One can be forgiven for losing track of the rules coming out of the Securities and Exchange Commission. From regulations that would reshape the wild west of cryptocurrencies to new restrictions on the equity markets, the SEC is fiddling with the rules in almost every area under its jurisdiction.
The affected spectrum of markets is vast. So too is the range of problems it has sought to address. If done properly, SEC rules can strengthen the integrity of markets and ensure investors have the information they need to make informed decisions. But some of the SEC's proposed solutions carry unintended and unwanted consequences that could easily get lost in the whirlwind of activity.
Government rules can stabilize markets over time or disrupt them depending on how the regulations are written. Sometimes the scales tip in favor of the beneficial side and other times they go the other way. One pending SEC rule has the weight of a pebble on the benefits side and an anvil on the negative side. Dubbed the "conflicts of interest" rule, the proposal attempts to codify part of the Dodd-Frank Act by preventing any institution that securitizes — or bundles — loans into bonds from betting against those same securities.
On its face, the rule makes a great deal of intuitive sense. Investors certainly benefit from knowing they aren't being sold a security that has been designed to fail. The SEC could use a rifle shot approach to prevent such conflicted behavior, which could augment the already high integrity of this market that serves millions of consumers and businesses. But its proposal is more like a bazooka that would threaten financial stability if allowed to go into effect as drafted.
In fact, the rule even targets the very investors it ostensibly aims to protect. It would subject them to the same insurmountable compliance regime for normal course trading as issuers and it would eliminate their critical voice in ensuring that securitization deals are put together in ways that match their fiduciary duty to clients.
The proposed rule would put three buckets of trades out of bounds for any entity, affiliate or subsidiary involved in securitization whatsoever. The first bucket would bar a financial institution from selling short a security that it helped to develop, which makes sense. That's clearly a conflict of interest. The second bucket would prevent an institution from creating a derivative that would short the original security, which is rare, but also a reasonable approach.
The third bucket of restrictions, however, would be a real problem if implemented. Under it, an institution would be prohibited from entering into any other transaction through which it would benefit from the actual or potential adverse performance or decline in market value of the security.
Among other things, this prohibition would make impossible a number of ordinary-course — and necessary — business activities, including using risk-mitigating trades. If read literally, the rule would seem to eliminate any firm's ability to engage in hedging of any kind.
The SEC says it will closely consider the impact of the rule on risk-mitigation trading. That is wise, as the conditions that it has proposed for normal trading and risk mitigation are too onerous for any institution to meet. These conditions would require a firm to monitor every trade and then disclose a specific and quantifiable risk that those trades are designed to hedge against.
But market hedging is not an exercise in ivory-tower management. Some of the analytics behind risk management might fall under the category of data and statistical science, but hedging itself involves many subjective trade-offs, macro decisions, and intuition for risks that don't appear on a company's enterprise-risk report.
The SEC's failure to take hedging of this kind seriously is a major blunder. The recent failures of Silicon Valley Bank and First Republic Bank were prime examples of this kind of mistake. They didn't take precautions against macro market conditions that made short-term borrowing more expensive than longer duration lending.
But no financial institution can produce a number that perfectly captures this type of risk. Those banks should have used derivatives that provide insurance against higher short-term rates. But it is by no means clear that such trades would be permitted under the proposal, because hedging such a risk is not a precise exercise.
The rule would make other types of risk management harder as well. Financial institutions with cross-border transactions need to hedge foreign exchange rates. Institutions with consumer loans that have exposure to changes in broad credit conditions should be allowed to occasionally hedge their risk. But neither of these types of risk management would be possible unless the SEC changes its rule.
Major economic shifts over the past several years have made granular quantification of certain risks impossible. But that seems to be what the SEC rule would demand if a firm were to try to hedge its exposure to certain economic environments. Market participants and regulators should call on the SEC to clarify and simplify its policies to bring it more in step with market practice and other prudential regulators. Now is exactly the wrong time for the SEC to jettison prudent risk management techniques.
