Regulatory cycles

Many analysts — albeit opponents of the new Administration — have likened President Trump’s victory to the proverbial dog catching the car that he is chasing. The overall point being akin to that old saying: Be careful what you wish for, you may receive it.

That may apply on the regulatory front as well because there were multiple calls for tearing up the Dodd-Frank Wall Street Reform and Consumer Protection Act and starting from scratch. But while many in the industry have complained about the complex and costly aspects of Dodd-Frank and other financial regulations that the trading industry sees as onerous, the last thing the industry wants to deal with is having to digest an entirely new regulatory regime. 

Philosophical differences aside, the problem with huge new regulatory regimes — and Dodd-Frank was the largest regulatory overhaul since the one that followed the Great Depression — is that it entails major changes and cost. The industry must hire people to first learn and understand and then implement the new policies. This takes man hours and money, which have already been spent, so while the industry wants a break from certain aspects of this, they don’t want to go through another process of preparing for another regime. They would rather highlight the more costly and onerous aspects of Dodd-Frank to what appears to be a more friendly administration and trim the regulatory excess away. 

Crisis management 

“The [Commodity Futures Trading Commission] adopted a lot of rules in a relatively short period, and they did that because Congress told them to,” says Dan Roth president and CEO of National Futures Association. “Anytime you develop that many rules of that broad significance in a relatively short period of time, you are not going to get everything right. That is why it is useful to go back and revisit these things.” 

While Roth points out that the goal of the legislation is to always produce smart regulation, how that is defined often differs in times of crisis. And in case anyone has forgotten, Dodd-Frank was put together in a time of crisis. 

“Congress always wants to achieve smart regulation, at certain times their idea of smart puts a lot less emphasis on costs to the industry than at other times,” Roth says. “In a post-crisis environment I don’t think they are particularly focused on the cost to the industry; they are focused on what they perceive to be regulatory gaps. The question of smart regulation takes something that is focused — let’s make sure we are not imposing undue burdens — and when you are immediately post-crisis the focus is not on what is the burden. That is just the nature of the political process.” 
Roth highlights a problem with smart regulation. 

“A moment of crisis does not lend itself to careful thoughtful analysis. The public wants a quick response and they get a quick response, usually, and it is not always the most thoughtful response,” he adds. 

This highlights the problem of what happens in a crisis and also the problem of what happens when an industry and politicians feel they have a mandate to deregulate. 

“The industry wants to avoid a situation where there is this yo-yo effect where every four years there is a dramatic change in the regulatory environment and [you] build or rebuild a system,” Roth says. “Once you have taken the steps to achieve compliance with those rules there is a cost to changing those rules. When I say I am not hearing a call for broad repeal of Title VII [of Dodd-Frank], that is not just from Washington, I am not hearing it from the industry either.”

Neither are we. What we are hearing are complaints, sometimes more about the desire to punish than to make things right. When the global crisis hit, it gave carte blanche to Congress to fix the problem, and also to enforce its newfound powers to the limit. When Modern Trader talked to leading future commission merchants a couple of months ago there was less pushback against specific rules than an inability to work with the industry to make things right and excessive fines. RJ O’Brien Chairman and CEO Gerry Corcoran said, “what has been lifting the industry’s eyebrows are the high levels of fines for rule breaches that didn’t historically warrant those fines.” 

Chris Hehmeyer, who recently relaunched his firm that offers prop trading, introducing broker and commodity trading advisor services, pointed out that every fine seems to be at least $1 million these days. 

This is clear from the comments of numerous organizations representing brokers and the professional trading community. It doesn’t appear to be an accident that the global futures trade organization FIA is asking for not only smart regulation, but smart regulation and enforcement (see “Smart regulation,” below). 

“Making market reform work for America means addressing instances of operational and capital complexity and the enormous cost that the CFTC’s implementation of the Dodd-Frank Act has imposed on participants in American markets,” said CFTC Acting Chair Chris Giancarlo in a recent speech. “Certainly, there must be ways to implement the reforms of Title VII with less complication and expense.”

Giancarlo is somewhat new to the process, which is probably healthy. After years into its rollout, you can understand if some folks just what to get it over with and are a bit disconnected from the initial purpose of the legislation. 

The Securities Industry and Financial Markets Association (Sifma) has maintained support for Dodd-Frank — not that they had a choice — but called its execution excessive. 

Seven years after the crisis our financial firms and markets are safer and stronger. Capital holdings by firms have increased and leverage decreased substantially,” Sifma noted in a white paper. “‘Too big to fail’ has largely been addressed by new requirements such as living wills and orderly liquidation authority. Sifma continues to believe implementation must uphold the original spirit and intent of the legislation to safeguard our financial system, without constraining capital formation, credit availability and the financial industry’s ability to contribute to economic growth and job creation.“

The Managed Funds Association (MFA) has this to say on Dodd-Frank: “MFA supports efforts to enhance investment activity, capital formation and economic growth through a modernized regulatory framework that protects investors and enhances regulatory coordination. To increase market fairness and efficiency, this framework should consist of common-sense proposals that protect critical market infrastructure, reduce operational risk, harmonize and streamline reporting requirements, promote market transparency, and guard against systemic risk without stifling legitimate market activity or imposing arbitrary designations on non-bank financial companies.”

While boiler plate, these comments hint that the issues market users have with regulations are more about execution than its intent. Everyone wants the best for the industry — that goes without saying — but a new administration holds out hope to work for solutions, rather than to place blame. While two major parties are avoiding the real political differences on regulation, a more significant difference is the climate. The previous administration came into power in the midst of a crisis. The current administration has come in during a period of extended growth — albeit slow growth that many blame on the regulatory prescriptions of the previous administration. 

Various market environments tend to produce regulatory swings, but the people working in the industry need to know the rules so they can do business. “When there is a major market event and crisis like the credit crisis, that tends to exasperate the swings of the pendulum so it is not at all a surprise the pendulum swings pretty far to one side post crisis and probably not too surprising that at some point the pendulum starts to swing back,” Roth says. “Things are certainly going to change because things always change, the pendulum always swings, it is just a question of which direction. It is a natural thing.” 

Smart regulation asks whether you are accomplishing your goals. The answer may be more rules or more transparency but the point is to go back and look to see what is working. “After you adopt rules, it is very helpful thing to look back after a period and see if the rules are operating the way you expect them to. Are they achieving the regulatory policy you want to achieve; is there a smarter way to do it?” Roth asks. “It is best if that process occurs in a thoughtful manner rather than a debate in shrill tones. It is a good thing when people take a hard look at rules to make sure they are doing what they are supposed to be doing.” 

Cyber Security 

The MFA is keenly aware of their members’ responsibilities in safeguarding customer data, but is not as confident in the myriad of regulatory agencies that require their members to share this data. 

“Currently, each agency has its own sets of policies, procedures and protocols governing the protection of this information,” the MFA has noted. “Congress should require relevant financial regulatory agencies to adopt enhanced and consistent internal protections for the handling, dissemination, review, storage and, as appropriate, return of highly sensitive, confidential and proprietary information.”

Cyber threats have caused regulators to rethink a lot of their policies. For years there seemed to be a default reflex of demanding more information on customers. A year ago, Interactive Brokers Chairman Thomas Peterffy pointed out this irony. “You get more information and now you have to protect it,” he says. 

Data collection is no longer a harmless additional check, but a policy that brings in additional responsibilities and costs. 

“Generally, from a regulatory point of view, you should never ever ask for data if you don’t know exactly what you are going to do with it. Regulators have to be careful with that,” Roth says. “There is a tendency sometimes to ask for data because you can, rather than because you have a clearly defined business use for that data. All regulators have to make sure that whenever you are asking for any kind of data to a reporting mechanism that you know precisely why it is that you are asking for it and how you are going to use it.”

This is vital in today’s world where cyber threats are an ongoing problem. “You have to know exactly why you need this information and exactly how you are going to use it and exactly how you are going to safeguard it,” Roth adds. 

Which brings us to one of the more controversial CFTC regulations currently being proposed: Reg AT. 

This allows the CFTC to access the proprietary trading algorithm of traders. It was borne from the “flash crash” and other events that caused officials to worry that some rogue algorithm could cause a market disruption. The problem is that these algorithms are the secret sauce of proprietary traders. MFA noted, “We continue to believe – as current law requires – that regulators should seek a subpoena as part of any request for access to a firm’s most sensitive intellectual data. We have also expressed concerns about current provisions that would allow regulators to apply a one-size-fits all standard for the development, testing and monitoring of software.” 

The CFTC has altered its initial proposal, but still allows for the collection of proprietary data without a subpoena. Richard Baker, MFA president and CEO, applauded the changes which reduced the number of people the regulation would apply to but added, “MFA remains concerned, however, over how the CFTC will implement its source code review and what will happen with the proprietary information after CFTC officials review it. Protecting this information is vital.” 

As is making the financial regulatory structure work. Like all things, every few years financial regulation needs a shake-up. Hopefully, this is not a knee-jerk rejection of a previous administration’s policies but a careful review of stated goals and the execution on those goals. A new administration can take a new look at things and ask whether the rules are accomplishing those goals. They can be detached from previous policies because they are not invested in them. Though they need to be invested in the broader regulatory goals. 

“Any time you usher in a really significant new block of regulation it is going to take time for both the industry and the regulators to get a better understanding of what it needs. You hope that with time there is greater certainty and clarity for both the regulators and the regulated,” Roth says. “It is best that these types of changes occur in a thoughtful environment where you are trying to figure out what is working and what is not working.”