Early this month the Trump Administration published its second of a four-part series of recommendations on changing the regulation of the finance industry, weighing in on how to improve regulation of the capital markets. Last Thursday it published its third report, on the asset management and insurance industries. I found the first report on banking regulation, published in June, to be surprisingly moderate, particularly since the GOP House plan would pull out many of the oak trees planted by Dodd-Frank at their roots. Treasury’s October report (Report), A Financial System That Creates Economic Opportunities: Capital Markets, adopts a similarly moderate approach.
This blog will cover the third report in a later posting. For now I’ll make two quick observations on the third report. Its recommendation to shift to an “activities-based” (or functional) approach from an “entities-based” approach to regulating systemic risk has much to be said for it, and should be seriously considered. Dodd-Frank has been criticized for adopting the latter approach, but its authors likely had little choice but to respect the fiercely guarded territorial boundaries of the U.S. capital markets and banking regulators, given the extreme partisan backdrop to the act’s passage. On a lighter note, some have poked great fun, on Twitter and elsewhere, at Treasury’s recommendation to replace the term “shadow banking” with the term “market-based financing.” In the words of Matt Levine, the Administration apparently believes that “shadow banking” is a slur on the nonbank finance industry by suggesting it is unregulated, which it isn’t. But “shadow banking,” which was at the heart of the financial crisis, at least is suggestive of the creation of money-like substitutes for bank deposits. Banks and nonbank financial institutions alike borrow short and lend long, and both are subject to runs by short-term creditors. “Market-based financing” blandly covers just about anything that doesn’t have to do with a loan. Treasury’s second report covers the vast regulatory landscape of the securities and derivatives markets. Here my observations concern only one critical part of the Dodd-Frank Act. Dodd-Frank fundamentally restructured a part of the derivatives market that played a significant role in the financial crisis – the over-the-counter (OTC) market. In OTC transactions two parties contract directly with one another rather than through a clearing house or on an exchange.
The opacity of the OTC swap market contributed to the severity of the financial crisis. For example, leading up to the crisis financial institutions issued credit default swaps (CDS) directly to counterparties as insurance against defaults of subprime mortgage-backed securities and collateralized debt obligations (CDOs). Since CDS were not cleared or exchange-traded, no one knew who had what exposure. Among the largest sellers of CDS protection was AIG, which issued over $440 billion. The government bailed out AIG with a $85 billion loan to unwind its CDS transactions, and its counterparties received 100 cents on the dollar. The trouble was that regulators could not quantify AIG’s derivatives exposures due to the lack of transparency that was characteristic of the OTC swap market. They felt they had no choice but to rush in and rescue AIG because of its worldwide interconnections. The opacity of Lehman Brothers’ derivatives book, which consisted overwhelmingly of OTC trades, also contributed to the freezing up in the credit markets that occurred after its bankruptcy filing and the tortuous unwinding of its trades.
Future proposals to revisit regulation of the OTC derivatives is a good test case of whether the lessons of the financial crisis are truly “lessons learned.” A free-market bipartisan consensus during the Clinton Presidency, embodied in a law enacted in 2000, ensured that the OTC market would remain nearly devoid of regulatory oversight. The law prohibited what later helped lay the grounds for the financial crisis: among other things, it mandated (1) no clearing requirements that would have required capitalization of CDS guarantees, (2) no exchange requirement that would have made CDS pricing more transparent, and (3) no books and records requirements that would have allowed regulators to spot a buildup of systemic risk.
Dodd-Frank comprehensively addressed these gaps in OTC derivatives regulation. The law incentivizes migration of OTC transactions to clearing houses through lower capital requirements for cleared trades; promotes transparency by requiring standardized swap transactions to be traded on exchanges or electronic trading platforms; promotes pre-trade transparency and liquidity through “swap execution facilities” that allow all market participants to observe bid-offer prices; and requires that all swap transactions – whether cleared or uncleared – be reported on an intraday basis to “swap data repositories,” thus allowing regulators to monitor interconnectedness in the swaps market. Dodd-Frank also subjects non-centrally cleared OTC swaps to extensive margin requirements, thus mitigating counterparty risk.
The Report would leave Dodd-Frank’s new basic regulatory architecture governing the OTC market completely intact. In fact, the Report notes how OTC derivatives tend to be much more complex and customized than the standardized derivatives traded on exchanges, and pose considerably more risk to the parties that enter into these contracts. The proposals it does make would, by and large, rationalize the current regulatory framework. Capital markets regulation, like banking regulation, is fragmented. The Report makes sensible recommendations to harmonize SEC, CFTC, and banking agency regulation of OTC swaps to ensure consistent treatment, as well as harmonization with foreign regulations to minimize regulatory arbitrage, in which market participants migrate to less regulated jurisdictions. Moreover, the Report correctly observes that Dodd-Frank concentrates risk in clearinghouses and calls for enhanced regulatory oversight to address the implications for systemic risk. It calls on Dodd-Frank’s Financial Stability Oversight Council to continue to study the role of clearing houses in the financial system: “Regulators must finalize an appropriate regulatory framework for [clearinghouse] recovery or resolution to avoid taxpayer-funded bailouts.”
Although some might have expected the Administration to take a divisive “America first” approach to financial regulation, this is not the case. The Report does not recommend reducing regulation here below the standards in Europe and elsewhere, which could lead businesses to migrate to the U.S. As with U.S. bank capital regulations, the Trump Administration instead pushes for harmonization of margin requirements, both domestically and internationally.
A final note. I would recommend the Report as a short primer on the capital markets to anyone who wants to how they function and how they are regulated. A nice feature of the Report is that it clearly and accurately lays out the existing regulatory terrain before presenting each of its recommendations.
President Trump promised to “rip up” Dodd-Frank but thus far his Treasury Secretary (Steven Mnuchin) and National Economic Council Director (Gary Cohn) have taken an enlightened approach that preserves the substance of the protections put in place by Dodd-Frank. We look forward to assessing Treasury’s final two reports, on the asset management and fintech industries.
 Acharya, Cooley, Richardson, and Walter, Regulating Wall Street 8 (2011).