October 25, 2017

On October 6, 2017, the U.S. Department of the Treasury published the second of four planned reports in response to Presidential Order 137772, which outlined the Core Principles for regulating the U. S. financial system.  This Report, titled “A Financial System That Creates Economic Opportunities – Capital Markets,” focuses on the capital markets.  Many of the recommendations in the report are premised on the notion that by reducing regulatory burden and improving market function, investment and economic growth would be facilitated.  Most of Treasury’s recommendations call for regulatory action from the SEC and CFTC rather than legislative fixes. 

The Report focuses on supporting U.S. markets by:

  • Promoting access to capital for all types of companies, including small and growing businesses, through reduction of regulatory burdens and improved market access;
  • Fostering robust secondary markets in equity and debt;
  • Appropriately tailoring regulations on securitized products to encourage lending and risk transfer;
  • Recalibrating derivatives regulation to promote market efficiency and effective risk mitigation;
  • Ensuring proper risk management for central counterparties and other financial market utilities because of the critical role they play in the financial system;
  • Rationalizing and modernizing the US capital markets regulatory structure and processes; and
  • Advancing US interests by promoting a level playing field internationally.

We have summarized the key recommendations by topic below.  Stay tuned to our website as we track future regulatory and legislative changes that will be implemented pursuant to the Report. 

 

Promoting Access to Capital and Investment Opportunities

The Report outlines the decline in the number and size of IPOs in the U.S. over the past two decades and attributes the trend to increased regulatory burdens imposed on public companies, particularly the Sarbanes-Oxley Act.  The goal of the recommendations is to expand access to capital broadly, which in turn would create greater investment opportunities for the general public. 

  • Remove Non-Material Disclosure Requirements.  Repeal of four provisions of the Dodd-Frank Act and any related rules.  The four provisions cover disclosure of conflict minerals, mine safety, resource extraction and pay ratio, which should be regulated by another agency other than the SEC.
  • Eliminate Duplicative Requirements.  Amend Regulation S-K to remove duplicative, overlapping, outdated or unnecessary provisions.  The Report supports the SEC’s 2016 (1) proposal to remove disclosure requirements that duplicate financial statement disclosures already required under GAAP, and (2) recommendations on simplifying and modernizing disclosures in its FAST Act report.
  • Permit Additional Pre-IPO Communications.  Expand “testing the waters” to all companies, not just EGCs, that permits communications with potential investors, who are qualified institutional buyers and institutional accredited investors, prior to filing a registration statement for an IPO. 
  • Address Concerns on Shareholder Proposals.  The SEC should (1) evaluate the role of proxy advisory firms; (2) revise the $2000 stock ownership requirement to some other measure such as the shareholder’s dollar holding in company stock as a percentage of his or her liquid net assets, and (3) increase the resubmission thresholds for repeat proposals.
  • Shareholder Rights and Dual Class Stock.  With conflicting interests between companies and investors posed by dual class stocks, the SEC should ensure that offering documents provide adequate disclosure of dual class stock and its effect on shareholder voting. 
  • Allow Business Development Companies to Use Securities Offering Reform. Revise the securities offering reform rules to permit business development companies that file Forms 10K, 10Q and 8K to avail themselves of other provisions available to “well-known seasoned issuers,” including the safe harbor for business information and forward-looking information. 
  • Modify Eligibility Requirements for Scaled Regulation.  Alleviate the regulatory burdens that disproportionately impact smaller companies, including broadening eligibility for status as a smaller reporting company, broadening non-accelerated filer to include entities with up to $250 million in public float from the current $75 million, and lengthening the time a company may be considered an emerging growth company (EGC) to up to 10 years from the current 5 years.
  • Review Rules for Interval Funds. Interval funds are closed-end funds in which periodic redemptions are offered.  Review rules to encourage creation of closed-end funds that invest in offerings of smaller public companies and private companies whose shares have limited or no liquidity. 
  • Review and Consolidate Research Analyst Rules.  Harmonize the Global Settlement and research analyst rules to determine which provisions should be retained, amended or removed and that would result in a single set of rules for financial institutions. 
  • Increase Flexibility for Regulation A Tier 2.  (1) Expand Regulation A eligibility to include Exchange Act reporting companies; (2) take steps to increase liquidity in the secondary market for Tier 2 securities (Regulation A+ “mini IPO” offerings of up to $50 million) by exempting them from state registration requirements; and (3) increasing the Tier 2 limit to $75 million from the current $50 million.
  • Crowdfunding. Revise rules to (1) allow single-purpose crowd-funding vehicles advised by a registered investment adviser; (2) prioritize alignment of interests between the lead investor and other investors; (3) waive the limitations on purchases in crowdfunding offerings for Regulation D “accredited investors;” (4) raise the maximum revenue requirement from $25 million to $100 million; and (5) raise the limit on how much can be raised over a 12-month period from the current $1 million to $5 million. 
  • Create Appropriate Regulatory Structure for Finders. The SEC, FINRA, and states should propose a new regulatory structure for finders and other intermediaries in capital-forming transactions, one which would assist smaller companies in raising capital.
  • Review Rules for Private Funds Investing in Private Offerings. Review provisions under the Investment Company Act that restricts unaccredited investors from investing in a private fund containing Rule 506 offerings.
  • Empower Investor Due Diligence Efforts. Federal, state financial regulators and SROs should work to centralize reporting of individuals and firms that have been subject to adjudicated disciplinary proceedings or criminal convictions and make such service free to the public.

 

Equity Market Structure

The Report focuses on improving the secondary market for less liquid stocks by more appropriately tailoring regulation and on promoting greater transparency and reducing unnecessary complexity of equity markets.

  • Fragmentation of Liquidity and Promoting Liquidity in Less Liquid Stocks.  Consider (1) consolidating liquidity for less-liquid stocks on a smaller number of trading venues; (2) permitting issuers of less-liquid stocks, in consultation with their underwriter and listing exchange, to suspend Unlisted Trading Privileges for their securities and select the exchanges and venues upon which their securities will trade; (3) amend Regulation NMS to allow issuers of less-liquid stocks to choose to have their stock trade only on a smaller number of venues until liquidity in the stock reaches a minimum threshold; and (4) define the measure to determine which stocks are “illiquid,” such as using the average daily volume.
  • Dynamic Tick Size.  Evaluate allowing issuers, in consultation with their listing exchange, to determine the tick size for trading of their stock across all exchanges.
  • Maker-Taker and Payment for Order Flow. Consider rules to mitigate the potential conflicts of interest that arise due to compensation arrangements by requiring additional disclosure to address misaligned incentives of fees and rebates in the maker-taker markets and payment for order flow. 
  • Market Data. (1) Clarify that broker-dealers may satisfy their best execution obligations by relying on Securities Information Processor (SIP) data rather than proprietary data feeds to eliminate the need to subscribe to costly data feeds, which would help reduce the barriers to entry for new broker dealers; and (2) amend Regulation NMS to enable competing consolidators to provide an alternative to the SIPs.
  • Order Protection Rule. Consider amending the Order Protection Rule (1) to give protected quote status only to registered national securities exchanges that offer meaningful liquidity and opportunities for price improvement; (2) to withdraw protected quote status for orders that do not meet a minimum liquidity threshold.  Any newly registered securities exchange should receive the benefit of protected order status for some period of time to allow the exchange an opportunity to thrive.
  • Reducing Complexity in Equity Markets.  Review whether exchanges and Alternative Trading Systems (ATSs) should harmonize their order types and make recommendations as appropriate to address market complexity.
  • Regulation ATS.  Amend Regulation ATS to eliminate unnecessary disclosure of confidential information, or limit such disclosure to the SEC, and to simplify the disclosures to reduce compliance burdens and promote comparability across competing ATSs.

 

The Treasury Market

The goal of the recommendations is to close the data gap among the major intermediaries in the Treasury securities market.

  • Principal Trading Firms (PTF) Trade Reporting. PTFs do not meet the definition of “dealer” so are not required to register with the SEC, become members of FINRA or report their activity to FINRA’s Trade Reporting and Compliance Engine (TRACE).  Close the data gap with respect to PTFs by requiring platforms operated by FINRA member broker-dealers that facilitate transactions to identify customers in their reports of Treasury security transactions to TRACE.
  • Bank Trade Reporting. Supports the Federal Reserve Board’s efforts to collect treasury transaction data from its member banks.
  • Treasury Futures Data Availability. Recommends that the CFTC share daily its Treasury futures security transaction with Treasury to improve cross-market monitoring of Treasury cash and futures trading activity.
  • Treasury market Central Clearing.  Continue with the regulatory regime to keep up with developments in the clearing and settlement arrangements in the Treasury interdealer brokers market.
  • Effect of Regulation on Secured Repurchase Agreement (Repo) Financing.  Reiterates its recommendations from the Banking Report to improve the availability of secured rep financing (e.g., recalibration of the U.S. Global Systemically Important Banks risk-based capital surcharge).

 

Corporate Bond Liquidity

The Report reiterates its recommendations from the Banking Report to improve secondary market liquidity for corporate bonds, including implementation of the Volcker rules’ market-making exception.

 

Securitization

The Report found that post-crisis reforms have gone too far toward penalizing securitization relative to alternative, often more traditional funding sources, and as a result, have dampen the attractiveness of securitization and potentially cutting off or raising the cost of credit to corporate and retail consumers.  The goal of the recommendations is to improve the functioning of the securitization market.

  • Capital Requirements.  Bank regulators should (1) rationalize the capital required for securitized products with the capital required to hold the same disaggregated underlying assets; (2) decrease the surcharge on securitization exposures by adjusting the parameters of the simplified supervisory formula approach and the supervisory formula approach; and (3) align the risk weight floor for securitization exposures with the Basel recommendation.  Bank capital for securitization exposure should sufficiently account for the magnitude of the credit risk sold or transferred in determining required capital instead of tying capital to the amount of the trust that is consolidated for accounting purposes.  Capital requirements should be recalibrated to prevent the required amount of capital from exceeding the maximum economic exposure of the underlying bond.  The Federal Reserve Board should consider adjusting the global market shock scenario for trading exposures to more fully consider the credit quality of the underlying collateral and reforms implemented since the financial crisis.   
  • Liquidity Requirements.  Adjust bank liquidity standards to consider inclusion of senior securitizations with a proven track record of performance as a level 2B high-quality liquid assets for purposes of the Liquidity Coverage Ratio and the Net Stable Funding Ratio.
  • Risk Retention. Federal bank regulators should (1) expand qualifying risk retention exemptions across eligible asset classes based on the unique characteristics of each securitized asset class, through notice-and-comment rulemaking, (2) enhance disclosure requirements and underwriting safeguards to provide added confidence to investors in securitized products; (3) review the mandatory five-year holding period for third-party purchasers and sponsors; and (4) provide a qualified exemption for collateralized loan obligation risk retention for managers that do not originate the loans that they select for inclusion in their securitization.  Congress should designate a lead agency, from among the six that promulgated the Credit Risk Retention Rulemaking, to be responsible for future actions related to the rulemaking.
  • Disclosure Requirements.  The SEC should (1)recalibrate the scope of asset-level data required by Reg AB II by reducing the number of reporting fields for registered securitization and refine definitions to better standardize the reporting requirements on the remaining required fields; (2) add flexibility to the current asset-level disclosure requirements; (3) review its three-day waiting period for registered issuance to consider requiring only one or two business days; and (4) signal that it will not extend Reg AB II disclosure requirements to unregistered 144A offerings or to additional securitized asset classes. 

 

Derivatives

Although Title VII of Dodd-Frank improved oversight of swap dealers and major swap participants and reduced risk of contagion effects of default by requiring central clearing and promoted trade on regulated platforms, the Report notes the differing regulatory landscapes for regulating swaps by the CFTC and for security-based swaps by the SEC pose challenges for market participants.

  • Harmonization Between CFTC and SEC.  The CFTC and SEC should jointly review their respective rulemakings under Title VII to harmonize rules and eliminate redundancies, minimize distortive effects on the markets and duplicative and inconsistent compliance on market participants.  Under this review, the SEC should finalize its Title VII rules, consider the prospects for alternative compliance regimes, and include public comment as part of the process.  Congress should consider further action to achieve harmonization in the regulation of swaps and security-based swaps.
  • Margin Requirements for Uncleared Swaps.  (1) The U.S. bank regulators should consider providing and exemption from margin requirements for affiliated transactions similar to the exemptions in the CFTC and non-U.S. requirements; (2) the CFTC and bank regulators should (a) work with their international counterparts to amend the uncleared margin framework, (b) amend their rules to allow for more realistic time frames for collecting and posting margins, and (c) reconsider the one-size-fits-all treatment of financial end users for purposes of margin on uncleared swaps and tailor their requirements to focus on the most significant source of risk; and (3) the SEC should re-propose its margin rule for uncleared security-based swaps to align with the margins rules of the CTFC and bank regulators. 
  • CFTC Use of No-Action Letters.  The CFTC should take steps to simplify and formalize all outstanding staff guidance and no-action relief and amend any final rules that have proven to be infeasible or unworkable in order to reduce the need for no-action relief.
  • Cross-border Issues.  The CFTC and SEC should (1) make their swaps and security-based swaps rules compatible with non-U.S. jurisdictions to avoid fragmentation, redundancies, undue complexity and conflicts of law; (2) adopt outcomes-based substituted compliance regimes for comparable non-U.S. derivatives regulation; and (3) reconsider approaches to transactions that are arranged, negotiated, or executed by personnel in the U.S.
  • Capital Treatment in Support of Central Clearing.  With regard to regulatory capital requirements for banks, (1) in the near term, allow deduction of  initial margin for centrally cleared derivatives from the supplementary leverage ratio (SLR) denominator and use a risk-adjusted approach for valuing options to better reflect exposure; (2) in the long term, transition regulatory capital requirements from the current exposure methodology (CEM) to an adjusted version of Basel Committee’s standardized approach for measuring counterparty credit risk exposures (SA-CCR) calculation that provides an offset for initial margin and recognition of appropriate netting sets and hedging.  The bank regulators should conduct regular comprehensive assessment of how the capital and liquidity rules impact incentives to centrally clear derivatives and whether such rules need recalibration. 
  • Swap Dealer De Minimis Threshold.  The CFTC should maintain the swap dealer de minimis registration threshold at $8 billion and any change to the threshold be subject to formal a rulemaking and public comment process.
  • Definition of Financial Entity.  Congress should amend Section 2(h)(7) of the Commodity Exchange Act to provide the CFTC with rulemaking authority to modify and clarify the scope of the financial entity definition and the treatment of affiliates that would provide an exception from the clearing requirement if they engage in swaps primarily to hedge the business risks of a commercial affiliate.  Any amendment would provide the SEC analogous rulemaking authority with respect to security-based swaps.
  • Position Limits.  The CFTC should finalize its position limit rules with a focus on detecting and deterring market manipulation and other fraudulent behavior, including to (1) ensure the appropriate availability of a bona fide hedging exemptions for end users  and explore whether to provide a risk assessment management exemption; (2) consider calibrating limits based on the risk of manipulation (e.g., by imposing limits only for spot months of physical delivery contracts where the risk of potential market manipulation is greatest); and (3) consider the deliverable supply holistically when setting the limits (e.g., for gold, consider the global physical market and not just U.S. futures).
  • SEF Execution Methods and MAT Process.  The CFTC should (1) consider rules to permit swap execution facilities (SEF) to use any means of interstate commerce to execute swaps subject to a trade execution requirement, with the goal of impartial access for market participants and promoting pre-trade price transparency; (2) reevaluate the “made available to trade” (MAT) determination process to ensure sufficient liquidity for swaps to support a mandatory trading requirement; and (3) consider clarifying SEF rules to address the associated market fragmentation.
  • Swap Data Reporting. The CFTC should continue with its “Roadmap” effort to standardize reporting fields across products and swaps data repositories, harmonize data elements and technical specifications with other regulators, and improve validation and quality control processes.

 

Financial Market Utilities

Financial market utilities (FMUs), including those FMUs that are central counterparties (CCPs), play and integral role in supporting and facilitating the transfer, clearing, or settlement of financial transactions.  Eight of the nine FMUs have been designated by FSOC as systematically important financial market utilities (SIFMUs).  Unlike the rest of the Report, which calls for streamlining regulatory requirements, the Treasury is calling for heightened regulatory and supervisory authority for FMUs.

  • ‘Advance Notice’ Review Process.  Agencies that supervise the SIFMUs (the Federal Reserve, CFTC and SEC) should (1) closely review changes to the SIFMUs rules, operations, and procedures that may present material risks; and (2) study how they can streamline the existing review process to be more efficient and appropriately tailored to the risk that a particular change may pose.  The Treasury recommends that additional resources be provided to the CFTC to enhance its supervision of CCPs. 
  • Federal Reserve Bank Account Access.  The Federal Reserve should review (1) what risks may be posed to the U.S. financial stability by the lack of Federal Reserve Bank deposit account access for FMUs with significant shares of U.S. clearing business and how to address such risks, and (2) whether the interest rate paid on SIFMUs deposits at Federal Reserve Banks may be adjusted on a market-based evaluation of comparable private sector opportunities.
  • Resilience, Recovery, and Resolution.  The CFTC should (1) incorporate in future supervisory stress tests additional products, different stress scenarios, liquidity risk, and operational and cyber risks, and (2) coordinate with the FDIC on the development of viable recovery wind-down plans for CCPs that are SIFMUs.  U.S. regulators should (a) in coordination with their international counterparts, focus additional recovery and resolution planning efforts on non-default scenarios; (b) continue to take part in cross-border crisis management groups (CMGs) to share relevant data and consider the coordination challenges that domestic and foreign regulators may encounter during cross-border resolution of CCPs.

 

Regulatory Structure and Process

The Report notes the increasing fragmentation, overlap and duplication in the framework for the regulation of securities and derivatives products, as products with both features and market participants engaging in both markets have increased.  The Report does not call for a merger of the CFTC and SEC, but calls instead for the agencies to coordinate and harmonize oversight and regulation of the securities and futures markets.

  • Restoration and Exemptive Authority.  Congress should restore the CFTC’s and SEC’s full exemptive authority and remove the restrictions on exemptions imposed by Dodd-Frank.
  • Economic Analysis in Rulemaking.  Recommends (1) the CFTC’s and SEC’s enhanced use of regulatory cost-benefit analysis as discussed in the Banking Report; (2) that when conducting rulemakings, the CFTC and SEC be guided by the Core Principles for financial regulation laid out in Executive Orders 13772, 12866 and 13563; and (3) agencies take steps, as part of their oversight authority, so that SRO rulemakings consider economic analysis when proposed rules are developed at the SRO level.
  • Using a Transparent, Common Sense, and Outcomes-Based Approach.  Recommends that the CFTC and SEC make fuller use of their ability to solicit comment and input from the public, including increase use of advance notices of proposed rulemaking and conducting regular, periodic reviews of agency rules for burden, relevance, and other factors.  Treasury recommends that the agencies consider the goals of principles-based regulation and continue their joint outcomes-based effort to harmonize rules and requirements. 
  • Regulatory Guidance Outside of Rulemaking.  Discourages the use of guidance (e.g., interpretive bulletins, FAQs, and no-action letters) to impose regulatory requirements and burdens outside of notice-and-comment rulemaking.
  • Update Definitions under the Regulatory Flexibility Act (RFA).  Recommends that agencies review and update definitions so that RFA analysis appropriately considers the impact on persons who should be considered small entities.
  • Self-regulatory Organizations.  Recommends that the CFTC and SEC conduct comprehensive reviews of the roles, responsibilities and capabilities of SROs under their respective jurisdictions and make recommendations for operational, structural, and governance improvements of the SRO framework.

 

International Aspects of Capital Markets Regulation

Treasury believes bilateral and multilateral cooperation with international jurisdictions is key to advancing U.S. interests by enabling U.S. companies to be competitive in domestic and foreign markets.

  • Bilateral Regulatory Cooperation.  Supports U.S. regulators and Treasury in (1) maintaining a dialogue with international partners to address conflicting or duplicative regulation; (2) reaching outcomes-based, non-discriminatory substituted compliance arrangements with other regulators to mitigate regulatory redundancy and conflict, as appropriate.
  • Multilateral Regulatory Cooperation.  Recommends that (1) the U.S. members of international financial standard-setting bodies (SSBs) advocate for and shape international regulatory standards that are aligned with domestic financial regulatory objectives; and (2) U.S. agencies stay alert to developments abroad and engaged in international organizations. 
Attorneys
Hong Le Webb