International Cooperation in a New Data-Driven World
Commissioner Kara M. Stein
Brooklyn Law School International Business Law Breakfast Roundtable
March 26, 2015
Thank you, Professor Karmel, for that kind introduction. Before I begin my remarks, I am required to tell you that the views I am expressing today are my own, and do not necessarily reflect those of the United States Securities and Exchange Commission (SEC), my fellow Commissioners, or the staff of the Commission.
It is a privilege to be with you all today. As many of you know, I am following in the footsteps of Professor Karmel, who served as an SEC Commissioner from 1977 to 1980. Overlooking the conference table in my office, I have a photograph of the Commission of which she was a member. As the first female Commissioner at the SEC, Professor Karmel continues to be a source of inspiration for many of us.
I am also pleased to be speaking at an event sponsored by the Block Center for the Study of International Business Law. In creating the Center, Brooklyn Law School recognized back in 1987 that the business world and financial markets were transitioning from a national to a global model.
As a Commissioner, I observe the implications of this transition every day. In fact, during my first few months at the Commission, I remember being struck by the extent of the Commission’s involvement with the international community. Every week, SEC staff are engaged with regulators and financial organizations from around the world. I had the privilege of directly witnessing and participating in this important collaborative work in February when I traveled to Seoul, South Korea, to attend a board meeting of the International Organization of Securities Commissions (IOSCO) as the representative of the SEC.
Today, I want to talk about the vital importance of international cooperation in the regulation of securities markets. First, I will discuss the collaboration between the Commission and international regulators as we work on reforms following the financial crisis. Second, I would like to highlight the importance of paying attention internationally to products that may transmit risk across borders, such as swaps. Finally, I will touch on disclosure and accounting matters, and how we might move beyond longstanding impasses. I hope each of these topics will leave you with an appreciation for how vital the collaboration between the SEC and our international regulatory counterparts is and will continue to be.
International Coordination Is Crucial For Addressing Systemic Risk in the 21st Century
It’s a truism that our financial system is globalized, interconnected, and complex – and only grows more so each day. Geographic boundaries have not contained our markets for some time. Transactions can be executed in one place, the counterparties can be located in another, and the economic impact sometimes felt in a third place. Companies themselves have grown so big and cross so many regulatory frameworks that it can be hard to know who regulates what aspect and how. Financial networks can move billions of dollars world-wide in a fraction of a second.
The financial crisis of 2008 brought home for many of us just how interconnected and global our financial system is. In 2008, I was working for United States Senator Jack Reed. I vividly remember closed-door meetings where the Secretary of the Treasury and the Chair of the Federal Reserve Board briefed members of the Senate Banking Committee on the scope of the crisis that was unfolding. Everyone attending these meetings was stunned at how broad and pervasive the problems were, with the impacts being global in consequence. We were making decisions focused on the United States financial system and how such decisions would affect the American people. But we all knew the consequences would be felt around the world.
The collapse and rescue of the American International Group (AIG) is a good example of the global interconnectivity and the transmission of risk that we saw play out in 2008. It encapsulates many of the key lessons we need to learn in terms of regulatory oversight going forward and the importance of international collaboration.
Many of us are familiar with the story of AIG’s collapse and rescue. Its subsidiary in London wrote massive amounts of credit default swaps (CDS) on funds of mortgage-backed securities (MBS) known as collateralized debt obligations (CDOs). When those CDOs plummeted in value, AIG was forced to put up increasing amounts of margin on its CDS, and potentially pay out on their obligations as well. AIG’s securities lending operation also ran into significant difficulties. Had the Federal Reserve and the Treasury Department not stepped in with over $180 billion in rescue money to help AIG meet its obligations and unwind key transactions, AIG would have collapsed.
I’m not here today to debate the wisdom or necessity of the rescue, or how the money should have been used. For the purposes of our conversation today about how globalized our world is, I want to note that over half the recipients and over half the total dollars went to foreign banking organizations – both in the case of the CDS rescue and for the securities lending rescue. Similar results were found in an analysis of the Federal Reserve System’s emergency lending programs: six of the largest fourteen recipients of the Fed’s rescue were foreign banking organizations.
This is not to criticize the Fed or argue that it was inappropriate to extend emergency credit to these foreign banking organizations. I’m simply highlighting that we live in a deeply interconnected world in which both the risks and the shocks can and do extend beyond our borders. It is critical, therefore, that we all learn the basic regulatory lessons of the AIG collapse: that risk can hide in unexpected places, that it can be transmitted easily across geographic boundaries, and that shocks can be felt far from the locus of the problem. Without a doubt, the response to this reality has to be global.
And indeed it was. Not only did governments and central banks coordinate the financial rescue efforts of 2008, but reforms, by and large, have moved together globally as well. Leaders of the Group of Twenty met in Pittsburgh in September 2009 and laid the foundation for important globally coordinated reform efforts. There, leaders committed to broader and better regulatory oversight, including higher capital for institutions, reform of the over-the-counter swaps market, compensation reforms to end excessive risk-taking, and resolution authority to hold firms and their shareholders accountable for failure.
That vision was put into place in the United States by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act). The Dodd-Frank Act created the Financial Stability Oversight Council (FSOC) and empowered it to look out for, and respond to, entities and activities that could imperil our financial stability. It mandated higher capital and other standards at the largest banks and systemically significant financial firms. To rein in excessive risk-taking, it adopted the Volcker Rule, mandated reform of incentive compensation, and implemented asset-backed securities reforms. It adopted new legal authorities to enable the government to hold financial firms, their executives, and their shareholders accountable for failure. It set out a new regulatory regime for over-the-counter swaps, required registration and supervision of entities that previously were outside the regulatory purview, and created a consumer protection agency to police the entire consumer credit marketplace. The Dodd-Frank Act also created the Office of Financial Research (OFR), as a source of independent expertise and analysis.
The United States is well on its way to implementing these reforms. While the Dodd-Frank Act takes U.S. financial stability as its touchstone, the agencies implementing it certainly think about the global impact of its reforms. Indeed, many of the Dodd-Frank Act’s provisions have important international components or implications. The Volcker Rule takes a global approach to reducing the risks for U.S. banking groups. Title VII swaps regulation is a global effort, and I’m going to speak in greater detail about that shortly. Even asset-backed security reforms have global elements. If firms can simply avoid risk retention obligations by structuring the transactions in a foreign jurisdiction, yet export those same risks right back to the United States, we haven’t made much progress.
I believe that U.S. regulators can, and should, take a fairly forward-leaning approach to preventing regulatory arbitrage through foreign jurisdictions. However, I recognize that there is only so much we can do. Nothing replaces solid cooperation and collaboration between regulatory counterparts around the world. That’s why I’ve been pleased to see the U.S., including the Commission, playing an integral role working with international organizations such as the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO).
These international organizations are just like us. No one gets everything right. Moreover, national regulators always retain the authority and the responsibility to make final decisions regarding their own jurisdictions. In fact, the U.S. has properly resisted locking financial regulatory matters into binding legal documents, such as trade agreements. But developing the habits of cooperation and collaboration are critical. Moreover, these venues provide an opportunity for regulators around the world to focus our thinking and test our assumptions.
Let’s also remember that international cooperation doesn’t necessarily mean uniformity in results. Take the Volcker Rule for example. The U.S. has its own approach; the United Kingdom has a different version; and the rest of Europe is considering a hybrid of the two. Diverging somewhat in how we manage risks to our financial stability is a good thing. A little flexibility and divergence can make systems more resilient to unexpected stresses.
But when certain products – like swaps – allow risks to move across borders at lightning speed, having strong international regulatory cooperation is vitally important and just makes good sense. And that’s the topic to which I will now turn.
Effective Swaps Regulation Demands Global Collaboration on Data Aggregation and Margin
Working together is crucial when financial transactions, like swaps, can move risk across international borders at lightning speed. A swap, which is one type of “derivative” financial product, is simply a contract that obliges the parties to it to exchange money based on the occurrence of some other event, indices, or market change. Common types of swaps are interest rate swaps, commodity swaps, equity swaps, and credit default swaps.
Swaps played a major part in amplifying the risks, uncertainties, collapses, and bailouts that cascaded around the world in 2008. Having recently adopted final rules on swap data repositories and swaps reporting, the SEC is in the final stages of its rulemaking responsibilities for swaps. I want to highlight two areas where I believe it is particularly important to coordinate and cooperate: swaps reporting and margin.
Among the key lessons of the financial crisis – especially regarding the collapse of AIG – is that neither regulators nor market participants had any idea how swaps exposures linked firms and markets together. The rescue of AIG was predicated upon the fear that its collapse would lead to a series of swaps defaults, which would cascade across the largest financial firms in the world through their unregulated and interlocking over-the-counter swaps exposures. What was most striking from my perch at the Senate Banking Committee was that regulators essentially had almost no information about how big their exposures were, and who was connected to whom.
Governments around the world determined never to let this kind of blind response to a financial disaster happen again, especially in regards to products like swaps, that connect the biggest firms in the world to one another. Here in the U.S., the Dodd-Frank Act mandated a reporting regime in which every swap transaction would be immediately reported to a swaps data repository (SDR), with the information for most transactions disseminated to the public too. The reporting regime would allow regulators to aggregate and analyze the swaps data and identify the interconnections and hidden risks arising from these products.
While the concept of swaps reporting is simple, the execution to date has not been. Five years into global reform of the swaps market, and regulators in the U.S. and around the world have encountered significant obstacles to obtaining usable data for themselves, let alone trying to aggregate that data across borders.
One aspect of the problem has been insufficient attention to data standardization and quality, both here in the U.S. and around the world. I’m pleased that the Commission is working to produce a swaps reporting taxonomy to address this issue. Taxonomies sound boring but are actually really important. They involve things like naming conventions and data ordering: do you enter month-day-year like we do in the U.S., day-month-year as they do in Europe, or year-month-day as they do in Asia? Getting those kinds of simple things right can be the difference between data that is unreliable, and data that can identify a hidden financial vulnerability.
It is important that we get this right on a global basis. If we want to be able to aggregate and analyze data from SDRs around the world, we need one global data taxonomy. Given the global reach of our largest financial firms, failing to aggregate regulatory data would significantly undermine our efforts to address systemic risk globally.
Enabling global aggregation of swaps data is one of the reasons I have been pushing so hard on across-the-board adoption and usage of standards like the Legal Entity Identifier (LEI) system. As some of you know, an LEI is an alpha-numeric reference code that uniquely identifies legal entities engaging in financial transactions globally. It enables risk managers and regulators alike to instantly and precisely identify parties to financial transactions. I’ve been encouraging LEI be adopted at every possible place in the Commission’s rules. I’m pleased our swaps reporting rule from this January does that. I was also pleased that our January swaps reporting rule moves us forward with other commonly identified tags, such as unique product identifiers.
In the fall of last year, the FSB laid out a pathway towards establishing globally harmonized data elements for what gets reported to swap data repositories worldwide. Better late than never, and I’m pleased that the Commission is participating in this effort. I hope that we can lead the adoption of these and other tools that can allow regulators here in the U.S. and around the world to tap the power of technology and do their jobs more efficiently and effectively.
Equally important is international collaboration on a robust approach to swaps margin. Margin is one of the most crucial tools regulators – and firms – have to address the risk of swaps. By having each side to a trade post cash or high quality collateral up-front and on an on-going basis, margin requirements minimize the likelihood that a failure at one firm will cause a chain of collapses at other firms. Margin is especially important in markets that remain over-the-counter.
Banking and securities regulators globally have been working to develop international minimum standards for swaps margin. Collaborating on minimum standards on margin is critical to combatting the pressures of a race-to-the-bottom that could occur as jurisdictions compete for the short-term benefit of high-risk, under-margined swaps business. A strong global “floor” on margin is also critical to preventing the emergence of “swaps evasion jurisdictions,” like the kind we have seen in the tax world.
However, I also believe we should be able to go beyond that floor when it is necessary. One area I’m closely following is the requirement to collect initial margin, which AIG largely failed to do and which cost it dearly when large margin calls came in. Is the international margin proposal too lax when it comes to the collection of initial margin? I look forward to considering the views of commenters as these proposals are refined.
Can We Move Globally Towards Better Disclosure and Better Accounting Standards for a Data-Driven Century?
The final topic I would like to discuss today emphasizes the importance of international collaboration on accounting and disclosure. As both practitioners and scholars of securities law, you know that accounting is the foundation for much of what we do. Everything from our financial reporting regime to oversight of financial firms’ liquidity and capital depends upon reliable, consistent, comparable, and understandable accounting.
Over the last decade or so, the accounting community has been engaged in a robust conversation about whether the United States should abandon United States Generally Accepted Accounting Principles (U.S. GAAP) and move to the International Financial Reporting Standards (IFRS). This is an extremely complicated and controversial topic. I’d like to highlight some of my current thoughts.
First, it is difficult to deny the appeal of a single set of globally-recognized, high-quality accounting standards. It’s a wonderful vision. But, beyond the simplistic allure of a universal set of comprehensive standards lies a myriad of shortcomings. The question is, what can we achieve and how would we get there?
I am not convinced of a need to abandon U.S. GAAP in favor of IFRS. That is not to say that U.S. GAAP is perfect. Nor is IFRS perfect. I’m also not convinced that providing financial statements in two different sets of accounting standards would be beneficial for either investors or issuers. With complexity in both businesses and products on the rise, it seems that presenting information in a dueling set of financial reporting standards does not really aid in understanding.
To be frank, this debate between dueling standards needs to move on. Neither regime worked ideally in the financial crisis, and neither may serve investors well in today’s post-financial crisis, technologically disrupted, and data-driven world. In practice and in reality, accounting standards may vary between jurisdictions due to legal and cultural factors, as well as differences in perspective. Remember, IFRS is not consistently implemented around the world.
Rather than debating the winner of the battle between U.S. GAAP versus IFRS, we should be thinking anew about what kind of accounting regime we want going forward. With technology increasingly transforming our world and the financial crisis still fresh in our minds, now may be a good time to reimagine our approach globally.
In other words, while convergence makes sense, the question for me is, what are we converging to. Is it a regime that offers clear, predictable, and comparable accounting that facilitates electronic analysis? Or is it so flexible that investors cannot use it to compare companies, and companies themselves do not have the certainty they need to withstand scrutiny?
Currently, the SEC’s Division of Corporation Finance is spearheading a project to examine the effectiveness of corporate disclosures. While the initiative was initially named “The Disclosure Overload Project,” its mission has been broadened to also address whether we need to enhance, improve, and in some cases add disclosure.
I’d like to suggest that we might be able to use this initiative to address accounting and financial reporting as well. Much work has already been done to converge U.S. GAAP and IFRS, and we should not recreate that wheel. Rather, I’m suggesting that, post-financial crisis, we think about the next step – where should accounting be in the 21st century, a century in which technology and globalization are transforming the way the entire world does business? In a highly interconnected, digital world, can we reimagine accounting so that we minimize differences and maximize global investment and access to capital? While this may be an aspirational goal, if we avoid an outcome-dependent approach, I believe we can begin to move beyond the constraints of the current debate. We should be looking, on a globally coordinated basis, at the real needs of investors and issuers in the 21st century and re-imagining our accounting regimes to better serve them. We can adopt the best of what we have here in U.S. GAAP, in IFRS, and the best of the new thinking out there.
It has been a pleasure offering a few thoughts on international issues today. Whether it is our approach to systemic risk, examining the potential for the transmission of risk though products, like swaps, or a new approach to disclosure and accounting, I believe that the Commission and the people we serve can benefit from being robustly engaged with the international community. We will never be harmonized and may never be perfectly converged. However, through respectful dialogue and vigorous advocacy, we can move forward advancing the values we hold dear – protecting investors, ensuring fair and orderly markets, and facilitating capital formation.
 On the history of the CDO as a trading desk and fund, see Nicholas Dunbar, The Devil’s Derivatives (2011).
 See U.S. Government Accountability Office, Financial Crisis: Review of Federal Reserve System Financial Assistance to American International Group, Inc. (GAO-11-616), Sept. 2011, available at http://www.gao.gov/new.items/d11616.pdf.
 James Felkerson, $29,000,000,000,000: A Detailed Look at the Fed’s Bailout by Funding Facility and Recipient, Working Paper No. 698, Levy Institute, Dec. 2011, at 33 available at www.levyinstitute.org/pubs/wp_698.pdf.
 Leaders Statement, The Pittsburgh Summit, Group of Twenty, Sept. 24-25, 2009, available at www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.
 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), Pub. L. 111-203, §§ 112, 120 (2010).
 Dodd-Frank Act, § 161 et seq.
 Dodd-Frank Act, §§ 619, 621, 941 et seq., 951 et seq.
 Dodd-Frank Act, § 201 et seq.
 Dodd-Frank Act, §§ 401 et seq., 701 et seq., 801 et seq., 931 et seq., 1001 et seq.
 Dodd-Frank Act, § 151 et seq.
 See Kara M. Stein, Statement at Open Meeting: Credit Risk Retention, Oct. 22, 2014 (discussion regarding foreign-related safe harbor), available at http://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370543245465#.VRLR1WOMByI.
 See Kara M. Stein, The Volcker Rule: Observations on Systemic Resiliency, Competition, and Implementation, Feb. 9, 2015, available at http://www.sec.gov/news/speech/volcker-rule-observations-on-systemic-resiliency-competition.html#.VRG-wGOMByI.
 Securities and Exchange Commission, Security-Based Swap Data Repositories Registration, Duties, and Core Principles, Release No. 34-74246, Feb. 11, 2015, available at http://www.sec.gov/rules/final/2015/34-74246.pdf; Regulation SBSR – Reporting and Dissemination of Security-Based Swap Information, Released No. 34-74244, Feb. 11, 2015, available at http://www.sec.gov/rules/final/2015/34-74244.pdf (Regulation SBSR).
 See Leaders Statement, The Pittsburgh Summit, Group of Twenty, Sept. 24-25, 2009, available at www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.
 Dodd-Frank Act, §763.
 See Financial Stability Board (FSB), Feasibility Study on Approaches
to Aggregate OTC Derivatives Data, Sept. 19, 2014, available at http://www.financialstabilityboard.org/2014/09/r_140919/.
 Addressing the challenges of indemnification and data sharing are also critical. See id.
 See Mary Jo White, Statement at Open Meeting Concerning Rules Regarding Security-Based Swap Data Repositories and Regulation SBSR, Jan. 14, 2015, available at http://www.sec.gov/news/statement/2015-spch011415mjw.html#.VRLffWOMByI; Kara M. Stein, Statement on Swap Data Repositories (SDR) and Reporting and Dissemination of Security-Based Swap Information (SBSR), Jan. 14, 2015, available at http://www.sec.gov/news/statement/security-based-swap-regulations-commissioner-stein.html#.VRLf72OMByI.
 See Financial Stability Board, FSB publishes Feasibility Study on Aggregation of OTC Derivatives Trade Repository Data, Sept. 19, 2014, available at http://www.financialstabilityboard.org/2014/09/pr_140919/.
 Basel Committee on Banking Supervision and Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives, Sept. 2013, available at http://www.bis.org/publ/bcbs261.pdf. The international approach significantly informed the proposal put forward by the U.S. banking regulators and the Commodity Futures Trading Commission in September 2014. See Department of the Treasury Office of the Comptroller of the Currency et al, Proposed Rule on Margin and Capital Requirements for Covered Swap Entities, Sept. 24, 2014, available at http://www.gpo.gov/fdsys/pkg/FR-2014-09-24/pdf/2014-22001.pdf; Proposed Rule on Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, Sept. 23, 2014, available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister092314a.pdf.
 See, e.g., Senate Banking Committee, Securities, Insurance and Investment Subcommittee, The Role of the Accounting Profession in Preventing Another Financial Crisis, April 6, 2011, available at http://www.banking.senate.gov/public/index.cfm?Fuseaction=Hearings.Hearing&Hearing_ID=0f533e5b-dc43-4fc2-a415-5df2ae8806da; See, e.g., Frank Partnoy and Jesse Eisinger, What’s Inside America’s Banks? How Wall Street Could Blow Up the Economy—Again, The Atlantic, January/February 2013.
 For example, I’ve spoken about the need to add and enhance disclosure of short-term wholesale financing by financial firms. See Kara M. Stein, Remarks Before the Peterson Institute of International Economics, June 12, 2014, available at http://www.sec.gov/News/Speech/Detail/Speech/1370542076896#.VRMJH2OMByI.