In 2010 the Basel Committee on Banking Supervision proposed new global liquidity and capital adequacy standards for the world’s banks and financial institutions.119 The new proposals, commonly known as “Basel III,” are intended to replace the current liquidity and capital adequacy minimum ratios for banks and financial institutions known as “Basel II.”120 The new guidelines on liquidity and capital adequacy proposed by Basel III were the most concrete response from the Basel Committee on the global financial crisis. Unsurprisingly, Basel III proposed increasing the liquidity and minimum capital adequacy ratios for international banks and retail deposit institutions.
Under Basel III, the minimum requirement for capital adequacy would be raised from the current requirement of 2% of banks’ net assets to 4.5%. In addition to the minimum capital equity ratio of 4.5%, banks would be required to provide a capital buffer of up to 2.5% by 2019.121 The capital conservation buffer is to allow for build-up during good times and a countercyclical measure during market stress. Hence, under the Basel III proposal, the minimum common equity capital ratio for all banks and retail deposit institutions would be 7.0%, representing a significant increase from Basel II.122
Under the proposed Basel III guidelines there would also be an increase in 2013 in the minimum Tier 1 capital liquidity ratio of 4.5% of a bank’s net assets;
this would rise steadily to 6.0% by 2015.123 The minimum total capital ratio would be set at 8.0% of total bank net assets and the minimum total capital including the conservation buffer would increase from 8.0% in 2013 and be phased in to 10.5% in 2019.124 According to the Basel Committee, “strong capital requirements are a necessary condition for banking sector stability but by themselves are not sufficient. Equally important is the introduction of stronger bank liquidity as inadequate standards were a source of both firm level and system wide stress.”125
The Basel III proposals are deliberately aimed at improving the capital adequacy and liquidity of international banks. The Basel Committee considered 119 Basel Committee on Banking Supervision 2010 (The Basel Committee’s response to the financial crisis: Report to the G20, October 2010, Basel: Bank for International Settlements).
120 The Basel Committee on Banking Supervision is based at the Bank of International Settlements in Basel, Switzerland, and is made up of a number of central bank representatives, including: the United States, the United Kingdom, Australia, Spain, China, Germany, France, Italy, Japan, Russia, Sweden and The Netherlands.
121 Basel Committee Report. Ibid., (n. 119), p. 16.
122 Ibid., (n. 119, p. 16.
123 Ibid., (n. 119), p. 16.
124 Under Basel III the minimum total capital including the conservation buffer will be 8% in 2013, 8.0% in 2014, 8.0% in 2015, 8.625% in 2016, 9.25% in 2017, 9.875% in 2018 and 10.5% in 2019.
125 Ibid., (n. 119), p. 6.
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that one important lesson to be learnt from the current financial crisis was that a number of financial institutions, including banks, did not respond well to the liquidity crisis confronting the international financial system. The post-GFC world would require new minimum benchmarks for liquidity and capital adequacy that would better position banks for external shocks and bouts of market stress.
Conclusion
The proposals for reform that have been discussed in this chapter have demonstrated a clear commitment from domestic and international regulators and policymakers to reform and overhaul the current regulatory framework. There is an undeniable sense that the regulatory and supervisory framework that existed in the lead-up to the crisis was inadequate and was prone to failure. Regulatory gaps, a lack of coordination and cooperation, regulatory arbitrage and failure to properly regulate financial innovation all contributed to make the financial crisis much worse than would otherwise have been the case.
Systemic failure in regulation coupled with widespread market failure combined to create the perfect financial storm. The storm that is now known as the global financial crisis emerged to engulf and undermine the world’s financial system and place in peril the entire international economy. Given the deficiencies and failings in international regulation it is not surprising that many of the proposals of reform make recommendations for enhanced regulation of financial markets, financial intermediaries, banks, investment banks, and consumer protection.
There may well have been insufficient or inadequate regulation of financial markets, which contributed to a lack of market discipline. However, it remains unclear why state regulation on its own would be the panacea for the perceived failings of a market-based financial system. The build-up of risk in financial institutions and financial markets had not been properly understood by anyone.
Regulators, policymakers, government and sophisticated market participants were unaware of the impending meltdown, yet many benefited from the financial innovation and global housing bubble during the boom times.
Many of the proposed reforms are indeed sensible and would make improvements to the way financial markets are regulated and supervised. However, there may also be a risk that the reforms would go too far and impose too high a burden on market participants and market intermediaries, which could lead to less financial innovation. A proper balance is needed to ensure that financial markets are properly and adequately regulated so that they are safe, reliable and sound. At the same time, financial innovation should be encouraged so long as the instruments and markets that are developed in the future serve a useful purpose, are properly understood and are not the subject of abuse.
Chapter 7
New Financial Markets Regulation
Introduction
The reform proposals discussed in Chapter 6 led to the development of new regulatory initiatives in the United States, the United Kingdom and other jurisdictions. The financial markets regulatory reforms in the US and the UK represented a comprehensive response to the financial crisis. The introduction of the Dodd-Frank Wall Street Reform and Consumer Protection Act 20101 in the US heralded a new era for the comprehensive regulation of financial markets, financial products and financial intermediaries. The Dodd-Frank Act 2010 also introduced groundbreaking reforms for consumers of financial services and residential mortgages.
The Dodd-Frank Act 2010 implemented many of the reforms that were proposed by a number of regulators, including the US Federal Reserve, the US Securities Exchange Commission, the Commodities and Futures Trading Commission, the US Department of the Treasury and the Office of the Comptroller of the Currency.
The reforms were designed to provide enhanced regulation and supervision of financial markets and financial intermediaries in the US. Most notably, the Act provides for comprehensive regulation of credit default swaps and centralized clearing of OTC derivatives contracts.
The Dodd-Frank Act 2010 established the Financial Stability Oversight Council (FSOC) to provide supervision and regulation of non-bank financial institutions.
The Financial Stability Council will also be responsible for providing up-to-date research and information concerning the activities and financial condition of banks, including non-bank financial entities that have total consolidated assets of
$US50 million. In addition to these new initiatives the Act also introduced new measures designed to regulate the activities of advisers to hedge funds, including private equity fund managers and investment banks.
Significantly, the Dodd-Frank Act 2010 also introduced comprehensive measures to provide greater investor protection. One of these reforms included establishing a new Office of the Investor Advocate, which has the responsibility of representing and promoting the interests of aggrieved retail investors. The Act introduced comprehensive reforms designed to improve financial protection
1 Pub L 111-203 H.R. 4173. The Act was passed by Congress “to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.”
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to consumers of financial products, financial services and financial markets. To achieve the stated aim of improving consumer protection, the Act established the Bureau of Consumer Financial Protection, providing the Bureau with a legal mandate to investigate allegations of consumer abuse.
New legislation similar to the Dodd-Frank Act 2010 has also been introduced in the UK in the form of the Financial Services Act 2010 (UK).2 The FSA 2010 introduces new measures aimed at protecting consumers, including providing them with compensation and redress if they have suffered loss or damage. Importantly, the FSA 2010 also introduces the new objective of promoting the financial stability of the UK financial system.
Both Acts are consistent with the overall objective of improving the way financial markets, financial products and financial intermediaries are regulated and supervised in the US and the UK. At the centre of both legislative initiatives are the twin objectives of promoting financial stability and providing adequate protection to consumers and investors in financial markets.
The Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010. The Act was a joint effort of Congressmen Barney Frank and Senator Chris Dodd. The legislation represented the responses of the House and Senate to the global financial crisis. The Act introduced sweeping reforms to the US financial architecture, including new regulation for OTC derivatives.
Regulation of OTC Swaps Markets
As is discussed in Chapter 2, OTC derivatives, including credit default swaps, synthetic derivatives and structured financial products, played a significant role in the current crisis. Credit default swaps had previously been largely unregulated and not subject to supervisory oversight by the Security Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC). The use of financial instruments such as credit default swaps also introduced potential conflicts of interest for hedge fund advisers and investment bankers.
The conflicts of interest were the subject of much enquiry and investigation by the US Senate Subcommittee into Wall Street and the Financial Crisis.3 It was alleged by the US Senate enquiry that conflicts of interest existed because
2 Hereinafter referred to as “FSA 2010.”
3 US Government 2011. United States Senate (Wall Street and the financial crisis:
anatomy of a financial collapse Majority and Minority Staff Report, April 13, 2011, Washington, DC: US Senate Permanent Subcommittee on Investigations). See also Chapter 6 in this volume.
New Financial Markets Regulation 171 investment banks would often take opposite positions to the clients they had been advising. The use of structured financial products, including credit default swaps, was often used to alter the risk profile of residential mortgage-backed securities so that the security would attract a higher investment rating.
The Dodd-Frank Act 2010 considered that the time had come to regulate all OTC swaps markets and all financial intermediaries dealing in OTC derivatives.
The definition of “swap,”4 and “swap dealer” under the Dodd-Frank Act 2010 had the same definition as under the Commodity Exchange Act 1936.5 Congress and the US Senate were also clearly of the view that before any rule-making would take place, the SEC and the CFTC would consult with each other and with any other regulator so as to achieve regulatory consistency and comparability.6
The issue of regulatory consistency was important given the previous history of disagreements and turf wars between the two regulators. Regulatory consistency was to be achieved as far as possible in relation to any new rule or order that was issued by the SEC or CFTC in relation to “swaps, swap dealers, derivative clearing organizations with regard to swap, eligible contract participants,”7 including
“security-based swap dealers, security-based swap participants, major security- based swap participants, eligible contract participants with regard to security- based swaps, or security-based swap execution facilities,”8 and “mixed” swaps.9
The Dodd-Frank Act 2010 also confirmed existing limitations on the jurisdiction and authority of the CFTC to makes rules or orders for: security-based
4 The term “swap” was defined to include “an interest rate swap, a rate floor, a rate cap, a rate collar, a cross-currency rate swap, a basis swap, a currency swap, a foreign exchange swap, a total return swap, an equity index swap, an equity swap, a debt index swap, a debt swap, a credit spread, a credit default swap, a credit swap, a weather swap, an energy swap, a metal swap, an agricultural swap, an emissions swap, and a commodity swap.” Dodd-Frank Act 2010, Section 721.
5 See Section 1a of the Commodity Exchange Act 1936 (7 U.S.C.). See also section 711 of the Dodd-Frank Act 2010: “the terms ‘prudential regulator,’ ‘swap,’ ‘swap dealer,’
‘major swap participant,’ ‘swap data repository,’ ‘associated person of a swap dealer or major swap participant,’ ‘eligible contract participant,’ ‘swap execution facility,’ ‘security- based swap,’ ‘security-based swap dealer,’ ‘major security-based swap participant,’ and
‘associated person of a security-based swap dealer or major security-based swap participant’
have the same meanings given the terms in section 1a of the Commodity Exchange Act (7 U.S.C. 1a), including any modification of the meanings under section 721(b) of this Act.”
6 Dodd-Frank Act 2010, Section 712(a)(1) and (2).
7 See Ibid., Section 712(a)(1).
8 See Ibid., Section 712(a)(2).
9 See Ibid., Section 712(8), which provides that for “mixed swaps” “The Commodity Futures Trading Commission and the Securities and Exchange Commission, after consultation with the Board of Governors shall jointly prescribe such regulations regarding mixed swaps, as described in section 1a(47)(D) of the Commodity Exchange Act (7 U.S.C.
1a(47)(D)) and in section 3(a)(68)(D) of the Securities Exchange Act of 1934 (15 U.S.C.
78c(a)(68)(D)), as may be necessary to carry out the purposes of this title.”
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swaps,10 activities or functions concerning security-based swaps,11 security-based swap dealers,12 major security-based swap participants,13 security-based swap data repositories,14 associated persons of a security-based swap dealer or major security-based swap participant,15 eligible contract participants with respect to security-based swaps16 and swap execution facilities with respect to security-based swaps.17
The Act also confirmed existing limitations on the jurisdiction of the SEC to regulate and make rules or impose orders with respect to: swaps,18 rules and orders in relation to activities or functions concerning swap dealers,19 major swap participants,20 swap data repositories,21 persons associated with a swap dealer or major swap participant,22 eligible contract participants with respect to swaps23 and swap execution facilities with respect to swaps.24
The limitations imposed on the SEC and CFTC jurisdictions were to ensure that there would be no confusion over the roles and responsibilities of each regulator. In effect, exclusive jurisdiction would be conferred on the CFTC over the regulation of OTC swaps markets except in the case of securities-based swaps, which would remain under the scope and ambit of the SEC. In relation to “mixed swaps,”25 the SEC and the CFTC would be required to consult with each other and the Board of Governors to ensure that any rules or orders were jointly issued.26
10 Section 712(b)(1)(A).
11 Section 712(b)(1)(B).
12 Section 712(b)(1)(B)(i).
13 Section 712(b)(1)(B)(ii).
14 Section 712(b)(1)(B)(iii).
15 Section 712(b)(1)(B)(iv).
16 Section 712(b)(1)(B)(v).
17 Section 712(b)(1)(B)(vi).
18 Section 712(b)(2)(A).
19 Section 712(b)(2)(B)(i).
20 Section 712(b)(2)(B)(ii).
21 Section 712(b)(2)(B)(iii).
22 Section 712(b)(2)(B)(iv).
23 Section 712(b)(2)(B)(v).
24 Section 712(b)(2)(B)(vi).
25 The term “mixed swap” is defined to include a “security-based swap [which]
includes any agreement, contract, or transition that is as described in section 3(a)(68) (A) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(68)(A)) and also is based on the value of 1 or more interest or other rates, currencies, commodities, instruments of indebtedness, indices, quantitative measures, other financial or economic interest or property of any kind (other than a single security or a narrow-based security index) or the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence (other than an event described in subparagraph (A)(iii)).” Dodd- Frank Act 2010, Section 721.
26 Ibid., Section 712(a)(8).
New Financial Markets Regulation 173 The Dodd-Frank Act 2010 also made provision for the possibility that agreement could not be reached by the CFTC and the SEC to jointly prescribe rules and regulations in a timely manner in relation to their joint rule-making authority. The Act provided that the FSOC would have authority to resolve any dispute involving joint rule-making within a reasonable time of a request being made.27
Importantly, the Dodd-Frank Act 2010 arms the CFTC and the SEC with legal authority to deal with any “abusive swaps.” The term “abusive swaps” is defined in Section 714 to include any types of swaps or security-based swaps that the Commodity Futures Trading Commission or the Security Exchange Commission considers “detrimental to – (A) the stability of a financial market;
or (B) participants in a financial market.” Section 714 provides legal authority to either the CFTC or the SEC to collect all relevant information as may be necessary and to issue a report with respect to the abusive swaps.
The Act goes further to give authority to the CFTC and the SEC to undertake a joint study in relation to OTC swap regulation in the United States, Asia and Europe. The joint report aims to provide detailed information on clearing house and clearing agency regulation in the United States, Asia and Europe. The report must also contain information which identifies areas of regulation around the world that are similar in the United States, Asia and Europe, including other areas of regulation that can be harmonized.28
The purpose of the joint report is to evaluate the costs and benefits of harmonizing US regulation of OTC swaps with swaps regulation from other jurisdictions. By harmonizing regulation, not only is the objective of regulatory consistency achieved but the problem of regulatory arbitrage is also overcome. In essence, if all of the world’s OTC swaps markets are harmonized from a regulatory perspective there is little or no incentive for financial intermediaries to engage in
“regulatory window shopping.” This is because regulation would be the same in all jurisdictions, thereby curtailing the incentive for financial intermediaries to transact in lower-cost jurisdictions.
Systemic Risk Swaps
The Dodd-Frank Act 2010 also introduced heightened regulation for institutions that pose systemic risk. All swap entities that pose systemic risk to the US financial sector will be subject to heightened prudential supervision.29 Not only will entities which pose a systemic risk to the United States be subject to heightened prudential supervision and regulation but also any firm that is placed into receivership or declared insolvent as a result of swap or security-based swap activity will not receive taxpayer funds.30
27 See Section 712(3).
28 See Section 719(4)(c)(1).
29 Section 716(c).
30 Ibid.
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The prohibition of the use of taxpayer funds for any potential bailout is an obvious change in US government policy, which had previously allowed the use of taxpayer funds to prevent a liquidation or for government-sponsored bailouts.
Section 716 of the Act makes the prohibition clear and goes further, prohibiting any “federal assistance”31 for government-sponsored bailouts of any swap entity or security-based swap entity or activity.32 The prohibition of any bailout of swap entities follows the widespread public outcry over the bailouts of Wall Street investment banks and hedge funds at the height of the crisis.
In addition to the prohibition on government-sponsored bailouts of swap entities and security-based swap entities, a ban on proprietary trading in derivatives has also been imposed by Section 716(m) of the Dodd-Frank Act 2010.33 The ban on proprietary trading in derivatives puts into place the so-called Volcker Rule.34 Section 619 of the Dodd-Frank Act 2010 implements the Volcker Rule to prohibit “banking entities from engaging in proprietary trading or from investing in, sponsoring, or having certain relationships with a hedge fund or private equity fund.”35
Standardized Algorithmic Models
Another important initiative of the Dodd-Frank Act 2010 was the proposal to commission a joint study by the SEC and the CFTC to investigate the use of standardized computer-readable algorithmic descriptions.36 The objective of the proposed study is to assess whether standardized computer-readable algorithms can be used to describe both complex and standardized financial derivatives.37 The
31 The term “federal assistance” is broadly defined to include “the use of any advances from any Federal Reserve credit facility or discount window that is not part of a program or facility with broad-based eligibility under section 13(3)(A) of the Federal Reserve Act, Federal Deposit Insurance Corporation insurance or guarantees […].” Section 716(b).
32 The Dodd-Frank Act 2010, Section 716(a) provides for the general prohibition on federal assistance to be made to any swap entity: “Notwithstanding any other provision of law (including regulations), no Federal assistance may be provided to any swaps entity with respect to any swap, security-based swap, or other activity of the swaps entity.”
33 Section 716(m) provides that “an insured depository institution shall comply with the prohibition on proprietary trading in derivatives as required by section 619 of the Dodd- Frank Wall Street Reform and Consumer Protection Act.”
34 The Volcker Rule derives its name from former Chairman of the US Federal Reserve, Paul Volcker. The Volcker Rule and its implementation are discussed in more detail below.
35 US Federal Reserve System, Rules and Regulations, Federal Register, Volume 76, No. 30, Monday February 14, 2011 pp. 8265–78 at p. 8265.
36 Section 719(b).
37 According to Section 719(2) the “algorithmic descriptions shall be optimized for simultaneous use by – (A) commercial users and traders of derivatives; (B) derivative clearing houses, exchanges and electronic trading platforms; (C) trade repositories and regulator investigations of market activities; and (D) systemic risk regulators.”