As we enter 2022, and the U.S. Securities and Exchange Commission pursues an agenda which is more ambitious than we have seen from a market watchdog in decades, it may be fair to say the regulator has never had a more extensive or time critical suite of topics to address since its inception in June 1934. Of course, proposing extensive rule changes is not the same as getting them through the process of U.S. rulemaking, particularly in the current political climate. Still, nothing ventured nothing gained.
2022 will be an incredibly busy year for all U.S. asset managers with the policy agenda brim full of important issues under review. From insider dealing reform to proxy advisors, from meme stock and cryptocurrency fads to a more serious overhaul of the fundamental structure of equity trading, there is no corner of the U.S. markets that it seems the SEC will shy away from addressing.
Its chairman, Gary Gensler, who has produced an amazing catalogue of 49 new pieces of regulation in the past year, must thread the needle carefully to foster greater transparency, competition and investor protection while at the same time not stifling the market at a very sensitive point in history. This mandate is made ever more complex at a time where several new innovations like digital currencies and environmental, social and governance (ESG) themes seem in need of balanced and proportionate rulemaking. Given his background, 2022 looks set to be a huge year for the SEC regardless.
Mr. Gensler is a former Goldman Sachs executive who served as chairman of the Commodities Futures Trading Commission under President Barack Obama, where he notably took a hard line on regulating the US$400 trillion derivatives market following the housing crisis in 2008. Immediately prior to taking the chair at the SEC, Mr. Gensler also served a stint as a professor at the Massachusetts Institute of Technology, a tenure that convinced many supporters of cryptocurrencies that he would be sympathetic to their cause. However, this has not turned out to be the case, at least so far. In fact, he has said digital money should be regulated as securities instead of as currencies, much to the horror of the growing crypto industry. 2022 will be the year where jurisdiction over cryptocurrency, digital assets, stable coins and all other areas of distributed ledger technology will be decided upon and rulemaking at the SEC and elsewhere is likely to occur.
Some of the key issues on the extensive agenda for 2022 include:
It is almost a certainty that new rules focusing on environmental, social and governance issues will come forth this year. The regulations that emerge are likely to be far less draconian than the ESG rules that already have been adopted by the European Union and will likely address two main points: greenhouse gas emissions and diversity on company boards of directors. The latter point will not only focus on gender diversity but, because of the recent strength of the Black Lives Matter movement, also attempt to rectify racial injustice. Mr. Gensler has already advocated for climate and “human capital” metric disclosures for public companies as well as far more stringent disclosure regimes for providers of funds and investment services.
A Focus on Environmental Risks to Investors:
Mr. Gensler has asked SEC staff to draw up regulations requiring disclosures of “a variety of qualitative and quantitative information about climate risk” in company 10K filings. He added that although most major corporations make climate disclosures, the information provided is not consistent or comparable across companies. He wants climate disclosures to be “decision useful” to investors, detailing such things as emissions data and how close the company is to achieving climate goals. The SEC’s climate regulations are also likely to take aim at fund managers who offer funds that claim to be climate-friendly.
The SEC is also likely to require companies to disclose Scope 1 and Scope 2 greenhouse gas emissions—Scope 1 being emissions from a company’s operations and Scope 2 from its use of electricity and similar resources. Disclosure of Scope 3 emissions—that is, emissions generated by third parties in a company’s supply chain—could also be required. “When it comes to sustainability-related investing, there’s currently a huge range of what asset managers might mean by certain terms or what criteria they use,” he said. “I think investors should be able to drill down to see what’s under the hood of these funds.”
Many firms will hope that the SEC doesn’t add to the ESG rule fragmentation that is fast becoming a problem in itself, as regulators and other bodies roll out rules across the globe. The SEC has also floated the idea of linking its rules to a particular global benchmark, like the framework created by the Task Force on Climate-Related Financial Disclosures. This would be most welcomed by U.S. asset managers rather than the creation of another unique and idiosyncratic ESG weighing and measuring system.
A Focus on Social Issues:
In terms of its focus on diversity and inclusion, this is an area likely to intensify in 2022. The SEC last year already approved a board diversity rule encouraging (but not requiring) companies on Nasdaq’s public exchange to have at least two diverse directors—one who identifies as female and another who is an “underrepresented minority or LGBTQ+”. The rule will require companies on the exchange to annually disclose their board-level diversity data. Companies not meeting the diversity objectives will be required to explain why in their proxy statement, information statement for their annual shareholder meeting, or on their website concurrently with their proxy statement or information statement. Failure to meet the requirements—effective Aug. 8, 2022, or the date the company files its proxy or information statement for its annual shareholder meeting during 2022 (whichever is later)—could result in a company being delisted from Nasdaq.
Further to the Nasdaq rules, Mr. Gensler seems very attentive to the theme of broader workforce diversity and employee composition. The SEC has touted a rule that could have significant ramifications for U.S. workforce and hiring practices and which “could include a number of metrics, such as workforce turnover, skills and development training, compensation, benefits, workforce demographics including diversity, and health and safety,” Mr. Gensler tweeted in August 2021. Soon after that tweet, while attending the Senate Banking Committee in September, Mr. Gensler said: “I think investing in a company—the human capital, the workforce—is a key asset. I’ve always found that if you’re going to buy a company or sell a company—when I was doing that at Goldman Sachs—that people really wanted to have a thorough review of that workforce and its ups and downs.”
The debate about ESG rules is also likely to expose the differences among members of the commission. Hester Pearce, a Republican appointee to the SEC, for example, has opposed forcing firms to adopt ESG disclosures because there are no widely accepted definitions of the practices. ESG rulemaking is a political hot potato in every country across the globe, however it can be particularly divisive in the U.S. where some States have a much greater carbon and petrochemical dependence than others. 2022 will be the year the SEC adopts ESG rules, and the scale and breadth of those rules will be worth watching.
In just one appearance before the House of Representatives last year,1 Mr. Gensler promised to take on a range on market structure issues including payment for order flow, trade settlement timing, social media promotions of meme stocks and many others. Mr. Gensler tends to “go big” when grappling with market events and this certainly rings true of his willingness to address payment for order flow (PFOF). It is estimated that the top U.S. brokerage firms generated about US$2.5 billion in rev¬enues in 2020 alone and that an elimination of PFOF would wipe that revenue stream away with one stroke of Mr. Gensler’s pen.
“The high concentration of retail orders routed to a small number of wholesalers raises a number of questions about market structure,” Mr. Gensler said, referring to the payment for order flow issue raised by the Robinhood brokerage. “In essence, does this segmentation and related sector concentration best promote fair, orderly, and efficient markets?” While posing these as questions, he said he asked his staff to consider what policy changes might be recommended without saying what he prefers.
It seems unlikely that there will be an outright ban on the practice of PFOF, as is the case in the U.K. and Canada. After all, thanks to Robinhood and brokers like them, many novice investors have begun investing in equities, which is a good thing. However, given the system is quite opaque, Mr. Gensler is likely to seek greater transparency so investors can see exactly what they are getting with the so called “free trades” and are assured the broker is acting in the best interests of their clients under the existing best execution rules.
Another sub-plot to the GameStop event of 20202 was that it put the framework for U.S. clearance and settlement of securities transactions under the spotlight like never seen before. It has led to widespread and vociferous calls demanding the U.S. trade settlement cycle be reduced from the current two days to one or even same day, as the current method is seen by some as archaic in an era of lightening paced activity.
Other areas of market structure likely to come under Mr. Gensler’s watchful gaze include reporting and transparency for total return and other security-based swaps stemming from the spectacular collapse of Archegos Capital Management in 2021.3 The lack of disclosure due to the entity type and instruments used meant that the Archegos collapse blind-sided the SEC completely, an event which Mr. Gensler will be keen not to see reoccur.
This is another area where the SEC is likely to be sharply divided. While Mr. Gensler has expressed the need to regulate digital currencies as securities, Pearce believes they should be allowed to flourish unimpeded. It’s also an area where the cryptocurrency community have been up in arms at Mr. Gensler’s approach to date. He previously likened cryptocurrency to the “Wild West” and pledged to increase scrutiny, both to enhance investor protections and increase collaboration between other federal agencies that regulate commodities trading and banks. The crypto community were up in arms with some of Mr. Gensler’s comments at the Senate Banking Committee where he said of cryptocurrency: “This asset class is rife with fraud, scams, and abuse in certain applications. We can do better.” The SEC has already taken legal action against Coinbase’s purported crypto lending platform called “Lend” and that process is ongoing.
Cryptocurrency is an area where the SEC will probably not act alone. This owes to the fact that the definition of cryptocurrency and who has jurisdiction in the U.S. often depends on the type of digital currency or asset. Currency issues involve not just the SEC, but also the Commodity Futures Trading Commission, the Federal Reserve and Office of the Comptroller of the Currency. Each of these bodies claim jurisdiction and each will have to reach a joint decision on crypto’s fate to have a comprehensive U.S. solution. Without exception, whenever the SEC has been formally asked (including prior to Mr. Gensler’s stint) for a determination on whether a cryptocurrency is a currency or a security, the answer has been the latter. Mr. Gensler said that the SEC will “be very active in trying to bring this market into what I’d call the investor protection framework.”4
The other major area of scrutiny that the SEC will have to decide is the extent to which it will allow investors to put money into crypto-based exchange traded funds (ETFs). While it allows Bitcoin futures ETFs, it rejected a proposal to amend the rules to allow for an ETF that tracked spot movements in the digital currency. Given the huge current demand, it’s unclear how long the SEC can resist the pressure being brought to bear to free up crypto trading. It is an emotive and complex topic which makes rulemaking difficult but also inevitable.
During the pandemic, the SEC looked at cyber security defenses at asset managers and concluded that while many were robust, there’s a lot of variability in the standards. Mr. Gensler told the SEC’s Asset Management Advisory Committee in September 2021 that he asked staff to develop proposals “both on the issuers’ side and on the funds’ side. These could address issues such as cyber hygiene and incident reporting.”
It appears likely the SEC under Mr. Gensler will decide to set minimum consistent cyber standards, a bar which no firm will be allowed to drop below. In addition, there may be a requirement to cyber proof second and third-party vendors, because investor protection is only as strong as the weakest link. The New York State Department of Financial Services has already adopted a comprehensive rule for financial institutions that work on Wall Street, so the new SEC rule will apply to those beyond New York’s reach.
The cybersecurity focus extends beyond the SEC and has become a key pillar of U.S. national security concerns. Cybersecurity, par-ticularly ransomware, has received the full attention of the Biden administration. The Department of Justice unveiled its Civil Cyber-Fraud Initiative in October 20215, which made it clear the agency will be less tolerant of companies that do not report ransom-ware, breaches, and other cyberattacks promptly to the government. Also, the U.S. Treasury, through its Office of Foreign Assets Control (OFAC), has issued sanctions on ransomware criminals and the financial networks they use,6 while the Financial Crimes Enforcement Network (FinCEN) has updated guidance to banks and financial institutions regarding their responsibilities to report suspected ransomware payments transmitted over their networks.