Today’s [July 23, 2014] reforms will fundamentally change the way that most money market funds operate. They will reduce the risk of runs in money market funds and provide important new tools that will help further protect investors and the financial system in a crisis. Together, this strong reform package will make our financial system more resilient and enhance the transparency and fairness of these products for America’s investors.
Posts Tagged ‘Systemic risk’
Today [July 23, 2014], the Commission considers adopting long-considered reforms to the rules governing money market funds. I commend the hard work of the staff, particularly the Division of Investment Management and the Division of Economic and Risk Analysis (“DERA”), who worked tirelessly to present these thoughtful and deliberate amendments. It is well known that the journey to arrive at the amendments considered today was a difficult one, and I can confidently say that this has been, at times, perhaps one of the most flawed and controversial rulemaking processes the Commission has undertaken.
Money market funds (MMFs) have, since the 2008 financial crisis, been deemed part of the nefarious shadow banking industry and targeted for regulatory reform. In my paper, The Broken Buck Stops Here: Embracing Sponsor Support in Money Market Fund Reform, I critically evaluate the logic behind current reform proposals, demonstrating that none of the proposals is likely to be effective in addressing the primary source of MMF stability—redemption demands in times of economic resources that impose pressure on MMF liquidity. In addition, inherent limitations in the mechanisms for calculating the fair value of MMF assets present a practical limitation on the utility of a floating NAV. I then offer an unprecedented alternative approach—mandatory sponsor support. My proposal would require MMF sponsors to commit to supporting their funds as a condition of offering a fund with a fixed $1 NAV.
Legal and economic issues involving mandatory public disclosure have centered on the appropriateness of either Securities and Exchange Commission (SEC) rules or the D.C. Circuit review of SEC rule-making. In this longstanding disclosure universe, the focus has been on the ends of investor protection and market efficiency, and implementation by means of annual reports and other SEC-prescribed documents.
In 2013, these common understandings became obsolete when a new system for public disclosure became effective, the first since the SEC’s creation in 1934. Today, major banks must make disclosures mandated not only by the SEC, but also by a new system developed by the Federal Reserve and other bank regulators in the shadow of the Basel Committee on Banking Supervision and the Dodd-Frank Act. This independent, bank regulator-developed system has ends and means that diverge from the SEC system. The bank regulator system is directed not at the ends of investor protection and market efficiency, but instead at the well-being of the bank entities themselves and the minimization of systemic risk. This new system, which stemmed in significant part from a belief that disclosures on the complex risks flowing from modern financial innovation were manifestly inadequate, already dwarfs the SEC system in sophistication on the quantitative aspects of market risk and the impact of economic stress.
Dealers and major participants play a crucial role in the derivatives market, a market that has been estimated to exceed $710 trillion worldwide, of which more than $14 trillion represents transactions in security-based swaps. In the United States, the Commodity Futures Trading Commission (“CFTC”) and the SEC share responsibility for regulating the derivatives market. Out of the total derivatives market, the SEC is responsible for regulating security-based swaps. As evidenced in the most recent financial crisis, the unregulated derivatives market had devastating effects on our economy and U.S. investors. In response to this crisis, Congress enacted the Dodd-Frank Act and directed both the CFTC and SEC to promulgate an effective regulatory framework to oversee the derivatives market.
The Dodd-Frank Act established that certain swap contracts which previously were traded bilaterally (directly between buyers and sellers) must be traded through clearinghouses instead. Critics of this clearing mandate have mounted two main objections: a clearinghouse shifts risk instead of reducing it; and a clearinghouse could fail, requiring a bailout. In my article Clearinghouses as Liquidity Partitioning, recently published in the Cornell Law Review, I counter both objections by showing that clearinghouses engage in a socially valuable function that I term liquidity partitioning. Liquidity partitioning means that when one of its member firms becomes bankrupt, a clearinghouse keeps a portion of the firm’s most liquid assets, and a matching portion of its short‑term debt, out of the bankruptcy estate. The clearinghouse then applies the first toward immediate repayment of the second. Economic value is created because the surviving clearinghouse members are paid much more quickly than they would be in a bankruptcy proceeding. Meanwhile, the bankrupt member’s outside creditors are not paid any less quickly: they still are paid at the end of the bankruptcy proceeding, which the clearinghouse does nothing to prolong. These rapid cash payouts for clearinghouse members reduce illiquidity and uncertainty in the financial sector, the main causes of contagion in a crisis. And because the clearinghouse holds only liquid assets, it avoids the maturity mismatch between short‑term liabilities and long‑term assets that characterizes the balance sheets of many financial institutions. A clearinghouse therefore is much less likely than its members to fail during a crisis.
A clearinghouse achieves liquidity partitioning by engaging in netting. Thus, when a member fails, the clearinghouse uses short‑term debts owed to the member to immediately repay short‑term debts owed by the member. In this way, cash is intercepted on its way toward the bankruptcy estate and redirected toward other financial firms, who may be suffering their own liquidity shortages. The clearinghouse thereby shifts cash from lower-value to higher-value uses, decreasing liquidity pressure on the financial sector and thus the need during a crisis for a taxpayer-funded bailout.
How should we think about regulating our dynamically changing financial system? Existing regulatory approaches have two temporal flaws. The obvious flaw, driven by politics and human nature, is that financial regulation is overly reactive to past crises. The Dodd-Frank Act, for example, puts much weight on reforming mortgage financing.
There is, however, a less obvious flaw: that financial regulation is normally tethered to the financial architecture, including the distinctive design and structure of financial firms and markets, in place when the regulation is promulgated. This type of grounded regulation can have value as long as it is monitored and updated as needed to adapt to changes in the financial architecture. Yet without that monitoring and updating, it can quickly become outmoded—such as occurred in 2008 when the pre-crisis financial regulatory framework, based on the dominance of bank-intermediated funding, failed to address a collapsing financial system in which the majority of funding had become non-bank intermediated.
Asset managers who tuned in to last month’s Financial Stability Oversight Council’s (“Council”) conference regarding the industry’s potential systemic importance heard no surprises. The US Treasury Department and regulators did not defend the September 2013 report by the Office of Financial Research (“OFR Report”) which had suggested that the industry’s activities as a whole were systemically important.  Rather, officials continued to emphasize that they hold no predisposition toward designation. It was left to academics at the conference to argue that asset managers could pose systemic risk.
The U.S. banking agencies have finalized higher leverage capital standards for the eight U.S. bank holding companies that have been identified as global systemically important banks (“U.S. G-SIBs”) and their insured depository institution (“IDI”) subsidiaries. The agencies also proposed important changes to the denominator of the U.S. Basel III supplementary leverage ratio (“SLR”). A number of these proposed changes are intended to implement the Basel Committee’s January 2014 revisions to the Basel III leverage ratio.
The recent discussions surrounding Michael Lewis’s new book, Flash Boys, revealed a profound and uncomfortable truth about modern finance to the public and policymakers: Machines are taking over Wall Street. Artificial intelligence, mathematical models, and supercomputers have replaced human intelligence, human deliberation, and human execution in many aspects of finance. The modern financial industry is becoming faster, larger, more complex, more global, more interconnected, and less human. An industry once dominated by humans has evolved into one where humans and machines share dominion.