Are ETFs Making Some Asset Managers Too Interconnected to Fail?

Exchange traded funds (ETFs) sit at the center of the COVID-19 crisis selloff.[1]  This isn’t surprising, since ETFs are a low-cost highly liquid vehicle for trading entire sectors, asset classes, and even global economies.  Yet the use of ETFs as a preferred crisis trading tool, and the Federal Reserve’s unprecedented mid-crisis purchasing of bond ETFs,[2] reinvigorates a long-standing debate on the systemic importance of ETF sponsors.

In a new article, I argue that the largest ETF sponsors are becoming systemically important due to interconnectedness – a material factor in the 2008 global financial crisis (GFC).  Although large … Read more

Cleary Gottlieb Discusses Fed’s Final “Stress Capital Buffer”

On March 4, the Federal Reserve finalized a significant integration of its stress testing regime with its ongoing supervisory capital requirements, by introducing a new “stress capital buffer” requirement for firms subject to the Federal Reserve’s CCAR supervisory stress tests.  An institution-specific stress capital buffer will be determined for each CCAR firm as part of the 2020 CCAR exercise and is intended to take effect October 1, 2020.  However, given the uncertainty and stress in the market caused by COVID 19 mitigation measures, it remains to be seen whether the Federal Reserve could modify the implementation timeline.

The Federal Reserve’s … Read more

Operational Failures and Financial Crises

Past financial crises have been characterized by panics, runs, and restrictions on the availability of credit, and our crisis prevention measures (including capital regulation, deposit insurance, and the lender of last resort) have been adopted in light of this historical experience.[1]  These forms of financial stability regulation pay limited attention to operational risks, however, and as the technologies by which financial services are delivered become increasingly complex, operational risks may become a transmission mechanism as well as a source of financial distress.  In the future, financial crises may look more like a rolling blackout than a bank run.

Take … Read more

Congress Should Endorse the Federal Reserve’s Extraordinary Measures

The rapid spread of Covid-19 and massive change in behavior required to curb it have transformed the trajectory of the world’s economy.  Just a few short weeks ago, the United States was basking in the longest period of sustained economic growth on record.  The country now faces what could be the steepest decline in economic activity in its history.  The long-term health of the country and the economy remain fluid and will be determined in part by how policymakers respond.  The Federal Reserve quickly recognized the unprecedented nature of the threat and has intervened aggressively to stem the pain this … Read more

Gibson Dunn Discusses the Coronavirus, Private Equity, and Portfolio Company Finances

With confirmed cases of COVID-19 now in more than 50 countries and the death toll rising almost daily, experts are predicting that the situation will get significantly worse before it gets better. Concerns over the impact of the virus have caused significant volatility in the stock markets over the last week and the potential scale of the impact across a very wide  range  of  industries  is  just  beginning  to  be  realized. Therefore for private equity sponsors now is the time to be checking their financing documents to fully understand how COVID-19 might have an impact on the operations and financial … Read more

Cleary Gottlieb Discusses New SEC Rules on Guaranteed and Collateralized Securities

On March 2, 2020, the SEC adopted rule changes to simplify the financial disclosures that are required when an issuer offers debt securities with guarantees.[1]  The old requirements were complex, and in some circumstances burdensome, and the utility of some resulting disclosures for investors was doubtful.  As discussed below, the new requirements are easier to apply and permit substantially simpler disclosures in some cases.

The SEC also adopted rule changes applicable to a similar, less common situation – securities that are collateralized by a pledge of shares (typically shares of a subsidiary of the issuer).

The new rules have … Read more

Operating Systems: How Tech Is Changing Asset Management

The impact of technology on finance (FinTech) is one of the hottest topics in business, law, and regulation, with academics and practitioners considering a host of issues that include cryptocurrencies, robo-advice, initial coin offerings, and algorithmic analyses of big data.  Yet very little analysis has been devoted to the world’s largest financial industry: asset management.

The Rise of Concentrations of Digital Technology: Financial Operating Systems

In a new paper, we identify and explore a topic of major significance in FinTech: the rise of financial operating systems (FOS) and their evolution in the global asset management industry. These digital technology ecosystems … Read more

Cleary Gottlieb Discusses Fed’s Final “Stress Capital Buffer” Requirement

On March 4, the Federal Reserve finalized a significant integration of its stress testing regime with its ongoing supervisory capital requirements, by introducing a new “stress capital buffer” requirement for firms subject to the Federal Reserve’s CCAR supervisory stress tests. An institution-specific stress capital buffer will be determined for each CCAR firm as part of the 2020 CCAR exercise and is intended to take effect October 1, 2020. However, given the uncertainty and stress in the market caused by COVID 19 mitigation measures, it remains to be seen whether the Federal Reserve could modify the implementation timeline.

The Federal Reserve’s … Read more

Coronavirus, Systemic Risk, and Lessons from 2008

The greatest single-day decline in the stock market this century, widespread fear and uncertainty, shuttered schools, an end to large gatherings everywhere from NBA games to the South by Southwest festival – these are just a few of the signs that the United States and the rest of the world will face some very tough economic times in the months and years ahead. The prospect of another crisis, and the increasing probability of another worldwide recession, have many looking back to 2008. A brief comparison of the two crises brings the lessons of the past into focus, in addition to … Read more

Why Stock Markets Are Essential at the Time of Coronavirus

If stocks were still traded in pits, stock exchanges would have been shut down in China, Korea, Italy and possibly elsewhere a while ago. A bunch of men shouting and feverishly passing each other sheets of papers would have spread coronavirus faster than the now infamous Korean sect.

But stock exchange trading was automated everywhere long ago, including at the Borsa Italiana in Milan. Nowadays, the only virus that can be transmitted by trading shares is panic selling. Is that an even better reason for shutting down stock markets, as some high-profile Italians politicians, including former Prime Minister … Read more

Why Financial Regulation Keeps Falling Short

Modern finance is fast moving, extremely complex, and contributes to pervasive unknowns. Yet the processes governing how finance is regulated are typically slow, highly deliberative, and often reflect deeply ingrained and incredibly optimistic assumptions about our ability to understand the financial system and the potential impact of regulatory intervention. In our new paper, “Why Financial Regulation Keeps Falling Short,” we identify the key drivers of this fundamental mismatch between finance and financial regulation, demonstrate how this mismatch contributes to undesirable policy outcomes, and lay the conceptual foundations for understanding how the processes governing the creation of financial regulations … Read more

How Common Ownership Can Lead to Tax Avoidance

In recent years there has been a surge in research that explores the sources of variation in corporate tax avoidance. Following this stream of research, tax scholars have begun to acknowledge the potential effect of ownership patterns on firms’ tax behavior.[1] A few recent empirical studies have examined the effect of institutional ownership, particularly quasi-indexers, on the tax behavior of portfolio firms.[2] These studies found a significant positive correlation between tax avoidance and institutional ownership, indicating that the emerging ownership structure in the U.S. economy – common ownership – plays an outsized role in instances of corporate tax … Read more

How Shareholder Rights Affect Firms’ Financing Decisions

Several decades of research have found that capital structure and financing decisions are influenced not only by market frictions such as taxes and bankruptcy costs but also by conflicts between managers and shareholders. In a new paper, we test whether and to what extent limited rights for shareholders to file derivative lawsuits influence firms’ capital structure and financing decisions.

To examine changes in firms’ capital structure and financing decisions, we exploit the staggered passage of Universal Demand (UD) laws by 23 U.S. states. These laws limit shareholders’ ability to file a derivative lawsuit on behalf of a firm by forcing … Read more

Man versus Machine: A Comparison of Robo-Analyst and Traditional Research Analyst Investment Recommendations

Advancements in financial technology (FinTech) are revolutionizing product offerings across the financial services industry. As of 2018, more than $50 billion had been invested in 2,500 companies that are redefining the way in which individuals participate in financial markets (Accenture, 2018). Innovations in FinTech also appear to benefit end users, with recent evidence indicating that FinTech is enhancing lending and brokerage activities (D’Acunto et al., 2019; Fuster et al., 2019; Tang, 2019; Vallee and Zeng, 2019). Despite its growing importance and relevance, our understanding of how FinTech affects the production of investment information and the role of sell-side research analysts … Read more

Reversing the Fortunes of Active Funds

Recent years have witnessed a considerable growth of passive funds at the expense of active funds. This trend picked up in 2019, a year that saw passive funds surpass active funds in total assets under management. The continuous decline of active funds is a cause for concern. Active funds engage with and monitor management and participate in their portfolio companies’ decisions. The costs of these activities are born exclusively by active funds; the benefits, by contrast, are spread over all shareholders, including passive funds that free-ride on the efforts of active funds. Consequently, the contraction of active funds threatens to … Read more

Davis Polk Offers Financial Institutions Enforcement Update

To assist legal and compliance officers of financial institutions, this memorandum summarizes key recent developments in criminal prosecutions and regulatory enforcement actions involving financial institutions during November and December 2019.

Among the significant matters and trends:

  • The last two months saw substantial activity on the insider trading front, and of note the U.S. Court of Appeals for the Second Circuit held in United States v. Blaszczak that the government need not satisfy the “personal-benefit” test for insider trading when proceeding under a Title 18 theory.
  • There was additional enforcement activity relating to “spoofing,” including a record-setting fine by the CFTC

Read more

Contracts of Inattention

Bloomberg’s multi-talented Matt Levine recently wrote:

One of my favorite recent stories in bond documents is the one about how private equity firms changed a sentence in bond documents, which usually says that companies can’t make restricted payments if “a Default or Event of Default shall have occurred,” to instead say that they can’t make the payments if “an Event of Default shall have occurred.” (here)

As Robert Smith of the Financial Times (quoted in Levine’s piece) explains:

To a layman, [the foregoing likely] sounds the same. But there is an incredibly important distinction.

If you miss an Read more

Davis Polk Discusses FSOC’s Shift to an Activities-Based Approach

The Financial Stability Oversight Council’s (FSOC) recently revised guidelines (the 2019 Guidelines)[1] on how it will identify and address financial stability risks are a major shift from the guidelines it issued in the immediate aftermath of the Financial Crisis (the 2012 Guidelines).  The 2019 Guidelines draw upon lessons learned from FSOC’s ultimately fruitless attempts to designate nonbank financial companies as systematically important.  Instead, building on one of the original purposes of the Dodd-Frank Act,[2] which was then emphasized in one of the Treasury Reports, the 2019 Guidelines focus on identifying and regulating systemically important … Read more

Wachtell Lipton Offers Acquisition Financing Year in Review: The Decade of Debt

2019 was another strong year for corporate borrowers, continuing a decade-long run marked by historically low interest rates and strong credit markets.  Over the last 10 years, total U.S. corporate bonds outstanding rose from $6 trillion to nearly $10 trillion, while leveraged loans expanded to $1.2 trillion from $500 billion.

But even in the midst of this bull market, new opportunities and challenges arose.  Two major trends from the last year stand out—the increased participation of “non-traditional lenders” as a financing source and the continued evolution of “debt default activism” as a material concern for borrowers.

The Acquisition Financing Markets

Read more

Artificial Intelligence, Finance, and the Law

The progress and promise realized and presented by artificial intelligence in finance has been remarkable.  It has made finance cheaper, faster, larger, more accessible, more profitable, and more efficient in many ways.  Yet for all the significant progress and promise made possible by financial artificial intelligence, it also presents serious risks and limitations.

My recent article, Artificial Intelligence, Finance, and the Law, in the Fordham Law Review, offers a study of those risks and limitations – the ways artificial intelligence and misunderstandings of it can harm and hinder law, finance, and society.  It provides a broad examination of inherent … Read more