk. We also, of course, need to fully understand the impact of any action we could take on the capital formation process and the fair and the efficient functioning of the markets.
Thank you for your patience and for having me here today. I would be happy to answer any questions you may have.”