New-ish and Key Trends in Financial Regulation
There are many specific regulatory developments affecting one sector of financial services or another, and at times it can be challenging to step back and identify what the broader trends are. Just one agency might be considering a host of impactful rules.
Here I mention some broader trends reflected by all of the individual developments we see across the financial-service landscape. This is not intended to be an exhaustive list, but I find the following trends to be especially interesting and potentially impactful.
AI and Third-Party Vendors
AI is a hot topic and will have an obvious impact on financial services. Less obvious might be that federal regulators already regulate use of the technology and have sought to further expand their supervision. For example, the CFTC recently proposed an operational resilience framework that will affect vendors leveraging AI tools; the SEC proposed a rule to address conflicts posed by predictive-analytics tools (i.e., AI) used by broker-dealers and investment advisors; and more generally the FSOC is hosting a forum on AI and financial services next month involving all of the FSOC agencies.
The other related trend will be further reliance on third parties who have AI expertise by financial institutions. Some financial service providers will develop AI capabilities in house, but in the first instance many will start their AI journey through vendor partnerships. Regulators will reflect on key principles and protections related to cyber and operational risk, conflicts of interest, and AML/KYC requirements, to name a few. Key takeaway: U.S. financial regulators will not regulate the technology, but will return to bedrock policies and principles and how they’re implicated by AI — this is already happening. In particular, look for market regulators to require more transparency into AI systems leveraged by registered entities through existing supervisory powers, which will create tension with their vendors.
Capital Markets
Treasury Markets. Treasury markets are undergoing a significant change as much of the market will be cleared for the first time, due to a recently adopted SEC rule. This market-structure reform is intended to reduce settlement risk, enhance liquidity, and increase transparency into the market, but in the short term will increase costs to participants (legal, onboarding, collateral, etc.). Meanwhile, the SEC also adopted a rule requiring many market makers to register as broker dealers (who heretofore have not been registered), some of whom trade in those markets. Key takeaway: at the moment there is only one clearinghouse for these markets — DTCC’s FICC. Look for new entrants and other service providers to assist Treasury-market participants address new obligations and related pain points. Also look for potential concentration of participants as costs climb.
Basel Endgame - Private Credit Markets - Cleared Markets. Federal prudential regulators are poised to finalize a rule proposal implementing the Basel III Endgame standards. Setting aside the merits of the proposal, if implemented the standards would have a significant impact on capital markets in a variety of different ways. First, Basel Endgame implementation could raise costs on securities underwriting, including fixed-income underwriting. Some argue this would put bank underwriters at a further disadvantage vis a vis alternative asset managers in the competitive credit markets. Alternative asset managers help make up the “shadow banking” system that prudential regulators have discussed for many years now. Suffice to say, implementing the Basel Endgame standards would further stoke the debate around whether there should be more review or supervision of the “shadow banking” sector, a topic the FSOC has already addressed through interpretive guidance.
Second, the Basel Endgame implementation could raise costs on derivatives clearing activities. Dodd-Frank required more clearing of derivatives trading, and prudential regulators have addressed certain issues through their capital and liquidity requirements on banks to help facilitate this policy goal. Some commentators have argued that the Basel Endgame proposal would undermine that goal by unnecessarily increasing capital costs for derivatives clearing activity for banks’ customers. It remains to be seen whether the prudential regulators will address those arguments in a final rule. Key takeaway: look for the prudential regulators to finalize the Basel Endgame rulemaking this year, but with possible revisions to reduce the burden on banks’ underwriting and clearing activities. Also look for further concentration of FCMs, the number of which has declined since passage of Dodd-Frank.
Consumer Finance and Crypto
The CFPB has been active in its rulemaking efforts to address various fees paid by consumers. The CFPB has proposed a rule on bank overdraft fees as well as finalized a rule on credit-card-penalty fees. The CFPB also is considering rules on personal financial data rights, mortgage servicing, financial data transparency, and supervision of larger participants involved in consumer-payment markets (see below for further discussion).
The CFPB’s proposed rule on larger participants in consumer payments is especially worth noting. While Congress debates the appropriate oversight of crypto markets and stablecoin issuance; the SEC litigates whether certain crypto assets are securities; and the CFTC continues to allow the listing of derivatives on various crypto assets; the CFPB has proposed to supervise crypto-asset companies. Their proposal potentially would capture crypto assets by defining “consumer payment transactions” to include the transfer of “funds,” which could include “digital assets that have monetary value and are readily usable for financial purposes, including as a medium of exchange.” Key takeaway: unless another regulatory regime preempts the CFPB (e.g., the CFTC or SEC), the CFPB could become the first federal regulator to proactively make new policy that would bring some crypto-asset firms under its supervision.
More Retail Derivatives Trading
The pandemic highlighted the trend, but derivatives markets – both futures and options – have seen an influx of retail traders. This trend appears to be enduring, which is partly the reason why the CFTC recently proposed a rule related to “event contracts,” proposing to ban the entire category of “political contests” and other types of events. To explain, apart from important public policy questions related to the merits of certain types of event contracts (mostly binary options), the CFTC has seen a flood of “self-certification filings” for event contracts, which are the procedural mechanism for listing new futures and options on exchanges supervised by the CFTC. The agency has grown increasingly anxious about their resources to review all of these filings appropriately and ensure their legality. Key takeaway: more retail trading will lead to more product innovation, increasing pressure on market regulators to assess the legality and even appropriateness of these products.
Chevron Doctrine Review – The Loper Supreme Court Cases
Last but not least, and perhaps the most consequential of all regulatory developments this year, is the U.S. Supreme Court’s review of the Chevron doctrine, a foundational regulatory principle in the U.S. for more than 40 years. Under the Chevron framework, a court must defer to an executive agency’s interpretation of an ambiguous statute that it administers so long as the agency’s interpretation is reasonable. The Chevron doctrine is currently under review by the U.S. Supreme Court, as the court considers the constitutional issues presented by petitioners in Loper Bright Enterprises v. Raimondo and Relentless Inc. v. Department of Commerce (“Loper”).
The Chevron doctrine has two steps: first, in reviewing an agency action or rule, a court must look to determine whether Congress addressed the issue, and if clearly this is so, the court must implement Congress’ intent – the matter stops there; second, if the statute is silent or ambiguous, a court must defer to an agency’s reasonable interpretation of the statute regardless of whether the court would adopt that interpretation on its own.
What will the Supreme Court decide? I believe it is a safe assumption that the Chevron doctrine will be modified or repealed, based on the fact that (1) the Supreme Court presently has a majority of conservative justices, some of whom have openly expressed concerns about the Chevron doctrine; (2) in recent terms the Court has declined to apply or reference the Chevron doctrine when historically it had done so when presented with similar facts; and (3) cert was granted by the Court after all, which combined with the foregoing suggests that the Court is poised to make a change rather than affirm the doctrine.
Assuming the Court modifies or overturns the Chevron case, what would happen next? What would the practical implications be? How would enforcement programs at the financial regulators be affected? These are fascinating questions.
The following is likely to happen:
Rulemaking agendas at the financial regulatory agencies would become more modest in size and ambition;
Litigation of rulemakings likely would increase – already signs can be observed suggesting an increasing willingness to litigate over a rulemaking, even before the Loper case has been decided.
What is harder to predict is what Congress would do, if anything, in response to the Loper case. The Congressional Research Service has pointed out that Congress has had plenty of opportunity to address the Chevron doctrine, but so far has not.
As a former regulator as well as Senate staffer, I have experienced firsthand the practical value in Congress legislating with broad brush strokes, thereby allowing the agency implementing a law the ability to fill in details. Congress rarely has the time, patience, or expertise to legislate on every thorny and technical issue needing resolution. There is also political value in this approach – if a stakeholder is unhappy with a law or regulation, an elected official might enjoy the flexibility of blaming an agency’s implementation of a law rather than his or her own lawmaking for such disappointment, thereby shielding him- or herself from constituent blowback.
Some have suggested that Congress might take steps to fortify its technical expertise, and begin to pass more technical laws that leave less discretion to the implementing agency. On the other hand, the political incentives that have made the Congress more dependent on its chamber leadership, and arguably less dependent on the technical expertise of the committees – at least from a process point of view – would not seem to allow the Congress to become a more technical lawmaking body.
In any event, resolution of the Loper case is destined to make a lasting impact on the heavily regulated financial-services sector in the U.S. Key takeaway: the exact ruling in the Loper case will be important, and more than likely will constrain regulatory agendas and increase litigation of agency rules.
