When Congress announced a compromise was reached last Friday reconciling the House and Senate version of financial reform it was thought a bill could be on the President’s desk before the Fourth of July holiday but that appears less likely due to some last minute changes and the death of longtime West Virginia Senator Robert Byrd.
A last minute assessment tax on large banks and hedge funds threatened to derail the process as Sen. Scott Brown (R-Mass), whose support the Administration was counting on, vowed to vote against it if the tax remained. Bill sponsors agreed to take out the assessment but a replacement funding mechanism is still being considered that may also create conflict. And Brown reportedly hasn’t yet decided whether he will vote for the bill despite the removal of the tax assessment.
One idea being floated is an increase in the deposit insurance assessments banks pay to the Federal Deposit Insurance Corporation (FDIC).
In a piece for Forbes, former FDIC Chairman Bill Isaac argued against such a measure. He said it would politicize a system put in place solely to protect depositors and maintain stability in the banking system. “It would be a serious mistake to allow the politicians to increase FDIC insurance premiums simply because they want to increase taxes without calling them tax increases,” Isaac noted.
As it stands, the legislation would require a significant portion of over-the-counter trading be conducted on electronic trading facilities and cleared through a central counterparty clearing house. It includes some of the “Volcker Rule” in concept but is watered down. Originally the rule would have prevented any systemically important bank holding company from engaging in proprietary trading as well as investing its own capital in hedge funds or private-equity funds. In the final version of the bill, banks will be allowed to provide no more than 3% of a fund’s equity, and will be limited to investing up to 3% of the bank’s Tier 1 capital in hedge funds or private equity funds.
Based on initial analysis, many of the more stringent recommendations have been watered down. “The lobbyists for Wall Street should all get bonuses for a job well done,” says David Matteson, partner with Drinker Biddle & Reath. “Historically investment banks have made significant profits in the over-the-counter markets and it makes sense that the banks wanted to protect that profit making and that is why they lobbied pretty strongly to keep as much of that OTC business as possible. That is the push/pull in this because the banks have made a lot of money making markets in these OTC instruments or issuing OTC instruments and they don’t want to give up those profits.”
But many would argue it is the pursuit of those profits that led investment banks to create and market risky products that in part led to the crisis in the first place. “The whole reason we are looking at this financial reform legislation is because banks assumed too much risk and had to be bailed out,” Matteson says. “Banks want to continue to generate profits and take risk but we as a society are saying ‘wait a minute we don’t want to allow you to put the financial system at risk again where tax dollars are going to have to be used to bail you out if those risks all of a sudden overwhelm [the system].’”
From a hedge fund perspective, the agreement eliminates a provision in the Investment Advisors Act that exempts hedge fund managers who advise less than 15 clients and do not hold themselves out to the public as investment advisors.
According to Matteson, any advisor that manages a private fund relying on the 3c1 or 3c7 exemption (basically every hedge fund) has to register with the SEC as an investment advisor if they manage more than $150 million.
The bill may have a larger affect on managers who manage less than $150 million because they will now come under jurisdiction of individual state regulators. “A lot of midsize hedge fund managers are going to deal with state investment advisor registrations,” Matteson says. “Because any state can adopt their own rules, hedge fund managers are going to need to know about the laws of each state where their investors are located to know they are in compliance with those local laws.”
Matteson says that there is not much in the bill that will affect commodity trading advisors as long as they operate strictly in the futures space. Those commodity trading advisors (CTAs)/commodity pool operators (CPOs) who also trade securities may be affected by the elimination of the exemption.
Gary deWaal, general counsel at Newedge, says that the legislation could affect where trading comes from. “The banks are being required in the long term to get out of proprietary trading, so big traders will leave the banks and join hedge funds and private equity firms and foreign firms that aren’t subject to the restrictions,” he says.
Kevin McPartland, senior analyst at Tabb Group, says for traders, from an OTC derivatives perspective, the new legislation will mean more transparency into pricing and liquidity than is in the current market structure.
For brokers, the new legislation means that they will need to help their clients navigate this new market structure. “The more standard products will be required to be traded on electronic platforms, most likely swap execution facilities. It’s possible that certain dealers could create their own swap execution facilities. With multiple clearinghouses and different requirements based on the size of a position, there’s so much logic that has to be gone through to determine how a trade needs to be executed and cleared. That will come back to the brokers in helping their clients properly execute or book a trade,” McPartland says.
DeWaal says the bill will elevate the importance of FCMs. “Most of the impact of the bill won’t be felt until a year after enactment because that’s when the regulations are due. We’re already seeing clients who are trading OTC today, trying to figure out how to trade on exchange, and clearinghouses [aren’t] waiting for the implementation of new regulations. What the bill’s going to do is accelerate that process.”
Summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act