June 5, 2018

Senate Appropriations – Financial Services and General Government Subcommittee “Review of the FY2019 Budget Request for the U.S. Commodity Futures Trading Commission & the SEC”

Key Topics & Takeaways

  • SEC Best Interest Standard: Subcommittee Chairman James Lankford’s (R-Okla.) last question was on the SEC-proposed standards of conduct for investment advisors, and if SEC Chair Jay Clayton could provide some information on what will come out of the proposed rule. Clayton it is a goal of the SEC that retail investors can have candid conversations with financial professionals about their compensation and incentives, so they can make informed decisions. He did not provide a specific timeline on a new rule but said the agency would not “take forever” because this issue has been active for several years.
  • De Minimus Threshold: Lankford asked CFTC Chair Christopher Giancarlo about the decision to keep the swap dealer de minimus level at $8 billion in notional value rather than $3 billion. Giancarlo said that the $3 billion threshold, when first explored, was an “educated guess” and that the CFTC had little data about swap dealer size. Giancarlo said that after collecting data for years, the CFTC determined that dropping the de minimus threshold would gather in a negligible amount of new data about swap dealers, as most of the entities that would be captured would be small regional banks, agricultural co-ops, and power utilities.
  • Volcker Rule: There were several questions about the SEC’s recently-proposed changes to the Volcker Rule. Clayton noted that the trading landscape encompasses a wide variety of firms, and that the regulatory burden of the rule was out of proportion to the total trading activity of small banks.  Sen. John Kennedy (R-La) asked witnesses if they thought reform to the Volcker Rule was coming too soon after the financial crisis, but the witnesses both defended the proposed rule changes as moderate. 

Witnesses

Opening Statements

Chairman James Lankford (R-Okla.)

In his opening statement, Lankford outlined the two agencies’ budget requests for FY 2019. The Securities and Exchange Commission (SEC) requested a $6 million dollar increase to $1.685 billion, and the Commodity Futures Trading Commission (CFTC) requested a $32.5 million increase to $281.5 million. Lankford also expressed an interest in hearing more about capital formation from Chair Clayton, and on hearing more about the CFTC’s cybersecurity plans and regulatory actions.

Testimony

The Honorable Jay Clayton, Chairman, Securities and Exchange Commission

In his testimony, Clayton argued that his FY19 budget request will allow the SEC to make significant investments in its information technology (IT) infrastructure and improve cybersecurity defenses. He prefaced a detailed discussion of the budget request by noting that the SEC budget request is: 1) deficit neutral, 2) reliant on continued access to the reserve fund for future IT investments, and 3) allows the SEC to fill 100 positions to address regulatory priorities. Clayton said that the increased funding request will allow the SEC to expand its capabilities in critical ways, including investments in its multiyear, strategic IT program. The budget request will also allow the SEC to take more action to improve the regulatory environment for capital formation and expand enforcement activities with a new, bulked up cyber unit and retail task force. Clayton also argued that increased funding is necessary for the SEC to keep pace with technological changes in markets and expand its depth of expertise in market surveillance, analysis, broker-dealer operations and electronic trading. Clayton briefly discussed the SEC’s new rulemaking on a best interest standard for financial professionals.

The Honorable J Christopher Giancarlo, Chairman, Commodity Futures Trading Commission

In his testimony, Giancarlo discussed the importance of derivatives markets for end-users and the ability of derivatives to create market and price stability. Giancarlo also noted that the United States is the only major economy with a dedicated derivatives market regulator and then pivoted to discuss changes in international derivatives market. He noted that a Chinese exchange recently opened a yuan-denominated oil futures contract to non-Chinese market participants and noted the possibility of China allowing international market participants to trade Chinese futures contracts in other products, including soybeans. Giancarlo said that opening China’s domestic futures market to international participation is part of a “long-term” plan by the Chinese government to increase their influence over the prices of key industrial commodities. Giancarlo said that preserving the primacy of U.S. derivatives markets should be a priority of policymakers and said that “good regulation is our competitive advantage.” He closed with a brief discussion of the CFTC’s budget request and said it would give the CFTC the resources necessary to efficiently monitor derivatives markets.

Question and Answer

Best Interest Standard

Lankford’s last question was on the SEC-proposed standards of conduct for investment advisors, and he asked if Clayton could provide some information on what will come out of the proposed rule. Clayton said there are two types of financial professional that investors deal with – investment advisors, who have a longer relationship with a client, and broker dealers, whose relationship is more “episodic.” Clayton said the SEC wants to keep those relationships intact, improve them, and clarify requirements financial professionals are subject to. He said it is a goal of the SEC that retail investors can have candid conversations with financial professionals about their compensation and incentives, so they can make informed decisions. He also noted the SEC’s town halls on the rule and said the agency wants to hear from investors about what they want out of their relationships with investment advisors. He did not provide a specific timeline on a new rule but said the agency would not “take forever” because this issue has been active for several years. 

Swaps Regulations and De Minimus Threshold

Lankford discussed a recent white paper by the CFTC Chairman on swaps regulations, and asked Giancarlo to walk the Subcommittee through the paper and any staffing needs related to it. Giancarlo said he believed that Congress got Title VII of the Dodd-Frank Act right, and that current swaps rules have been successful in important ways (he specifically noted the clearing mandate as a success, though he hedged by saying that the “supersized” clearinghouses raised new oversight questions). Giancarlo said one way the swaps rules could be improved is to not rely on the notional amount of swaps but net positions. He said the current reliance on notional value is “biased against swaps.” Giancarlo also said that regulators need a clearer picture of counterparty credit risk to identify trouble spots in the financial system.

Lankford asked Giancarlo about the decision to keep the swap dealer de minimus level at $8 billion in notional value rather than $3 billion. Giancarlo said that the $3 billion threshold, when first explored, was an “educated guess” and that the CFTC had little data about swap dealer size. Giancarlo said that after collecting data for years, the CFTC determined that dropping the de minimus threshold would gather in a negligible amount of new data about swap dealers, as most of the entities that would be captured would be small regional banks, agricultural co-ops, and power utilities. Giancarlo outlined discussions with those entities, in which many said if they were forced to comply with swap dealer registration they would likely severely curtail their operations to stay under the new threshold (Giancarlo also said that there is an estimated $300 million in compliance costs for registered swap dealers). Giancarlo said the harm to smaller dealers was not outweighed by any regulatory benefit and noted that large financial institutions must still register. 

Volcker Rule

Sen. John Kennedy (R-La.) asked Clayton and Giancarlo if changes to the Volcker Rule are coming “too quickly.” Giancarlo defended the changes contemplated to the Volcker Rule as narrow and moderate, and argued that separating proprietary trading and market making is difficult to execute in practice and was critical of the current presumption of proprietary trading that banks are subject to. Lankford later asked Clayton about Volcker Rule changes, and Clayton noted that the trading landscape encompasses a wide variety of firms, and that the regulatory burden of the rule was out of proportion to the total trading activity of small banks.  

Cybersecurity Disclosure

Sen. Chris Van Hollen (D-Md.) began by noting a recent White House report that discussed the impact of cyberattacks on U.S. companies, as well as the SEC’s recently issued guidance on guidelines for issuers on disclosure of cyber events. Van Hollen noted that there is still much ambiguity of what makes a cyber event or attack “material” and thus necessary of disclosure and asked for Clayton’s thoughts on this issue. Clayton noted the recent significant enforcement action against Yahoo! for their failure to disclose a breach and said that he is willing to work with Congress on the issue because disclosure is part of “good corporate hygiene.” Van Hollen recommended that the SEC look at the Office of Management and Budget’s (OMB’s) cyber disclosure guidelines and said they could provide a clearer definition for issuers and investors on what constitutes a material cyber event.

E-Delivery of Mutual Fund Documents

Sen. John Boozman (R-Mont.) noted that earlier that day, the SEC approved changes to Rule 30e-3 that replaced the current opt-in with an opt-out from electronically delivered mutual fund communications with investors. Boozman raised concerns with the rule change and its impact on elderly investors, especially in rural areas. Clayton defended the rule change, saying it was a “substantial departure” from what was originally proposed, and noted that the rule requires mutual funds provide extensive notice and opportunity to opt-in to paper communications to investors over a two-year transition period.

Dollar Pricing of Derivatives

Boozman asked Giancarlo to discuss the importance of dollar pricing for derivatives for farmers. Giancarlo said that it is a “tremendous advantage” for US farmers that they can price production in U.S. dollars. Giancarlo said policymakers should not be complacent that dollar pricing will be the status quo indefinitely, as countries like China will press for futures in their own currency as major consumers. 

Agency Budget Requests

Lankford noted the size of the CFTC’s budget request increase and asked what Giancarlo’s expectations are for future requests. Giancarlo noted that the CFTC has had flat funding for years, until a slight decrease in FY18, and that the requested increase is necessary because it would make up for not having modest increases in prior years. Giancarlo said that FY20’s increase would not be as big as FY19s. Giancarlo also said the increase was necessary to address places where the CFTC has had to make cuts in recent years, including in mission critical expenses such as examiners and technology. Giancarlo also said the agency is having attrition issues and have not been able to backfill positions due to budget constraints. He defended the $32 million increase necessary to acquire both the technology and personnel needed to accomplish the agency’s mission.

Lankford asked Clayton to describe the steps the SEC would take to modernize systems under the F19 request. Clayton said that the SEC needs to retire old systems and build new ones and protect data that is collected as part of its regulatory mission. In response to a follow-up question on data security of collected information, Clayton said the SEC “won’t take retail investor information” unless it is necessary to fulfill the agency’s mission.

Cryptocurrencies

Lankford asked Clayton and Giancarlo to describe their agencies’ work on cryptocurrencies and tokens, and if they had additional staffing needs related to these areas. Clayton said that the agencies have worked together on this topic and have developed new regulatory approaches. He defended the SEC’s regulation of transactions and issuers/traders of securities of all kinds and said that policymakers should pay attention to it due to money laundering and other concerns. Giancarlo agreed with Clayton that their agencies had worked well to develop new regulatory approaches and said that he believed the message was received by markets that unregistered initial coin offerings (ICOs) would not be tolerated.

Capital Formation

Lankford expressed concern about the decline in total number of public companies and the sluggish initial public offering (IPO) market and asked if activist investors and regulatory complexity are discouraging companies from entering public markets. Clayton said he shared concerns about the relative decline in public capital markets and noted that the last ten years have seen large changes to corporate governance dynamics for many reasons, including concentration of holdings and more shareholder involvement in governance decisions. Clayton said that policymakers should ask if things have “changed for the better.”

For more information on this hearing, please click here.