Thursday, July 22, 2021

SEC’s Gensler cautions crypto, signals potential rules on swaps that brought down Archegos

By Lene Powell, J.D.

In keynote remarks at the ABA Virtual Derivatives and Futures Law Committee Mid-Year Program, SEC Chairman Gensler discussed potential rulemaking for increased reporting of security-based swaps that were implicated in the startling meltdown of Archegos Capital in March, which caused serious fallout for several banks. Gensler also discussed other topics including security-based swaps rules set to take effect in November, alignment of SEC and CFTC rules, and diversity and human capital disclosures.

But in Q&A following the speech, Gensler was peppered with questions about cryptocurrency ETFs and protection of retail investors investing in crypto assets.

Burning questions about crypto. The first crypto question related to Bitcoin ETFs. Kathryn Trkla, the panel’s interlocutor and a partner at Foley & Lardner, noted that former CFTC Chair Tim Massad and SEC Commissioner Hester Peirce have called on the SEC to approve Bitcoin ETFs, and asked what else must happen for the SEC to move forward with approval.

Gensler said that while the SEC is technology neutral, it is not neutral regarding the need for investor protection. Approval of products depends on whether a market is prone to fraud and manipulation. That is a challenge in many underlying crypto token markets, said Gensler, because crypto platforms are not subject to a federal regulatory regime. Gensler said he’ll continue to work with anyone, including the CFTC and Congress, to try to bring greater investor protections to the market.

Trkla’s next question was about protections for crypto investors. Gensler cut in.

"You’re not going to ask me anything on derivatives, I’m guessing, Katie," Gensler said with a smile.

Trkla defended the question, pointing out that crypto-asset issues cross over into the derivatives space. She noted that the ABA derivatives committee has a subcommittee on crypto assets with 80 members.

Gensler suggested thinking of the "duck test." If it quacks like a duck and waddles like a duck, it’s a duck. The Howey test for whether an instrument is a security was established by the Supreme Court and affirmed multiple times. And the SEC has spoken to it," said Gensler.

"And so if your client is asking you to kind of get over the line, bring them back from over the line," said Gensler. "There are a lot of projects asking for your client’s advice, whether it’s, you know, can we get away with this or get away with that. Bring ‘em back to the right side of the line. So investors are protected."

Gensler added that attorneys should keep in mind when advising clients that whether a product is called a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities, products are implicated by the securities laws and must work within the securities regime. This also holds whether crypto markets are called platforms, decentralized finance, or something else.

"If these products are securities-based swaps, the other rules I've mentioned earlier, such as trade reporting, will apply. Then any offer sale to retail participants, of course, must also comply with our securities laws and register and be on-exchange if exchanges are affected by those rules as well," said Gensler.

Archegos collapse and family office rules. Gensler observed that the collapse of Archegos Capital, a family office, highlighted the lack of transparency in single-name and narrow based equity swaps markets, also sometimes called total return swaps. While the SEC does not yet have reliable information on the size of these markets, they have played an important role in capital markets, said Gensler.

Gensler explained that Archegos used total return swaps based on underlying stocks that had significant exposures, and their prime brokers were on the other side of the family office. The limited transparency in this market, combined with potential shortcomings in market participants’ risk management, contributed to the firm's taking overly large positions and assess subsequent system wide tremors when firms started to unwind those positions.

Moreover, Archegos wasn’t the first time these markets have seen a significant meltdown. Gensler pointed out that Long Term Capital Management, a firm that had about $1.3 trillion in derivatives and collapsed in 1998, had a significant total return swap portfolio as well.

Gensler observed that swaps reporting rules scheduled to come online in November and next February will provide greater transparency in these markets. But Gensler said the SEC also has authorities under Section 10B of the Exchange Act to mandate certain disclosures and position limits for security-based swaps. The Archegos collapse has indicated that position reporting, including provisions regarding position aggregation, may be an important reform to consider, said Gensler. This would be carried out through a notice and comment rule proposal.

Gensler also noted that the SEC has not yet finalized rules for security-based swap execution facilities (SBSEFs). He has asked staff to recommend how to best harmonize with the CFTC’s regime for swap execution facilities (SEFs), which has been up and running for nine years. He envisions that the SEC will put out another notice and comment rulemaking to get further comments from the public and try to best harmonize.

In response to Trkla’s question whether further regulation may be needed for family offices, Gensler somewhat sidestepped a direct answer, instead emphasizing that entities must comply with anti-fraud and manipulation provisions of the securities laws, and that counterparties must have appropriate risk management.

CFTC Commissioner Dan Berkovitz has called for more stringent regulation of family offices. In contrast, CFTC Commissioner Brian Quintenz and SEC Commissioner Peirce believe that current regulations are enough.

The Archegos collapse caused several banks severe losses when they were caught unaware by the amount of Archegos’ swap exposure and did not have risk management measures in place sufficient to respond to the crisis. This has led to at least one securities class action, with a Credit Suisse investor alleging that the bank’s operational weaknesses led to billions of dollars in losses.

Human capital and diversity. Finally, Trkla noted that Rep. Maxine Waters, as chair of the House Committee on Financial Services, has held a hearing about diversity in financial services and brought surveys of large banks the nation's 31 largest investment firms for data on their diversity and inclusion. She asked if the SEC is considering disclosure requirements to shed light on or provide transparency around corporate board and senior executive diversity.

Gensler responded that yes, he has asked staff to offer a rule proposal to the Commission about many issues including diversity of the staff. He thinks investors are looking for more information about human capital and diversity at companies, and the SEC has received comments earlier in the year containing strong recommendations about such disclosures, both in terms of the entire workforce and at the board level.