Topics covered in this issue include:
- Year in Review: Top Cryptocurrency Stories of 2017 While the explosion in bitcoin’s value dominated the news headlines, cryptocurrency in 2017 was filled with worthy topics of discussion.
- ERISA Fiduciary Rule Facing Precarious Future After being the target of a deluge of industry criticism and regulatory delays, the Department of Labor’s Obama-era fiduciary rule may yet be significantly altered – or potentially repealed and replaced.
- Treasury Review of FSOC’s Systemic Risk Oversight Recommends Activities-Based Approach
- After the Dodd-Frank Wall Street reforms enabled the Financial Stability Oversight Council to designate financial firms as “systemically important financial institutions,” a recent Treasury report has recommended a greater emphasis on specific activities rather than on designated institutions.
- Replacing LIBOR in Derivatives Agreements With the UK’s Financial Conduct Authority set to discontinue LIBOR by the end of 2021, answering the question of what will take its place is becoming increasingly important.
Year in Review: Top Cryptocurrency Stories of 2017
After lingering on the periphery of financial markets for the past several years, cryptocurrency has finally started to move into the mainstream. While the explosion in Bitcoin’s value dominated the news headlines, cryptocurrency in 2017 was filled with worthy topics of discussion. For the purposes of this article, we narrowed it down to what we see as the top three cryptocurrency-related stories of 2017.
ICOs and Regulators
In the past 12 months, markets witnessed a rapid rise in the number and value of initial coin offerings (ICOs), a fundraising model whereby a venture will issue a cryptographic token in exchange for startup capital. The nature and use of these tokens varies greatly from project to project. ICOs rapidly went from being an infrequent niche offering to a common occurrence that in some cases attracted more than $100 million. Hundreds of ICO-backed projects were launched, and all-time cumulative ICO funding surged from $295.45 million at the end of 2016 to $3.77 billion as of Nov. 25, according to CoinDesk data.
The increased popularity of ICOs inevitably brought increased scrutiny and regulatory attention. On July 25, the Securities and Exchange Commission (SEC) published an investor bulletin warning about the potential hazards of the new investment space. On the same day, it released an investigative report warning that “virtual” organizations’ offers and sales of digital assets may be subject to the requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934. On Nov. 1, the SEC issued a statement regarding celebrities’ “potentially unlawful promotion” of ICOs after stars including Paris Hilton, Floyd Mayweather and DJ Khaled publicly endorsed the investments. The SEC warned that such celebrities “often do not have sufficient expertise to ensure that the investment is appropriate and in compliance with federal securities laws” and their endorsement could be considered illegal if compensation isn’t sufficiently disclosed.
An enforcement crackdown accompanied the increased scrutiny. On Sept. 29, the SEC took emergency enforcement action against Maksim Zaslavskiy, REcoinGroup Foundation LLC (REcoin) and DRC World Inc. (also known as Diamond Reserve Club) (Diamond), alleging they defrauded investors in a pair of ICOs, in violation of the anti-fraud and registration provisions of the federal securities laws. Similarly, the SEC obtained an emergency asset freeze against an ICO fraud that raised up to $15 million from thousands of investors by falsely promising a thirteenfold profit in less than a month, and also prompted a California company to halt its ICO after raising registration concerns. In a December statement, SEC Chairman Jay Clayton noted the rapid rise of ICOs and explored questions regarding the legality and risks of the various products available.
Outside the U.S., China’s central bank instituted an immediate ban on ICO funding, which it said had “seriously disrupted the economic and financial order” in that country’s burgeoning financial market. The U.K.’s Financial Conduct Authority issued a stern warning to investors that they should avoid ICOs unless they are willing and able to lose their entire investment.
However, none of the regulatory pushback has slowed the rapid pace of ICO issuances, which looks primed to continue in 2018.
CBOE and CME Begin Trading Bitcoin Futures
The second significant cryptocurrency development of 2017 was the launch of Bitcoin future trading on the Cboe Global Markets (Cboe) and CME Group (CME) exchanges, which the Commodity Futures Trading Commission (CFTC) approved Dec. 1. A potentially momentous development in the movement of digital currency into mainstream markets, the move should improve the access to and ease of Bitcoin trading for both Wall Street and individual investors.
While such futures were previously available on some unregulated overseas cryptocurrency exchanges, Bitcoin’s debut on established U.S. exchanges should enhance its legitimacy and attract a broader investor audience. In addition, the exchanges could potentially bring a measure of stability to the relatively volatile cryptocurrency market by providing investors with an easy means to short the currency. Although concerns regarding volatility remain, cryptocurrency adopters see the move as part of a greater shift toward its legitimization, bringing improved liquidity and sophisticated trading options while reducing the risk of market manipulation.
The Rise of the ‘Hard Fork’
Finally, 2017 saw the launch of Bitcoin Cash, created by a so-called hard fork of Bitcoin’s blockchain. Rather than creating a brand-new cryptocurrency from scratch, this hard fork created a duplicate blockchain of Bitcoin that shares its transaction history, but with entirely independent future transactions and balances. In general, an investor who owned Bitcoin at the time of the hard fork in August would have instantly owned an equal amount of Bitcoin Cash — prompting some observers to consider it “free money.” However, some providers indicated they would not distribute Bitcoin Cash, sparking a backlash among consumers demanding access to their forked coins.
From a taxation perspective, the Internal Revenue Service (IRS) issued guidance on the treatment of virtual currencies in 2014 but has since offered little insight into the matter. However, the IRS has typically considered traditional windfalls of “free money” to be taxable income, meaning investors could face tax liabilities as a result of the hard fork.
None of the three cryptocurrency developments discussed herein has fully run its course yet and we can expect further evolution on each in the year ahead as investors and regulators alike continue to chart a course through this rapidly evolving sector.
ERISA Fiduciary Rule Facing Precarious Future
Since its original release as a proposed rule in April 2015 and as a final rule a year later, the Department of Labor’s (DOL's) so-called fiduciary rule — which expands the “investment advice fiduciary” definition under the Employee Retirement Income Security Act of 1974 (ERISA) — has endured a turbulent year.
After receiving considerable criticism from the financial services industry and a promise to repeal from President Donald Trump, the rule finally came into partial effect on June 9, 2017, albeit with an additional transition relief period stretching until Jan. 1, 2018, to allow for further study and possible changes. On Aug. 31, the DOL proposed an 18-month extension for the transition period for the best interest contract exemption and other prohibited transaction exemptions from Jan. 1, 2018, to July 1, 2019, in effect delaying the implementation of significant elements of the rule. This delay was submitted to the White House Office of Management and Budget on Nov. 1 and adopted as a final rule on Nov. 29, 2017.
For private funds, the main effect of the fiduciary rule is that behavior previously considered basic marketing without any fiduciary implications could now be considered investment advice with potential liability under ERISA’s high standard of care and conflict prohibitions for fiduciaries. Covered investment advice under the new fiduciary rule is defined as a recommendation to a plan, plan fiduciary, plan participant (including a beneficiary), IRA or IRA owner for a fee or other direct or indirect compensation. A “recommendation” is a communication that, based on the surrounding facts and circumstances, a reasonable person would consider to be a suggestion that the recipient engage in or refrain from taking a particular course of action relating to investing, whether buying, holding or selling a particular investment or managing investments or investment accounts.
Moreover, the more tailored the communication is to a particular investor or investors, the more likely the communication will be considered a recommendation. Although general communications in newsletters, widely attended conferences, media reports, general market data and general marketing materials may fall outside the new fiduciary rule, it may not take much targeting to land on the wrong side of the line dividing general communications from fiduciary advice. More information in our previous update regarding the fiduciary rule is available here.
In the wake of further delays in the implementation of the DOL’s rule, the Securities and Exchange Commission (SEC) announced it was drafting its own version of the rule. The SEC has been collecting public comments on a possible rule, with Chairman Jay Clayton stating that the next step would be the release of a proposed rule, which he indicated is currently being drafted. In recent testimony to the Senate Banking Committee, Clayton said an SEC rule would seek to preserve investors’ choice to use a broker or investment adviser, be understandable to investors and be applied uniformly across all kinds of investment accounts. Clayton also expressed a desire for a rule produced out of cooperation between the SEC and the DOL. However, no timeline has been made public for the release of a potential SEC-DOL replacement rule.
The Department of the Treasury (Treasury) also recently released a report in which it supported the DOL’s efforts to re-examine the rule, stating that a “delay in full implementation of the Fiduciary Rule is appropriate until the relevant issues are evaluated and addressed to best serve retirement investors.” In addition, the Treasury offered its support of the SEC’s “engagement on the topic,” and encouraged the financial markets regulator and the DOL to “work with the states to evaluate the impacts of a fiduciary rule across markets.” Although general in its comments regarding the fiduciary rule, the Treasury’s report offered further evidence of the Trump administration’s desire to identify an alternative to the current rule, be it via amendments to the DOL rule or by the repeal and replacement of the rule with a regulation of its own.
At present, it remains unclear exactly what 2018 will bring for the fiduciary rule. However, the investment management industry should remain alert for future developments in order to ensure compliance with any amendments or replacement rules that may emerge, while remaining in compliance with the transition period requirements that did go into effect in 2017.
Treasury Review of FSOC’s Systemic Risk Oversight Recommends Activities-Based Approach
The U.S. Department of the Treasury (Treasury) recently released its long-awaited review of the determination and designation processes of the Financial Stability Oversight Council (FSOC), created under the Dodd-Frank Wall Street Reform and Consumer Protection Act, and its activities related to identifying so-called systemically important financial institutions (SIFIs).
Significantly, among the report’s recommendations is a shift away from the designation of specific nonbank institutions, such as insurance companies, as “systemically important.” Although the report is not binding, its observations offer insight into the Treasury’s vision for regulatory activities and its future plans for the regulation of financial markets.
The report was prepared and released in response to President Donald Trump’s April 21, 2017, memorandumto Treasury Secretary Steven Mnuchin requesting a review of FSOC’s process of determining SIFI status. Part of the White House’s overall efforts to streamline and reduce regulations across all federal departments and agencies, the memorandum stated that SIFI designations “have serious implications for affected entities, the industries in which they operate, and the economy at large.” While the White House emphasized the importance of ensuring these processes “promote market discipline and reduce systemic risk,” it also asked the Treasury to consider whether affected entities are “afforded due, fair, and appropriately transparent process” while their SIFI status is determined. Specifically, it requested an assessment of the transparency, due process, impact on moral hazard, costs and benefits, predesignation opportunities for firms to de-risk, and post-designation opportunities for re-evaluation.
Within that mandate, the Treasury completed its review and, on Nov. 17, released the report, which evaluates and provides recommendations regarding FSOC’s process both for determining if nonbank financial companies shall be designated and supervised as SIFIs and for designating financial market utilities (FMUs), such as clearinghouses and settlement firms, as systemically important.
Nonbank Financial Companies
In regards to nonbank financial companies, the Treasury said it heard several “significant criticisms” from industry stakeholders involving issues such as transparency and the analytical process used to determine each firm’s status. In addition, the report stated that “it is difficult to predict with precision the impact that the failure of any nonbank financial company will have on financial stability” and, as such, indicated it was worth considering whether designating specific firms as “systemically important” was the appropriate regulatory approach.
Instead, the Treasury recommended that FSOC prioritize an activities-based or industrywide approach to potential risks posed by nonbank financial companies, calling SIFI designation “a blunt instrument for addressing potential risks to financial stability.” In its place, the Treasury recommends adoption of a three-step process to assess potential risk: i) review potential risks to financial stability from activities and products; ii) if potential risk is identified, work with relevant regulators to address the risk; and iii) if a company could pose a risk to financial stability, consider designation only after consultation with relevant regulators. This model would allow for greater input from specific market regulators and provide affected firms with the ability to address potential risks, while shifting FSOC toward a broader focus on overall market risk.
The recommendation will likely be welcomed by the insurance and investment management industries, which have argued that their firms do not pose systemic risks similar to those posed by banks, and have complained about the regulatory burdens that accompany SIFI designation. Few nonbank entities have received SIFI designation, and even fewer such designations remain in effect. Prudential Financial remains the only insurance company with an active, unchallenged SIFI designation, with MetLife contesting its own SIFI status in federal court (and the government’s appeal stayed pending the release of the Treasury’s report) and American International Group’s designation being revoked in September 2017.
Treasury also recommended other reforms to enhance FSOC’s efforts, including:
- Strengthening the “analytic rigor” of the determination analyses.
- Amending the consolidated assets threshold it applies at stage one of its determination process from the current $50 billion, in order to “more appropriately tailor” it to assess a firm’s risk.
- Improving engagement and transparency during the determination process, including engagement with the entities under review and their primary regulators, as well as with the public.
- Providing a clear “off ramp” for designated entities to achieve rescission of their SIFI status.
The report also explores FSOC’s authority to designate FMUs, which perform clearing, settlement and transmission services within the financial markets, and makes several recommendations for enhancements. Most notably, it recommends retaining the designation process for FMUs while adding “important enhancements to improve the analytical rigor, engagement, and transparency of the process, and ensuring that the designation process is individualized and appropriately tailored.”
In addition, the Treasury recommends that significant issues related to FMU operation, designation and resolution be examined further. These include the Federal Reserve’s authority under Dodd-Frank to maintain an account for a designated FMU and an FMU’s access to the Federal Reserve’s discount window lending, which can be perceived as giving these institutions a market advantage.
It is instructive to view the Report in the context of the Trump administration’s frequent criticisms of Dodd-Frank. For example, the administration hailed the House of Representatives’ June 2017 passage of the Financial CHOICE Act, which repeals portions of the law, including a number of the systemic-risk provisions at the heart of the statute. While the ultimate outcome of the legislation is in doubt this election year, the November Treasury Report illuminates the Administration’s likely approach should these provisions survive in their current form.
Replacing LIBOR in Derivatives Agreements
In July 2017, the CEO of the U.K. Financial Conduct Authority (FCA), Andrew Bailey, announced that the FCA will discontinue the London interbank offered rate (LIBOR) at the end of 2021. LIBOR is an interest rate index that is used in calculating floating or adjustable rates on trillions of dollars in bonds, loans, derivatives and other financial agreements.
A phase-out of LIBOR will be a major undertaking, and will raise many questions including regarding the existence of a successor rate for new transactions and what the fallback rate should be for existing transactions. Many of these questions remain unanswered for now.
Why LIBOR Is Being Replaced
The interbank offering rates (IBORs) are floating rates based on the actual or purported interbank offered rates for short-term loans in various currencies and maturities based on daily surveys of major banks. There are IBOR rates for each major currency (USD-LIBOR/GBP-LIBOR/EUR-EURIBOR/JPY-TIBOR). Following alleged manipulation of LIBOR after the financial crisis, the U.K. government decided to regulate the setting and administration of LIBOR, as well as the submission of rates by banks used to create LIBOR and placed these activities under the supervision of the FCA.
The alleged manipulation also prompted a review of major financial benchmarks and, in 2014, both the Financial Stability Board (FSB) and the Financial Stability Oversight Council (FSOC) in the U.K. reported concerns over the reliability and robustness of IBORs. The main issues raised by the FSB and the FSOC were that the rates banks report in order for these benchmark rates to be created do not have to be based on actual transactions, and overly rely on transactions in a relatively low-volume market, which increases the potential for manipulation. As a consequence, the FSB recommended that IBORs, and other similar benchmark rates, be determined to the greatest extent possible based on real transaction data. The FSB also recommended the development of alternative nearly risk-free reference rates (RFRs), because the counterparty risk of banks facing each other, which is accounted for in the IBORs, does not necessarily make sense for many of the transactions using the IBOR benchmarks.
In the U.S., following the FSB recommendations, the Federal Reserve assembled a group of financial institution representatives known as the Alternative Reference Rates Committee (ARRC) in order to identify alternative, transaction-based reference interest rates to replace USD-LIBOR. In June 2017, the ARRC announced that it had identified a new and currently unpublished overnight “broad Treasuries repo financing rate,” based on transaction-level data from certain tri-party and bilateral repo clearing platforms, as a potential successor to the USD-LIBOR (the Secured Overnight Funding Rate, or SOFR).
The following month, the FCA announced that despite its efforts to improve the setting of LIBOR, it had proven difficult to ensure that LIBOR rates and submissions were linked to actual transactions. The FCA concluded that it was unsustainable for market participants to indefinitely rely on reference rates that are not supported by an active underlying market, and announced that the LIBOR would be transitioned away by the end of 2021. It is important to note that there will not be a “ban” on LIBOR at the end of 2021, and in fact, LIBOR may still be published after that date by the LIBOR administrator (currently the ICE Benchmark Association), if it can obtain sufficient submissions from major dealers. There is no assurance that this will be the case. The FCA has the regulatory power to compel major dealers to provide submissions, although the dealers currently, if reluctantly, provide submissions on a voluntary basis. The FCA has announced that after 2021, it will not use its regulatory power to compel submissions, and given the environment, it is questionable whether the dealers will continue to voluntarily provide the submissions.
The FCA also noted in its announcement that alternative benchmarks should be established during the transition period in order to avoid disruptions and, as could be expected, attention in the U.S. turned to the potential alternative SOFR freshly announced by the ARRC.
It should also be noted that in the European Union, a new regulation on benchmarks in financial instruments/contracts will become effective on Jan. 1, 2018 (the EU Benchmark Regulation). Certain provisions, including rules relating to “critical benchmarks” (which are expected to include LIBOR), are already effective. One of these rules gives the relevant competent authority (in this case the FCA) the power to require the administrator of a critical benchmark to continue to provide the benchmark until it is transitioned to a new administrator. The relevant authority can also force dealers to commit to provide quotes to the benchmark administrator. However, under such powers, the relevant authority cannot impose these requirements on administrators and dealers for more than 24 months. The FCA and the relevant dealers nevertheless agreed to extend this period until the end of 2021.
Transition to a LIBOR Successor/Fallback Rate
The replacement of LIBOR has direct consequences for derivatives transactions, and in 2016 the International Swap and Derivatives Association (ISDA) established working groups on alternative risk-free rates and the development of fallbacks. Recently ISDA arranged a webcast to provide an update on the direction taken by its working groups. Although no consensus has yet emerged, ISDA has outlined the following approach:
- ISDA will recommend a fallback rate to replace the USD-LIBOR if it is permanently discontinued. ISDA confirmed that the current approach (which may still change) is to consider SOFR as the successor/fallback rate for USD-LIBOR.
- ISDA will amend the 2006 ISDA definitions in order to change the existing fallback mechanism if the reference rate in derivatives transactions is discontinued. This change, however, will apply only to derivatives transactions entered into after the date of the amendment.
- ISDA will develop a mechanism to change the fallback in existing transactions. ISDA typically facilitates this type of industrywide amendment by publishing a protocol amending all relevant derivatives transactions between two signatories of the protocol. During the ISDA webcast, it was mentioned that ISDA will most likely adopt the same approach in this instance.
Difficulties and Issues Raised by Market Participants
Buy-side market participants have raised multiple issues with the approach outlined above, most of which revolve around the choice of SOFR as a fallback rate and the risk of value transfer occurring upon the fallback provision being triggered.
Indeed, one of the main issues is the fact that SOFR is an overnight rate while the LIBOR rates have different rates for specific tenors. In addition, the LIBOR takes into account bank credit risk while SOFR is a risk-free rate. In order to avoid significant value transfer on the day the fallback is activated (due to these differences between the structures of LIBOR and SOFR), ISDA has proposed that the fallback will be publicly available as a screen rate and quotes will be based on tenors at one, three, six and 12 months (just like the LIBOR). In order to achieve this, the ISDA working group proposed that the fallback will consist of the SOFR plus a spread. The spread would be based on a snapshot of the LIBOR SOFR basis (i.e., the difference between the cash price and the futures price) across different maturities on the LIBOR's last day of existence. The spread would then be frozen from that point. After ISDA outlined this proposal, buy-side market participants were quick to point out that since the spread calculation will be based on a snapshot of the basis market on LIBOR’s final day, certain market participants could manipulate the spread by influencing the basis market during the previous days. One way to make market manipulation more difficult would be to base the fallback rate on a historical average, but certain market participant are concerned that a long-dated average would distort the rate. For now, there is no definitive solution to this problem, although lately the ISDA working group appears to be giving more consideration to a historical average approach in order to avoid market manipulation.
Another issue is the creation of a liquid market for SOFR swaps and LIBOR-SOFR basis swaps (which will be necessary to price the spread for different terms). The fact that the SOFR is still unpublished and should only be published in the first half of 2018 limits the work that can be done by the ISDA working group and by market participants to define a transition plan that will greatly depend on the liquidity of SOFR swaps and LIBOR-SOFR basis swaps. In addition, the historical data set available to determine a methodology for calculating the spread will be limited because the SOFR is a new index. Certain market participants have pointed out that it will be difficult to know how the spread will differ in case of market stress, especially because the LIBOR is an unsecured rate while the SOFR is a secured rate (which can create differences in volatility in case of market stress). In summary, only a little progress can be made until the SOFR is published, and the fact that it is a secured rate, and that little historical data will be available because SOFR is a new rate, will complicate the task of the ISDA working group in determining a fair spread for various maturities.
Finally, the fallback in the ISDA definitions will only be triggered if a “permanent discontinuance” of a benchmark rate occurs. The ISDA working groups in charge of this matter are creating a test that is based on the occurrence of the following events:
- Insolvency of an IBOR administrator without a successor being promptly appointed (within a specific time frame).
- A public statement from the administrator that it will cease publishing the IBOR, either permanently or indefinitely, without a successor being appointed.
- A public statement from the supervisor of an IBOR administrator that the IBOR has been permanently or indefinitely discontinued.
- A public and official statement from the supervisor to the IBOR administrator that the IBOR may no longer be used.
However, since the FCA is merely proposing to cease requiring dealers to make submissions (and not to prohibit the use of the IBORS), LIBOR could potentially continue to exist past the end of 2021 on the basis of fewer quotes. If it does, based on the above definition of “permanent discontinuance,” this would not cause LIBOR to be permanently discontinued and the ISDA fallback would not be triggered. This point is currently being discussed by the ISDA working group.
Although many issues remain unresolved at this time, a consensus for one or maybe multiple successor rates to LIBOR will likely emerge in the near future. The successor rate(s) may come from the work currently being conducted by ISDA, the Federal Reserve, or other industry or regulatory initiatives. Market participants are advised to monitor developments in the area, especially if they are contemplating entering into derivatives transactions maturing after the end of 2021.
Finally, it should also be noted that although ISDA working groups are working in the context of derivatives, the issues they are grappling with are also relevant to other financial agreements, and the work conducted by ISDA working groups could influence the selection of a consensus successor to LIBOR in this broader context as well.