Thought Leadership
Policy Library

The CFS Policy Library provides public access to compiled academic, regulatory and practitioner papers on topics of financial and regulatory policy. As to each of these topics, the compiled materials in the CFS library demonstrate the considerable amount of study and thought that has been previously brought to bear by thought and action leaders. By providing an easy means to access such work — work that inevitably reflects different considerations and may reach divergent conclusions — CFS hopes to facilitate open and informed debates on significant policy issues, debates that CFS aims to push beyond each of our personal instincts and inclinations to make the best use of our society’s available (and ever-changing) knowledge.

If you are aware of other papers or materials that should be included under one of our listed compilations, or if you would like to see the CFS Policy Library expanded to cover other specific topics, please send us an email to

Steven Lofchie

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Show All Broker Dealer/Fiduciary Duty
Central Clearing Cost-Benefit Analysis
Executive Compensation Hedge Funds
Market Liquidity Concerns Position Limits
Rating Agencies Risk Retention
Shadow Banking Short Sales
Systemic Risk Too-Big-to-Fail
Transparency Virtual Currency
Volcker Rule
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Broker Dealer / Fiduciary Duty

Historically, broker-dealers have not been subject to a fiduciary duty in their dealings with customers. This means that legally, and contrary to many customers’ expectations, brokers are not obligated to act in their clients’ best interests when providing investment advice, which stands in contrast to rules governing the conduct of investment advisors, who are bound by a fiduciary duty and who often perform similar functions as brokers. Despite the apparent loophole for brokers, however, brokers are subject to the antifraud provisions of the securities laws, and investors can pursue claims for misrepresentation, suitability, and breach of contract through SROs.

The financial crisis renewed concerns about broker-dealer regulation as conflicts of interests at firms such as Goldman Sachs were pulled into the limelight. Dodd-Frank responds by authorizing, but not requiring, the SEC to implement heightened disclosure and compensation rules, and standards of conduct. Despite Dodd-Frank’s lofty rhetoric, the legislation has not garnered heated debate. Some commentators suggest that this is because, as a practical matter, imposing fiduciary duties won’t change much, while others attribute this reaction to an anticipated lack of teeth in future rulemakings. That being said, extending an overly broad standard could create pitfalls: for example, it could create conflicts of duties for broker-dealers in the course of some of their traditional roles, such as when acting as dealers or underwriters.

February 2011 Stock Broker Fiduciary Duties and the Impact of the Dodd-Frank Act
Thomas Lee Hazen (Univ. North Carolina School of Law)
Rules and standards proscribed by the SEC and SROs provide a robust basis for regulating the conduct of broker-dealers, even in the absence of an explicit fiduciary standard. This is especially true in cases where the broker-dealer is acting as more than a mere “order taker,” since in these cases the SEC has implicitly recognized the existence of fiduciary duties. Accordingly, while Dodd-Frank gives the SEC the authority to impose “heightened” standards of care, the extent of existing standards dictates that anticipated changes will not create the “sea change” that some broker-dealers fear. That being said, explicitly adopting a fiduciary standard would provide needed clarification and additional guidance to broker-dealers and their customers.
January 2011 Regulatory Coverage Generally Exists for Financial Planners, but Consumer Protection Issues Remain
U.S. Government Accountability Office
Between 2000 and 2008, the number of financial planners (a group including financial advisers, trust advisors, wealth managers, etc.) in the U.S. grew by over 100%. Despite its growing significance, the profession remains governed by a patchwork of state and federal investment advisor, securities and broker-dealers laws and SRO rules. As a result, enforcement of regulations can be inconsistent, and questions exist about consumers’ understanding of the roles, titles, standards of care, and conflicts of interest that a financial planner may have. Despite these problems, the GAO concludes that an additional level of regulation specific to financial planners is unnecessary and would be largely duplicative. The GAO notes that this finding is consistent with the opinions of a majority of stakeholders including regulatory agencies, consumer groups, and financial services companies.
January 2011 Study on Investment Advisors and Broker-Dealers
U.S. Securities and Exchange Commission
As mandated by DFA, the SEC conducted a study to assess the effectiveness of the dual regulatory regimes that apply to investment advisors and broker-dealers. Noting the inconsistent standards governing the two groups, the Report recommends that the SEC invoke its rulemaking authority to implement a “uniform fiduciary standard” for both groups. The standard would require that brokers, dealers and investment advisors, when providing personalized investment advice, act in the best interest of the customer without regard to the financial or other interests of the party providing the advice. In addition, citing several studies submitted by stakeholders, the Report concludes that imposition of a uniform standard would not substantially increase compliance costs. This approach differs from proposals that would harmonize regulation by removing the broker-dealer exclusion from the Advisers Act (i.e. subjecting broker-dealers to investment advisor registration). The Report concludes that removing the exclusion could be both disruptive and duplicative, and could encourage affected broker-dealers to realign their business units at added costs to both firms and customers.
August 2010 How to Improve Retail Investor Protection After the Dodd-Frank Wall Street Reform and Consumer Protection Act
Barbara Black (Univ. of Cincinnati College of Law)
Under DFA, the SEC is charged with harmonizing the standard of conduct applicable to broker-dealers (BDs) and advisers and with considering a prohibition against mandatory arbitration clauses in customer agreements. Recent debate on these topics overlooks the interrelatedness of the two issues: as investors seek damages arising from breaches of new standards, limiting the use of arbitration agreements will direct these claims to courts, a move that could ultimately undermine DFA’s intent. Black argues that adopting a fiduciary duty for BDs would be inappropriate because fiduciary duties are too amorphous to be helpful. Instead, BDs and investment advisors should be held to professional standards of care and competence, as outlined in the article. However, Black cautions that courts are unlikely to imply a private cause of action for breaches of the new standards. Thus, investors would be better served if the SEC continues to permit mandatory arbitration agreements. Arbitration forums are equitable and allow investors to receive damages for negligent investment advice, even in the absence of a legal cause of action. Consequently, limiting the use of arbitration will most likely hurt retail investors.
February 2010 Reforming the Regulation of Broker-Dealers and Investment Advisers
Arthur B Laby. (Rutgers Univ. School of Law)
Over the past twenty-five years, changes in the financial services industry have blurred the line between brokers and advisors. Particularly in cases where brokers market themselves as financial advisors and/or receive fee-based compensation, the two groups perform similar functions yet are regulated under different legal regimes. Laby argues that this inconsistency is untenable. However, simply adopting a fiduciary standard for all broker-dealers (BDs) overlooks important features of the relationship between BDs and their clients. Specifically, when acting as dealers or underwriters, BDs are in an adversarial position towards their clients. Imposing a fiduciary duty would create a conflict of duties in these instances. Accordingly, reform must enhance BDs’ duties, on the one hand, without impeding traditional roles. To this end, Laby recommends adopting heightened disclosure rules for principal transactions, limiting principal transactions to securities for liquid instruments, explicitly prioritizing brokers’ duties and employing qualified independent underwriters to oversee public offerings. In addition, Laby acknowledges that simply extending fiduciary obligations to all brokers would overwhelm regulators, and policymakers must address the need to efficiently allocate limited resources. Laby recommends increasing the monetary threshold for registration or exempting brokers from adviser registration while subjecting them to the Advisors Act’s antifraud provisions.
2006 Transforming Rhetoric into Reality: A Federal Remedy for Negligent Brokerage Advice
Barbara Black (Univ. of Cincinnati College of Law)
Black contends that a fundamental deficiency in the current federal regulatory scheme governing broker-dealers is that customers have no federal remedy for injuries caused by the investment advice of incompetent or negligent salespersons. Despite the lofty rhetoric embodied in federal securities laws, Congress and the courts have been reluctant to create or infer private remedies for investors. As a result, investors who are victims of broker negligence must defer to state agency or tort law to seek redress. However, state laws provide inadequate protection and are inconsistently interpreted. Therefore, Congress should amend the Securities Exchange Act to establish federal standards of care and provide investors with an express remedy for broker negligence.
Central Clearing

In response to the narrative of the role of derivatives in the recent financial crisis, Dodd-Frank requires central clearing of standardized swaps. Critical to implementing the mandate is a determination of what types of derivatives must be cleared. To this end, commentators warn that regulators have a fine line to walk: giving the definition too narrow a scope will subvert Dodd-Frank’s effect, while casting too wide a net will impede trading in less fungible, but legitimate, products. In addition to defining what types of swaps must be cleared, the legislation raises a host of related issues. For example, regulators must contend with systemic risks posed by clearing houses, determine margin requirements for cleared and non-cleared transactions, and consider how to promote particular central counterparties without imposing unmanageable barriers to entry.

Many commentators have doubted the efficacy of central clearing for derivatives products. For one thing, parties can escape central clearing by trading customized rather than standardized derivatives. Other critics remark that the legislation is misguided because only the most liquid products, which pose little systemic risk, are likely to be cleared. One alternative or complement to mandatory clearing uses capital requirements on non-cleared transactions to increase incentives for market participants to clear trades.

September 29, 2015 In Defense of Derivatives: From Beer to the Financial Crisis
Bruce Tuckman (New York University Stern School of Business and Senior Fellow at the CFS)
Tuckman argues that derivatives were not the central cause of the economic crisis of 2007-2008. He uses the Anheuser-Busch Corporation to demonstrate how businesses use derivatives to minimize variability in costs and profits. He criticizes some of the initiatives set in motion by Dodd-Frank. First, rules that treat derivatives in isolation are unlikely to reduce the overall risk of individual financial firms or the financial system. Second, rules that make derivatives harder to use will reduce derivatives risks, but the reduction will be at the expense of increasing business risks. Policies aimed at holistic risk management, reporting, and supervision would be more successful in reducing systemic risk.
April 2011 Counterparty Risk Externality: Centralized Versus Over-the-Counter Markets
Viral Achaya (New York Univ.) and Alberto Bisin (New York Univ.)
The authors explain why opacity in the OTC markets creates a market failure. While the payoff on each position depends somewhat on the counterparty risk assumed by the other party, this information is generally non-public. As a result, there is no way for market participants to price this risk or penalize counterparties for taking on too much risk. Thus, opacity leads to a “counterparty risk externality” and encourages excessive risk exposure and inefficient risk-sharing. To alleviate the problems posed by opacity, the authors recommend creating a centralized clearing mechanism that essentially serves as a data repository. Clearing would mitigate externalities by facilitating greater transparency and enabling counterparties to condition contract terms based on overall positions. The authors note that centralized exchanges can provide similar benefits, but at the cost of restricting trading.
April 2011 Does a Central Clearing Counterparty reduce Counterparty Risk?
Darrel Duffie (Stanford Univ.) and Haoxiang Zhu (Stanford Univ.)
The authors show that although central clearing of derivatives can, in theory, reduce counterparty risk, fragmentation among CCPs diminishes such benefits. Separate central clearing of one class of derivatives can actually reduce netting efficiency. Similarly, when multiple derivatives classes are cleared, it is always more efficient to clear them on the same CCP rather than multiple CCPs. As a policy matter, these results recommend a move toward the joint clearing of standard interest rate and credit default swaps in the same CCP or greater interoperability among CCPs and participants.
March 21, 2011 Private Law and the Public Sector’s Central Counterparty Prescription for the Derivatives Markets
Joanne P. Braithwaite (London School of Economics)
Braithwaite contends that implementation of rules to move OTC trading to central counterparty clearing houses (CCPs) is faltering because policymakers have not given sufficient weight to the legal nature of CCPs. Debates thus far have focused on the technical aspects of how clearing should work in practice. However, exploring clearing as a matter of private law would help in identifying the system’s inherent benefits and limitations. In particular, Braithwaite’s provides insight into what factors rules related to contract standardization, collateralization, netting, insolvency, and CCP membership should consider. Braithwaite’s also addresses the concern novation in CCPs will concentrate risk in the CCP itself, potentially creating a new source of systemic risk that regulators must address.
March 2011 Market Structure, Counterparty Risk, and Systemic Risk
Dale W.R. Rosenthal (Univ. of Illinois - Chicago)
Rosenthal studies how an initial bankruptcy affects counterparty behavior in both bilateral and centrally-cleared markets. His results indicate that bilateral markets pose greater potential for systemic risk, larger externalities (i.e. volatility), in addition to liquidity and funding crises. Further, the different market effects are apart from any concerns about adverse selection and are due strictly to market structure. While these results indicate that there is a benefit to trading on centrally-cleared markets, Rosenthal cautions that bilateral markets have small startup costs and thus are important for financial innovation.
February 2011 The Legal Origin of the 2008 Credit Crisis
Lynn A. Stout (UCLA School of Law)
Stout attributes the financial crisis to the Commodities Futures Modernization Act of 2000 (CFMA), which removed constraints on speculative OTC derivatives trading. Prior to the CFMA speculative trading was performed on organized exchanges, with only hedging transactions permitted in OTC markets. The CFMA allowed speculative OTC trading in derivatives for the first time resulting in exponential increases in the size of the OTC market and the level of systemic risk. Stout concludes by noting that Dodd-Frank’s attempt to turn back to the clock by reimposing a clearing requirement on speculative financial derivatives is commendable. However, the significant amount of discretion given to the CFTC in defining exemptions from the clearing requirement could undermine the statute if the CFTC uses its authority to diminish the scope of clearing.
September 2010 The Emergence and Future of Central Counterparties
Thorsten V. Koeppl (Queen’s Univ.), Cyril Monnet (Fed. Reserve Bank of Phil.)
The authors consider whether central clearing, which has been beneficial for the clearing of exchange-traded products, should be extended to OTC markets. They conclude that the use of CCPs in OTC markets is less beneficial compared to exchange-based markets because customization diminishes CCPs ability to fully guarantee performance or mandate clearing. However, that is not to say that CCPs are irrelevant to OTC markets. The authors explain that bargaining in bilateral contracts leads to an inefficient allocation of default risk relative to the gains from customization; however, CCPs can offer a transfer scheme to remedy this imbalance. A CCP can provide diversification benefits and partial insurance through novation even for customized contracts. This would provide an incentive for counterparties to clear OTC transactions and enable CCPs to manage both individual counterparty risk and overall market risk.
September 2010 What is Clearing and Why is it Important?
Ed Nosal (Chicago Fed. Reserve Bank), Robert Steigerwald (Chicago Fed. Reserve Bank)
The authors explain clearing through the lens of counterparties’ inability to “commit,” or keep their promises to perform contractual obligations. Clearing corrects for this risk by using insurance to protect counterparties’ in the event of default. This results in a more efficient means of exchange and benefits society at large.
June 2010 The Inefficiency of Clearing Mandates
Craig Pirrong (Univ. of Houston)
Pirrong warns that, while central clearing for derivatives can lead to a more efficient allocation of risk, this mechanism is vulnerable to moral hazard and adverse selection, both of which are difficult to control. Pirrong argues that the bilateral market is less vulnerable to moral hazard because it does not treat dealer balance sheets as public goods, and each market participant must internalize its own risks and costs. The result is a market with more effective pricing mechanisms, decreased moral hazard, and lower adverse selection costs. On balance, it is more efficient to forego the risk-sharing benefits of central clearing to forego moral hazard and adverse selection costs. As an alterative to central clearing, Pirrong recommends an auction-type mechanism that would facilitate the replacement of defaulted OTC derivative positions. This would mitigate the primary weakness of OTC markets (i.e. counterparty risk) while exploiting their information and incentive benefits.
March 2010 Policy Perspectives on OTC Derivatives Market Infrastructure
Darrell Duffie (Stanford Univ.), Ada Li (New York Federal Reserve), and Theo Lubke (New York Federal Reserve)
The authors discuss several policy responses that could solve what the authors consider the primary problems undermining the safety of the derivatives market: limited transparency and failures in risk management. Central clearing is an important means of addressing these problems, and the authors recommend several policies that would ensure that clearing is implemented safely and efficiently. Among others, regulators should take steps to: 1) demand strict acceptance criteria to market participants that wish to clear their trades with CCPs; 2) require members to post initial and variation margin; 3) require members to contribute capital to a pooled CCP guarantee fund; 4) use adjustments in capital requirements to discourage excessive risk-taking; and 5) encourage joint clearing in the same CCP to encourage netting. Regulators should also address the fact that, as a result of mandated clearing, CCPs will themselves become more systemically important. Therefore, regulators must ensure that CCPs have financial resources and risk management designs that are robust enough to withstand extreme loss scenarios.
2010 Let’s Make it Clear: How Central Counterparties Save(d) the Day
Cyril Monnet (Federal Reserve Bank of Philadelphia)
Cyril contends that one of the biggest problems limiting the viability of central clearing in OTC markets is establishing a payment scheme that compensates CCPs for clearing risks without discouraging low-risk traders from clearing. CCPs for OTC products face increased risk due to their limited ability to net counterparty risk for customized contracts and higher replacement cost risk. While a CCP’s natural response might be to increase payments to its default funds, increasing costs could discourage low-risk traders from clearing. This would result in a CCP with a higher concentration of high-risk traders, leaving the CCP potentially unstable. To resolve this, Cyril recommends that CCPs subsidize their OTC risk management activities using its centralized market clearing activities. This would induce low-risk traders to clear trades through CCPs, and, while it would increase costs for traders on centralized exchanges, would result in overall gains.
September 2009 Centralized Clearing for Over-the-Counter Derivatives
William Balson (RBS Acquisition Co.), Gordon Rausser (Univ. of California - Berkeley), and Reid Stevens (Univ. of California - Berkeley)
The authors recommend a public-private structure for CCPs to manage risk propagated through the OTC market. The problem with the proposed private CCP structure is that, while it creates a private good by reducing counterparty default risk, it creates an undersupply of public and impure goods. The authors argue that explicit government involvement is necessary to correct this imbalance. This could be achieved by having CCP members pay the government a fee for the insurance it provides as “guarantor of last resort.” This structure would cure the private system of its moral hazard problem, discourage excessive risk taking, and provide regulators with the tools needed to manage systemic risk ex ante.
August 2009 How Should We Regulate Derivatives Markets
Darrell Duffie (Stanford Univ.)
Duffie attributes the severity of the financial crisis, in part, to the unregulated derivatives market. Clearing can be an effective tool for mitigating future problems associated with standardized derivatives assuming that clearing houses are themselves well capitalized. However, he questions the effectiveness of using legal definitions to segregate the types of derivatives that must be cleared, as market participants can easily de-standardize their contracts to avoid clearing. A better approach involves using capital regulation to increase incentives for market participants to have a larger fraction of their derivatives cleared. This could be done by reducing capital requirements for banks with cleared positions or requiring a specified fraction of netted exposures to be cleared.
July 6, 2009 The Treasury Department’s Proposed Regulation of OTC Derivatives Clearing and Settlement
Christopher Culp (Univ. of Chicago)
Culp contends that proposals to mandate central clearing of OTC derivatives are misguided because they assume that standardized OTC derivatives played a far greater role in the recent crisis than is reasonable, thus ignoring other important risks. Worse still, central clearing is likely to engender significant legal and regulatory uncertainty, impede financial innovation, increase overall costs, and undermine the competitiveness of U.S. derivatives participants. Culp also addresses a more fundamental problem inherent in all financial product regulation: product innovation is generally one step ahead of product regulation. Thus, regulation would be more effective if aimed at improving enterprise-wide supervision of financial institutions across all of their risk-taking activities, as opposed to focusing on specific products.
June 4, 2009 Testimony before the Senate Agricultural Committee, Hearing on Regulatory Reform and the Derivatives Markets
Michael W. Masters (Masters Capital Management, LLC)
Masters argues that mandatory exchange clearing of OTC derivatives is necessary to prevent another systemic crisis. Exchange clearing would solve the catalysts of the recent crisis - specifically, the complex web of exposures between dealers and the excessive amount of leverage made permissible through minimal margin requirements. The new clearing process should require both novation and margin requirements. Masters attributes Wall Street’s opposition to higher regulatory standards out of concern for the fact that 1) increased transparency will reduce bid-ask spreads; 2) novation will diminish the value of dealers’ credit ratings by enabling any two counterparties to trade with one another; and 3) trading profits will decrease due to stricter leverage requirements. Last, Masters addresses Wall Street’s objections that swaps are too customized to clear. This problem can be resolved by focusing on clearable vs. non-clearable, rather than standardized vs. customized, derivatives.
January 2009 The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of Default Risks Through a Central Counterparty
Craig Pirrong (Univ. of Houston)
Pirrong argues that market participants’ preference for the bilateral risk-sharing model suggests that the purported benefits of central clearing are illusory and may not increase overall welfare. Specifically, Pirrong explains how CCPs can actually increase the cost of asymmetric information - leading to mispricing - and merely transfer, rather than reduce, many market risks and costs. Moreover, even if one assumes that bilateral structures create greater negative externalities than central clearing, that fact taken alone does not justify mandated clearing. In fact, because netting largely transfers risk from counterparties to creditors, and because the solvency of other creditors may have systemic implications, simply reducing the losses that dealers suffer may do nothing to mitigate systemic risk. This relationship, coupled with the potential for increased default risk, asymmetric information costs, and institutional constraints, undermine the notion that central clearing is the cure-all remedy that its advocates envision.
June 9, 2008 Testimony before the U.S. Senate Subcommittee on Securities, Investment and Insurance of the Committee on Banking, Housing and Urban Affairs, Hearing on Reducing Risks and Improving Oversight in the OTC Credit Derivatives Market
Craig S. Donohue (CME Group Inc.)
Donahue addresses the risks created by the credit derivatives OTC market and the need to implement an integrated exchange with CCP clearing. OTC market shortcomings - specifically, a severe lack of transparency and standardization - exacerbate mispricing and limit participants’ abilities to protect themselves. Combined, these issues contribute to unreasonable levels of volatility and liquidity risk. Moving credit derivatives onto an exchange model would foster price transparency and standardization, while the use of CCPs would streamline the mark-to-market process, guarantee performance, and allow participants to efficiently net exposures.
Cost-Benefit Analysis

To the extent that a regulation imposes social or market costs without creating corresponding benefits, that regulation is deemed undesirable. As an example, observers often assume that increased transparency is always good. Yet, to the extent that disclosures impose collection and distribution costs on firms, create regulatory costs, and do not provide useful information for market participants, disclosure should be limited.

Turning to U.S. financial reform, commentators, including agency staffers, have criticized SEC and CFTC cost-benefit analyses as outdated, overly-simplistic, and politically motivated. In addition, many studies overstate benefits by failing to account for intangible costs, such as those arising from legislative and regulatory inefficiency. The DC Circuit Court recently echoed this sentiment when it vacated the SEC's Proxy Access Rule. It found that contrary to the SEC's statutory mandate to consider the rule's impact on efficiency, the agency failed to conduct any quantitative or empirical analysis.

As industry groups seek to challenge provisions of Dodd-Frank, the DC Circuit’s decision will inevitably subject regulators’ work to enhanced scrutiny.

July 22, 2011 Business Roundtable and U.S. Chamber of Commerce v. SEC
D.C. Circuit Court
The D.C. Circuit Court vacated the SEC’s proxy access rule 14a-11 on the basis that the SEC failed to adequately consider the rule’s effect on efficiency. The rule would require boards to include in firm proxy materials persons nominated to the board of directors by qualifying shareholders. Among the rule’s benefits, the SEC cited a reduction in free-rider and collective action concerns, and reduced postage costs for shareholders. Costs included a potentially adverse effect on company performance, mailing costs for boards, and expenses incurred to challenge shareholder nominees. The court rejected the SEC’s conclusion that the rule was net beneficial by noting that it lacked any empirical or quantitative backing. The ruling is likely to further delay the implementation of Dodd-Frank reforms by demanding more robust economic analysis by rulemakers.
June 13, 2011 Report of Review of Economic Analyses Performed by the Securities and Exchange Commission in Connection with Dodd-Frank Act Rulemakings
Office of the Inspector General of the SEC
The Report reviewed the rulemaking process for rules related to, among other things, risk retention and clearing agency standards. While the SEC formed teams with sufficient expertise to conduct a thoughtful review of the relevant releases, the Report criticizes the SEC for failing to work more closely with the Commission’s economists in conducting cost-benefit analyses. Cost-benefit analyses is fundamentally an exercise in economics; thus, the Commissions failure to more thoroughly incorporate the insights of trained economists is troubling.
April 15, 2011 An Investigation Regarding Cost-Benefit Analyses Performed by the Commodity Futures Trading Commission in Connection with Rulemakings Undertaken Pursuant to the Dodd-Frank Act
Office of the Inspector General of the CFTC
The Report assesses the cost-benefit analyses employed by the CFTC in connection with rulemakings regarding requirements for Designated Contract Markets, and regulations for Swap Dealers and Major Swap Participants. The Repot criticizes the CFTC’s over-reliance on the opinion of the Office of General Counsel (OGC) at the same time that recommendations from the Office of Chief Economist (OCE) went unheeded. This stands in obvious contrast to what is expected of sound cost-benefit analyses. For example, the OCE recommendation to address the operational and compliance costs for parties being covered under “Swap Dealer or “Major Swap Participant,” was ignored. Also problematic was the fact that the OGC tended to rely on an outdated and stripped-down cost-benefit methodology at the expense of a more robust approach offered by the OCE.
March 30, 2011 Review of CBO’s Cost Estimate for the Dodd-Frank Wall Street Reform and Consumer Protection Act
Douglas Elmendorf (Congressional Budget Office)
The CBO study provides an estimate of direct spending and revenue expected to result from implementation of DFA from 2010-2020. The CBO concluded that the DFA would increase revenues and direct spending by $13.4 billion and $10.2 billion, respectively. This amounts to a $3.2 billion deficit reduction. Revenue would stem primarily from fees assessed on various financial institutions, while costs are primarily attributable the financing of the Orderly Liquidation Fund. Other relevant expenses include those associated with expanding the size and responsibilities of regulators such as the SEC and CFTC; however, such expenses would be largely offset by increased revenue, resulting in net cost of $.1 billion.
2011 Dodd-Frank: Quack Federal Corporate Governance Round II
Stephen M. Bainbridge (UCLA School of Law)
Bainbridge uses the SEC’s gross underestimation of the costs associated with implementing the Sarbanes-Oxley Act of 2002 to cast a larger criticism of the “boom-bust-regulate” pattern that characterizes U.S. corporate governance regulation. With Dodd-Frank U.S. policy makers are at it again, and while some corporate governance provisions are meaningless symbolism, others are likely to have serious adverse consequences. For example, proxy access, which lacks any empirical basis, is likely to facilitate the growth of divided and adversarial boards. Executive compensation reforms are based on similarly dubious footing and will impose direct and indirect costs on boards. Bainbridge concludes by noting the addition of new corporate governance reforms is symptomatic of the “ratchet effect,” which anticipates that government will increase in size and scope following every crisis in response to public pressure; however, this growth will not be matched by corresponding efficiencies or subsequent reductions.
January 2011 Understanding Financial Regulation
Eric. J. Pan (Cardozo School of Law)
In examining what factors drive financial regulation, Pan highlights the influence of resource constrains. First, Pan addresses the cyclical pattern of lighter-to-heavier regulatory activity before and after crises. In the aftermath of any crisis, regulators face intense pressure to demonstrate that they are in control of the financial markets and, consequently, rely on public strategies. However, as resource constraints force regulators to reduce costs yet maintain oversight, they revert to private strategies such as self- or principles-based regulation. Resource constraints also affect decisions to adopt potentially suboptimal public regulation, either because private regulation is inappropriate (e.g. systemic risk regulation) or too expensive. In these cases, regulators adopt “blunter strategies” such as the Volcker Rule, or abandon regulatory strategies in favor of extra-regulatory solutions such as bank fees and size limitations. These strategies are less costly, but not as fine-tuned.
March 2010 The Cost of the Financial Crisis: The Impact of the September 2008 Economic Collapse
Phillip Swagel (Georgetown Univ. - McDonough School of Business)
In order to understand the potential value of economic reform, Swagel attempts to quantify the economic and budgetary costs resulting from the financial crisis. Swagel identifies budgetary costs of $73 billion associated with TARP, the guarantee of bank liabilities, and bailouts of Bear Stearns, Fannie Mae and Freddie Mac. However, economic costs associated with the depletion of income and jobs created the largest loss: GDP decline created an income loss of $650 billion, while losses from real estate and stock declines amounted to trillions of dollars. Swagel also assesses the human costs of the crisis, taking into account factors such as increases in poverty and foreclosure rates.
March 2009 Does the Sarbanes-Oxley Act Have a Future
Roberta Romano (Yale Law School, NBER)
Romano examines the likelihood of amending SOX’s most costly provisions - those imposing compliance costs on small firms. In so doing, she assesses the SEC’s disappointing history in conducting thorough cost-benefit analyses. For example, agencies cite “ambiguities” in quantifying costs and benefits to justify significant discretion in construing results. Also problematic is the fact that the SEC has traditionally been a lawyer-centered agency with economists playing a relatively marginal role in decision-making. Thus, despite the relevance of economics in any cost-benefit analysis, SEC decisions have tended to focus on policy, at the expense of thorough quantitative assessments. Romano also stresses the difficulties inherent in amending any piece of financial reform legislation, even in cases where the legislation’s failings are apparent. Her analysis suggests that it is easier to draft legislation in times of crisis founded on good intentions that produce unintended and substantial costs, than it is to correct such legislation thereafter. One way of mitigating the potential for crisis-induced blunders is to include a sunset provision, which would allow policy makers to revisit legislation and remove some of the roadblocks that typically constrain legislation from being changed.
September 2008 Designing Smarter Regulation with Improved Benefit-Cost Analysis
Robert W. Hahn (AEI, Brookings Inst.)
Hahn faults the standard cost-benefit methodology used by policy makers for employing an overly narrow cost component. The standard model ignores important cost components such as those associated with political inefficiency and design and implementation. As a result of these shortcomings, benefits are often overstated leading to excess regulation.
November 2006 Focusing More on Outputs and on Markets: What Financial Regulation Can Learn from Progress in Other Policy Areas
Lawrence J. White (New York Univ. - Stern)
White argues that in conducting cost-benefit analyses, policy makers should move from an input-oriented process toward an output-oriented one with greater reliance on markets. The primary shortcomings of input-oriented processes is that they typically use a one-size-fits-all approach that create unnecessary costs associated with poor fit. An output-oriented approach - for example, the cap-and-trade program - allows firms to chose how regulatory mandates are met by creating a market for permits where high-polluting firms buy permits from low-polluting firms. This allows regulators to monitor overall pollution levels without needlessly interfering with firm decisions. Turning to financial regulation, White explains how a similar scheme could be applied to the Community Reinvestment Act and NRSRO reform.
August 2005 Variation in the Intensity of Financial Regulation: Preliminary Evidence and Potential Implications
Howell E. Jackson (Harvard Law School)
Jackson laments the absence of research on how to determine the optimal level of regulation for financial markets. This is surprising given the important role of cost-benefit analysis in crafting regulations. Admittedly, there are numerous difficulties inherent in quantifying many of these costs and benefits, with societal benefits being particularly difficult to measure. Despite these limitations, Jackson presents some data on regulatory costs in the U.S. and other countries. Even after making adjustments for the size of U.S. financial markets, the costs of regulation in the U.S. are substantially higher than comparable costs in other jurisdictions. Jackson also finds that compared to the U.K. and Germany, the intensity of securities enforcement actions in the U.S. is significantly higher; not only are there more regulators, but they carry bigger sticks than their foreign counterparts.
March 2002 SEC Operations: Increased Workload Creates Challenges
General Accounting Office
The Report notes that around 1996, the SEC’s workload started to increase at a much higher rate than SEC staff resources. These limited staff resources have resulted in substantial delays in SEC regulatory and oversight processes, which hamper competition and reduce market efficiency. For example, the SEC has failed to keep pace with a growing number of SRO rule filings related to the registration of new exchanges. Such delays can cause the applicant SRO to lose competitive advantage. Similar delays occur for responses to interpretative guidance and exemption requests. In addition to resource limitations, constraining factors include: high staff turnover resulting in more inexperienced staff and regulatory delays; securities laws, which require SEC approval of market innovations, lead to regulatory bottlenecks; and suboptimal budgetary and strategic planning processes.
Executive Compensation

Debate surrounding executive compensation has focused on how compensation-based incentives affect executive risk-taking. Traditionally, corporate boards sought to align executive pay with shareholder interests through the issuance of equity interests; however, studies suggest that such alignment may encourage executives to focus on short-term results. Alternative approaches seek to align executive incentives with a broader set of interests. This approach is backed by at least one empirical study, which demonstrated that companies whose pay packages sought to decouple shareholder and executive interests actually performed better during the financial crisis.

On the policy front, regulators have shied away from directly intervening in setting compensation plans. Rather, recent legislation such as Dodd-Frank has relied on disclosure and shareholder activism as the primary tools for combating perceived abuses. Policymakers hope that reforms such as “say-on-pay,” and pay vs. performance disclosure will shame corporate boards and executives into adopting reasonable pay packages. Critics of the new disclosure regime question whether the new mandates will withstand the scrutiny of cost-benefit analysis and caution that the rules favor institutional interests.

April 2011 Excess Pay Clawbacks
Jesse Fried (Harvard Law School) and Nitzan Shilon (Harvard Law School)
The authors explain that “excess pay” - excessively high payouts to executives arising from errors in compensation-related metrics - can impose substantial costs on shareholders even in the absence of misconduct. However, a survey of S&P 500 firms reveals that excess pay policies, where they even exist, typically lack the teeth necessary to compel recoupment of excess payouts. Although Dodd-Frank alleviates the problem by requiring executives to return payouts based on earnings misstatements, the mandate is subject to significant loopholes. Particularly troubling is the fact that executives may keep windfalls from stock sales following faulty earnings announcements. To remedy this shortcoming, the authors suggest requiring executives to publicly disclose their intention to cash out equity compensation or implementing a “hands-off” arrangement whereby executives have no discretion over when their equity is cashed out.
March 2011 Bank CEOs, Inside Debt Compensation, and the Global Financial Crisis
Frederick Tun (Boston Univ. School of Law), and Xue Wang (Emory Univ. - Goizueta Business School)
The authors test the hypothesis that bank CEO’s inside debt holdings reduce risk-taking and the agency cost of debt within banks. They find that CEO’s inside debt holdings preceding the financial crisis are positively associated with bank performance and negatively associated with bank risk-taking during the crisis. The authors speculate that this most likely occurs because executives’ claims on the firm are unfunded and unsecured; therefore, CEOs holding these claims face the same default risk that outside creditors face.
2011 Dodd-Frank: Quack Federal Corporate Governance Round II
Stephen M. Bainbridge (UCLA School of Law)
Bainbridge’s title pays homage to what many experts consider the regulatory overreaction that resulted in the Sarbanes-Oxley Act of 2002 (SOX). Like SOX, Dodd-Frank imposes several corporate governance requirements that are destined to prove ineffective from a cost-benefit perspective. Bainbridge takes particular issue with executive compensation reforms such as “say-on-pay” that have little empirical support, are driven solely be institutional investor interests, and strip boards of important governance tools. Bainbridge also reminds readers of the important role that board-centrism has played in U.S. corporate governance and why shareholders have traditionally delegated operational and policy decisions to boards: shareholders have neither the information nor the incentives necessary to make these important decisions. While regulations like say-on-pay may not in themselves cripple the relationship between boards, companies, and their shareholders, compensation regulations are part of a larger regulatory trend that is critically eroding director primacy.
September 24, 2010 Testimony before the Committee on Financial Services, U.S. House of Rep., Hearing on “Executive Compensation Oversight After the Dodd-Frank Wall Street Reform and Consumer Protection Act”
Martin Neil Baily (Brookings Inst., Squam Lake Report)
While Baily welcomes Dodd-Frank’s contributions to compensation regulation, he urges rule makers not to overlook the significant conflict that exists between financial institutions and the public. To limit this conflict, rules should aim to encourage banks to internalize their costs. To this end, Baily offers several guidelines. i) Regulators should focus exclusively on the structure of pay, rather than the level of pay. Limits on the level of compensation could push talented employees into unregulated firms or banks in other countries. ii) Structures should defer a significant portion of senior management’s compensation and make it contingent on the firm surviving without extraordinary government assistance. iii) Cash compensation should constitute a relatively high portion of compensation. This is because equity compensation, which aligns management and shareholder interests, encourages excessive risk taking.
August 2010 Bank CEO Incentives and the Credit Crisis
Rudiger Fahlenbach (Swiss Finance Institute) and Rene M. Stulz (Ohio State Univ., NBER, ECGI)
By looking at bank CEO pay structures and trading activity prior to the financial crisis, the authors examine how performance-based compensation for CEOs affected bank performance. They find no evidence that banks with a better alignment of the CEO’s interest with those of shareholders had higher returns during the crisis, thus undermining the incentive-based rationales put forward in support of Dodd-Frank executive pay provisions. To the contrary, there is some evidence that banks with CEOs whose incentives were better aligned with shareholder interests actually performed worse during the crisis. Overall, bank CEOs did not sell or hedge holdings prior to the crisis and suffered immense wealth losses. The authors offer an explanation for these result by suggesting that CEOs focused on shareholder interests took actions they believed the market would welcome, which, ex post, proved costly.
February 2010 Executive Compensation Restrictions in the Troubled Asset Relief Program
Congressional Oversight Panel
The Report reviews the implementation and effectiveness of executive compensation restrictions imposed subsequent to the enactment of TARP. The objective of the restrictions was to compel TARP recipients to incorporate the public interest into compensation practices in part by shifting compensations plans from cash based to stock-based. The Report focuses primarily on the role of the Office of the Special Master for Executive Compensation, which negotiates executive pay for institutions that received “exceptional assistance.” The Report criticizes several aspects of the reform’s implementation. First, the Panel questions the pay plans themselves - specifically, their reliance on stock-based pay with four-year sale restrictions - by challenging whether those mechanisms were truly well-suited for achieving the stated objectives. Second, the Special Master’s lack of disclosure about how decisions were reached, and its failure to administer its clawback authority renders the Office’s work both unhelpful and suspect.
2010 Paying for Long-Term Performance
Lucian Bebchuk (Harvard Law School) and Jesse Fried (Harvard Law School)
Focusing on equity-based compensation, the primary component of executive pay, the authors examine how such compensation should best be structured to tie pay to long-term performance. In drafting compensation schemes, consideration must be given to the limitations on the unwinding of equity incentives, incorporating both grant-based and aggregate limitations on unwinding. Drafters should seek to prevent the gaming of equity grants at the front end and the gaming of equity dispositions at the back end. Finally, compensation schemes should limit executives’ use of hedging and derivative transactions that weaken the tie between executive payoffs and the long-term stock price that well-designed equity compensation is intended to produce.
January 2010 Executive Compensation and Business Policy Choices at U.S. Commercial Banks
Robert DeYoung (Univ. of Kansas), Emma Y. Peng (Fordham Univ.), Meng Yan (Univ. of New Hampshire)
The authors asses how the terms of CEO compensation contracts at large commercial banks affected business decisions and find strong evidence that CEOs with risk-taking incentives took more risks. In addition, they find that bank boards altered CEO compensation to encourage executives to exploit new growth opportunities, and bank boards set CEO incentives in a manner designed to moderate excessive risk taking. These relationships were strongest during the latter part of the sample period, after deregulation and technological change had expanded banks’ capacities for risk-taking.
June 25, 2010 Guidance on Sound Incentive Compensation Policies
Department of the Treasury, OCC, FDIC, OTC
The Final Guidance provides principles-based guidance on sound incentive compensation practices for banking organizations supervised by the Federal Reserve, the OCC, the FDIC, and the OTS. To reduce the likelihood that misaligned compensation structures will contribute to another systemic crisis, firms should adopt compensation management practices that account for systemic safety and soundness. To that end, compensation plans should address the alignment of incentives, not only between employees and shareholders, but should incorporate the public interest as well. Banks will be subject to liability for failure to adequately develop and monitor their incentive compensation arrangements, while “Large Banking Organizations” will be especially scrutinized.
December 2009 Incentive Compensation in the Banking Industry: Insights from Economic Theory
Christopher Phelan (University of Minnesota, Fed. Reserve Bank of Minneapolis), and Douglas Clement (Fed. Reserve Bank of Minneapolis)
The authors apply the theory of mechanism design to executive and non-executive compensation practices in the financial industry. Mechanism design relies on the notion that rules must be incentive compatible, i.e., they should channel’s people’s natural self-interest towards the institutional goal. Current compensation practices are not incentive compatible. Banks account for their own interests by determining the minimum amount they can pay employees while accounting for the need to adequately incentivize employees to act in the bank’s interest. However, such schemes do not explicitly consider the government’s interest - the desire to avoid a bailout situation - resulting in compensation designs that are not incentive compatible. To alleviate this problem, the government could charge debt default insurance premiums that increase as banks adopt riskier compensation schemes. This would ensure that the bank’s owners are paying the full costs of the risks they are motivating their employees to take.
June 2009 Regulating Bankers Pay
Lucian A. Bebchuk (Harvard Law School) and Holger Spamman (Harvard Law School)
While the authors agree with the premise that current executive compensation practices are in need of regulatory overhaul, they argue that proposals seeking to use pay to align executive and shareholder interests are misguided. Instead, reform should seek to decouple executives’ incentives from those of shareholders, rather than align them. The problem with recent proposals such as “say-on-pay” is that they continue to encourage excessive risk-taking because shareholders can benefit from such risk. More troubling still is the fact that these proposals discourage executives from considering the stakes of creditors and preferred shareholders (i.e., the government). A better framework entails aligning executive interests with those of regulation generally, such as reducing moral hazard. This could be done, for example, by tying executive pay to metrics not tied specifically to common share performance, but to metrics that consider the corporate entity as a whole.
2009 Say on Pay: Cautionary Notes on the U.K. Experience and the Case for Shareholder Opt-in
Jeffrey N. Gordon (Columbia Law School)
Gordon examines data from the UK’s adoption of “say-on-pay.” His results undermine the rule’s stated objectives - to curb excessive CEO pay by making boards more accountable to shareholder interests. First, Gordon’s results indicate that pay continues to increase. Second, the rule has had the effect of imposing a one-size-fits-all model for executive pay. Gordon cautions that this problem might be exacerbated in the U.S. because of the relatively significant influence that proxy advisors exert on the proxy process. A toned-down alternative to “say-on-pay” is an opt-in vote, which would give shareholders the right to opt-in to an advisory vote. This regime would allow corporate governance activists to focus on firms with the most questionable practices. Gordon also stresses the importance of distinguishing compensation regulation in financial versus non-financial companies. While compensation packages for non-financial companies typically raise concerns solely of a corporate governance nature, packages for financial companies can have systemic implications. Oversight in these instances might be better delegated to a systemic regulator, rather than shareholders.
2009 The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008
Lucian A. Bebchuk (Harvard Law School), Alma Cohen (Harvard Law School), and Holger Spamann (Harvard Law School)
The authors use SEC data to tabulate actual payouts for executives at Bear Stearns and Lehman from 2000-2008. Their results indicate that, contrary to the standard narrative that the firms’ executives saw their wealth decimated during the financial crisis, executives actually came out ahead from 2000-2008 by consistently cashing out equity positions. This result poses an obvious contrast to what most shareholders experienced during the same period and suggests that executives’ ability to claim high payouts based on short-term results may have encouraged excessive risk-taking. The authors conclude the piece by stepping back from the debate about whether or not perverse incentives actually caused the financial crisis. Rather, they urge policy makers to focus on the fact that if perverse incentives exist (and it appears that they do), steps should be taken now to diminish the likelihood that they could cause harm in the future.
July 2008 Shareholder Remuneration Votes and CEO Compensation Design
Mary Ellen Carter (Boston College), and Valentine Zamora (Boston College)
Using a sample of large UK firms from 2002-2006, the authors examine the role that mandatory advisory shareholder compensation votes (similar to “say-on-pay” provisions) play in executive compensation design, focusing particularly on whether boards incorporate negative votes into pay designs. Results indicate that shareholders disapprove of higher salaries, weak pay-for-performance sensitivity in bonus pay, and greater potential dilution in equity pay, particularly stock option pay. In addition, there is some evidence that boards selectively respond to past negative votes by curbing excess salary, bonus, and stock option grants in the current year, and by further reining in only excess salary in the following year.
Hedge Funds

Dodd-Frank ushered in a new, but largely anticipated, regulatory regime for hedge funds. The two justifications underlying the measures include systemic risk oversight and investor protection. Consequently, Dodd-Frank’s measures are aimed at disclosure — of trading positions, liquidity and corporate governance procedures, among other things. In addition, the industry will inevitably be affected by new rules for swaps and proprietary trading. .

In terms of systemic risk oversight, many commentators challenge the assumption that hedge funds disproportionately contribute to systemic risk by noting that hedge funds performed better than the market during the financial crisis. Further calling into question the efficacy of the new measures is the fact that banks and broker-dealers, which are already heavily regulated, are perhaps the largest source of systemic risk. Turning to investor protection, critics maintain that hedge funds are only open to high net worth individuals and institutions, two groups that have the resources to protect their own interests. In sum, critics maintain that market participants, including hedge funds, their investors and their counterparties, are in the best position to monitor the sector and have done an adequate job doing so.

July 15, 2009 Testimony before the Senate Banking Committee, Prepared Statement for Hearing on Regulating Hedge Fund and Other Private Investment Pools
Richard Bookstaber (Author of A Demon of our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation)
Bookstabers contends that heightened hedge fund regulation is necessary to monitor hedge funds’ potential use of excessive leverage, which can lead to systemic risk. Even prudently managed funds may pose systemic risk if positions, in the aggregate, are too concentrated. In particularly, hedge funds should be required to submit detailed data providing regulators with the information necessary to measure “crowding” and aggregate levels of leverage and exposure. Regulators, for their part, should provide standardized terms for financial products. Bookstabers also rebuts fears that hedge fund data is too sensitive to be disclosed by noting that prime brokers and government agencies currently collect similar data, and security breaches have not been a concern. Finally, legislators must consider legislation that would afford federal regulators with the authority to intervene in the event that data suggests unsupportable risk is apparent.
July 15, 2009 Testimony before the Senate Banking Committee, Hearing on Regulating Hedge Fund and Other Private Investment Pools
Commissioner Parades (SEC)
Parades stresses the extent to which hedge funds are already subject to regulation. Specifically, hedge funds must comply with prohibitions relating to fraud, insider trading, market manipulation and certain disclosure requirements. Additionally, market discipline holds fund managers accountable in the form of due diligence imposed by creditors and investors. Additional regulation must weigh the substantial benefits private funds create - such as market liquidity, capital formation and job creation - with the costs that such regulation would entail. These costs could include moral hazard, opportunity costs arising from resources being diverted away from more productive endeavors, and the creation of barriers to entry in the private fund sector. If regulations are adopted, legislators should draft new legislation specific to the risks that hedge funds pose and that would specifically enable regulators to address systemic risk concerns. It would be inappropriate to simply remove existing exemptions from the Investment Advisor and Investment Company Acts as those laws were not designed to deal with systemic risk or activities specific to private funds.
May 7, 2009 Testimony before the U.S. House of Representatives Committee on Financial Services, Hearing on Perspectives on Hedge Fund Regulation
Richard H. Baker (Managed Funds Association)
Baker contends that although hedge funds only pose a relatively small amount of systemic risk, hedge funds constitute a significant source of capital, and it would be imprudent for any regulatory proposal to ignore this fact. Contrary to the views of other stakeholders, however, Baker argues that regulation should be extended to all private funds, not just hedge funds. To achieve this, policymakers could amend The Investment Advisors Act by deleting the exemption that currently enables private funds to avoid registration. That being said, any registration requirement should include a de minimus exception to avoid overly burdening small funds. This change would enable the SEC to collect key systemic data and monitor signs of fraud. In addition, before enacting any legislation, the government must ensure that adequate resources are available for enforcement, particularly in light of existing staffing constraints at the SEC and other regulatory agencies.
May 7, 2009 Testimony before U.S. House of Representatives Committee on Financial Services, Hearing on Perspectives on Hedge Fund Registration
James Chanos (Coalition of Private Investment Companies)
Chanos cautions that, as indicated by the recent crisis, heightened regulation does not imply greater investor protection, and legislators should carefully consider appropriate objectives and whether new regulations can achieve them. Although Chanos notes that only rarely will a hedge fund cause systemic risk, he concedes that registration and heightened disclosure requirements for private funds are desirable goals. Some disclosures that would be useful for regulators include litigation history, compensation and expense structures, conflicts of interests, investment policies and valuation methodologies. However, heightened disclosure is subject to the caveat that over-disclosure could infringe upon trade secrets and/or confuse investors. In addition, Chanos takes issue with the proposed Hedge Fund Advisor Act of 2009, which creates a registration mandate by amending the Investment Advisors Act to delete the current exemption for private advisors. The Advisors Act was designed with retail mutual funds in mind and is not well-suited for private funds that maintain significant counter-party risk and are targeted at sophisticated investors. As an alternative, Chanos proposes drafting new legislation specific to private funds, rather than piggy-backing off of legislation designed for a different purpose.
January 15, 2009 Best Practices for the Hedge Fund Industry
Asset Managers’ Committee to the President’s Working Group on Financial Markets
The Report encourages all hedge funds to adopt a comprehensive best practices framework designed to reduce systemic risk and foster investor protection. The Committee focused on disclosure, valuation, risk management, trading and business operations, compliance, conflicts, and business practices. Companies should disclose to investors all material information (prior to and over the course of the investment), and provide a private placement memorandum and audited financial statements. Funds should separate portfolio management functions from valuation functions, create a valuation committee and disclose the percentage of investments allocated to hard-to-value assets. Managers should determine a fund’s risk profile and develop measures designed to ensure that actual risk is consistent with the risk profile. In addition, funds should separate operational functions and develop processes capable of monitoring relationships with counterparties and investments types. Lastly, funds should have a compliance infrastructure overseen by a Chief Compliance Officer and create a code of ethics, training programs and a process for handling conflicts of interest.
2009 The Law and Economics of Hedge Funds: Financial Innovation and Investor Protection
Houman B. Shadab (New York Law School)
Shadab argues the outperformance of hedge funds during the recent financial crisis suggests that additional regulation would not be beneficial. He attributes the sector’s success to the applicable federal securities laws, “ungovernance” structures, and industry- and fund-specific contract provisions. This legal regime gives fund managers significant flexibility in drafting partnership agreements in ways that reduce agency costs and foster performance-based incentives. As a result, managers seek to develop innovative strategies, adapt those strategies to changing market conditions, and generate alpha. Moreover, Shadab dismisses calls for mandatory hedge fund registration, arguing that as a matter of law and practice, hedge funds already make adequate disclosures. Shadab also suggests that regulators should consider opening hedge funds to larger classes of investors or lifting some of the trading and compensation restrictions imposed on mutual funds. As the recent crisis indicates, hedge funds benefit from employing strategies that mutual funds and banks either lack incentives to employ or are barred from employing. In addition, hedge funds provide diversification benefits and reduce investors’ net exposure to market risk.
November 13, 2008 Testimony Before the House of Representatives Committee on Oversight and Government Reform, Hearing on Hedge Funds and the Financial Markets
Andrew W. Lo (MIT)
Lo recommends a broader approach to regulatory reform - one that is focused on financial functions, not financial institutions. Financial functions consist of a payments system, a pooling mechanism for undertaking large-scale investments, resource transfer, risk management, information provision for coordinating decisions, and a means of contracting and managing agency problems. He also proposes the establishment of a Capital Markets Safety Board (CMSB), which would maintain data on hedge funds and other private pools of money to assess systemic risk levels.
November 13, 2008 Testimony Before the House of Representatives Committee on Oversight and Government Reform, Hearing on Hedge Funds and the Financial Markets
David S. Ruder (Northwester Univ. Law School)
Ruder posits that, while hedge funds are likely not responsible for the recent crisis, hedge funds do pose systemic risk through their use of leverage and complex derivatives. Consequently, he encourages heightened regulation, particularly in the form of increased disclosure of risk positions. Specifically, Ruder recommends vesting the SEC with the responsibility of inspecting and obtaining hedge fund risk information and determining whether the funds’ risk management systems are effective. The SEC, working in conjunction with the Federal Reserve, would then have the information necessary to monitor systemic risk. Ruder cautions, however, that regulation should not attempt to directly regulate hedge funds’ activities and should only seek to monitor overall risk levels.
November 13, 2008 Oral Testimony Before the House of Representatives Committee on Oversight and Government Reform, Hearing on Hedge Funds and the Financial Markets
George Soros (Soros Fund Management, LLC), John Alfred Paulson (Paulson & Co.), James Simons (Renaissance Technologies, LLC), Philip Falcone (Harbinger Capital Partners), Kenneth Griffin (Citadel Investment Group, LLC)
Witnesses agreed that increased disclosure of hedge fund positions would be beneficial to the financial system and that a federal regulator should be given authority to intervene if there is evidence of a problem. As to whether managers should be required to personally invest in every fund they run, witnesses concurred that, as a practical matter, all managers already personally invest in their funds. Witnesses disagreed as to what extent the government should amend the tax laws to treat carried interest as ordinary income. Witnesses also disagreed as to what extent hedge funds cause systemic risk and to what extent regulators should set leverage and margin requirements.
2008 Fending for Themselves: Creating a U.S. Hedge Fund Market for Retail Investors
Houman B. Shadab (New York Law School)
Among developed nations, the U.S. has one of the least accessible hedge fund markets. Shadab argues that regulators could alleviate this deficiency by opening hedge funds to sophisticated retail investors. In explaining his case, Shadab particularly takes issue with the fact that U.S. securities laws are based on the misguided premise that the primary danger facing retail investors is fraud. However, the reality is that retail investors are at least as vulnerable to market disruptions and investment risk. Yet retail investors are free to engage in complex trading strategies, invest in hedge fund-like products, and even invest in “safe” investments such as CMOs. Not only do such investments expose investors to substantial risks but they also typically perform worse than hedge funds. Thus, the SEC could open the U.S. hedge fund market while still fulfilling its mandate to protect investors by removing existing restrictions for sophisticated retail investors. Shadab outlines a regulatory framework capable of achieving this.
December 2007 Hedge Funds, Financial Intermediation, and Systemic Risk
John Kambhu (Federal Reserve Bank New York), Til Schuermann (Federal Reserve Bank New York), Kevin J. Stiorh (Federal Reserve Bank New York)
The authors discuss banks’ use of counterparty credit risk management (CCRM) as a tool for limiting banks’ exposure to hedge funds. Officials have traditionally relied upon banks’ incentives to monitor their own risk exposures as an adequate means of regulating the hedge fund sector and limiting corresponding risk. However, hedge fund characteristics such as opacity, convex compensation structures, and potentially high systemic risk levels have spurred increasing calls to regulate the sector directly as a more effective means of limiting hedge fund-led market disruption. The authors argue that, although CCRM is subject to market inefficiencies such as agency conflicts, free-rider problems, and moral hazard, it remains the most efficient check on excessive hedge fund risk-taking.
September 2003 Implications of the Growth of Hedge Funds
U.S. Securities and Exchange Commission
The Report’s primary recommendation entails requiring hedge funds to register under the Advisors Act. This requirement would be relatively non-intrusive, as it would not interfere with managers’ ability to effectuate investment strategies or investor agreements. Past experience with registration requirements indicates that registration reduces the potential for misconduct and increases the likelihood that misconduct will be discovered earlier. Registration will also foster more consistent compliance practices across the sector. Contrary to the views of many private-sector individuals, the SEC maintains that registration should only be required of hedge funds specifically and should not extend to other private funds. Other recommendations include requiring funds to distribute brochures containing minimum disclosure requirements to all investors and prospective investors, and requiring base-line valuation methodologies.
Systemic Risk

As the financial markets have become increasingly integrated and complex, interconnectedness, a component of systemic risk, has become a concern for policymakers. At a basic level, systemic risk arises because when financial firms are highly interconnected, one bank’s default may inhibit its counterparty’s ability to meet its obligations to its counterparties, and so on down the line. Thus, while reliance on a variety of financial parties should yield diversification benefits, in a system where financial firms, their creditors and the capital markets are highly interconnected, losses affecting one participant can wreak havoc on others.

Dodd-Frank addresses some of these concerns by creating the Federal Stability Oversight Council (FSOC). FSOC is charged with monitoring levels of systemic risk at firms deemed Systemically Important Financial Institutions (SIFIs). Several commentators have observed that while a systemic risk regulator is a necessary component of reform, it is itself insufficient. That’s because financial firms and their counterparties lack incentives to internalize risk. Until regulators address these incentives, by, for example, imposing Too-Connected-To-Fail capital charges, systemic risk will remain unmanageable. Adding to FSOC’s shortcomings is a dearth of helpful data. Necessary data include, for example, leverage, liquidity, correlation, concentration, and portfolio sensitivity. Still other commentators have stressed that due to the increasing globalization of the financial markets, no individual country will be able to effectively monitor systemic risk levels. Thus, a national risk regulator must have authority to coordinate oversight efforts with other countries.

April 2011 Systemic Risks and Macroprudential Bank Regulation: A Critical Appraisal
David VanHoose (Baylor Univ.)
VanHoose addresses the unexplored pitfalls associated with establishing a macroprudential regulator by focusing particularly on the Financial Stability Oversight Council. The fundamental concern is that systemic risk regulation has the potential to create over-reliance on centralized governmental supervision at the expense of private market discipline. Also problematic is the fact that the creation of a macroprudential risk regulator may i) increase regulatory capture by large financial institutions; and ii) create adverse incentives for financial institutions, thereby creating externalities that could be avoided by using private contracting or something akin to a cap-and-trade mechanism.
2011 Regulating Systemic Risk: Towards an Analytical Framework
Iman Anabtawi (UCLA School of Law), Steven L. Schwarcz (Duke Univ. School of Law)
The authors argue that regulatory measures intended to foster system stability suffer from the absence of a theoretical framework addressing how systemic risk arises and how regulation can be used to control it. As a result, current measures are largely incoherent and are likely suboptimal. The authors address this deficiency by analyzing how systemic risk is transmitted and offer a framework from which better regulation can be designed. The authors also explain why government intervention is necessary. Although market participants could, theoretically, be relied upon to minimize systemic risk, they are highly unlikely to do so as a result of behavioral failures such as conflicts of interest, complacency, complexity and a tragedy of the commons. For systemic risk regulation to be effective it must address both the causes of systemic risk and the behavioral failures that afflict market participants.
February 12, 2010 Testimony before the Subcommittee of Security and International Trade and Finance, Hearing on Equipping Financial Regulators with the Tools Necessary to Monitor Systemic Risk
Daniel K. Tarullo (Federal Reserve Board of Governors)
The financial crisis revealed important gaps in data collection and systemic risk analysis. Particularly problematic are data deficiencies related to maturity transformation, leverage and market aggregation. Closing these gaps must be a fundamental goal of financial reform legislation. Specifically, reform must 1) ensure that supervisory agencies have access to high-quality, standardized and timely data, and 2) to make such data available to other government agencies and private analysts. Tarullo cautions, however, that reform must be informed by a sound cost analysis. Data collection is expensive, and at some point, tradeoffs may be faced where a particular type of information would be costly to collect and would only have limited benefits.
February 12, 2010 Testimony before the Subcommittee of Security and International Trade and Finance, Hearing on Equipping Financial Regulators with the Tools Necessary to Monitor Systemic Risk
John C. Liechty, (Penn State - Smeal College of Business, Committee to Establish the National Institute of Finance), Allan I. Mendelowitz (Committee to Establish the National Institute of Finance)
The witnesses posit that regulation aimed specifically at SIFIs is misguided and is not an effective means of monitoring system risk. That’s because even if there were no large, systemically important institutions, there would still be the risk of systemic failure. Individual institutions are not responsible for causing systemic risk; rather, it is the relationships between firms and their relative asset concentrations that are the primary culprits. The witnesses propose the creation of the National Institute of Finance, which would be charged with collecting data from a broad range of US entities and analyzing that data for signs of unacceptable systemic risk levels. While FSOC is a step in the right direction, its lack of permanent staff and authority to collect many types of data ensure that FSOC will be little more than a hollow promise.
2010 Is Systemic Risk Relevant to Securities Regulation?
Anita Anand (Univ. of Toronto)
Traditionally, mitigating systemic risk has fallen within the realm of financial institution or prudential regulation rather than securities law. However, developments in financial markets, including the rise of securitization trading, are blurring the line between prudential regulation and securities law. This evolution makes systemic risk increasingly relevant to securities regulation. Consequently, Anand argues that securities regulation should expand to encompass mitigating systemic risk as an objective.
January 2010 Financial Crisis, Interconnectedness and Regulatory Capital
Jorge A. Chan Lau (IMF, Tufts Univ. - Fletcher School of Law and Diplomacy)
Chan Lau expands upon recent calls for adopting higher quality capital requirements that reflect the systemic risk posed by financial institutions. He proposes a conceptual methodology for assessing Too-Connected-to-Fail (TCTF) capital charges. TCTF has been recognized as one of the contributing factors to the systemic risk of a financial institution. A TCTF capital charge would induce institutions to internalize the costs associated with their interconnection and could provide incentives to avoid excessive homogeneity among financial institutions and to reduce the reliance on a limited number of counterparties. The TCTF capital charge could also be useful for defining the perimeter of regulation. Since the TCTF capital charge relies on measuring the systemic risk contribution of an institution, it could also help to determine what institutions should be covered by the perimeter of regulation.
October 19, 2009 The Feasibility of Systemic Risk Measurement,” Written Testimony prepared for the U.S. House of Representatives, Financial Services Committee
Andrew W. Lo (MIT - Sloan School of Management)
Lo stresses that for systemic risk regulation to be efficient regulators must identify the proper trade-off between systemic risk and its rewards. Achieving this will require the establishment of objective, quantitative systemic risk measures and a regulatory body capable of collecting system-wide data. These measures should account for leverage, liquidity, correlation, concentration, sensitivities, implicit guarantees and, perhaps most significantly, connectedness. In addition, policy makers should require enhanced disclosures concerning counterparties, leverage and portfolio sensitivities from all systemically important firms. Portfolio sensitivities, which should be based on a given set of economic scenarios, are particularly important as they can be used to assess system-wide sensitivities.
August 2009 On Systemically Important Financial Institutions and Progressive Systemic Mitigation
James B. Thomson (Federal Reserve Cleveland)
Thomson explains that establishing a financial stability supervisor, while necessary, is itself insufficient to provide an adequate framework for stability. Policy makers must also deal proactively with SIFIs by encouraging time-consistent incentives for market-participants. Thomson’s proposal incorporates the “4 Cs” of systemic importance (contagion, concentration, correlation, and conditions) to determine the extent to which individuals firms pose systemic risk, and places firms into regulatory categories based on the level of risk they pose. The ultimate objective of progressive systemic mitigation is to improve economic efficiency by promoting socially compatible risk incentives for SIFIs and to increase fairness in the financial system by leveling the playing field; the means of achieving this are reducing, through regulatory taxes, the advantages of being systemically important.
April 1, 2009 Steps toward a New Financial Regulatory Architecture
Sandra Painalto (Federal Reserve Cleveland)
Painalto proposes a unique regulatory framework called “tiered parity.” Under this framework, each financial company would be assigned to a tier tied to the firm’s complexity and the degree of systemic risk it poses. For example, a three-tired framework could have categories labeled “noncomplex,” “moderately complex,” and “systemically important,” and each tier would be subject to corresponding degrees of regulatory requirements and supervisory oversight. The primary benefit this framework confers is that it recognizes the different risks associated with, for instance, a community bank versus a financial conglomerate. It would also discourage institutions from becoming needlessly large and complex. When combined with the establishment of a macroprudential regulator and a resolution process for nonbank financial companies, this tiered approach would be a significant step toward controlling systemic risk.
2009 Systemic Risk and the Pursuit of Efficiency
Kartik B. Athreya (Federal Reserve Richmond)
Athreya examines how economics basics such as efficient resource allocation and spillover risk should inform policy decisions. He concludes that ex post, discretionary intervention (e.g., bailouts) undermines efficient resource allocation. That’s because in the absence of discretionary intervention, firms are forced to internalize their costs and risks, primarily through informed contracting. However, the likelihood of ex post government intervention provides an incentivize for firms to misprice significant risks. Thus, the goal for policy-makers should be to do as much as possible to ensure that institutional arrangements strive for efficiency ex ante. The successful pursuit of this objective requires credible commitments to withhold assistance in the wake of a shock.
2009 Global Financial Stability Report, Chapter 2, “Assessing the Systemic Implications of Financial Linkages”
International Monetary Fund
In examining proposals for systemic risk regulation, the Report focuses specifically on the too-connected-to-fail problem, which must be accounted for in future systemic risk surveillance. To this end, the Report proposes the use of four complementary assessments: i) the “network approach” focused on network externalities and potential “domino” effects; ii) the “co-risk model, focused on institutional level risk; iii) the “distress dependence matrix,” which estimates system-wide loss given the failure of a particular institution; and iv) the “default intensity model,” which estimates the potential for linkage-induced failures. Collectively, these tests provide a comprehensive account of system linkages that will alert regulators of potential problem spots. The Report also stresses the importance of addressing systemic linkages at a global level. Globalization has made it almost impossible for an individual country to adopt an effective surveillance mechanism. Information gaps further exacerbate this problem. Thus, increased cross-border, cross-market and cross-firm transparency are imperative; information agreements might be a helpful step to accomplishing this.
October 2, 2008 Systemic Risk and the Macroeconomy: An Attempt at Perspective (Speech)
James Bullard (Federal Reserve Bank St. Louis)
Bullard explains that, while the failure of a firm in any industry can produce dangerous externalities, the financial sector is uniquely susceptible to systemic risk concerns. The sector’s inherent attributes such as interconnectedness, leverage, and liquidity mismatch are to blame for the sector’s risk potential. However, while in an ideal world financial firms would invest in practices designed to mitigate systemic risk, in reality firms lack the incentives and resources to do. Thus, government supervision is necessary. To this end, Bullard recommends i) enhanced supervision of financial firms; ii) Federal Reserve oversight of payment and settlement systems; and iii) the creation of a framework to liquidate non-bank financial firms. Further, regulation should be designed to limit the possibility of future bailouts, which produce unacceptable direct and indirect costs.
March 2002 Systemic Risk and Financial Consolidation: Are they Related?
Gianni De Nicolo (IMF), Myron L. Kwast (Federal Reserve Board of Governors)
The authors argue that firm interdependencies, as measured by correlations of stock returns, provide an indicator of systemic risk potential. A study of large U.S. firms from 1989-1999 shows a positive trend in return correlations, suggesting that the systemic risk potential in the financial sector increased during that period. In addition, consolidation at the sample firms appears to have contributed to interdependencies during the period. However, the authors find that factors other than consolidation were also responsible for the upward trend in return correlations. Although they stop short of identifying what those factors might be, the authors speculate that short-term lending and derivatives trading between firms may play a role. These results reinforce the fact that while consolidation has likely enabled firms to compete on a global scale, consolidation has important systemic risk implications that regulators should address.
Market Liquidity Concerns

Major markets have become less illiquid. Three categories of readings – industry studies, official reports, and news articles — illustrate concerns and vulnerabilities. In part, a meaningful gap exists between growing concerns among market participants and the response in the regulatory community.

  • Industry studies illustrate that a new consensus has emerged among asset managers and now J.P. Morgan regarding risks related to less liquidity in major markets.
  • Official reports concentrate largely on future regulation of shadow banking. Although a minority of regulators acknowledges risk, the shape of regulators’ likely response remains unclear.
  • News reports highlight the geographic and market diversity of risks.

August 27, 2015 Has corporate bond market liquidity fallen?
Yuliya Baranova, Louisa Chen and Nicholas Vause (Bank of England)
Many investors report recent declines in market liquidity, suggesting dealers have become less willing to trade corporate bonds and other fixed-income securities due to additional costs of holding them on their balance sheets. Some fear that if asset managers began to sell these securities then prices could fall sharply. Focusing on high-yield corporate bonds, we use an econometric model to investigate whether the typical responses of dealer inventories and market prices to falls in asset manager demand have changed in recent years. We find that dealer holdings act less as a shock absorber than they did around a decade ago. Instead, bond spreads rise more. We also find that greater declines in issuance now follow these shocks.
July 21, 2015 Fixing the Fed's Liquidity Mess
Lawrence Goodman and Stephen Dizard (Wall Street Journal)
Every Treasury Secretary since the late 1930s could proclaim with confidence that the U.S. bond market is the deepest and most liquid in the world. Today's illiquid debt markets threaten the potency of this pledge. And it puts the global economy at risk for another financial crisis.
July 15, 2015 Addressing Market Liquidity
Post-Crisis, the fixed income markets have adapted to changes due at least in part to regulatory reforms intended to enhance the safety and soundness of the global financial system. Monetary policy, record new issuance, and financial regulatory reform have contributed to reduced dealer inventories and lower bond turnover. Issuers have been motivated by historically low interest rates to issue new debt in record amounts, which means that there are now many more bonds in the bond market. In this low rate environment, asset owners in search of income to meet their needs have increasingly “reached for yield” which has tended to push yields down across asset classes. As a result, there is debate about the extent to which liquidity risk premia (i.e., the cost of liquidity) are properly priced in to bond prices and whether the market liquidity of portfolios is appropriate in this market. The combination of these factors (some of which are permanent, while others are temporary) brings us to today’s focus on liquidity.
July 15, 2015 Shadow Casting
Maha Khan Phillips (CFA)
In April 2015, the International Monetary Fund (IMF) called—and not for the first time—for greater oversight of the industry. “The evidence calls for a better supervision of institution-level risks,” warned the IMF, identifying several key risks to which investors and regulators should be paying better attention. Quoting the IMF’s unofficial motto that “complacency must be avoided,” former US Treasury Secretary Robert Rubin also issued warnings in a speech given in March 2015 at the Federal Reserve Bank of Atlanta. Pointing out that much had been done to strengthen the prudential regulation and supervision of the sector, he said more still would have to be done in the future. “We must remain vigilant for changes in the system that increase systematic [i.e., systemic] risk, and we should make appropriate changes to regulation and structure of regulation as necessary,” Rubin declared.
July 13, 2015 Joint Staff Report: The U.S. Treasury Market on October 15, 2014
U.S. Department of Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, U.S. Securities and Exchange Commission, U.S. Commodity Futures Trading Commission
The U.S. Treasury market is the deepest and most liquid government securities market in the world. It plays a critical and unique role in the global economy, serving as the primary means of financing the U.S. federal government, a significant investment instrument and hedging vehicle for global investors, a risk-free benchmark for other financial instruments, and an important market for the Federal Reserve’s implementation of monetary policy. On October 15, 2014 (“October 15”), the market for U.S. Treasury securities, futures, and other closely related financial markets experienced an unusually high level of volatility and avery rapid round-trip in prices.
June 18, 2015 Liquidity Pitfalls Threaten Parched Markets
Robin Wigglesworth (Financial Times)
Welcome to the desert. The financial industry’s great debate du jour is “liquidity”, specifically how parched it looks at the moment. Liquidity is tricky to define, but essentially means the ease of trading a financial security quickly, efficiently and without moving the price too much. Traders and money managers differ on the extent, but almost everyone agrees that liquidity has deteriorated across nearly every market, a downturn some fear could exacerbate or perhaps even spark another financial crisis. While that may be far too shrill, there is clearly cause for some concern.
June 11, 2015 Treasury Volume Raises Liquidity Concerns
Robin Wigglesworth (Financial Times)
One of the more worrying aspects of the sell-off in the US Treasury market is the relative paucity of actual selling. While the 10-year Treasury yield has risen from below 1.9 per cent in mid-April to a peak of almost 2.5 per cent this week, traders say the increase has been driven by lower amounts of trading than the steepness of the climb would suggest. Investors, bankers and analysts have in recent years been worrying over the deteriorating trading conditions in corporate bond markets, but increasingly some are fretting that the liquidity of the biggest and most actively traded market of them all — US Treasuries — should be the biggest concern.
April 5, 2015 Broken Bond Market Complicates Fed's Plan to Raise Rates
Michael J. Casey (Wall Street Journal)
Whether it is banks’ reluctance to commit to buying and selling bonds, shortages in the securities used as collateral in short-term money markets, or the disproportionate role of heavyweight issuers in the supply of U.S. corporate bonds, dysfunction is everywhere. As the Federal Reserve prepares to raise rates, this is raising questions about how well it can manage the credit creation process, the transmission mechanism through which it pursues its economic goals. It might also mean it is risking financial turmoil. Bond geeks are decrying illiquidity — the idea that there aren’t enough standing bids or offers in the marketplace for investors to move quickly in or out of large positions.
March 31, 2015 Annual Report 2014 (Pages 31-34)
JPMorgan Chase & Co.
But many things will be different — for example, there will be far more risk residing in the central clearinghouses, and non-bank competitors will have become bigger lenders in the marketplace. Clearinghouses will be the repository of far more risk than they were in the last crisis because more derivatives will be cleared in central clearinghouses. It is important to remember that clearinghouses consolidate — but don’t necessarily eliminate — risk. That risk, however, is mitigated by proper margining and collateral. We have long maintained that it is important to stress test central clearinghouses in a similar way that banks are stress tested to make sure the central clearinghouses’ capital and resources are sufficient for a highly stressed environment. Clearinghouses are a good thing but not if they are a point of failure in the next crisis.
March 31, 2015 Keynote Remarks at FRB Atlanta
Robert Rubin (Council on Foreign Relations)
I believe that possible economic and market effects of unwinding the Fed’s vast increase in its balance sheet — from under $1.0 trillion before the financial crisis to $4.5 trillion now — and the commensurate increase in liquidity, could have substantial impacts whenever that unwinding occurs and however it is accomplished. To turn to the unwinding risks first, monetary policy decisions always involve large uncertainties. And those uncertainties were almost surely heightened with such great increases, creating unprecedented conditions. In some circles, the greater concern about navigating these unchartered waters is inflation. But my view is that there is at least an equal chance monetary action could push the economy into a downturn.
March 27, 2015 Fed Focuses On Shadow Banking As It Gauges Financial System Risk
Christopher Condon and Ian Katz (Bloomberg)
Federal Reserve officials, fresh from the latest round of tests designed to ensure the safety of the biggest banks, are now peering into the darker corners of the financial system as they assess the risks of another crisis. One source of concern: tighter regulation of banks is prompting more borrowers to seek funding through the $25 trillion shadow banking system -- money-market mutual funds, hedge funds, brokerages and other entities that face fewer restrictions. “These institutions are a significant and growing source of credit in the economy,” Dennis Lockhart, president of the Atlanta Fed, said in a March 20 speech. “They are part of an interconnected financial system that, in extreme circumstances, is prone to contagion.”
March 26, 2015 Financial Policy Committee statement from its Meeting, 24 March 2015
Bank of England
The Committee remains concerned that investment allocations and pricing of some securities may presume that asset sales can be performed in an environment of continuous market liquidity, although liquidity in some markets may have become more fragile. Trading volumes in fixed income markets have fallen relative to market size and recent events in financial markets, including in US Treasury markets in October 2014, appear to suggest that sudden changes in market conditions can occur in response to modest news. This could lead to heightened volatility and undermine financial stability. The Committee judges that there is a need for market participants to be alert to these risks, price liquidity appropriately and manage liquidity prudently.
March 26, 2015 Liquidity Storm could throw UK into chaos, Bank of England warns
Szu Ping Chan (Telegraph)
The Bank of England has warned that a global liquidity storm could endanger financial stability if investors suddenly demanded their money back, adding that the threat of a Greek default posed "significant risks" to the UK. The Financial Policy Committee (FPC), which is in charge of maintaining financial stability at the Bank, said liquidity - or the degree to which assets can be easily traded - may have become "more fragile" in some markets. Policymakers, including Bank Governor Mark Carney, said they would work with the Financial Conduct Authority to assess whether asset managers could cope with a rapid change in market conditions.
March 25, 2015 Oaktree Memo: Liquidity
Howard Marks (Oaktree Capital)
My wife Nancy's accusations of repetitiveness notwithstanding, once in a while I think of something about which I haven't written much. Liquidity is one of those things. I'm not sure it's a profound topic, and perhaps my observations won't be either. But I think it's worth a memo.
March 22, 2015 Shadow-Credit Rise Is Good Sign
Michael J. Casey (Bloomberg)
Seven years after the financial crisis, lending in the so-called shadow-banking system finally appears to have bottomed out, a reversal that could presage a long-awaited uptick in U.S. economic growth. The New York-based Center for Financial Stability says that February showed an increase in the short-term credit that circulates among investment banks like Goldman Sachs Group Inc. and big nonbank managers of money-market funds such as Vanguard. That is after 82 months of decline in this measure of market finance, dating to the March 2008 panic over the failure of Bear Stearns & Co.
March 22, 2015 Bank of Japan Research Casts Doubt on Kuroda’s Comfort on Bonds
Kevin Buckland and Shigeki Nozawa (Bloomberg)
The Bank of Japan’s own researchers are undermining Governor Haruhiko Kuroda’s view that the market is functioning fine as the central bank buys an unprecedented amount of debt. Some indicators suggest liquidity in Japanese government bonds is falling after long-term yields dropped, regulations changed and the central bank bought debt, according to a BOJ report published on March 19. A gauge of expected bond price swings was set for its biggest quarterly gain since 2013 as two-year notes remained untraded from March 19-20 at Japan Bond Trading Co., the nation’s largest inter-dealer debt broker.
March 19, 2015 Bond Liquidity, Mortgage Lending and Merger Associates
Matt Levine (Bloomberg)
Has any financial story been more relentlessly covered in the last few years than the market's worries about bond market liquidity drying up? In its latest quarterly review, the Bank for International Settlements included a thoughtful little article about the question, and it's I guess what you'd expect if you'd been following things? Like: Sovereign liquidity is mostly back to pre-crisis levels but some people still worry. Corporate liquidity is below pre-crisis levels, though some of that is because "trading volumes have not kept pace with the surge in debt issuance." The main factor seems to be that "market-makers are focusing on activities that require less capital and less willingness to take risk," and "are trimming their inventories, particularly by cutting holdings of less liquid assets."
March 19, 2015 Liquidity Conundrum: Shifting risks, what it means
Morgan Stanley Research Global and Oliver Wyman
Financial regulation and QE are at the heart of a huge shift in liquidity risk from banks to the buy-side, which is increasingly a concern for policy makers. This shift is far from over: we expect liquidity in sell-side markets to deteriorate further, as regulation shrinks banks’ capacity another 10-15% over the next two years. Our interviews with asset managers highlighted their concerns over scarcer secondary market liquidity, particularly in credit and in Europe. There's a liquidity conundrum in fixed income markets facing policy makers and investors: how it’s resolved will have long term investment implications across banks, asset managers and infrastructure players. At its heart is the huge shift in liquidity risks to the buy side and asset owners as the twin forces of financial regulation and QE have played out. New rules have driven a severe reduction in sell-side balance sheet and banks’ liquidity provision.
March 13, 2015 Financial Market Volatility and Liquidity — a cautionary note.
Chris Salmon (Bank of England)
As Executive Director for Markets at the Bank of England it is my job to manage the balance sheet, implementing various policy decisions that the Bank makes. I am also responsible for ensuring that the Bank extracts as much ‘market intelligence’ from financial market developments as is possible to inform those decisions. But it’s not my job to set policy. And my punch line will reveal me to be the central banker that I am: there are reasons to be cautious. In particular, recent periods of financial market volatility suggest that there are reasons to be cautious about the robustness of liquidity in core financial markets.
February 25, 2015 Liquidity Shortage: Houston, We Have a Problem
Lawrence Goodman (CFS)
The world is plagued by a shortage of financial market liquidity despite an overabundance of central bank liquidity. CFS Divisia data reveal that since 2011, the needed correction in reducing the role of market finance in the economy has fallen too far and compromised financial market liquidity.
February 16, 2015 Emerging Fund Managers Stuck in Buy-And-Hold as Trading Shrivels
Sujata Rao (Reuters)
A collapse in day-to-day trading in emerging bonds is forcing fund managers to increasingly rely on buy-and-hold investment strategies, with more and more of them unable to sell securities when they most need to do so. There is a disconnect between booming new issue markets and the moribund secondary trade picture. This may even worsen if near-zero or negative Western bond yields bring more entrants into emerging markets where, according to BNP Paribas, the average stock of a dollar bond trades less than twice a year - down from 4-5 times back in 2007. Emerging debt, like Western junk-rated corporate bonds, is a casualty of a liquidity crunch caused by tighter bank regulation after the 2008 crisis. Default rates are still low but many fear a turn in sentiment that forces funds to rush for the exits, only to find it doesn't exist.
January 15, 2015 Global Dollar Credit: Links to U.S. Monetary Policy and Leverage
Robert N McCauley, Patrick McGuire and Vladyslav Sushko (BIS)
Since the global financial crisis, banks and bond investors have increased the outstanding US dollar credit to non-bank borrowers outside the United States from $6 trillion to $9 trillion. This increase has implications for understanding global liquidity and monetary policy transmission. We analyse the links between US monetary policy, leverage and flows into bond funds, on the one hand, and dollar credit extended to non-US borrowers, on the other. Prior to the crisis, global banks drew on low US dollar funding rates and easy leveraging to extend dollar credit to non-US borrowers. After the Federal Reserve announced its large-scale bond purchases in 2008, however, investors responded to compressed long-term US Treasury rates by buying higher yielding dollar bonds from non-US issuers. Thus, US unconventional monetary policy contributed to shifting the balance of dollar credit transmission from global banks to global bond investors.
January 14, 2015 No Relief as Shrinking Repo Leaves Bonds Exposed: Credit Markets
Liz McCormick (Bloomberg)
Bond investors are bracing for another year of reduced liquidity and the potential for violent swings as a key part of U.S. debt markets that expedites trading of everything from Treasuries to junk bonds shrinks further.
December 18, 2014 Notice Seeking Comment on Asset Management Products and Activities
Financial Stability Oversight Council
Consistent with its responsibility to identify risks to the financial stability of the United States, the Financial Stability Oversight Council (Council) is issuing this notice seeking public comment on aspects of the asset management industry (Notice), in particular whether asset management products and activities may pose potential risks to the U.S. financial system in the areas of liquidity and redemptions, leverage, operational functions, and resolution, or in other areas. The Council is inviting public comment as part of its ongoing evaluation of industry-wide products and activities associated with the asset management industry.
November 19, 2014 Shriveling Shadow Banking Limits Liquidity and Damages the Economy
Lawrence Goodman (CFS)
“Market finance” (or what some like to call “shadow banking”) is shriveling to the detriment of the economy and financial market liquidity. Access to market finance has shriveled by 45% in real terms since 2008 - the largest cyclical drop in the last 40 years.
November 15, 2014 The Current State and Future Evolution of the European Investment Grade Corporate Bond Secondary Market: Perspectives from the Market
ICMA Secondary Market Practices Committee
The study on which this report is based is the result of increasing concern that the secondary markets for European credit bonds have become critically impaired and are no longer able to function effectively or efficiently. This impairment is largely attributed to the unintended consequences of banking regulation and extraordinary monetary policy, and raises further concerns about increased market volatility, frozen capital markets, risks to economic growth, and the prospect of another financial crisis. The study focuses primarily on the European investment grade non-financial and financial corporate bond secondary market. While liquidity has clearly eroded post-crisis, mainly as a result of stricter capital requirements for market-makers and unusually benign market conditions, the story is more nuanced than simply the end of liquidity. There are arguments to suggest that the levels of market depth and liquidity experienced between 2002 and 2007 were largely the result of banks mispricing balance sheet and risk, and overtrading in cash bonds being driven by the Credit Default Swap (CDS) and structured product markets.
October 20, 2014 Did Bank Rules Kill Liquidity? Volcker, Frank Respond
Yalman Onaran and Dakin Campbell (Bloomberg)
Last week’s market gyrations sparked questions about whether bank regulations implemented after the 2008 financial crisis exacerbated price declines by limiting the ability of Wall Street banks to make markets. As stocks and some corporate bonds fell last week, some hedge-fund managers said higher capital requirements had curbed Wall Street trading desks’ ability to cushion the declines by stepping in to buy securities -- what is known as providing liquidity. Also blamed: the Dodd-Frank Act’s Volcker Rule that limits federally insured banks from speculating on some assets, including corporate debt.
June 1, 2014 The Liquidity Challenge: Exploring and Exploiting (IL)Liquidity
Money is gushing through the global financial system thanks to years of central bank largesse. Yet trading liquidity has been on a downward slope. It is getting harder and more expensive to transact in size. What does this mean for investing and portfolio construction, and how should investors weigh the risks and opportunities? A group of 80 BlackRock investment professionals debated the topic at a recent gathering in London. Our conclusions: Market liquidity has declined since the 2008 financial crisis. The situation is challenging in U.S. corporate bonds—and more so in euro and sterling equivalents. Volumes are concentrated in new issues and trading sizes are declining—even as these markets have doubled in size in the past seven years. Traditional liquidity providers such as dealers and banks have pulled in their horns due to risk aversion and a post-crisis gusher of regulations that make this business less attractive. And rising rates (a likely scenario) could cool investors’ infatuation with corporate bonds and hit the market’s lifeblood: new issuance
February 18, 2014 End of the Free QE Lunch
Lawrence Goodman (CFS)
Nobel Laureate Milton Friedman noted that “there is no such thing as a free lunch.” Well, based on CFS monetary and financial data, it appears that the seemingly free lunch from quantitative easing (QE) is nearing an end.
March 27, 2012 Demand for U.S. Debt Is Not Limitless
Lawrence Goodman (Wall Street Journal)
The conventional wisdom that nearly infinite demand exists for U.S. Treasury debt is flawed and especially dangerous at a time of record U.S. sovereign debt issuance.
March 10, 2011 Treasury Maturities : The Other Fiscal Problem
Lawrence Goodman (CFS)
Despite legitimate concerns regarding the budget deficit, large refinancings of debt represent an equally severe — yet lesser known challenge.
Position Limits

In recent years, commodities markets have witnessed increases in volatility and speculative trading. This has prompted a renewed look into the role played by financial investors, those that trade for speculative, rather than hedging, purposes. The commodities markets were developed as a means for commodity users to hedge risks and conduct price discovery; however, critics fear that financial investors interfere with these important functions and ultimately drive up prices. In response, Dodd-Frank authorizes the CFTC to establish new limits on the number of contracts individual investors can hold, subject to exemptions for hedgers.

Dodd-Frank’s opponents contend that setting limits is a dubious undertaking for two primary reasons. First, there is a dearth of economic research showing that speculative trading has significantly affected volatility and prices. Second, the CFTC lacks the data it would need to set useful limits. If correct, these problems suggest that Dodd-Frank’s mandate could ultimately hinder price discovery and deplete liquidity in commodities markets.

Although the public debate surrounding position limits has centered on commodities trading, Dodd-Frank’s mandate extends to security-based swaps. Although the underlying asset is of course different, the concerns compelling the legislation are similar. Specifically, security-swap traders have been criticized for driving up equity prices by cornering the market for swaps of the underlying stock. However, commentators have questioned the extent to which this type of manipulation is even possible.

November 18, 2011 Position Limits for Futures and Swaps, Final Rule, 76 Fed. Reg. 71626
Commodity Futures Trading Commission
This is the CFTC’s adoption of a final rule on position limits, “which establishes a position limits regime for 28 exempt and agricultural commodity futures and options contracts and the physical commodity swaps that are economically equivalent to such contracts.” In setting such limits, the CFTC stated that it is not required to find that excessive speculation exists or is likely to occur. Nor is the Commission required to make an affirmative finding that position limits are necessary to prevent sudden or unreasonable fluctuations in prices. Instead, the Commission must set position limits “prophylactically.” Further, “the Commission disagrees that it must first determine that position limits are necessary before imposing them or that it may set limits only after it has conducted a complete study of the swaps market. Congress did not give the Commission a choice. Congress directed the Commission to impose position limits and to do so expeditiously.”
October 19, 2011 Position Limits Rumors Become Reality: CFTC Adopts Final Position Limits Rule Under Dodd-Frank, Cadwalader Clients & Friends Memo
Paul J. Pantano, Jr., Athena Y. Eastwood, Jonathan H. Flynn, Bryan Shipp, Elizabeth Hastings
On October 18, 2011, the CFTC adopted, by a vote of 3 to 2, a final rule regarding position limits for certain physical commodity derivatives pursuant to the Commodity Exchange Act, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The authors of this memorandum highlight the main features of the final rule.
October 18, 2011 Opening Statement, Commissioner Michael V. Dunn, Public Meeting on Final Rules Under the Dodd-Frank Act
Commissioner Michael V. Dunn (Commodity Futures Trading Commission)
Commissioner Dunn states that that “position limits are, at best, a cure for a disease that does not exist or a placebo for one that does. At worst, position limits may harm the very markets they are intended to protect.” He also states that he is “still left with the conclusion that no one has presented to this agency any reliable economic analysis to support either the contention that excessive speculation is affecting the markets we regulate or that position limits will prevent excessive speculation.” “To be clear, no one has proven that the looming specter of excessive speculation in the futures markets we regulate even exists, let alone played any role whatsoever in the financial crisis of 2008. Even so, Congress has tasked the CFTC with preventing excessive speculation by imposing position limits. . . . After we implement position limits, in all likelihood, the prices of heating oil and gasoline will not drop precipitously as some have strongly suggested. . . .. Position limits may actually lead to higher prices for the commodities we consume on a daily basis.”
December 15, 2010 Testimony before the Subcommittee on General Farm Commodities and Risk Management of the Committee on Agricultural, House of Representatives, Hearing to Review Implementation of Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act Relating to Position Limits
Terrance A. Duffy (CME Group)
Before the CFTC can move forward in its rulemaking with respect to position limits, Dodd-Frank requires the CFTC to make an empirical finding that position limits are necessary to prevent excessive speculation. The CFTC currently lacks evidence of excessive speculation, and to the extent that a potential for such speculation exists, futures exchanges already address these concerns. In addition, the CFTC must wait to impose limits on futures exchanges until it can simultaneously impose limits on economically equivalent swaps. In light of the lack of data necessary to impose limits on swaps, and the CFTC’s inability to show that position limits are indeed necessary, the Commission cannot act against futures. Duffy further warns that arbitrary position limits do more harm than good: they increase costs to hedgers and consumers and fail to solve underlying supply-demand issues. Duffy also expresses concern that limits will be extended to contracts for which they serve no beneficial purpose. These includes limits on non-physical contracts, non-spot month physical contracts, and contracts where the final price is based on an externally calculated index that is unaffected by the futures market. In such instances, limits are likely to prevent prices from reaching equilibrium. More productive tools for monitoring these types of contracts include accountability levels and exchanged-based surveillance tools.
December 15, 2010 Testimony before the Subcommittee on General Farm Commodities and Risk Management of the Committee on Agricultural, House of Representatives, Hearing to Review Implementation of Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act Relating to Position Limits
Jerry Moran (U.S. Senator)
Senator Moran cautions that before the CFTC can propose position limits, it must have access to information necessary to determine what those limits should be and how they can be enforced. Contrary to what some commentators say is a mandate for the CFTC to create position limits within a specified time period, in actuality, Dodd-Frank qualifies the Commission’s rule-making authority. Specifically, Dodd-Frank requires the CFTC to determine that position limits are “appropriate.” As it stands, the OTC markets lack transparency sufficient to provide the level of information necessary to make such a judgment. At a minimum, before the CFTC proceeds with its rulemaking, it must establish swap data repositories that can facilitate comprehensive data collection.
December 15, 2010 Testimony before the Subcommittee on General Farm Commodities and Risk Management of the Committee on Agricultural, House of Representatives, Hearing to Review Implementation of Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act Relating to Position Limits
Joel G. Newman (American Feed Industry Assoc.)
Newman explains that agricultural commodity markets were established as a means for legitimate businesses to hedge risks unique to producers and end-users. While this system welcomes speculation as a means of providing liquidity, the dramatic increase of financial investors has distorted the functioning of these markets. Increased volatility undermines the ability of bona fide hedgers to rely upon the futures markets as their primary risk mitigation tool and results in higher prices for producers, end users and consumers.
January 28, 2010 CFTC Proposes to Set Position Limits in the Energy Futures Market, Cadwalader Clients & Friends Memo
Steven Lofchie, Robert Zwirb, and Mark Highman
The article comments on the CFTC’s rationale for regulation in connection with its proposed position limits rule. It observes that in recent years, calls for the imposition of tighter standards upon energy derivatives have been premised on the view that speculation in those derivatives, including trading by swap dealers and investments by passive index funds, was responsible for the rise of the price of energy products. This view, however, has not been confirmed by empirical evidence. Indeed, a study by CFTC economists issued in 2008 made the politically inconvenient finding that oil prices rose inversely to swap dealer and index fund activity in energy derivatives. Instead, it appears that the agency has abandoned the notion that the purpose of position limits is to address an actual current or past problem in the marketplace. In other words, it appears that the original rationale for regulation—that energy derivatives had artificially inflated the price of oil—has been abandoned (and a new one adopted in its place) because it could not be proved. In fact, the CFTC points out that its NPR “does not speak to whether there was excessive speculation in the regulated derivatives market for the major energy commodities.” Rather, the agency and its chairman cite the CEA for authority that the statute authorizes the CFTC “to impose speculative position limits prophylactically.” This means, according to the CFTC, that it “need not demonstrate that there has been excessive speculation in the regulated derivatives markets for the major energy commodities” — but only that there might be.
January 15, 2010 The Relationship of Unregulated Excessive Speculation to Oil Market Price Volatility
Michael Greenberger (Univ. of Maryland)
Citing congressional and expert research, Greenberger asserts that the physical derivatives markets are overrun by speculation, which has led to increased volatility and higher prices. This occurs because speculators have no stake in discovering the fair price of a commodity, but only hope to profit from directional bets. As a result, when speculators make up too large a share of the futures market, they have potential to upset the critical dynamic between consumers and producers, thereby undermining the adherence of prices to market fundamentals. To reign in this speculation, the CFTC should 1) set position limits for all physical futures on an aggregated basis; 2) reconsider its definition of “bona fide hedging transaction” (i.e. a transaction not subject to position limits) and exclude from that definition hedging of financial risk.
2010 Black Gold and Fool’s Gold: Speculation in the Oil Future’s Market
John E. Parsons (MIT)
Parsons offers a dose of skepticism regarding economists’ common view that speculation played no role in oil’s dramatic price increase during 2003-2008. Rather, Parsons attributes oil’s price increase to the fact that oil transformed from a commodity to a financial asset, which made it vulnerable to speculative bubbles. However, even to the extent that speculation affected oil’s prices in recent years, Parsons argues that position limits will not prevent future price bubbles from occurring. That is because the purpose of limits is to constrain manipulation and limit the sudden rise of order flows that would disrupt an orderly market. However, contrary to public nomenclature surrounding the topic, manipulation is a distinct problem from speculation. Further, manipulation and cash-flow imbalances are short-lived problems when compared to the extended rise in prices characteristic of speculative bubbles such as oil or housing.
Summer 2010 No Theory? No Evidence? No Problem!
Craig Pirrong (Univ. of Houston)
Pirrong addresses the difficulties inherent in testing whether speculators distort prices and the obvious fallacy behind assertions that speculators have such an effect. He explains that because speculators typically exit their positions prior to expiration, speculators do not influence spot market prices to the extent alleged. Pirrong also challenges the empirical bases on which speculation critics base their claims. Pirrong’s own analysis underscores his assertion that speculation does not create price bubbles and that asset price movements tend to be driven by market fundamentals. These results imply that not only will proposed position limits not reduce speculative bubbles, they will also constrain markets’ most important functions: price discovery and risk transfer. Particularly troubling are the proposed crowding out provisions that would restrict hedgers that receive hedging exemptions from holding any speculative positions at all.
August 5, 2009 Testimony Before the Commodity Futures Trading Commission, “CFTC Hearings to Discuss Position Limits, Hedge Exemptions and Transparency for Energy Markets.”
John D. Arnold (Managing Partner, Centaurus Advisors, LLC)
Arnold who runs a commodity-focused hedge fund argues that while the CFTC should impose hard limits on physical commodity futures contracts as they approach expiry and should have transparency and oversight into all financially settled contract positions on exchange and over-the-counter, it should not impose hard limits on financial contracts. Physical futures and financial futures, according to Arnold, serve different functions in the market and should be regulated differently. While hard position limits on physical contracts have significantly reduced volatility in the days surrounding contract expiry, financial trading by contrast has led to less volatility and greater liquidity for the commercial hedger. “Despite a steady increase in financial trading volumes and open interest by all market participants (including index funds and ETFs), volatility of natural gas has shown a steady decrease over the past ten years.” Financial and physical futures contracts are not fungible; position limits on financial contracts would increase transaction costs and volatility.
August 5, 2009 Testimony Before the Commodity Futures Trading Commission, “Hearing on Energy Position Limits and Hedge Exemptions.”
Elliot Chambers (Chesapeake Energy Corporations’ Corporate Finance Manager)
Elliot observes that Chesapeake utilizes risk-management tools, such as OTC derivatives, to provide cash-flow certainty and that its risk-management program provides it with cash flow that helps them continue their capital-intensive drilling activity. He argues that as a company that uses risk-management tools to responsibly manage their core business of finding and producing natural gas, if overly stringent position limits are imposed or a more restrictive application of hedge exemptions is put in place, they believe their ability to continue to protect their exposures would be severely and negatively impacted. With respect to the role of speculation on commodity prices, he states Chesapeake does not agree that commodity prices increased in 2008 solely because of speculative positions. Instead, basic economic principles of supply and demand served as the main cause of prices increasing — and subsequently decreasing. This is demonstrated by the fact that as prices rose, commodity investors were actively selling in the market — just like producers such as Chesapeake, thus, acting as a much-needed cap on prices.
August 5, 2009 Testimony Before the Commodity Futures Trading Commission, “Energy Position Limits and Hedge Exemptions”
Paul N. Cicio (Industrial Energy Consumers of America)
Cicio argues that excessive speculation in the natural gas market is real and must be stopped immediately; that speculative transactions should be directly tied to managing the risk of the underlying commodity; and that speculative transactions based on other investment objectives like diversification of investment portfolios and hedging against inflation are not consistent with the managing of risk of the underlying commodity. Funds like the United States Natural Gas Fund undermine price formation. To mitigate the impact of such funds, speculative aggregate position limits are essential. In lieu of aggregated position limits, position limits must be applied to speculative financial transactions.
August 5, 2009 Statement of Steven Graham on behalf of the American Trucking Associations, Inc., Hearing on Energy Position Limits and Hedge Exemptions
Steven Graham (on behalf of the American Trucking Associations, Inc.)
Citing testimony and statements from Greenberger and Masters, the ATA contends that the market fundamentals, including the increased demand from China and India, supply disruptions in Nigeria and Venezuela, and the declining value of the U.S. dollar do not fully explain the dramatic rise and fall of the price of oil last year; that “a significant increase in the amount of dollars invested in the petroleum derivatives market by non-commercial participants” leads the ATA to conclude that this “increased speculation may be partially responsible for the dramatic rapid increase in oil prices.” Accordingly, “reasonable position limits should be imposed that ensure the ability of consumers that physically possess the underlying commodity to effectively hedge market risk while limiting excessive speculation from investors that have begun using the derivatives markets for asset accumulation.”
August 5, 2009 Testimony Before the Commodity Futures Trading Commission, “Excessive Speculation: Position Limits and Exemptions.”
Michael Greenberger (Law School Professor, University of Maryland School of Law on behalf of Americans for Financial Reform)
Professor Greenberger argues that recent energy price spikes defy market fundamentals and that the overwhelming consensus is that unchecked excessive speculation has caused consumer price spikes in energy and food staples. Greenberger maintains that while there has been a debate over this point generally “the great weight of independent and reasoned authority by many experts on, and observers of, these markets is that outsized excessive speculation within the physical derivatives markets has caused unnecessary volatility, including unnecessary and substantial price increases that consumers pay for everyday staples.” He urges the CFTC to recognize the difference between speculation that aids market liquidity and excessive speculation that destroys markets, arguing that when speculation is “excessive,” prices become unmoored from market fundamentals. He urges that exemptions from position limits not be granted to hedge financial risk and that the CFTC should seek legislation to set aggregate position limits.
August 5, 2009 Testimony Before the Commodity Futures Trading Commission, “Concerning Energy Position Limits and Hedge Exemptions”
John Hyland (Chief Investment Officer, United States Commodity Funds LLC)
Empirical data shows that the activities of large, unleveraged and passive index and single commodity tracking funds in the futures market have resulted in little or no price disruption even as the overall size of the funds’ positions have increased dramatically. Instead of disrupting the futures market, the funds provide a steadying force by adding significant liquidity to the market. In 2008, nearly 325,000 individual investors gained access to the futures market through investments in the Funds. These investors were able to enter the futures market without the traditional settlement risk attendant to futures contracts acquired on a leveraged basis, due to the unleveraged nature of the Funds’ investments. Rather than acting as a source of risk, the Funds provide investors with a transparent, highly regulated, and unleveraged vehicle through which to hedge their pre-existing price risk in commodities.
August 5, 2009 Testimony of Michael W. Masters, Managing Member/Portfolio Manager, Masters Capital Management, LLC Before the Commodity Futures Trading Commission
Michael W. Masters (Managing Member/Portfolio Manager, Masters Capital Management, LLC)
Masters argues that today’s energy derivatives markets suffer greatly from excessive speculation with speculators far outnumbering bona fide physical hedgers and therefore playing the dominant role in conditions. He asserts that over 90% of trading in oil futures involves speculators trading with each other. In this environment, speculators drive prices to levels that do not reflect actual supply and demand. He argues that the CFTC must take strong action to protect the commodities derivatives markets from excessive speculation. It is absolutely essential that the CFTC take aggressive action to strictly limit the positions of speculators across all energy derivatives markets. These limits must treat all active speculators equally, extend across all trading venues, and be enforced at the control entity level. Passive investment in the commodities derivatives markets (index swaps/funds, ETFs, ETNs, etc.) should be banned.
August 5, 2009 Testimony Before the Commodity Futures Trading Commission, “The Role of Speculators in Setting the Price of Oil.”
Philip K. Verleger, Jr. (Haskayne School of Management, University of Calgary, PKVerleger LLC)
Professor Verleger found that changes in crude prices are uncorrelated with flows of money into the two key WTI oil futures contracts offered by the InterContinental Exchange and the New York Mercantile Exchange. In other words, money flows into oil contracts have not affected oil prices. Changes in crude prices are also uncorrelated with flows of money into or out of commodity funds. Again, the correlation is zero. He also states that commodity index funds act to stabilize oil price movements and that imposing position limits on passive investors—or even banning passive investment in oil futures—would not affect the spot price of oil but would alter the incentive to hold inventories. If stocks decline, as history suggests they would, the market will become more volatile. Finally, although the CFTC seems inclined to impose position limits on banks and financial institutions that use futures markets, this would be a mistake because it would raise the cost of investing in oil and gas development, thus further frustrating the nation’s effort to achieve energy independence.
August 5, 2009 Written Testimony Before the Commodity Futures Trading Commission, CFTC Hearing on Price Discovery, Position Limits and Hedge Exemptions
Mark D. Young (Kirkland & Ellis LLP on behalf of the Futures Industry Association)
Position limits no matter how well-meaning create real market migration risk and pushing price discovery of agricultural, energy or metals markets to overseas or other trading venues would be contrary to the purposes of the Act. FIA’s primary concern is that restrictive position limits would lead to market migration and have serious ramifications for the price discovery process. Well-capitalized market participants that want price exposure in the commodity in excess of the CFTC limit may shift their positions to the foreign exchange. As more and more market participants follow suit, the focal point for price discovery shifts too, from the U.S. to overseas. Arbitrage may smooth out pricing disparities in the two markets, but the foreign exchange becomes the price leader, the U.S. exchange the price follower.
July 29, 2009 Testimony Before the Commodity Futures Trading Commission, CFTC Hearings to Discuss Position Limits, Hedge Exemptions and Transparency for Energy Markets
Donald Casturo (Managing Director, Goldman, Sachs & Co.)
Casturo argues that the role that is played by non-traditional participants such as index investors and other financial participants often has been mischaracterized and that some of the courses of action that have been proposed not only will fail to address the perceived harms but also will have unintended consequences that may be disruptive to liquidity and the markets generally. He makes two major points: First, increased participation by financial investors, both in commodity indexes and in single commodity products, has brought new capital to the markets that has facilitated the ability of commercial market participants to hedge their price exposures. Second, swap dealers have largely replaced the floor traders as the predominant source of liquidity to buyers and sellers in the commodities markets and play an important role in providing liquidity, price discovery and customized risk management products to end-users on favorable credit terms. Simply eliminating or limiting swap dealer hedge exemptions will impair liquidity, have other unintended consequences and would very likely not achieve the stated objective.
July 29, 2009 Written Testimony Submission for CFTC Hearings on the “Application of Position Limits and Exemptions from Position Limits in Energy Markets.”
Adam Felesky (Chief Executive Officer, BetaPro Management Inc.)
BetaPro ETFs currently have assets in excess of Cdn. $2.5 billion among 38 passively managed ETFs. While much of the public discourse would suggest that commodity-based ETFs were a factor in the rise in the price of oil, the data clearly does not support this conclusion. Data shows that commodity-based ETFs attract sellers when commodity prices are rising and buyers when commodity prices are falling. Instead of being a source of volatility, commodity-based ETFs have been a source of price stability. Similar results have been experienced by our largest competitor in the United States as evidenced in their securities filings and further supported by the Commission’s September 2008 Staff Report on Commodity Swap Dealers and Index Traders. The inverse relationship between the net notional exposure of our long and short commodity-based ETFs and the price of crude oil continues to persist today. Accordingly, commodity-based ETFs should not be viewed negatively and should not be restricted from providing benefits to investors, particularly when they are not a source of market manipulation or speculation.
July 29, 2009 Testimony Before the Commodity Futures Trading Commission, Proposed Testimony of Dr. Henry Jarecki
Dr. Henry Jarecki (Chairman of Gresham Investment Management)
Gresham was formed to implement a conservative long-only tangible asset portfolio. Jerecki fears that his business will be throttled in “the false understanding that commodity futures index purchases can cause prices to rise.” He argues that high open interest does not cause high prices because for every long there is a short. Indeed, there must be a balance. “When the open interest is high, there are not only more long positions than there have previously been but also more short positions. Does this mean that a high short position causes prices to rise? The idea is of course absurd, but no more absurd than the idea that high open interest causes high prices.” He also argues that the futures markets are not where the world’s prices are made; instead they are made in the physical marketplace. With respect to index funds, Jerecki argues that it is inaccurate to believe that index providers are the cause of high oil prices. It is also obvious that the flows into index funds do not correlate with oil price increases. In some periods, for example, the correlations are indeed negative. This is relevant because the CEA talks about “causing fluctuations in the price” of a commodity, and the flow data shows that this causative element does not exist. It is, thus, illogical to apply position limits at the level of firms like Gresham that passively implement the investor’s decisions and it is actually counterproductive for many reasons.
July 29, 2009 Opening Statement of Peter Krenkel, President of Natural Gas Exchange, Inc., Before the Commodity Futures Trading Commission, Hearing on Energy Position Limits and Hedge Exemptions
Peter Krenkel (President of Natural Gas Exchange, Inc.)
Representing an electronic trading and clearing system for energy products, Krenkel states that while position limits and accountability levels are useful tools in protecting market integrity, NGX supports a regime that is not overly formulaic and can stay current, reacting swiftly to changing conditions. An appropriate regime must also take into account the needs of emerging markets, to ensure additional regulation avoids the risk of driving business away from the transparent exchange-traded markets. Control of at least spot month position limits should shift to the regulator, in this case the CFTC, for contracts that are regularly used interchangeably across marketplaces (’look-alikes’). However, exchanges should continue to set limits and accountability levels for products that are not regularly used interchangeably across marketplace since the exchange is in the best position to understand the relevant considerations for those markets, and to develop and apply an appropriate position limit/accountability regime, in particular where those markets are still emerging.

The scope of the current exemption for bona fide hedgers can remain as is. NGX has not seen evidence based on the trading patterns of non-traditional hedgers in our markets that warrants special treatment for these entities compared with commercial hedgers. These institutions, including ETFs, bring necessary liquidity and provide commercial entities with much needed ability to hedge their risks and manage their operations. While certain controls on speculation are appropriate, additional controls for non-traditional hedgers are not justified, in our contracts, at this time, and risk pushing positions from the transparent markets to the bilateral markets.
July 29, 2009 Testimony Before the Commodity Futures Trading Commission, Regarding Open Hearings to Discuss Energy Position Limits and Hedge Exemptions
John J. Lothian (President & CEO, John J. Lothian & Company, Inc.)
While position limits are a necessary tool for moderating market volatility and speculative fervor, they represent mere “speed bumps” in the financial markets and are “the Maginot Line of futures trading.” The best cure for high prices is high prices and the best cure for low prices is low prices. When position limits are set, they should be set dynamically on a regular pre-defined interval and aggregated across market for positions held by one controlling entity or person. Financial hedgers, including index traders, ETFs and ETNs should be exempt from position limits because they play a bona fide economic role, similar to that of commercial hedgers, and therefore should be exempt. Applying position limits on financial hedgers will have the impact of fragmenting liquidity, negatively impacting the price discovery process and making the markets less fair and efficient. Investors will turn to OTC solutions that are far less transparent than regulated exchanges. Position limits for financial hedgers invites regulatory arbitrage by participants, resulting in decreased market transparency and increased counterparty risk.
July 29, 2009 Testimony of Blythe Masters Managing Director & Head of the Global Commodities Group, J.P.Morgan, Before the Commodity Futures Trading Commission, Hearing on Energy Position Limits and Hedge Exemptions
Blythe Masters (Managing Director & Head of the Global Commodities Group, J.P.Morgan)
Blythe Masters, who is also chair of the Securities Industry and Financial Markets Association (SIFMA) states that while J.P.Morgan wholeheartedly supports efforts to prevent excessive speculation as well as to improve the regulatory framework for “over the counter” derivatives, it also believes that those efforts must be undertaken with the broader understanding that speculation itself plays an essential role in commodities markets. He states that JP Morgan’s experience shows that investors sell following price appreciation and vice versa in order to maintain constant dollar values invested. This tends to stabilize price action rather than drive it. “We are aware of no credible academic study or analysis that demonstrates that the presence of non-commercial interests in commodity markets has been detrimental and many that reach the reverse conclusion.” He recommends that the CFTC further enhance its Special Call authority to implement a comprehensive reporting system that will give the Commission the data necessary to view an entity’s aggregate positions in OTC contracts; the CFTC should look through the swap dealers and apply position limits at the market participant level to eliminate the ability to use the OTC markets to exceed positions that would otherwise apply if the participant had transacted on regulated exchanges, furthering the mission of preventing excessive speculation; and that hedge exemptions for transactions related to a non-commercial practice are necessary to allow financial intermediaries to mitigate their exposure to those transactions.
July 29, 2009 Testimony Before the Commodity Futures Trading Commission, Energy Position Limits and Hedge Exemptions
Tyson Slocum (Director, Public Citizen’s Energy Program)
Slocum argues that deregulation has eroded transparency over energy trading markets, opening the door to harmful levels of speculation that deny consumers access to adequately competitive markets. The CFTC must use its authority to strengthen its oversight over swaps dealers, index funds and other players in OTC markets to protect families from unfair energy prices and preserve market integrity. He contends that the bulk of the “speculators” are financial institutions, such as Goldman Sachs, JP Morgan Chase/Bear Stearns, Morgan Stanley, Citigroup and Bank of America/Merrill Lynch, who have turned energy markets into lucrative profit centers for the firms, taking full advantage of the lack of regulatory oversight over their operations to maximize market power and control information. Specifically, banks dominate energy trading markets through their role as swaps dealers and as managers of index funds, which facilitates successful proprietary trading operations. He urges the CFTC to enact position limits across all energy products and markets for all index traders, swaps dealers and proprietary traders. Such limits must be aggregate—applying across all energy contracts in all markets for all months.
July 29, 2009 Testimony at CFTC Hearings to Discuss Position Limits, Hedge Exemptions and Transparency for Energy Markets
Donald Casturo (Goldman Sachs & Co.)
Casturo elaborates on the pivotal role that financial investors and swap dealers play in futures markets: investors absorb price risk otherwise born by producers, ultimately lowering hedging costs. Investors also help correct market imbalances that continually arise between hedging producers and consumers. To avoid undermining this critical dynamic, limits must consider producer and consumer hedge ratios, the size of the physical commodity market and the size of the futures market. Casturo also criticizes recent calls to limit exemptions for swap dealers. Dealers make markets for commercial hedgers and thereby facilitate price discovery and liquidity. While it might appear that dealers take large, speculative positions in the futures markets, this is really a misconception - the dealer’s position is actually a byproduct of its need to manage its multiple exposures as a market maker. Limiting this ability would do more harm than good as it would fail to remedy the potential for excessive speculation and would diminish the benefits that dealers currently provide.
July 29, 2009 Testimony at CFTC Hearings to Discuss Position Limits, Hedge Exemptions and Transparency for Energy Markets
Jeffrey C. Sprecher (IntercontinentalExchange, Inc.)
Sprecher cautions the CFTC against imposing position limits in the absence of any quantitative study showing that speculation in futures markets causes increased prices. That being said, to avoid potentially anticompetitive regulation, Sprecher urges consistency in how new rules are enforced. For example, the CFTC, rather than individual exchanges, should be responsible for monitoring and setting aggregate position levels. Similarly, limits should be consistent across exchanges and not based on a percentage of a particular exchange’s open interest. Last, position limits must be flexible and account for the price differentials between spot and futures markets - an approach consistent with current distinctions between expiry month limits and future month accountability levels. Mandating hard limits across all future months could drain liquidity, inhibit price signals and increase risk for longer-dated portions of the price curve.
July 28, 2009 Testimony Before the Commodity Futures Trading Commission, “Position Limits and the Hedge Exemption, Brief Legislative History.”
General Counsel Dan M. Berkovitz (Commodity Futures Trading Commission)
The CFTC’s General Counsel reviews the legislative history of the mandate in the CEA concerning position limits and the exemption from those limits for bona fide hedging transactions.
July 28, 2009 Testimony Before the Commodity Futures Trading Commission On Behalf of the American Public Gas Association
Laura Campbell (Assistant Manager of Energy Resources, Memphis Light, Gas & Water)
APGA believes that the Commission’s conclusion reached in 1981 remains equally true today, and therefore supports additional regulatory controls, such as stronger speculative position limits, if a reasoned judgment can be made based on currently available, or additional forthcoming market data and facts, that such controls are necessary to address the unintended consequences arising from certain speculative trading strategies and/or to reign in excessively large speculative positions. However, APGA also recognizes that limits that cover only some of the variety of linked markets will not solve the problem, it would likely only push trading activity onto the less regulated market segments. Accordingly, to the extent that speculative investment may be increasing the price of natural gas or causing pricing aberrations, APGA strongly encourages the Commission to take strong remedial action. APGA’s testimony also refers to concerns that have been raised with respect to the size of positions related to, and the role of, passively managed long-only index funds. In this instance, the concern is not whether the positions are being taken in order to intentionally drive the price higher, but rather whether the unintended effect of the cumulative size of these positions has been to push market prices higher than the fundamental supply and demand situation would justify.
July 28, 2009 Testimony before the Commodity Futures Trading Commission
Sean Cota (President, Cota & Cota, Inc., Bellow Falls, Vermont on behalf of the Petroleum Marketers Association of America and the New England Fuel Institute)
Cota argues that it is abundantly clear that large-scale, institutional investors speculating in the energy markets continue to act as the driving force behind energy prices. The rise in crude oil prices, which reached $147 in July of last year only to fall dramatically to $33 in December, was not a result of supply and demand fundamentals — it was the direct result of excessively-leveraged speculators, index investors and hedge funds. Prices did not reflect the supply and demand outlook for a world in severe recession, and with no reliable predictions of recovery in the foreseeable future. Speculators were never intended to dominate the market and the markets were never intended to exist at their behest. Speculators are so large and lacking in fundamental knowledge of commodities trading that they have dramatically distorted these markets. In order to restore integrity and confidence in energy futures markets, the CFTC should impose strict position limits on all non-commercial market participants, and across all months and all markets; restrict index funds to much smaller position limits per individual investor in the fund or the same limits applied to speculators for the entire fund; and limit passive investors’ positions to prohibit them from banding together, and as a consequence, driving up prices.
July 28, 2009 Statement of Craig S. Donohue, Chief Executive Officer of CME Group Inc.
Craig S. Donohue (Chief Executive Officer of CME Group Inc.)
The debate regarding controlling excessive speculation in the energy markets by means of position limits or otherwise needs to be informed by two facts: first, it is rare for speculators, index traders and/or swap dealers to have control of a large share of the open interest in any futures contract, and second, efforts to control price or volatility by position limits is a failed strategy. So-called “speculators,” such as index funds and swap dealers, who are the focus of recent intense criticism, are not engaged in traditional speculative activity, i.e., trying to beat the market. Rather, swap dealers use futures markets to facilitate the hedging of more complex and specific risks accepted in connection with swap transactions with commercial customers and others. Denying or limiting their access to the futures markets will simply impede hedging activity by commercial market participants. Index funds aggregate the buying and selling decisions of many thousands of investors, most of whom are doing what they have been taught for decades to do: diversifying their investment portfolios and hedging inflation risks to their investment returns in order to maximize their retirement savings and their individual wealth. A review of the U.S. Oil Funds open positions shows that it was liquidating positions while oil prices were rising (contrary to the view of those same favored Congressional witnesses) and taking additional positions when oil prices were falling (again contradicting common expectations). Position limits are not a costless palliative to appease angry farmers or gasoline or heating oil buyers. Position limits, when improperly calibrated and administered, can easily distort markets, increase the costs to hedgers and effectively increase costs to consumers.
July 28, 2009 Testimony Before the Commodity Futures Trading Commission, Energy Position Limits and Hedge Exemptions
Ben Hirst (Senior Vice President and General Counsel for Delta Airlines on behalf of the Air Transport Association of America, Inc.)
Excessive speculation drives volatility--The financial health and security of the airline industry depends, in significant part, on a commodities market structure that is stable, rational and predictable. Today’s energy commodities markets, however, do not display these characteristics. Since 2005 we have seen a significant increase in the volatility of oil prices. This increase in volatility has been associated with a massive increase in speculative investment in oil futures. This increase in speculative activity is closely correlated with the increased volatility of oil prices, which has caused so much harm. We estimate that the speculative oil price bubble that began in mid-2007, peaked in mid-2008, and then plummeted abruptly, cost Delta $8.4 billion, compared with what we would have spent on jet fuel if the price of oil had remained at $60 a barrel. Investors with lawful motives, such as wealthy endowments, can drive speculative price bubbles. Broader implementation of position limits and stricter control over hedge exemptions are needed to address this problem. By imposing consistent position limits on all noncommercial traders across all markets, traders will continue to have the opportunity to invest in energy commodities, but only up to the level necessary to ensure adequate liquidity in the market. This would prevent a recurrence of excessive speculative activity that created the 2008 commodity bubble while ensuring that the markets continue to enjoy adequate liquidity to function efficiently. However it is derived, the formula for position limits should ensure both that an individual’s position does not represent an unduly large percentage of the deliverable supply or an unduly large percentage of the open interest outside the delivery month and that speculative traders, in aggregate, don’t hold an unduly large percentage of the total open interest.
July 28, 2009 Testimony Before the Commodity Futures Trading Commission
Todd E. Petzel, Ph.D. (Chief Investment Officer, Offit Capital Advisors, New York)
Observing that the U.S. futures markets have had federally mandated position limits for select agricultural commodities since 1936, while exchanges have been in charge of establishing position limits for other futures, Petzel maintains that the latter have strong incentives to set limits at the proper level in order to provide reliable, open, and non-manipulated markets to all users. If a market is perceived to be either inaccurate or easy to disrupt, those commercial participants simply will not trade. But a balance has to be maintained. Limits that are too large may allow for market disruption, but if the limits are too small there will not be enough capital in the market to provide regular liquidity or adequate transfer of risk. The growth of these markets over decades suggests the exchanges have generally gotten this balance right. While the proper size and effectiveness of position limits can be debated at great length, what cannot be disputed is the necessity of dealer hedge exemptions associated with any activity that is consistent with, and allowed by, the established position limits.
July 28, 2009 Testimony of Congressman Bart Stupak, U.S. House of Representatives
Congressman Bart Stupak (U.S. House of Representatives)
According to CFTC data, from January 2008 through the end of June 2008, index investors poured $55 billion into major commodity indexes, pushing the price of crude oil from $99 per barrel to $140 per barrel. That same market collapsed over the course of the next six months, with prices plummeting to $30 per barrel by December 2008 as investors withdrew $73 billion from the market. This was not a coincidence. The dramatic drop in oil prices was occurring at the same time index investors fled the market. The driving factor contributing to an increase in the price of oil this year was the surge of funding from index investors back into the oil markets. The CFTC should set aggregate trader position limits on energy contracts over all markets. With the growing number of markets, speculators can currently comply with exchange specific position limits on several exchanges, while still holding an excessive number of total contracts taken together. By setting strong aggregate position limits over all markets, CFTC would be able to curb excessive speculation by making sure traders are not amassing huge positions in a commodity in an attempt to play one exchange off another. Also see the supporting charts.
June 30, 2009 IEA Medium-Term Oil Market Report, Price Section
The International Energy Agency
The International Energy Agency examines whether the price of oil during 2009 was set by oil market fundamentals or by speculation. In particular it attempts to verify the “speculation view” of oil price formation, which holds that a growing participation in the oil futures market of non-commercial, especially financial, players can push the price above l that should result from purely fundamental factors — speculation causes prices to ’overshoot’ or ’undershoot.’ Most proponents of this view cite the trend of a growing amount of money placed in and out of commodities, oil in particular, by passive investors — index funds, pension funds and university endowments — as well as more active types of investors like hedge funds, which seems to have coincided with price movements. A look at net positions of non-commercial entities, as reported by the CFTC on a weekly basis, does not reveal any sound correlation with prices. Instead, a multitude of factors are at play in oil price formation. It concludes that fundamentals still seem to provide a reasonably plausible account of price movements both up and down; speculation, though its long-term impact on the price is neither quantifiable nor conceptually proven, does appear to have an impact on the spot market in the very short term, particularly on a day-to-day basis; and that index funds and other passive investors may add pressure to the market from the buy side, leading to claims that future prices are inflated beyond the level warranted by fundamentals, but no hard evidence is present. (See attachment to Verleger testimony.)
January 30, 2009 Issues Involving the Use of the Futures Markets to Invest in Commodity Indexes
U.S. Government Accountability Office
GAO reviewed eight empirical studies that addressed the relationship between speculation and prices and concluded that the studies “generally found limited statistical evidence of a causal relationship between speculation in the futures markets and changes in commodity prices — regardless of whether the studies focused on index traders, specifically, or speculators, generally.” GAO further explained that “all of the empirical studies we reviewed generally employed statistical techniques that were designed to detect a very weak or even spurious causal relationship between futures speculators and commodity prices. As result, the fact that the studies generally did not find statistical evidence of such a relationship appears to suggest that such trading is not significantly affecting commodity prices at the weekly or daily frequency.” This lack of relationship was found notwithstanding the fact that index investors largely have not been restricted by contract position limits that are used to prevent excessive speculation in the futures markets. GAO found that Index investors generally have not been restricted by position limits, because (1) they have obtained their index exposures primarily through OTC swaps not subject to position limits, and (2) swap dealers have received exemptions from CFTC that allow them to hold index-related futures positions in excess of the position limits. CFTC is currently deciding whether it should limit the exemptions.
October 2008 “Annex 1.2. Financial Investment in Commodities Markets” in Global Financial Stability Report: Financial Stress and Deleveraging, Macrofinancial Implications and Policy, International Monetary Fund
Sergei Antoshin, Elie Canetti, and Ken Miyajima
Estimates suggest that commodities assets under management totaled $270 billion in the second quarter of 2008, $175 billion of which were institutional investor flows linked to commodity indices. Commodity-indexed funds have attracted attention because of their aggregate size and rapid growth in recent years, and because, unlike many other investments, they represent a long-only investment in commodity futures. The authors hypothesize that if financial market participation influences commodity prices, increases in investment should precede price increases. They examine temporal causality between investor positions and prices of oil, copper, wheat, corn, soybeans, and rice. They find that a run-up in commodity prices was accompanied by increased investment flows to commodity index funds, but their analysis fails to find meaningful causal relationships between financial positions and prices of major commodities.
September 2008 Commodity Swap Dealers & Index Traders with Commission Recommendations
Commodity Futures Trading Commission Staff Report
The CFTC staff report showed that while crude oil prices on NYMEX rose during the first half of 2008, the actual level of speculative buying activity by index traders declined. In particular, while there was an increase in the net notional value of commodity index business in crude oil futures, it appears to be due to an appreciation of the value of existing investments caused by the rise in crude oil prices and not the result of more money flowing into commodity index trading. As crude oil prices were increasing during the period December 31, 2007 to June 30, 2008, the activity of commodity index traders in crude oil during this period reflected a net decline of futures equivalent contracts. In short, and somewhat surprisingly, the CFTC report found a negative correlation between the size of investment in the market by speculators and price levels. Notwithstanding the results of the CFTC’s report, the CFTC issued a series of recommendations to “better quantify the nature and accuracy of trading activity conducted on exchanges” with the primary burden being placed on swap dealers. The recommendations included: (i) removing swap dealers from the commercial category for reporting purposes and creating a new category for such traders for reporting purposes; (ii) developing and publishing a new periodic supplemental report on OTC swap dealer activity; and (iii) reviewing whether to eliminate the bona fide hedge exemption for swap dealers and replacing it with a limited risk-management exemption requiring non-commercial swap clients to abide by specified position limits.
July 31, 2008 Lehman Brothers Commodities Special Report: Index Inflows and Commodity Price Behavior
Daniel Ahn
The author examines the role of commodity indices whose large financial inflows have raised questions about their effect on markets. He estimates that roughly $98 billion of new financial inflows have entered commodity index funds since January 2006 alone. He finds that momentum-chasing and attempts at diversification by investors have driven these inflows. However, evidence of the indices’ effect on price returns remains ambiguous. Index inflows seem to have a positive, albeit weak, effect on market volatility. Also, all of the positive effects are concentrated in the smaller commodity markets, such as agricultural goods, not the energy markets, which have received so much attention. The long-term growth of market size and liquidity should eventually improve efficiency and diminish short-run distortions.
July 31, 2008 The Accidental Hunt Brothers: How Institutional Investors Are Driving Up Food and Energy Prices
Michael W. Masters (Masters Capital Management, LLC) and Adam K. White (White Knight Research & Trading)
Masters and White argue that the price discovery function of the commodities futures markets is “breaking down” due to excessive speculation by index speculators. Because futures price increases directly result in spot price increases, this speculation, which derives from institutional investors’ portfolio allocation decisions is leading to artificially high prices for commodities. From the beginning of 2004 to 2008, Index Speculators have poured $173 billion into these 25 commodities. This has caused futures prices to rise dramatically as the commodities futures markets were forced to expand in order to absorb this influx of money. Congress can put an end to excessive speculation by simply re-establishing meaningful speculative position limits that apply on all exchanges trading U.S.-based commodity futures contracts. These speculative position limits also need to be applied to transactions in the over-the-counter swaps market, since that market is now 9 times bigger than the futures exchanges. In addition to imposing speculative position limits, Congress should take the additional step of prohibiting or severely restricting the practice of commodity index replication.
July 2008 Interagency Task Force on Commodity Markets. Interim Report on Crude Oil
Interagency Task Force on Commodity Markets
In view of the robust increase in trading activity in the crude oil futures market that coincided with the rising price of crude oil, an interagency Task Force chaired by the CFTC examined if the behavior of some market participants had a possible impact on the price of crude oil. The Task Force surmised that if a group of market participants has systematically driven prices, detailed daily position data should show that that group’s position changes preceded price changes. The Task Force’s preliminary analysis, based on the evidence available to date, suggests that changes in futures market participation by speculators have not systematically preceded price changes. On the contrary, most speculative traders typically alter their positions following price changes, suggesting that they are responding to new information — just as one would expect in an efficiently operating market.

The evidence supports the position that changes in fundamental factors provide the best explanation for the recent crude oil price increases. Moreover, if speculative activity has pushed oil prices above the levels consistent with physical supply and demand, increases in inventories should emerge as higher prices reduce consumption and investment in productive capacity is encouraged. Although this process may take time to unfold, inventories of crude oil and petroleum products, according to available data, have declined significantly over the past year. The view that financial investors have pushed prices above fundamental values is also difficult to square with the fact that prices for other commodities that do not trade on established futures markets (such as coal, steel, and onions) have risen sharply as well.

The Task Force’s preliminary analysis also suggests that changes in the positions of swap dealers and noncommercial traders most often followed price changes. This result does not support the hypothesis that the activity of these groups is driving prices higher. The Task Force found that the activity of market participants often described as “speculators” has not resulted in systematic changes in price over the last five and a half years. In particular, the positions of hedge funds appear to have moved inversely with the preceding price changes, suggesting instead that their positions might have provided a buffer against volatility-inducing shocks.
June 2008 “The Oil Price Is a Speculative Bubble.” Working paper 08-007, Center for Energy and Environmental Policy Research, Massachusetts Institute of Technology
R. S. Eckaus (Center for Energy and Environmental Policy Research, Massachusetts Institute of Technology)
In a paper cited by CFTC Commissioner Bart Chilton for the proposition that speculation is a contributing factor to the rising price of oil, Eckaus asserts the price of oil “really is a speculative bubble,” and attempts to explain why fundamental factors play little role: “We cannot pick out the constraining effect or prices on demand without doing a lot of careful statistical analysis, which is beyond the extent of this note.” Eckaus, however, performs no econometric analysis.
2007 “Measuring the Influence of Commodity Fund Trading on Soybean Price Discovery.” Proceedings of the NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management
Gerald Plato and Linwood Hoffman
The increase in commodity fund trading in the agricultural commodity futures markets has raised concern that this trading is degrading the price discovery performance of these markets. The authors estimate the price discovery performance of the soybean futures and spot markets and find that the price discovery performance of the soybean futures market has improved along with the increased commodity fund trading. Their results indicated that a portion of the price discovered in the soybean futures market is passed to the spot market.
September 2006 “Has Speculation Contributed to Higher Commodity Prices?” in Martin Sommer, “The Boom in Nonfuel Commodity Prices: Can It Last?” in World Economic Outlook, International Monetary Fund
Sergei Antoshin and Hossein Samiei
Antoshin and Samiei examine the view that “speculation has magnified the impact of changes in the fundamental determinants of supply and demand (which have been supportive of higher prices) to an extent that in some cases prices have risen far in excess of levels justified by fundamentals.” Sommers observes that “despite the attractiveness of some of these arguments, however, the supporting evidence has often focused on correlations rather than tests of causality, and has tended to be anecdotal or circumstantial—based on, for example, the increased hedge fund activity accompanying the rise in prices or the deviation of prices from long-run marginal costs. The lack of solid evidence in part reflects data and definitional problems associated with defining and measuring speculation.” They find that for five commodities, the results “provide little support for the hypothesis that speculative activity (as measured by net long noncommercial positions) affects either price levels over the long run or price swings in the short run. In contrast, there is evidence (both across commodities and over time) that speculative positions follow price movements. These findings are consistent with the hypothesis that speculators play a role in providing liquidity to the markets and may benefit from price movements, but do not have a systematic causal influence on prices.”
August 18, 2005 “Position Limits for Cash Settled Derivative Contracts,” 25 Journal of Financial Markets 945-65
Hans R. Dutt and Lawrence Harris
Cash settlement of derivative contracts makes them susceptible to manipulation by traders who expect to close large positions upon final settlement. Cash settlement also increases underlying volatility when hedgers unwind their hedges if they have no incentives to control their trading costs. Limits on the positions that traders can carry into final settlement can be used to mitigate associated economic inefficiencies when surveillance is insufficient. This article develops a model that regulators can use to set these limits that is based upon microstructure theory. The empirical findings indicate that existing position limits are largely inconsistent with those suggested by the model.
April 2005 “Price Dynamics, Price Discovery and Large Futures Trader Interactions in the Energy Complex.” Staff Research Report
Michael S. Haigh, Jana Hranaiova and James A. Overdahl (Office of the Chief Economist, U.S. Commodity Futures Trading Commission)
Three CFTC economists examine the role, performance and impact of large speculative traders (primarily managed money traders) in derivatives markets. In particular, they study the relationship between futures prices and the positions of managed money traders (MMTs), commonly known as hedge funds, for the natural gas and crude oil futures markets. They also examine the relationship between the positions of MMTs and positions of other categories of traders (e.g., floor traders, merchants, manufacturers, commercial banks, dealers) for the same markets. Their results suggest that it is the MMT traders who are providing liquidity to the large hedgers and not the other way around. They also find no evidence of a link between price changes and MMT positions in the natural gas market, and find a significantly negative relationship between MMT position changes and price changes in the crude oil market.
2004 Detecting Manipulation in Futures Markets: The Ferruzzi Soybean Episode
Craig Pirrong (University of Houston)
Reducing the frequency and severity of manipulation improves market efficiency, and regulators use a variety of means, such as position limits, to prevent manipulation. However, Pirrong argues that, as long as manipulation can be detected, reliance on prevention in lieu of deterrence is inefficient. The current system’s reliance on prevention stems from the misguided notion that manipulation is “unprosecutable.” By analyzing a 1989 alleged case of manipulation, Pirrong demonstrates how economic and statistical analysis can be used to detect manipulation ex post, and explains why this approach is preferable to the preventative measures such as position limits.
Rating Agencies

During the financial crisis, structured debt securities carrying investment grade ratings lost value to an extent that seemed inconsistent with those lofty ratings. As a result, the crisis sparked renewed scrutiny of the three largest nationally recognized statistical rating organizations (NRSROs): Moody’s, Standard & Poors, and Fitch.

Criticisms of the current system are many and varied. For starters, the NRSROs act as government-sanctioned gatekeepers to the debt markets by assigning debt ratings to issuers and issues. However, the agencies’ important public function is complicated by the fact that the NRSROs use an “issuer-pays” model whereby the issuer pays the agency to assign a rating. This creates a conflict of interest because the agency is charged with producing an impartial analysis for public consumption at the same time that the agency has a financial stake in satisfying issuers. Another problem is that current rules governing institutional investors encourage over-reliance on agency opinions at the same time that they discourage investors from conducting their own due diligence. Last, some critics note that NRSROs are virtually immune from liability for publishing ill-conceived ratings.

While the virtues of these criticisms are themselves a subject of debate, they’ve sparked a host of reform proposals. These include increasing competition among rating agencies by reducing barriers to entry for non-NRSROs firms; moving to a subscriber-paid model; reducing regulatory reliance on agencies; and imposing a professional standard of conduct on agencies similar to that imposed on lawyers and accountants. Dodd-Frank adopts some of these proposals by limiting reliance on NRSROs, and by increasing disclosures as to conflicts of interest and issuer analysis.

March 2014 Forecasting Bank Credit Ratings
Periklis Gogas (Democritus Univ. of Thrace), Theophilos Papadimitriou (Democritus Univ. of Thrace), Anna Agrapetidou (Democritus Univ. of Thrace)
The authors set out to find the most important variables that contribute to Fitch's long term ratings of U.S. banks. Their optimum forecasting model, which is based upon data that is publicly available from the banks' financial statements, can reach 83.7% forecasting accuracy. The optimum forecasting model includes nine financial variables: five of the forecasting regressors are from the banks' balance sheet; three are performance ratios; and one comes from the income statement. The results indicate that credit ratings are largely based on historical data that is widely available to investors, bank officials, and the policy makers.
May 2, 2011 Does the Bond Market Want Informative Credit Ratings
Jess Cornaggia (Indiana Univ. - Kelley School of Business) and Kimberly Cornaggia (American Univ. - Kogod School of Business)
The authors examine the information content of Moody’s ratings compared to those produced by Rapid Ratings, an independent subscriber-paid firm, and find that the independent ratings provide more timely information. To explain these results, the authors’ demonstrate that regulated, influential investors benefit from sluggish downgrades. This is because regulatory reliance on relatively uninformative credit ratings allows banks, insurance companies and pension funds to holder riskier bonds and earn higher returns. The authors also offer an explanation for the disparity in informativeness between issuer-paid and subscriber-paid ratings. Among other things, they find that issuer-paid services are less likely to misclassify healthy issuers’ debt as distressed and more likely to misclassify distressed issuers’ debt as health.
July 2010 Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies
Securities Exchange Commission
The Report addresses the big three’s struggle to keep pace with the growth and complexity of the RMBS and CDO markets since 2002. Focusing particularly on conflicts of interest and valuation processes, the study found numerous holes in firms’ compliance policies. The Staff found that even in some instances where firms’ policies were themselves adequate, policies were improperly enforced. For example, procedures for reviewing employee trading were often loosely enforced. In other instances, the policies themselves were problematic. For instance, while each agency had procedures designed to prevent analysts from participating in fee discussions with issuers, these polices still allowed key participants in the ratings process to participate in fee discussions. Similarly, the staff concluded that while initial product valuations were robust, subsequent review processes lacked adequate oversight and analysis.
April 2, 2010 Why Did Rating Agencies Do Such a Bad Job Rating Subprime Securities?
Claire A. Hill (Univ. of Minnesota)
Hill asserts that the problems undermining the legitimacy of the ratings industry don’t derive from conflicts of interest inherent in the issuer-pays model. Would-be conflicts are mitigated by agencies’ reputational concerns, as is evidenced by the fact that many issuers do not receive AAA ratings. Rather the problem stems primarily from the fact that agencies “drank the Kool-Aid.” Specifically, the issuer-pays model gave the agencies a “can do” mindset regarding the task at hand - to achieve the rating the issuers desired, working with them to modify the deal structures as needed. That the issuers were paying motivated the agencies to drink the Kool-Aid; having drunk the Kool-Aid, the agencies gave the ratings they did. This problem could be mitigated by lessening institutional reliance on agencies or regulating issuer leverage. Hill also provides a critique of several reform proposals. For instance, she notes that the benefits of increased disclosure or oversight are likely illusory -why should the SEC be able to detect what self-interested money managers—those buying the securities in hopes of a big return—were not?
September 30, 2009 Testimony before the Committee on Oversight and Government Reform, House of Representatives, Hearing on Credit Rating Agencies and the Next Financial Crisis
Floyd Abrams
Abrams addresses a proposed change to the Private Securities Litigation Reform Act that would loosen the pleading standard for 10b-5 suits against rating agencies from bad faith to negligence. Subjecting agencies to increased, and potentially frivolous, litigation could incentivize agencies to narrow the scope of their rating analysis and adopt a homogenous approach. As a result, the market would have access to fewer ratings and those ratings that exist might be of lower quality.
September 30, 2009 Testimony before the Committee on Oversight and Government Reform, House of Representatives, Hearing on Credit Rating Agencies and the Next Financial Crisis
Financial Economist Roundtable
The Financial Economist Roundtable (FER) addresses the need for reform of the ratings industry, particularly with respect to three areas: 1) improving firm incentives by increasing transparency and accountability; 2) reducing regulatory reliance on agencies to encourage greater due diligence among investors and increase agency competition; and 3) requiring agencies to state a margin of error in their ratings for every tranche of securitized instruments to account for the greater downside loss exposure associated with these investments. The FER cautions against increased government supervision, noting that market forces are more effective tools for improving investor and agency performance.
September 30, 2009 Testimony before the Committee on Oversight and Government Reform, House of Representatives, Hearing on Credit Rating Agencies and the Next Financial Crisis
Lawrence J. White (NYU - Stern)
White explains that the primary problem facing the ratings industry is that the regulatory system delegates important safety judgments to SEC-designated NRSROs. Reform should seek to reduce reliance on agency-produced ratings, not impose heightened regulation. White proposes two means by which this can be accomplished: 1) by removing the NRSRO classification, and 2) by requiring regulated institutions (e.g., institutional investors) to bear the burden of demonstrating that their holdings are appropriate. Doing this would allow the market for agencies to be regulated solely by market forces, not by government classifications. In addition, it would foster a shift away from the issuer-paid model by forcing institutions to conduct their own research or hire outside advisors to do the same. It would also encourage competition and innovation and would rid the current system of its barriers to entry and conflicts of interest.
August 5, 2009 Testimony before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, Hearing on Examining Proposals to Enhance the Regulation of Credit Rating Agencies
John C. Coffee (Columbia Law School)
Coffee contends that proposed reforms (i.e. the Investor Protection Act of 2009 and the Rating Accountability and Transparency Act of 2009) fall short in two critical aspects. First, rating agencies do not perform due diligence but rely on the information provided by issuers. Any reform that fails to impose heightened due diligence requirements on the agencies will not solve the industry’s problem of credibility. Second, unlike accountants and lawyers, rating agencies have enjoyed immunity from liability for ill-conceived ratings. This immunity, coupled with the conflicts of interest inherent in the issuer-paid model, dictates that, even with increased industry concentration, ratings will continue to be overly optimistic. Accordingly, reform should impose a mild threat of litigation to counteract industry conflicts of interest.
August 5, 2009 Testimony before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, Hearing on Examining Proposals to Enhance the Regulation of Credit Rating Agencies
Mark Froeba (PF2 Securities Evaluations)
Froeba identifies three critical reform goals: 1) preventing another ratings-related financial crisis; 2) restoring investor confidence; 3) untangling the web of conflicting regulatory incentives currently in place. These goals can be accomplished by separating ratings analysis from the ratings business; restructuring employee compensation models; imposing some form of liability for unreasonably bad ratings; creating a professional organization charged with creating industry standards for ethical and education requirements; and introducing investor-pay incentives into the issuer-pay framework.
August 5, 2009 Testimony before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, Hearing on Examining Proposals to Enhance the Regulation of Credit Rating Agencies
James H. Gellert (Rapid Ratings)
Gallert assets that proposed regulation of the ratings industry fails to adequately address a fundamental problem endangering the industry and the financial markets: conflicts of interest and entrenched regulatory protection at issuer-paid firms. Effective legislation can mitigate these problems by providing proper oversight of the NRSROs and encouraging competition among firms by reducing barriers to entry for non-NRSROs. In addition, Gallert advises policymakers to consider issuer-paid and subscriber-paid firms separately as most of the problems undermining the industry’s credibility are unique to issuer-paid firms.
May 19, 2009 Testimony before the Subcommittee of Capital Markets, Insurance and Government Sponsored Enterprises of the Committee of Financial Services U.S. House or Representatives, Hearing on Approaches to Improving Credit Rating Agency Regulation
Stephen W. Joynt (Fitch Ratings)
Joynt highlights the benefits of the issuer-paid model, i.e., that it enables broad coverage to market participants for free, and stresses that conflicts of interest are effectively monitored through a robust set of firm policies. Critically, investor-paid models present their own conflicts and limit the availability of ratings to those investors that pay for the service. In addressing reform proposals, Joynt argues that calls for increased disclosure and due diligence, while reasonable, are misdirected and should be directed at the issuers themselves, not the ratings agencies. Similarly, he explains that calls for increased liability would have the effect of holding rating agencies liable “for failure to predict future events,” and at any rate, fraud detection and disclosure adequacy are the province of issuers, not credit analysts.
May 19, 2009 Testimony before the Subcommittee of Capital Markets, Insurance and Government Sponsored Enterprises of the Committee of Financial Services U.S. House or Representatives, Hearing on Approaches to Improving Credit Rating Agency Regulation
Frank Partnoy (Univ. of San Diego)
Partnoy posits that due to the current lack of incentives for agencies to “get it right,” firms pose a systemic risk to the broader financial markets. Central to this incentive mismatch is the transition of agencies from informational intermediaries to regulatory licensors who hold the keys to the financial markets for investors and issuers alike. As a result, leading NRSROs have become more profitable even as the quality of their ratings has declined. Partnoy attributes this paradox to the deference that regulators and private actors give to the rating agencies, and suggests that as long as this deference exists, agencies will continue to prosper even if their work quality is surpassed by non-NRSROs. Partnoy proposes the creation of a Credit Rating Agency Oversight Board charged with reducing investor reliance on ratings and regulating agency practices regarding disclosure, conflicts of interest, and rating methodologies. In addition, the SEC should be given greater jurisdiction over the industry, and the industry’s traditional exemption from liability should be lifted.
May 19, 2009 Testimony before the Subcommittee of Capital Markets, Insurance and Government Sponsored Enterprises of the Committee of Financial Services U.S. House or Representatives, Hearing on Approaches to Improving Credit Rating Agency Regulation
Eugene Volokh (UCLA School of Law)
Volokh address the First Amendment implications of rating agency liability and explains that agencies’ opinions (i.e., ratings) are generally entitled to the same level of constitutional protection as that provided to public news sources. In addition, factual assertions provided by agencies are protected absent a showing that the speaker knew that the statements were false or likely false. That being said, Congress is free to impose guidelines that issuers and agencies must comply with for a bond issue to gain regulatory permission to go forward. This process avoids First Amendment issues and would enable the government to oversee what and how information is disclosed to the public.
February 2009 Special Report on Regulatory Reform
Congressional Oversight Panel
The Committee explains that the most pressing regulatory issue regarding the rating agencies is the NRSRO designation, which has proven to be an unsuccessful means of quasi-public regulation. The Committee proposes the creation of a Credit Rating Review Board (CRRB) which, through two substantially different means, could be used to eliminate or scale back the NRSRO designation. Under the first model, the CRRB would replace NRSROs by providing regulatory approval for all new issues. This approach would create an opening of the market for private ratings and would discontinue the outsourcing of regulatory monitoring. Alternatively, the CRRB could be modeled after the Public Accounting Oversight Board, and would be responsible for auditing ratings to ensure adequate disclosure and sound methodologies.
December 2003 Testing Conflicts of Interest at Bond Ratings Agencies with Market Anticipation: Evidence that Reputation Incentives Dominate
Daniel M. Covitz (Federal Reserve Board) and Paul Harrison (Federal Reserve Board)
Although rating agencies have an obvious conflict of interest between providing objective analysis and pleasing clients, it is unclear to what extent that conflict actually influences ratings. The authors test whether these well-known conflicts of interest at bond rating agencies importantly influence their actions. They find that rating changes do not appear to be importantly influenced by rating agency conflicts of interest but, rather, that rating agencies are motivated primarily by reputation-related incentives.
Risk Retention

The collapse of the securitization market increased concerns on how asset-backed securities are packaged and sold. Policymakers have acknowledged that securitization plays a vital role in facilitating growth and access to capital for businesses and consumers alike. However, many are alarmed by the conflicts of interest that may exist in the typical securitization and in the originate-to-distribute model in particular. These conflicts arise from the fact that existing law does not prevent distributors from avoiding “skin in the game,” which can encourage the sale of poorly-inspected loans. .

In response, Dodd-Frank requires distributors of a securitization to retain at least 5% of the credit risk of assets collateralizing asset-backed securities, subject to some exceptions. It is hoped that retention will encourage more robust screening and monitoring of the underlying collateral.

While perhaps appealing in theory, critics observe that a blanket 5% retention rule is ill conceived as it ignores critical differences among classes of securities. Consequently, mandated retention could increase capital costs and still fail to achieve stated objectives. Rule makers also run the risk of interfering with accounting rules and will need to tread carefully to avoid creating ancillary consequences, such as forcing issuers to consolidate securitized assets. Some alternatives to mandated retention include focusing on the transfer process, e.g., requiring issuers to disclose their economic interests, and imposing risk-sensitive capital requirements to encourage retention.

March 11, 2011 Dodd-Frank and Basel III’s Skin in the Game Divergence and Why it is Good for the International Banking System
Eric Thompson (Boston Univ.)
Thompson assesses the efficacy of new regulations required by Dodd-Frank and Basell III that seek to reduce externalities incurred through the proliferation of originate-to-distribute (OTD) lending. Dodd-Frank, which reduces conflicts of interest by imposing a risk retention requirement, is a more effective mechanism for achieving this goal. Basel III, on the other hand, uses capital requirements to control the OTD system. Thompson challenges Basel III proponents by arguing that higher capital requirements give banks an incentive to churn loans because they restrict banks from making profits using traditional banking methods. Despite some of the apparent weaknesses of the Basel III regulation, however, Thompson argues that enforcing both regulations is nonetheless useful. Specifically, international regulatory divergence reduces the possibility that actors will game the system, thereby reducing systemic risk.
January 2011 Macroeconomic Effects of Risk Retention Requirements
Timothy F. Geithner (FSOC)
The Report proceeds under the premise that misaligned incentives resulting from the securitization process, and the originate-to-distribute model in particular, may have exacerbated the excessive lending that preceded the financial crisis. As a result, the goal of Dodd-Frank’s risk retention provisions is to undo the incentive and informational asymmetries produced by the recent growth in the securitization markets. Specifically, policymakers should consider: i) the need to incentivize issuers to be conscious of the risk in the underlying assets being securitized; ii) the roles that efficient capital and risk allocation play in pricing credit risk and reducing externalities; iii) the possibility that overly stringent retention requirements could constrain lending and have harmful macroeconomic effects; and iv) the desire to restore confidence in the securitization market.
October 2010 Report to the Congress on Risk Retention
Board of Governors of the Federal Reserve System
The Report proposes mechanisms through which rule makers should implement Dodd-Frank’s risk retention mandates. Such mechanisms are not limited to retention but could also include overcollateralization, subordination, and third-party credit enhancements. Noting that different types of asset securitizations are structured and act differently, the Report stresses that risk retention rules, applied uniformly across all security types, are unlikely to improve the securitization process. Rather, rule makers should tailor risk retention requirements for each class of securitized asset to reflect important differences between asset classes. The Report also cautions rule makers to thoroughly consider the interaction of risk retention and accounting rules, as this could have huge implications for credit availability. For example, sufficiently high risk retention levels (around 10%) might have the ancillary effect of requiring issuers to consolidate securitized assets. This, in turn, could depress earnings, raise capital requirements, and restrict credit. Other unintended consequences are also possible - for example, rules may create new incentives for firms to structure deals in ways that are sub-optimal just to avoid consolidation.
September 2010 Incentives and tranche retention in Securitisation: A Screening Model
Ingo Fender (Bank for Intl. Settlements), and Janet Mitchell (National Bank of Belgium, CEPR)
The authors examine how three retention mechanisms - equity tranche, vertical slice and mezzanine tranche retention - influence an originator’s decision to screen borrowers. They find that each mechanism affects originators’ incentives in a unique way. These results indicate that effective retention mechanisms can be used to increase the quality of collateral underlying the securitization. Moreover, mispricing may result when investors fail to understand this relationship between retention and collateral quality. Therefore, disclosure of retention information is an important tool for reform, subject to the condition that issuers should be restricted from hedging away disclosed risk exposures.
October 7, 2009 Testimony before the Subcommittee on Securities, Insurance, and Investment of the Committee on Banking, Housing, and Urban Affairs of the US Senate, Hearing on Securitization of Assets: Problems and Solutions
Andrew Davidson
In arguing against the imposition of a uniform and mandated retention rate, Davidson focuses on i) the need for tailoring and the likelihood that overly-simplistic regulations will do more harm than good; ii) the need to ensure that hedging prohibitions do not constrain legitimate hedging mechanisms (such as hedging of interest rate and market risks); and iii) the mechanics of the CMBS market and the overlooked role of first-loss investors. Regarding his third point, Davidson emphasizes that retention can be an effective tool regardless of whether it is held by the issuer, the originator or the first-loss buyer. Thus, proposals that preclude issuers from transferring this interest are unnecessary because first-loss investors essentially act as “securitizers” and have sufficient means for protecting their own interests. In addition, such myopic requirements could limit CMBS lenders’ ability to originate new loans by tying up important capital. Rather than limiting risk transfer for these types of transactions, regulation should focus on how risk is transferred (e.g. sufficient collateral disclosure, adequate due diligence).
October 7, 2009 Testimony before the Subcommittee on Securities, Insurance, and Investment of the Committee on Banking, Housing, and Urban Affairs of the US Senate, Hearing on Securitization of Assets: Problems and Solutions
George P. Miller (American Securitization Forum)
Miller attributes the breakdown of the securitization system to the mismanagement of leverage and liquidity risks, excessive reliance on credit ratings, deteriorating underwriting standards, gaps in data integrity and a general breakdown in the checks and balances thought to control system risks. While it is not apparent that misaligned incentives were a principle driver of the breakdown, reforms aimed at ensuring proper alignment are welcome. However, Miller advises against mandated retention of a specific portion of credit risk. Mechanisms, such as retention of equity risk used in conjunction with warranties and representations, already incorporate retention goals and provide for a more flexible framework than mandated retention. Moreover, mandated retention could undermine related policy goals such as the proper isolation of transferred assets (i.e. effecting a true sale) and redeployment of capital.
October 2009 Restarting Securitization Markets: Policy Proposals and Pitfalls, Global Financial Stability Report: Navigating the Financial Challenges Ahead (Ch. 2)
International Monetary Fund
The IMF cautions that blanket 5% retention requirements are dangerously simplistic. Research indicates that for a retention scheme to properly influence incentives, it must consider the size and form of retention, the quality of the loan pool, and projected economic conditions. For example, while equity tranche retention is useful for high quality loans, it has little impact for low-quality loans, particularly in a recessionary environment. This is because chances are high that equity tranche holders will be wiped out irrespective of diligent screening and monitoring. In reality, a retention scheme incorporating the factors described above would require a complex matrix of rules and would be difficult to enforce. In addition, retention regulations are complicated by existing accounting and capital requirements. If the interaction of these rules is miscalibrated, the retention might discourage securitization and make it more expensive. As an alternative, the IMF suggests encouraging covered bond issuance and standardizing representations and warranties.
September 2009 The Future of Securitisation: How to Align Incentives?
Ingo Fender (Bank for Intl. Settlements), and Janet Mitchell (National Bank of Belgium, CEPR)
The authors argue that structural weaknesses in securitization must be resolved in order to restore investor confidence. While risk retention measures can, in theory, be helpful tools for doing so, the viability of such schemes is subject to significant caveats. Specifically, the degree to which retention incentivizes issuers to screen borrowers is linked to how the retained stake will be affected by a downturn. This implies that imposing a blanket requirement on all issuers for all loan types will produce varying effects, depending on the characteristics of the security (i.e., its “thickness”), and the economic cycle. For example, retaining the equity tranche retention yields minimal incentives if the tranche is “thin” enough to be exhausted in a downturn and if the prospects of a downturn are high. These results suggest that any regulatory scheme must be flexible enough to adapt to various security types and that broad minimum requirements are likely to be too high or too low, as the case may be. In either case, the regulation would be inefficient. As an alternative to retention, mandating detailed disclosure of issuers’ retention would allow investors to choose appropriate retention levels. Complementary measures such as changes in compensation schemes, accounting rules and capital regulations could also be helpful.
October 24, 2008 Moral Hazard and Adverse Selection in the Originate-to-Distribute Model of Bank Credit
Antje Berndt (Carnegie Mellon Univ.) and Anurag Gupta (Case Western Reserve Univ.)
The authors compare the performance of borrowers whose loans are sold to an active secondary market versus those whose loans are retained by banks or are not actively traded. They find that borrowers in the former group significantly underperform the latter. These results suggest that securitization induces either inefficient screening or monitoring practices by banks. Further, the fact that such practices appear sustainable implies the existence of a market failure. These results have important implications for adverse selection and moral hazard problems associated with securitization and undermine the perceived value creation of the originate-to-distribute model in its current unregulated form. As such, the authors urge policy makers to, at a minimum, consider reforms such as position limits, increased disclosure, or the establishment of a loan trading exchange.
October 11, 2008 The Future of Securitization
Gunter Franke and Jan Pieter Krahnen
The authors contend that incentive misalignment is the principle factor undermining financial stability because it leads to “intransparency” about asset quality and risk exposure. This is particularly true for the securitization market, and the authors argue that such misalignment is the single most important cause of the market’s collapse. However, it’s unlikely that requiring risk retention is an appropriate or necessary solution. Instead, increased disclosure, particularly about the allocation of the first-loss tranche, is a more effective and less burdensome tool. Such disclosure would allow investors to understand a security’s true risk implications, would reduce externalities, and would make issuers’ retention policies subject to market oversight.
July 2007 Innovations in Credit Risk Transfer: Implications for Financial Stability
Darrel Duffie (Stanford Univ., NBER)
Duffie presents the contours of the credit risk transfer (CRT) process and the justifications supporting it. CRT benefits lenders by reducing capital costs and retention requirements and increases market efficiency; however, it also imposes costs on lenders. Costs include a “lemons premium,” associated with banks’ private information about a borrower’s default risk, and moral hazard, arising from the bank’s diminished incentive to control the credit risk of a loan it sells versus a loan it retains. Thus, banks can reduce overall cost of capital by determining the optimal level of credit retention. In particular, loan retention reduces moral hazard cost because it signals a higher-quality borrower. In addition, Duffie suggests that regulators can facilitate the adoption of optimal credit retention policies by imposing risk-sensitive regulatory capital requirements.
Shadow Banking

The shadow banking system (SBS) refers to the network of non-depository financial institutions that engage in traditional banking activities, i.e., maturity and liquidity transformation, but which fall outside traditional banking regulation. These institutions include, among others, money market mutual funds, investment banks, government sponsored-entities and structured investment vehicles. .

Despite its pejorative name, the SBS is an important feature of modern finance. The Federal Reserve estimated that in 2007, the volume of credit intermediated by the SBS was close to $20 trillion, almost twice that of the traditional banking system. Moreover, the financial crisis made clear that the SBS is vulnerable to runs, which can produce deleterious systemic consequences. Yet, because shadow banks fall outside the umbrella of banking regulation, these entities are not subject to measures intended to foster stability, such as federal backstops and bank capital requirements. .

Proposals for governing the SBS fall into at least two camps: one that focuses on the institutions that comprise (or should comprise) the SBS, and another that emphasizes function, e.g., maturity transformation, over institution-specific regulation. For example, Gorton and Metrick recommend the establishment of “narrow banks,” which would limit certain activities to approved institutions. Morgan Ricks, on the other hand, rejects this formalist rubric and recommends making federal insurance available to qualifying entities and restricting maturity transformation to such entities.

December 2010 The Region Interview with Gary Gorton
Gary Gorton (Yale Univ., NBER)
Gorton explains why shadow banking and traditional banking are not only quite similar, they’re also highly integrated. That is because the shadow banking system relies on repo, which in turn relies on securitization to enable firms to post collateral and get cash. Traditional banking, on the other hand, funds itself by securitizing loans that are subsequently used as collateral. Thus, a breakdown in one system can create a similar halt in the other. The relationship between the two systems implies that one way by which policy makers can help lending at all levels is to spur the securitization market. Additionally, much like the traditional banking sector, shadow banking is vulnerable to runs, which dry up liquidity and have deleterious effects. Thus, policy makers must begin to recognize that the shadow banking system is a fundamental component of modern finance, and develop means for addressing its vulnerabilities.
October 18, 2010 Regulating the Shadow Banking System
Gary Gorton (Yale Univ., NBER), and Andrew Metrick (Yale and NBER)
The authors analyze the growth of the SBS and how it can be regulated. Growth of the SBS is attributable to market innovations and regulatory changes that 1) eroded the competitive advantage of traditional banks; 2) increased the demand for collateral, which spurred securitization and repo; and 3) provided special safe harbor treatment for securitization and repo under the bankruptcy code. The authors offer a view of the financial crisis that is consistent with that provided by Adrian, Ashcraft, Boesky, and Pozsar. Specifically, the run on repo, spurred by the sudden collapse of AAA-rated securities, was a principle cause of the crisis. Thus, for reform to prevent future runs, it must stabilize repo and securitization markets. In responding to recent proposals, the authors note that while Dodd-Frank includes many provisions germane to parts of the SBS, it is nearly silent on money-market mutual funds (MMMFs), securitization, and repo. Applying successful approaches taken to prevent runs on traditional banks, the authors advise policymakers to focus on two key devices: 1) strict collateral guidelines for securitization and repo aided by the establishment of Narrow Funding Banks; and 2) government-guaranteed insurance for MMMFs aided by the establishment of Narrow Savings Banks.
September 17, 2010 Commons on “Regulating the Shadow Banking System”
Daniel K. Tarullo (Fed. Reserve)
Tarullo questions the Gorton-Metrick proposal, particularly its reliance on Narrow Funding Banks (NFBs). In an attempt to stabilize the repo market, the Gorton-Metrick proposal would significantly restrict all ABS by essentially limiting the ABS market to NFBs. It is unclear how such a sweeping overhaul could provide a net benefit, and to that end, a thorough cost-benefit analysis is necessary. Tarullo is also skeptical that the NFB model is desirable as it would grant a statutory monopoly to government-approved NFBs, potentially leading to non-competitive practices and highly correlated risk exposures. Tarullo proposes some ways in which the Gorton-Metrick framework could be improved. For example, rather than imposing such narrow restrictions on the ABS market, policy makers could also consider the use of repo insurance or bankruptcy safe harbors to incentivize institutions to use government-approved collateral.
August 30, 2010 Shadow Banking and Financial Regulation
Morgan Ricks (Harvard Law School, U.S. Treasury)
Ricks posits that maturity transformation - the financing of longer-term financial assets with short-term liabilities - is the primary function of the SBS. However, the process is inherently unstable and fosters externalities. Targeting these externalities is key to SBS regulation. To this end, Ricks recommends selectively extending the federal safety net to the SBS by implementing an insurance regime for qualifying creditors. Specifically, the regime should make short-term insurance available to firms whose assets meet a specified risk threshold and disallow non-qualifying firms from participating in the money markets, i.e. engaging in maturity transformation. In advocating a functional regulatory model, Ricks criticizes alternative proposals that adopt formalist approaches and are premised on the flawed assumption that the SBS will maintain its current dimensions. While the proposed regime would impose restrictions on many intermediaries that have traditionally escaped regulation, Ricks justifies these restrictions on efficiency grounds.
July 2010 Shadow Banking, Staff Report No. 458
Tobias Adrian (Fed. Reserve), Adam Ashcraft (Fed. Reserve), Hayley Boesky (Fed. Reserve), Zoltan Pozsar (Fed. Reserve)
Despite its significant decline in size since the financial crisis, the shadow banking system (SBS) continues to rival traditional banking in size and provides an important source of credit intermediation. The authors attribute the strain the SBS experienced during the financial crisis to the fact that, prior to 2007, the SBS lacked government backstops yet was presumed safe due to liquidity and credit puts (specifically, AAA-rated securities) provided by the private sector. However, market participants failed to accurately understand the potential instability of this support system, leading to unreasonably low capital positions and systemic risk. Critically, the authors urge that failure to account for such risk is an intrinsic feature of the SBS, implying that government intervention will again be necessary at some future point. In addition, the authors caution that regulatory arbitrage and innovation, collectively, will always lure bank activities out of banks and into the SBS. Thus, regulation that focuses on form alone (i.e. regulation targeted at banks) will be arbitraged away. To avoid this, regulators should focus on the credit intermediation process, which will be more difficult for market participants to evade.
Short Sales

The recent financial crisis has enlivened debate about the extent to which the SEC should regulate short selling to prevent potentially manipulative practices. While the SEC has acknowledged the virtues that short selling provides, including liquidity and pricing efficiency, the agency remains sensitive to the notion that short selling, and naked shorting in particular, can be used to drive down prices. These concerns led to the adoption of four emergency orders in 2008 alone as the SEC passed temporary rules that imposed pre-borrow and close-out requirements, as well as an outright ban on short sales for financial stocks. Since then, the SEC has adopted new permanent rules, such as Rule 201 of SHO, which combines a circuit breaker and alternative uptick rule to curb short sales in falling markets. Additionally, Dodd-Frank requires that the SEC must consider the efficacy of imposing heightened disclosure requirements for individual trades. .

In response to these and other changes, commentators have challenged the SEC’s empirical bases for supposing that restrictions achieve their stated objective. For example, at least one study demonstrates that naked short selling, which was a primary target of recent regulatory efforts, played little if any role in the crisis. Other studies indicate that the 2008 restrictions not only failed to slow price declines, but also resulted in overpricing and decreased liquidity. Still other critics caution that the seemingly benign disclosure requirements mandated by Dodd-Frank will increase transaction costs and thereby discourage useful trading. Added to these concerns is the fact that the SEC already faces resource constraints and will inevitably have difficulty keeping pace with its new mandates.

September 2010 Can Short Restrictions Result in More Informed Short Selling? Evidence from the 2008 Regulations
Adam C. Kolasinski (Univ. of Washington School of Business), Adam V. Reed (Univ. of North Carolina - Chapel Hill) and Jacob R. Thornock (Univ. of Washington)
The authors test the counterintuitive prediction that short sale constraints can actually increase the information content of short sales. Using market reactions to the 2008 short-sale ban and emergency order, the authors demonstrate that both regulations had two primary effects. First, the restrictions substantially increased trading costs. These increased costs drove uninformed short sellers out of the market, leaving a relatively higher number of informed short sellers and increasing the informativeness of short selling. The authors conclude by noting that their results should serve as a reminder to policymakers that restricting short sales may have the unexpected effect of increasing the information content of short sales.
June 7, 2010 Shooting the Messenger?’ The Impact of Short Sale Bans in Times of Crisis
Ian Appel (Univ. of Pennsylvania - Wharton) and Caroline Fohlin (Johns Hopkins Univ.)
Appel and Fohlin study the effect of short sale restrictions imposed by several countries during the financial crisis, and, contrary to similar studies, find that the restrictions resulted in improved or neutral market liquidity and lower volatility. The authors account for their unique results based on their use of foreign stocks vs. their ADR equivalents as controls. These results indicate that short selling bans may be a useful, temporary remedy to liquidity loss during financial crises.
May 10, 2010 Amendments to Regulations SHO (Final Rule)
Securities and Exchange Commission
The release explains the SEC’s rationale in adopting Rule 201, a circuit breaker rule that triggers a temporary short sale price test for a security that declines by 10% or more from the previous day’s closing. The rule will prohibit short sellers from selling at or below the current national best bid, thus giving preference to long sellers who will be able to sell at the bid. In addition to giving preference to long sellers, the rule will restore investor confidence during times of uncertainty because any continued price decline will more likely be due to long selling based on the issuer’s underlying fundamentals. The rule strikes a balance between its goal of preventing potentially abusive short selling and the need to allow for smooth market functioning. In particular, Rule 201 is limited to specific securities and is in effect for a limited time, thus reducing any impediments to overall market efficiency. In addition, the SEC notes that to the extent Rule 201 results in increased costs for short selling of triggered securities, a reduction in short selling generally and a reduction in long activity that incorporates short sales as part of a larger strategy, such costs are justified by perceived benefits of preventing abusive short selling.
May 2010 More Muscle Behind Regulation SHO? Short Selling and the Regulation of Stock Borrowing Programs
Douglas M. Branson (Univ. of Pittsburg School of Law)
Branson proposes stronger regulation of stock borrowing programs which currently do not disclose that the stock individual investors lend is often sold short, a practice antithetical to the lender’s interests. The SEC should require broker-dealers to provide risk-factor disclosures to investors to whom the firm offers participation in a stock borrowing program. Alternatively, lawyers could argue that, under common law, participations in the program amount to investment contracts, and therefore, securities, subject to formal or informal disclosure requirements.
March 2010 Review of the Policy Debate Over Short Sale Regulation During the Market Crisis
David P. McCaffrey (SUNY - Univ. at Albany)
McCaffrey provides a review of recent short sale regulations and explains the motivations underlying them. He then explains how the SEC’s responses to the financial crisis were the result of its relatively weak bargaining position and uninformed political fervor. Thus, regulatory approaches such as the 2010 circuit breaker rule reflect a compromise between public hostility toward short selling and empirical evidence questioning the effectiveness of such regulations.
2010 The Skinny on the 2008 Naked Short Sale Restrictions
Thomas J. Boulton (Miami Univ.), Marcus V. Braga-Alves (Marquette Univ.)
The authors assess the effect of the SEC’s 2008 emergency order restricting naked short sales to determine whether short sale restrictions result in overpriced securities. Unlike previous studies, the authors explicitly incorporate the parameters unique to the 2008 restrictions to test their overpricing hypothesis. Finding that the restrictions resulted in overpricing and reduced liquidity for the restricted stocks, Boulton and Braga-Alves urge policymakers to use caution before implementing additional regulation.
2010 A New Framework for the Global Regulation of Short Sales: Why Prohibition is Inefficient and Disclosure Insufficient
Emilios Avgouleas (Univ. of Manchester)
Avgouleas surveys empirical research to support his argument that not only did the 2008 short sale bans not create any welfare benefits, but they also had an adverse impact on volatility and liquidity. A more effective means of regulation entails a combined strategy of disclosure, strict settlement rules and short trading halts, rather than an outright ban or uptick rule. Avgouleas proposes how a complex circuit breaker could be implemented and explains what factors the system should incorporate such as the existence of negative news announcements and percentage price declines. The circuit breaker rule would preserve liquidity-enhancing short sales and the valuable information that these trades carry; would check downward price pressures resulting from herding or market irrationality; and would pave the way for a global framework for the regulation of short sales, resulting in greater cross-border liquidity and ultimately, lower cost of capital.
September 2009 Shackling Short Sellers: The 2008 Shorting Ban
Ekkehart Boehmer (Univ. of Oregon), Charles M. Jones (Columbia Business School) and Xiaoyan Zhang (Purdue University - Krannert School of Management)
The authors compare market responses in banned and non-banned stocks following the 2008 emergency order banning short sales on financial stocks and find that the restrictions did not provide much of an artificial boost in prices. While banned stocks’ returns rose the day the ban was announced, the authors attribute the price jump to the announcement of TARP and other bailout programs, which occurred on the same day. Other banned stocks underperformed their non-banned counter-parts reflecting possibly an illiquidity discount or the market’s interpretation of a company’s inclusion on the banned list as a negative signal. In addition to the ban’s failure to provide a price boost, stocks subject to the ban suffered a severe degradation in market quality, as measured by spreads, price impacts, and intraday volatility.
May 2009 Naked Short Selling: The Emperor’s New Clothes?
Veljko Fotak (Univ. of Oklahoma), Vikas Raman (Univ. of Oklahoma) and Pradeep K. Yadav (Univ. of Oklahom)
The authors test the trading behavior of naked short sellers during the 2008 financial crisis to investigate the validity of media speculation that naked-shorting triggered price declines in financial stocks during the period. They conclude that bear raids did not trigger declining prices but that sellers tended to intensify their selling in response to public news and existing price declines. Similarly, naked-shorting did not trigger credit downgrades, but rather, increased in response to downgrades. The authors also examine the effectiveness of SEC restrictions on naked-shorting. They find that while Regulation SHO has been net beneficial for pricing efficiency and has reduced manipulative shorting, the SEC’s 2008 emergency ban on naked-shorting actually increased pricing errors and failed to slow price declines.
January 14, 2009 Memorandum on Impact of the July Emergency Order Requiring a Pre-Borrow on Short Sales
Office of Economic Analysis of the S.E.C.
The OEA studied the effects of the SEC’s July 2008 Emergency Order, which imposed pre-borrow requirements for short sales of 19 issuers. The study concluded that the pre-borrow requirement may have reduced fails, but resulted in higher costs for all short sellers, even those whose actions were not related to fails. Specifically, the order resulted in significant decreases in short selling volume and increases in stock lending rates for stocks subject to the order. However, the order produced minimal to no changes in returns, daily volatility, short interest, market depth or overall volume.
2009 Regulating Short Sales
Ronel Elul (Fed. Reserve Bank - Philadelphia)
Elul offers an overview of short sale regulation in the U.S. along with a survey of economic literature on the topic. He notes that despite public fervor insisting on strong regulation, economic studies indicate that short-sales play a valuable role in financial markets and that restrictions result in overvaluation and/or delay in information transmission.
2009 Short Selling Regulation after the Financial Crisis - First Principles Revisited
Seraina N. Gruenewald (Univ. of Zurich - School of Law), Alexander F. Wagner (Harvard Univ., Univ. of Zurich), and Rolf Weber (Rechtswissenschaftliches Institute)
The authors urge regulators to reflect on first principles of market regulation before implementing new short sale regulations. These principles include the objective to maximize economic efficiency, which may include the maintaining of competition, the prevention of externalities and the protection of investors against fraud. Effective regulation must not only reduce inefficiencies, but the regulation’s benefits must exceed its costs. Using this framework, the authors explain how recent regulations violate these fundamental principles. Specifically, empirical research indicates that restrictions including short sale bans and the uptick rule are over-inclusive and disturb market efficiency. Of proposed regulations intended to curb abuses associated with short selling, direct market abuse legislation, circuit breakers and private disclosure are probably the most effective.
2008 The Uptick Rule of Short Sale Regulation - Can it Alleviate Downward Price Pressure from Negative Earnings Shocks
Lynn Bai (Univ. of Cincinnati College of Law)
The authors examined the effect of the short sale uptick rule on the overnight and intraday price movements and short sale volumes by incorporating data from the 2005 SEC pilot program, which exempted one-third of Russell 3000 Index constituents from the uptick rule. The study found no evidence that the uptick rule reduced the speed of price decline on those days, nor any evidence that the rule limited short sale volumes during regular trading hours. In terms of regulatory significance, the study lends support, albeit conditionally, to the SEC's decision to abolish the uptick rule; the condition being the absence of extreme market conditions that substantially exceed the typical pressure levels following negative earnings news.
June 28, 2006 Testimony before the United States Senate Committee on the Judiciary, Hearing on “Hedge funds and independent analysts: How independent are their relationships?
Owen A. Lamont (Harvard Univ.)
Lamont posits that restrictions on short selling are a symptom of the financial system’s overall bias against dissemination of negative information. These constraints cause stock prices to be overpriced and returns to be unreasonably low. While several stakeholders are responsible for imposing constraints, Lamont emphasizes the role that firms play. Firms may impede short selling by directing legal threats, investigations, lawsuits, and various technical actions at analysts and short sellers. To correct this bias, Lamont recommends changing the current system by making the equity lending system work better, by encouraging the development of institutions that channel capital into short selling, and by protecting analysts from lawsuits.

Too-Big-to-Fail (TBTF), a concept closely intertwined with interconnectedness, refers to financial institutions that are so large that their failure could wreak havoc on the financial system. Accordingly, an important policy consideration on the TBTF front has been whether bailouts of these firms are a necessary evil, or whether bankruptcy is preferable. In addition to immediate costs, bailouts create moral hazard and may incentivize firms to become so interconnected that they receive a de facto government guarantee. For example, a 2002 study found that firms paid average premiums of $14 billion for mergers that would bring the institutions over $100 billion in total assets. .

Dodd-Frank attempts to cure the TBTF dilemma by establishing the Orderly Liquidation Fund and a resolution authority for non-banks; by requiring firms to create “living wills;” and by subjecting TBTF firms to tougher capital requirements. However, commentators note that one of the difficulties in addressing TBTF ex ante is that market innovations are steps ahead of regulation; thus, regulations made in light of the recent crisis are unlikely to anticipate future catalysts. Thus, only time will tell whether the new measures are sufficient to reduce moral hazard and prevent future crises. That being said, observers have remarked that the most effective way for the government to reduce moral hazard is to adopt a stable, credible policy toward bailouts. This camp argues that the chaos surrounding recent failures stems from the market’s uncertainty as to whether bailouts were forthcoming, not from the failures themselves.

January 5, 2011 An End to Too Big to Let Fail? The Dodd-Frank Act’s Orderly Liquidation Authority
James F. Fitzpatrick IV (Federal Reserve Cleveland), James B. Thomson (Federal Reserve Cleveland)
The authors clarify two points about the implications of Dodd-Frank’s treatment of TBTF, i.e., Title II or the Orderly Liquidation Authority. First, Title II does not end, but does improve, the TBTF problem. While Title II mitigates the TBTF problem by restricting the possibility of an ex ante, government-funded resolution fund, what will truly be necessary to end TBTF is consistent and appropriate use of the resolution authority. Second, Title II does not replace bankruptcy as the default method for resolving large nonbank financial companies. Rather, the resolution authority is meant to be an exceptional power, and the implicit expectation in Dodd-Frank is that the majority of these troubled firms will continue to be resolved in bankruptcy.
2011 In Defense of Bailouts
Adam J. Levitin (Georgetown Univ. Law Center)
Levtin offers a new definition of systemic risk that accounts for the important role that political legitimacy plays in systemic risk regulation and bailouts. Systemic risk is the risk that firm failures will create a socially unacceptable impact on the broader economy. The main implications of this definition relate to the inability of ex ante regulation to provide the sole mechanism for resolving crises and the need for regulators to address the inevitability of bailouts. Levtin argues that ex ante regulation will never be sufficient because it is impossible for regulation to predict what future crises will require. Moreover, when the distributional results of a preset resolution regime (e.g., bankruptcy) are societally unacceptable, bailouts will occur. Thus, bailouts are not only inevitable, but are the proper response to financial crises. Accordingly, sound policy must address how future bailouts should be orchestrated. To this end, Levitin identifies important considerations such as whether bailouts should be institutionalized in an agency or require congressional action ex post.
2011 The Dodd-Frank Act: A Flawed and Inadequate Response to the Too-Big-to-Fail Problem
Arthur E. Wilmarth, Jr. (George Washington Univ. Law School)
Wilmarth argues that Dodd-Frank falls short of the changes that would be needed to prevent future taxpayer-financed bailouts and similar public subsidies to TBTF banks. Specifically, Dodd-Frank i) permits TBTF banks to grow ever-larger by failing to impose limits on mergers and acquisitions; ii) relies too heavily on capital-based regulation, which has repeatedly failed to prevent systemic crises; iii) relies too heavily on regulatory agencies that have failed to stop excessive risk taking in the past and are vulnerable to political influence from the financial industry. As important, Dodd-Frank fails to take steps necessary to limit the federal safety net. For example, the FRB retains authority to provide emergency liquidity assistance to protect bank creditors. Similarly, the Orderly Liquidation Fund will be obliged to borrowed funds from the Treasury rather than require pre-funding by TBTF banks.
September 2010 Is the Public Utility Holding Company Act a Model for Breaking Up the Banks that are Too-Big-to-Fail?
Roberta S. Karmel (Brooklyn Law School)
Karmel argues that TBTF is an outgrowth of deregulation and the emergence of mega-banks, which need to be broken up and rationalized. To this end, Karmel examines the efficacy of adopting an antitrust approach, similar to the one embodied by the Public Utility Holding Company Act of 1935 (PUHCA), which was used to break up the utility behemoths that emerged during the 1920s. This approach would combine many of the proposals already put forward such a deconcentration, capital limits, activities restrictions, and conflict of interest restrictions as an alternative to antitrust regulation. Although PUHCA itself could have been implemented more wisely, as evidenced by the entrenchment of the utilities, the Act serves as a useful framework. In advocating for the PUHCA approach, Karmel also argues that another Glass-Steagall Act is impractical given the evolution of banks into securities firms and vice versa.
June 2010 Bankruptcy or Bailouts
Kenneth Ayotte (Northwester Univ. Law School), David A. Skeel, Jr. (Univ. of Pennsylvania Law School)
The authors assess whether governmental rescues are preferable to bankruptcy. While the interaction of financial firms, systemic risk, and Chapter 11 is complex, careful analysis suggests that the widespread belief that bankruptcy should not be used to resolve financial firms is misguided. Although bankruptcy is not always the optimal response to financial distress, it is more effective than is generally realized. Turning to the recent crisis, the authors argue that bailouts increased uncertainty and moral hazard costs, and dampened the incentive of private actors to resolve distress before a desperate “day of reckoning” arose. These forces created substantial costs, over and above the direct and substantial cost to the taxpayer of rescue funding. While there is also a downside to allowing distress to be resolved through Chapter 11, the authors argue that firm-specific risks of Chapter 11 are overstated, and are not sufficient to justify recent policy.
June 2010 Now How Large is the Safety Net
Jeffrey M. Lacker (Fed. Reserve Bank Richmond), John A. Weinberg (Fed. Reserve Bank Richmond)
Empirical studies suggest that as of 2008, the federal safety net protected $25 trillion in liabilities: that’s 58% of all financial liabilities or three-fifths of the financial sector. Particularly troubling about these figures is that the safety net derives primarily from implicit government guarantees. Regulators are to blame for this because they perpetuate the belief that the government will err on the side of rescue in times of crisis, regardless of moral hazard costs or whether such intervention is indeed appropriate. This dilemma is exemplified by the relatively smooth unwinding of Lehman compared to market volatility following the firm’s bankruptcy. However, this volatility arose from uncertainty related to whether future interventions were forthcoming, not from the bankruptcy itself. Thus, it appears that the most dangerous form of interconnectedness during the crisis was firms’ common reliance on an ambiguous safety net policy. Proposals that would give the FDIC authority to settle troubled firms’ short-term debts only perpetuate this ambiguity problem. A better approach is to sharply curtail the power of government entities to provide funds to failing institutions. While this might reduce the availability of short-term credit, reducing the use of such credit to fund illiquid assets would enhance financial stability.
December 2, 2009 How Much Would Banks be Willing to Pay to Become “Too-Big-to-Fail” and to Capture Other Benefits
Elijah Brewer III (DePaul Univ. School of Business) and Julapa Jagtiani (Federal Reserve Bank Philadelphia)
The authors use market and accounting data from 1991-2004 to find that banks are willing to pay an added premium for mergers that will put them over the asset sizes that are commonly viewed as the thresholds for being TBTF. They estimate that firms paid at least $14 billion in added premiums in the nine merger deals that brought the organizations over $100 billion in total assets. The added premiums may be partially attributable to the perceived benefits of being TBTF.
October 29, 2009 Written Testimony before the Financial Services Committee of the U.S. House of Representatives
Timothy F. Geithner (Treasury)
Geithner explains the need for giving the government the authority to resolve failing financial institutions. As exemplified by the Lehman collapse, bankruptcy is not an effective tool for resolving systemically important financial services firms in times of severe economic stress. The Bankruptcy Code focuses almost exclusively on maximizing the interests of a firm’s creditors, with little or no concern for spillover effects. A receivership approach, such as the one currently used by the FDIC, allows the government to reduce the risk that failure would result in panic by creditors and shareholders of other firms and helps maximize the recovery value of the firm’s assets. Geithner also stresses the fact that the receivership would only be used in the rarest of cases, and most firm unwindings would continue to rely on bankruptcy.
October 22, 2009 Written Testimony before the Subcommittee on Commercial and Administrative Law, Committee of the Judiciary, U.S. House of Representatives
David A. Skeel, Jr. (Univ. of Pennsylvania Law School)
Skeel argues that, among resolution proposals, the bailout approach is misguided and that bankruptcy is the preferable, more cost-effective policy. Particularly problematic about the bailout approach is that i) it will increase the number of TBTF institutions, leading to more concentration in the financial services industry, and ii) it is backward looking and assumes the financial regulatory landscape is static. In defending the efficacy of bankruptcy, Skeel addresses critics’ arguments that the Lehman bankruptcy caused the financial crisis. The argument doesn’t pass muster for two reasons: i) the panic surrounding the Lehman bankruptcy did not derive from bankruptcy itself, but from the market’s failure to anticipate that a bailout was not forthcoming (i.e. moral hazard was the underlying problem); ii) empirical studies demonstrate that the Lehman bankruptcy did not trigger the 2008 panic. Skeel also addresses the benefits of bankruptcy, focusing particularly on the protections it affords distressed firms and reductions in moral hazard.
September 24, 2009 Testimony before the Committee on Financial Services, U.S. House of Representatives, Hearing on Experts’ Perspectives on Systemic Risk and Resolution Issues
Jeffrey A. Miron (Harvard Univ.)
Miron emphatically rejects proposals to grant the FDIC authority to resolve insolvent non-bank financial institutions. Among the key principles of an effective resolution system, such as bankruptcy, are the premises that the system is consistent and that someone has to lose. Requiring the FDIC to provide loans to failed institutions would shift these losses from private creditors to taxpayers, institutionalize government bailouts and exacerbate moral hazard. Miron stresses the critical role that bankruptcy plays in resource allocation and notes that although bankruptcies may have severe consequences, these consequences are preferable to bailouts which keep prices artificially high and delay necessary adjustments. In response to criticisms of the dilemma that FDIC authority doesn’t currently extend to banking subsidiaries of non-bank holding companies, Miron suggests extending FDIC resolution authority to those subsidiaries alone, but not to all non-bank financial institutions.
July 21, 2009 Testimony before the Committee on Financial Services, U.S. House of Representatives, Hearing on Systemic Risk: Are some Institutions Too Big To Fail And If So, What Should We Do About It?
Simon Johnson (MIT - Sloan School of Management)
Johnson contends that a central cause of the financial crisis is the effective veto power the financial services sector had on U.S. financial policy. As a result, the sector was able dominate banking policy at the same time that it was becoming more systemically dangerous. Particularly troubling is the fact that, despite the fact that recent interventions have stabilized the system, it’s also allowed some of the largest firms to become even bigger. To counter this trend, policy must be aimed at reducing the size of TBTF firms. This could be achieved using market-based pressures by including higher payments to the FDIC from institutions that pose greater systemic risk; higher capital requirements for bigger firms; and differential caps on compensation based on the cost of implied government assistance.
July 2009 Systemic Risk Regulation and the “Too Big to Fail” Problem
Borys Grochulski (Fed. Reserve Bank of Richmond), Stephen Slivinski (Cato Institute)
The authors examine the viability of tasking a government body, i.e. the Financial Services Oversight Council, with regulating systemic risk and giving it substantial discretion and power to identify and act on threats to the financial system. Such authority could actually exacerbate the risk of moral hazard because, as a practical matter, it guarantees government assistance to non-bank institutions (as occurred in the recent crisis). Further, while agencies have monitored bank risk-taking activities for some time, regulators cannot reasonably curb risk-taking among all non-banks as well. Thus, the creation of a systemic risk regulator could have the effect of extending the federal safety net, increasing moral hazard, while at the same time, failing to provide a reasonable means of risk oversight at non-bank institutions.
June 2009 Better Late than Never: Addressing Too-Big-to-Fail
Gary H. Stern (Federal Reserve Bank Minneapolis)
Stern asserts that the TBTF problem can only be addressed by reducing the expectation of a bailout for uninsured creditors, thereby reestablishing market discipline. This objective, in turn, can only be achieved by reducing policymakers’ incentives to bailout institutions, which is to say that policy must address potential spillovers. To this end, Stern proposes a program called systemic focused supervision (SFS), which departs from conventional bank supervision by focusing specifically on spillovers. The program relies on collecting information from financial institutions, looking across those institutions for signs of systemic risk and making corrective action a sufficiently high priority. Supervisors would be required to take specified actions (e.g., closing) against banks if capital levels fall below specified levels and other systemic risk measures are met.
June 2009 Addressing TBTF by Shrinking Financial Institutions: An Initial Assessment
Gary H. Stern (Federal Reserve Bank Minneapolis), Ron Feldman (Federal Reserve Bank of Minneapolis)
The authors reject the proposal that the TBTF problem can be resolved by making firms smaller. First, simply shrinking firms ignores the fact that many firms might not be large as measured by asset size, but may pose significant systemic risk. Second, keeping firms below the size threshold will prove difficult as policymakers will face tremendous pressure to allow firms to grow large after the initial breakup. Third, firms that are broken up may make future decisions that increase their systemic risk, without necessarily increasing their size. Less drastic reforms could be implemented to achieve similar effects. These measures include: i) expanding the FDIC’s ability to charge banks (through deposit insurance premiums) for activities that increase the potential for spillovers; ii) maintaining the current national deposit cap on bank mergers; and iii) modifying the merger review process for bank holding companies to focus on systematic risk.
March 2009 Too Big to Fail?: Recasting the Financial Safety Net
Steven L. Schwarcz (Duke Law School)
Schwarcz argues that the government’s focus on protecting banks and financial institutions is misguided. It relies on the outdated premise that banks are the primary source of financing and fails to protect the securitization market itself. Further, the cause of the financial crisis - a loss of confidence - could have been prevented if securities had maintained market values reasonably corresponding to intrinsic values. The focus on banks has the added shortcoming of fostering moral hazard among TBTF institutions. Thus, the government safety net should be recast to protect financial markets. To this end, Schwarcz proposes creating a “market liquidity provider of last resort,” which could be used to stabilize irrationally panicked financial markets This could be achieved by i) buying “free-falling” securities, or ii) entering derivatives contracts to reduce risks that the market is unable to hedge. This approach would mitigate moral hazard and resolve the too-big-to-fail dilemma.
2009 Should Increased Regulation of Bank Risk-Taking Come from Regulators or the Market?
Robert L. Hetzel (Federal Reserve Bank Richmond)
Hetzel criticizes the assumption that financial markets are inherently prone to speculative excess and subsequent collapse. Rather, such cycles are attributable to the extensive federal safety net, its corresponding moral hazard costs and its undermining of important market mechanisms. This safety net consists not only of deposit insurance and TBTF, but also includes off-budget housing subsidies, which contributed to the housing boom and general instability. In light of these concerns, market-based regulation is a better approach for minimizing risk taking. Creditors and debtors will only restrain risk-taking if they can lose money in the event of the failure of the counterparty. Thus, Hetzel proposes severely restricting the financial safety net and eliminating TBTF. This objective, however, can only be achieved if the government credibly commits to such a policy. Hetzel submits an extensive for proposal for how this could be achieved, and it entails closing the discount window and setting up setting up a conservatorship process for failing banks.
January 2009 An Ounce of Prevention: The Power of Public Risk Management in Stabilizing the Financial System
David Moss (Harvard Business School)
Moss asserts that i) contrary to the prevailing wisdom, New Deal policies such as deposit insurance worked to stabilize the financial system; ii) the recent financial crisis was driven by a deregulatory mindset that took post-New Deal financial stability for granted; and (3) that the dramatic response to the crisis produced a virtual guarantee for all systemically significant financial institutions. These results recommend a retreat from the deregulatory policy mindset that’s shaped the financial markets over the last few decades. Moss recommends imposing significant prudential regulation, requiring institutions to pay premiums for the federal insurance they already enjoy, and subjecting firms to an FDIC-style receivership process in the event of failure.

One of the key culprits blamed for the financial crisis was a general lack of transparency — among corporate executives, rating agencies, investment banks, traders, and the government. Thus, it’s hardly surprising that many of Dodd-Frank’s provisions require various entities to disclose more information about, for example, risk exposures, conflicts of interests, and trading positions, and to make that information more widely available. To a certain degree, enhanced disclosure has been found to increase efficiency, enhance overall stability and foster investor confidence and market discipline. The breakdown of the securitization market has been used as a prime example of what can happen when relevant risks are misunderstood or inadequately disclosed.

However, mandating firms to disclose more and new types of information imposes substantial costs. While some of these costs may be justified, critics of Dodd-Frank fault policymakers for failing to subject the legislation’s many disclosure mandates to cost-benefit analysis. Other critics point out that the complexity of modern financial products can undermine the usefulness of disclosure. For example, Gary Gorton notes that in the case of the subprime market it was the complexity of the securitization chain, not a lack of information, which led the market astray. Still other difficulties in interpretation arise because of the increasingly international nature of finance, where companies and products may be subject to multiple layers of complex regulation.

May 2011 Central Bank Transparency, the Accuracy of Professional Forecasts, and Interest Rate Volatility
Menno Middeldorp (Fed. Reserve Bank of New York)
Middeldorp examines the effects of increased transparency among central banks. While most studies support the view that transparency fosters lower interest rate volatility and economic stability, other studies question this proposition. To offer further clarity, Middeldorp conducts his own study that incorporates twenty-four economies of varying incomes. He concludes that higher transparency improves the accuracy of interest rate forecasts and reduces interest rate volatility.
2011 Transparency is the new Opacity: Constructing Financial Regulation after the Crisis
Caroline Bradley (Univ. of Miami School of Law)
Bradley considers the usefulness of transparency as a regulatory tool in the context of an international marketplace. She concludes that the value of transparency is consistently undermined because disclosures are simultaneously limited and excessive. On the one hand, regulators often fail to make disclosures as publicly available as they could. This is compounded by difficulties arising from translation and the fact that documents are typically only translated into a few languages. Alternatively, communications are overwhelming and create an information glut. This occurs because regulation is complex, intersectional, multilayered, and transnational, making the usefulness of disclosure limited. While some of these problems can be addressed easily by, for example, translating documents into more languages, problems attributable to legal complexity are more difficult to resolve. In such instances, transparency is not a sufficient regulatory device.
December 2010 Capital-Market Effects of Securities Regulation: The Role of Implementation and Enforcement
Hans B. Christensen (Univ. of Chicago - Booth School of Business), Luzi Hail (Univ. of Pennsylvania - Wharton), and Christian Leuz (Univ. of Chicago - Booth, NBER)
By studying two E.U. directives, the authors examine how tighter enforcement of market abuse and transparency regulation affect capital markets. On average, market liquidity increases and firms’ cost of capital decreases as E.U. member states tighten market abuse and transparency regulation. These effects are even more pronounced for companies in countries with stricter enforcement. The effects are also stronger in countries with traditionally stricter securities regulation and with a better track record of implementing regulation and government policies in general. The study casts some doubt on prior studies focused on schemes such as Sarbanes-Oxley that conclude that regulation typically has substantial net costs.
October 31, 2010 Disclosure, Venture Capital and Entrepreneurial Spawning
Douglas Cumming (York Univ.), and April Knill (Florida State Univ.)
The authors examine the extent to which securities regulation and IPO disclosure requirements in particular, help or hinder the supply and performance of venture capital and new business creation. Using data from 34 countries over the years 1998-2007, they find that more robust disclosure has a positive impact on the supply and performance of venture capital around the world, and a positive impact on business creation. They attribute these results to the notions that increased disclosure fosters investor confidence and facilitates the IPO market. In turn, venture capital-backed entrepreneurship, which is directly related to the IPO market, has a positive externality in terms of facilitating, encouraging, training and supporting new talent. Although the results don’t indicate which type of disclosure would be optimal, they reveal that more stringent IPO regulations have tended to encourage venture capital and new business creation.
May 2010 How did Financial Reporting Contribute to the Financial Crisis
Mary E. Barth (Stanford Univ. GSB), Wayne R. Landsman (Univ. of North Carolina)
The authors examine the role that financial reporting requirements for banks played in the financial crisis. While fair value accounting played little or no role in the crisis, transparency of information associated with asset securitizations and derivatives was likely insufficient for investors to properly assess organizational risks. They conclude that while bank regulators and accounting standard setters should work together to improve transparency, the goal of bank regulators - improving financial stability - is uniquely the province of regulators. Thus, changes in financial reporting requirements designed to improve transparency for the capital markets will not be identical to changes in regulations needed to strengthen the stability of the financial system.
March 26, 2009 What Future for Disclosure as a Regulatory Technique? Lessons from the Global Financial Crisis and Beyond
Emilios Avgouleas (Univ. of Manchester)
While most reform proposals have emphasized the role that inadequate disclosure played in the recent crisis, Avgouleas focuses on the limited usefulness of disclosure as a regulatory tool. For example, the crisis demonstrated that in some instances, even where risks were fully disclosed, the markets failure to fully understand risks due to complexity or socio-psychological factors resulted in market failure. Accordingly, for disclosure to work, Avgouleas argues that in specific contexts, such as bank regulation, it must be supplemented by protective regulation, e.g., business activity barriers and position limits. Further, regulators should rely on experimentation as a complement to empirical studies, which are complicated by socio-psychological factors such as bounded rationality.
August 2008 The Panic of 2007
Gary B. Gorton (Yale Univ., NBER)
Gorton attributes the financial crisis to an information breakdown that resulted directly from the complex securitization chain underlying the subprime market. Specifically, the interlinking of RMBS, CDO, ABS, CMBS, and CDS meant that, while risks were dispersed among many participants, few investors actually understood where the risks resided, nor were they able to value the underlying collateral as a practical matter. Central to Gorton’s argument is the notion that the use of ABX indices played a key role in the downturn by facilitating both price discovery and shorting of the housing market. Thus, while indices provided market information about the subprime market, the lack of understanding, or lack of transparency, about risk allocation created a crisis in investor confidence once housing prices began to drop.
March 2008 Disclosure’s Failure in the Subprime Mortgage Crisis
Steven L. Schwarcz (Duke Law School)
Schwarcz argues that the complexity of modern financial products undermines the disclosure paradigm underlying modern securities laws. This is evidenced by the subprime mortgage crisis where disclosure documents for MBS, CDO and ABS CDO securities complied with federal securities laws, and yet there was an apparent market failure to price the true risk. Schwarcz attributes this disconnect to institutions’ over-reliance on ratings and the high costs associated with hiring experts to thoroughly analyze complex financial products. To improve the existing disclosure-minded regime, regulators should require supplemental protections such as guaranties, certifications of quality endorsed by a government or government-endorsed entity, and/or risk retention by originators.
2008 Should Bank Supervisors Disclose Information About Their Banks
Edward Simpson Prescott (Fed. Reserve Bank Richmond)
In light of the expenses that bank supervisors incur in gathering bank information, and the potential usefulness of that information to investors, Prescott addresses proposals to have supervisors make such information publicly available. However, Prescott concludes that these proposals ignore the cost of disclosure. Specifically, supervisory disclosure would make it harder for the supervisor to collect information in the first place because banks would have a diminished incentive to disclose information. As a result, supervisors would be forced to accept lower-quality information or spend more resources collecting information. More generally, Prescott addresses the notion of information as a public good; however, he cautions that the benefits of disclosure are not without their costs, e.g. lower-quality information.
November 2007 Maintaining Stability in a Changing Financial System: Some Lessons Relearned Again
Thomas M. Hoenig (Fed. Reserve Bank of Kansas City)
Hoenig posits that the key development in financial intermediation in recent years is the transition from a bank-based system to a market-based system. As a result of the shift, investors are far removed from borrowers and must rely on a number of agents to make investment decisions. This structure has been facilitated by expanded access to financial information and a reduction in costs associated with gathering such information. In light of the wealth of market information available, Hoenig suggests that proposals to increase disclosure are misguided. That is because the real problem isn’t one of transparency; rather, the real problem is that there is so much information that, combined with the complexity of financial products, investors cannot possibly make appropriate risk assessments without relying on a long chain of agents. Thus, information problems go much deeper than suggested by calls for additional disclosure.
August 2007 Marking-to-Market: Panacea or Pandora’s Box?
Guillaume Plantin (Carnegie Mellon Univ.), Haresh Sapra (University of Chicago GSB), Hyun Song Shin (Princeton Univ.)
The authors assess the economic tradeoffs at stake in the debate between mark-to-market and historical accounting. While the conservatism of historical cost regimes leads to some inefficiencies, marking to market can spur its own inefficiencies. These inefficiencies arise because market values do not necessarily reflect fundamental values, yet can have real consequences for companies with exposures to the relevant assets. For example, short-term price movements can induce market participants to act in such a way as to amplify these price movements, creating a feedback loop. Accordingly, mark-to-market can inject artificial volatility that degrades the information value of prices, and induces sub-optimal decisions. The authors also note that marking-to-market is most distortive when claims are long-lived, illiquid, and senior. These attributes reflect the key balance sheet items of banks and insurance companies, explaining why these institutions have been such vocal opponents of shifting to a mark-to-market regime.
March 2000 Improving Public Disclosure in Banking
Board of Governors of the Federal Reserve System
The Study examines the viability of market discipline as a complement to bank supervision and regulation. Private-sector oversight, aided by improved transparency, can be consistent with the supervisory goals of limiting moral hazard and systemic risk. This conclusion is supported by empirical evidence suggesting that the riskiness of banking organizations is reflected in both equity prices and interest rates on the organization’s debt. Accurately priced risk is, in turn, aided by required and volunteered disclosures. The Study also notes the incentives that organizations have to disclose information, i.e., greater transparency may reduce borrowing costs. However, current disclosure practices could be improved, particularly as they relate to credit risk. To this end, firms should accelerate the public release of information and selectively make more information available.
September 1999 Towards Transparency in Finance and Governance
Tara Vishwanath (World Bank) and Daniel Kaufmann (Brookings Inst.)
The authors argue that, generally speaking, greater transparency is beneficial because it promotes efficient capital allocation, financial stability, and good governance and can reduce moral hazard. However, increasing information flow, without more, has the potential to pose unnecessary costs on businesses and regulators and prevents information from being put to its optimal use. Thus, policy makers must adopt a rigorous framework when considering regulations to increase transparency. This framework should encompass the following attributes: accessibility, comprehensiveness, relevance, and quality and reliability. Policy makers must also consider the possibility of unintended consequences, as disclosure may lead to undesirable outcomes such as speculation and market volatility. Finally, the authors caution that implicit in the use of disclosure as a regulatory tool is the notion that there are absolute limits to transparency, particularly if enforcement itself is inadequate.
Virtual Currency

As technology propels the development of virtual worlds, members of these communities are creating and circulating their own currency. “Fiat” money produced in virtual worlds shares some of the functions as more traditional forms of money (see “Virtual Currency Schemes” by the ECB). Today, there are many virtual currencies. However, due to Bitcoin’s dominant market share, the CFS policy library focuses largely on Bitcoin.

Bitcoin is an extraordinary development at the nexus of software engineering and monetary theory. Due to the complexity and multidimensional nature of the topic, CFS hosted a roundtable to delve into details regarding Bitcoin. As part of our background work, we assembled and digested a wide range of papers, posting our favorite offerings on issues covering technology (see “Bitcoin: A Peer-to-Peer Electronic Cash System”), monetary and investment, as well as legal and regulatory.

May 1, 2015 Bitcoin Needs Smart and Safe Regulation
Lawrence Goodman
Lawrence Goodman discusses how the advent of virtual money may be another ground-breaking chapter in the history of finance, yet operations outside regulatory bounds pose risks. Therefore, it is essential to create a forward-looking and largely hands-off regulatory environment that does not stifle the entrepreneurial energies that drive this industry.
January 27, 2015 The Age of Cryptocurrency
Paul Vigna and Michael Casey (The Wall Street Journal)
The Age of Cryptocurrency illustrates how cybermoney is poised to launch a revolution, one that could reinvent traditional financial and social structures while bringing the world's billions of "unbanked" individuals into a new global economy. Cryptocurrency holds the promise of a financial system without a middleman, one owned by the people who use it and one safeguarded from the devastation of a 2008-type crash.
January 26, 2015 Strategies for Improving the U.S. Payment System
Federal Reserve System
This paper presents a multi-faceted plan for collaborating with payment system stakeholders including large and small businesses, emerging payments firms, card networks, payment processors, consumers and financial institutions to enhance the speed, safety and efficiency of the U.S. payment system.
December 18, 2014 The Digital Revolution in Banking
Gail Kelly (Westpac / Group of Thirty)
The paper outlines the march of digital technologies into financial services and describes emerging policy questions.
October 7, 2014 Bitcoin: Technical Background and Data Analysis
Anton Badev and Matthew Chen (Federal Reserve Board)
This paper provides the necessary technical background to understand basic Bitcoin operations and documents a set of empirical regularities related to Bitcoin usage.
September 16, 2014 Innovations in payment technologies and the emergence of digital currencies
Robleh Ali, John Barrdear, Roger Clews and James Southgate (Bank of England)
Modern electronic payment systems rely on trusted, central third parties to process payments securely. Recent developments have seen the creation of digital currencies like Bitcoin, which combine new currencies with decentralised payment systems.
September 16, 2014 The economics of digital currencies
Robleh Ali, John Barrdear, Roger Clews and James Southgate (Bank of England)
Although digital currencies could, in theory, serve as money for anybody with an internet-enabled device, at present they act as money only to a limited extent and only for relatively few people.
December 1, 2013 Is Bitcoin a Real Currency?
David Yermack (New York University Stern School of Business)
Motivated by Bitcoin's rapid appreciation in recent weeks, I examine its historical trading behavior to see whether it behaves like a traditional sovereign currency. Bitcoin has exchange rate volatility an order of magnitude higher than the volatilities of widely used currencies, undermining Bitcoin's usefulness as a unit of account or a store of value. Bitcoin's daily exchange rates exhibit virtually zero correlation with bona fide currencies, making Bitcoin useless for risk management purposes and exceedingly difficult for its owners to hedge. Bitcoin also lacks access to a banking system with deposit insurance, and it is not used to denominate consumer credit or loan contracts. Bitcoin appears to behave more like a speculative investment than like a currency.
October 30, 2013 Overview of Bitcoin and the Bitcoin Network; Regulatory Stances Toward Bitcoin
Evan L. Greebel and Kathleen H. Moriarty (Katten Muchin Rosenman LLP)
This paper provides a summary explanation of the salient features of Bitcoins and the Bitcoin Network, as well as a brief overview of the current regulatory regimes grappling with Bitcoin, with particular emphasis on the US.
July 15, 2013 2013 Bitcoin Mid-Year Review and Outlook
Jonathan Stacke (The Genesis Block)
This mid-year review covers the following topics: macro trends, trading update, Bitcoin exchanges, entrepreneurs and venture capital, protocol developments, mining update, regulatory environment, global adoption, and notable events.
July 4, 2013 How Bitcoin Works Under the Hood
Scott Driscoll
The author explains the Bitcoin system: how sending money in Bitcoin works, Bitcoin transactions and the ledger system, anonymity, double spending and the block chain, mining and pools.
June 1, 2013 The Nature of the Form: Legal and Regulatory Issues Surrounding the Bitcoin Digital Currency System
Joshua J. Doguet
Part I of this Comment looks at the specific shortcomings of the current financial system, which prompted Bitcoin's development. It then explains how Bitcoin's architecture enables it to overcome these shortcomings. Part II reviews the legal barriers that private currencies face and analyze how they might apply to Bitcoin. Part III provides an overview of the Bitcoin economy by examining its participants and discussing the hurdles it must overcome if it is ever to become a mainstream currency. Part IV evaluates the motivations behind, and the merits of, three regulatory regimes, and also considers the Bitcoin community's likely response.
May 19, 2013 Mapping Bitcoin Adoption: A Global Perspective In 11 Graphs
Jonathan Stacke (The Genesis Block)
Bitcoin has made significant progress towards becoming the worlds first truly global currency over the past few years. To gain better perspective on bitcoin's impact, we took a look at global wallet downloads, demonstrated interest by region, exchange volumes across currencies, mining node locations, real-world interactions around bitcoin, and the major companies and investors pushing the bitcoin economy forward.
April 3, 2013 The Bitcoin Bubble and the Future of Currency
Felix Salmon (Reuters)
There are a couple of reasons why the bubble is sure to burst. The first is just that it's a bubble, and any chart which looks like the one at the top of this post is bound to end in tears at some point. But there's a deeper reason, too - which is that bitcoins are an uncomfortable combination of commodity and currency. Still, it's worth taking a look behind the bitcoin bubble, because there are fascinating implications for anybody who cares about payments, or currencies, or trust.
October 1, 2012 Virtual Currency Schemes
European Central Bank
This report begins by defining and classifying virtual currency schemes based on observed characteristics. Virtual currency schemes differ from electronic money schemes insofar as the currency being used as the unit of account has no physical counterpart with legal tender status. The first case study is on Bitcoin, a virtual currency scheme based on peer-to-peer network. The second case study is Second Life's virtual currency scheme, in which Linden Dollars are used. Thereafter, a preliminary assessment is presented of the relevance of virtual currency schemes for central banks, paying attention mostly to schemes which are more open and linked to the real economy (i.e. Type 3 schemes). The assessment covers the stability of prices, of the financial system and of the payment system, looking also at the regulatory perspective. It also addresses reputational risk concerns.
March 31, 2012 Nerdy Money: Bitcoin, the Private Digital Currency, and the Case Against Its Regulation
Nikolei M. Kaplanov (Temple University)
This Comment explores the lawfulness of using bitcoin, a privately-issued currency transacted on a peer-to-peer network, and the ability of the federal government to bar transactions between two willing parties. While there are no cases yet challenging the ability of parties in the United States to make transactions using bitcoins, there are policymakers who have denounced the use of bitcoin. This has led to the question of whether the federal government has the ability under current federal law to prohibit the use of bitcoins between willing parties. This Comment will show that the federal government has no basis to stop bitcoin users who engage in traditional consumer purchases and transfers. This Comment further argues that the federal government should refrain from passing any laws or regulations limiting the use of bitcoins. Should any claim arise, this Comment argues that there is a perfectly acceptable model with which to analogize bitcoin use: community currencies.
December 9, 2011 Bitcoin: An Innovative Alternative Digital Currency
Reuben Grinberg (Yale Law School)
Bitcoin is a digital, decentralized, partially anonymous currency, not backed by any government or other legal entity, and not redeemable for gold or other commodity. It relies on peer-to-peer networking and cryptography to maintain its integrity. Compared to most currencies or online payment services, such as PayPal, bitcoins are highly liquid, have low transaction costs, and can be used to make micropayments. This new currency could also hold the key to allowing organizations such as Wikileaks, hated by governments, to receive donations and conduct business anonymously.Although the Bitcoin economy is flourishing, Bitcoin users are anxious about Bitcoin's legal status. This paper examines a few relevant legal issues, such as the recent conviction of the Liberty Dollar creator, the Stamp Payments Act, and the federal securities acts.
November 1, 2008 Bitcoin: A Peer-to-Peer Electronic Cash System
Satoshi Nakamoto
A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network. The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work. The longest chain not only serves as proof of the sequence of events witnessed, but proof that it came from the largest pool of CPU power. As long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network, they'll generate the longest chain and outpace attackers. The network itself requires minimal structure. Messages are broadcast on a best effort basis, and nodes can leave and rejoin the network at will, accepting the longest proof-of-work chain as proof of what happened while they were gone.
September 17, 1999 Remarks before the Electronic Payment Symposium
Edward M. Gramlich (Federal Reserve Board)
The United States is not at the forefront in the adoption of electronic money systems, one area that would seem most eligible for the information revolution. Use of electronic money systems appears to be growing in at least a few foreign countries. In this talk I will try to assess the state of the electronic money transformation, here and abroad. I mention some promises, some stumbling blocks, and some technological and regulatory issues that will have to be dealt with as electronic money use proceeds. The idea of using technology to improve the efficiency of the payment system is very old.
Volcker Rule

The Volcker Rule, once implemented, will prohibit U.S. banks and their subsidiaries from engaging in proprietary trading, along with investing in hedge funds and private equity funds, subject to some exemptions. Proponents of the rule argue that banks, which receive implicit and explicit government protections and subsidies, should not use those subsidies to engage in speculative activities. Thus, the rule reduces moral hazard and insulates banks from risks unrelated to their essential functions, such as lending and market making. The Rule also hopes to prevent conflicts of interests that arise when banks act as both an investor and an advisor in the same or related transactions. .

The Volcker Rule has attracted fervent criticism. On a basic level, regulators have faced implementation challenges, particularly on matters related to defining key terms, such as "proprietary trading." More fundamental is the observation that, notwithstanding the ban on proprietary trading, banks remain exposed to the same risks as before - albeit indirectly - because their clients engage in the same trading strategies. An additional concern is that systemically important firms with relatively small banking units, such as Goldman Sachs, might easily avoid the rule by divesting their banking units. Last, the rule could put U.S. banks at a competitive disadvantage relative to their foreign counterparts that do not face similar prohibitions.

June 2011 The Volcker Rule and Evolving Financial Markets
Charles K. Whitehead (Cornell Law School)
Whitehead explains that the Volcker Rule, modeled after the Glass-Steagall divide, was advanced with the objective of separating traditional banking from investment banking. However, its means for achieving this goal, the prohibition on proprietary trading, ignores the fluid relationship that exists between banks and hedge funds. Specifically, banks’ rely heavily on hedge funds to transfer and diversify credit risk. As a result of this reliance and the concentration of proprietary trading activities at hedge funds, a downturn in the hedge fund industry may affect banks’ access to credit and cost of capital. This relationship leaves banks just as exposed to market risk as they were before Volcker, albeit indirectly. Whitehead urges policymakers responsible for implementing the legislation to consider not whether banks are engaged in proprietary trading, but rather, whether they are exposed to the risks associated with proprietary trading. Failure to account for this could result in legislation that is both counter-productive and costly.
April 2011 Conflicted Gatekeepers: The Volcker Rule and Goldman Sachs
Andrew F. Tuch (Harvard Law School)
Tuch explains how the Volcker Rule attempts to regulate standards of conduct for broker-dealers by prohibiting transactions involving certain conflicts of interest, i.e. transactions between banks and their counterparties, and between underwriters and investors. It’s both noteworthy and puzzling that while the rules stop short of imposing fiduciary duties on banks in their dealings with sophisticated investors, they impose fiduciary-like restrictions. Yet Congress expressly decided against imposing fiduciary duties on broker-dealers in dealings with sophisticated investors. Tuch attempts to explain this contradiction by surmising that the Volcker provisions are based in gatekeeper liability theory rather than agency theory, the traditional justification for fiduciary duties. Gatekeeper liability theory considers what liability rules would induce gatekeepers (banks) to take optimal precautions to deter misconduct by their clients, thereby reducing information costs between investors and the issuer. Tuch also examines the SEC’s 2007 enforcement action against Goldman Sachs regarding the firm’s marketing of CDOs and analyzes how the Volcker provisions would have deterred Goldman’s conduct. He concludes that the provisions will make it extremely difficult for banks to structure similar transactions in the future.
January 2011 Study and Recommendations on Prohibitions on Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds
Financial Stability Oversight Council
The bulk of the Study is devoted to defining propriety trading. It draws a distinction between “bright line” proprietary trading, which is typically limited to proprietary trading desks and is easily identified, and more subtle forms of proprietary trading. Focusing on the latter, the study admits to the difficulty in crafting precise definitions and cautions that rules should be flexible enough to account for the evolving nature of financial markets. For example, FSOC notes that rules should not prevent bona fide hedging, but hedging should not be used as a subterfuge for engaging in impermissible proprietary trading. However, the Study does not articulate the difference between the permissible and impermissible. FSOC proposes that the agencies place the burden of compliance on banks themselves and recommends holding the Board of Directors and CEO responsible for adequate compliance. Banks should be required to develop robust compliance systems entailing thorough oversight and quantitative reporting designed to identify evidence of improper risk and activity. The study also notes that in identifying conflicts of interest, agencies should adopt a flexible approach that accounts for the context of the relationship and transaction, and act with particular vigilance regarding complex, highly structured or opaque transactions.
February 4, 2010 Testimony before the Senate Banking Committee, Hearing on the Implications of the “Volcker Rules” for Financial Stability
Hal S. Scott (Harvard Law School)
The Volcker Rule proposes a solution to the “Too Big To Fail” problem by attempting to limit bank risk arising from non-traditional, risky activities. However, Scott argues that the Volcker restrictions miss the mark because the underlying concern of “Too Big To Fail” is not merely the likelihood of a bailout; rather, it is the threat that the entity poses systemic risk. In this regard, the Volcker restrictions are over-inclusive in that not all large banks pose systemic risk. The rules are also under-inclusive because firms that are systemically risky can avoid the restrictions by divesting their banking operations. This is especially a concern for firms like Goldman Sachs whose proprietary trading revenue substantially exceeds revenue from deposit-taking activities. By encouraging such firms to take themselves off the regulatory radar, the rules could have the undesirable consequence of increasing systemic risk while reducing the government’s oversight. Scott also addresses the difficulty of adequately defining proprietary trading. Definitions limited to hedge fund and private equity activity are unlikely to significantly reduce risk because these activities account for a small share of banks’ operations. Alternatively, providing too broad a definition risks impairing banks’ market-making role in consumer and government debt. Scott also warns that proposed limitations on private equity and hedge fund investments will have a disproportionately adverse effect on the private fund sector, without producing corresponding benefits elsewhere.
February 2, 2010 Testimony Before the Senate Banking Committee, Prohibiting Certain high Risk Investment Activities by Banks and Bank Holding Companies
Paul Volcker
Volcker asserts that proprietary trading restrictions at banks, and any other institution for which there is a federal backstop, are a necessary component of structural reform. Such restrictions would address the moral hazard problem accompanying “too big to fail” status, without impeding the strong public interest in providing a safety net for large institutions. Permitting banks to continue proprietary trading practices would have the effect of using taxpayer money to insure banks against risks arising from proprietary trades, a risk unrelated to banks’ essential functions such as market-making and lending.