Earlier this year the SEC re-proposed a broad conflicts of interest rule from more than ten years ago that was originally designed to prohibit traders from betting against the assets they sell.
If adopted in its current guise, the rule will impede normal, healthy hedging in the market, create major problems for compliance, and bring have severe economic consequences. Instead, the SEC must heed market advice and revisit the rule.
Introduced as part of the landmark Dodd-Frank Wall Street reform legislation, the aim of the rule was initially to address the root cause of the mortgage crisis. Before the 2008 financial crisis, banks could arrange synthetic RMBS CDOs only to take the opposite position, reducing the mortgage risk in their book by selling long exposure to their clients and then taking offsetting.
Building on this, the re-proposed rule prohibits underwriters, placement agents, initial purchasers, and sponsors of ABS and their affiliates from engaging in “any transaction that would involve or result in a material conflict of interest with respect to any investor in a transaction arising out of such activity”. The only exceptions would be for certain risk-mitigating hedging activities, liquidity commitments, and bona fide market-making.
However, with tightened underwriting guidelines hitting the securitization market after 2008, it is debatable how relevant this rule still is. For example, in the RMBS world, there are no synthetic transactions anymore, except only the government-sponsored enterprises Fannie Mae and Freddie Mac, but both are exempted from this rule.
The rule will also lead to unwanted consequences, and, if adopted as proposed, some perfectly normal hedging activities could be prohibited. For example, bank credit risk transfer transactions are a form of credit risk mitigating hedging, and an especially important one for banks.
The rule's proposed language would stipulate that bank's shut down these transactions, despite the fact that they are routinely used to manage credit risks.
Another example is interest rate hedging. It is a common hedging on the portfolio against loss caused by the fluctuation of interest rates, and recent events in the banking sector also highlighted the importance of banks’ ability to mitigate interest rate risks.
However, according to the proposals, interest rate hedging may constitute “conflicted transactions” to the extent that they increase in value when the ABS decreases in value, such as when interest rates rise.
Under such broad and vague definitions, it is almost impossible to come up with compliance programs that would make sense. The definition of a securitization participant is so broad that it covers not only the underwriters, initial purchasers, and placement agents, but also their affiliates across the world, even the ones that have information barriers.
As a result, different teams, including dealers, asset managers, and structuring managers will have to come up with different compliance programs. Even if they do, once a deal goes bad, some innocent party might still find themselves in violation of the rule under the broad definition purely by being in the wrong place at the wrong time.
If the rule is implemented in its current form it will be chaotic. The adverse economic consequences this could cause will most likely outweigh any foreseeable benefit the regulatory change might bring.
When the rule was first proposed in 2011, the SEC received many comments criticizing its workability. This iteration is no different, with the regulator revieving a swath of submissions from across the market.
This time around the rule may be enacted, but if the SEC fails to make reasonable adjustments based on market feedback there may be very chaotic consequences.