U.S. to eye high-speed traders, money funds

Stability council to release third report on risks to the economy

WASHINGTON (MarketWatch) — Federal regulators on Thursday will detail threats to financial stability, with expectations that concerns will focus on high-speed computerized trading, money-market funds and bank vulnerabilities in today’s low-interest rate environment.

The recommendations will be released by the Financial Stability Oversight Council, which is a multi-agency panel charged with identifying risks to the economy to Congress.

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Regulatory observers agree that the report — the third of its kind — will focus some attention on systemic market structure issues, including the impact of computerized high-speed trading and the expansion of dark pools, which are trading systems that are not openly available to the public where buyers and sellers submit orders anonymously.

“It is a cause célèbre for a lot of regulators,” said Larry Tabb, founder of the capital markets research firm Tabb Group. “The biggest issue is not necessarily what happens during 99.9% of time, it is when market data issues arise and firms can’t adequately value risk, so they don’t want to risk their capital.”

More sophisticated rules seeking to prevent another so-called “flash crash” that shook the markets in 2010 took effect earlier this month. Tabb contends that they won’t be enough to convince the council that the risk to the economy from computerized high-speed trading is gone. Read about high-speed trading in the council’s 2012 report.

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In addition to market structure issues, risks associated with mortgage REITs, money-market funds and large financial institutions are also all expected to be spotlighted in the report.

Publicly traded mortgage REITs include Annaly Capital Management /quotes/zigman/189739/quotes/nls/nly NLY +0.38%  , American Capital Agency /quotes/zigman/110324/quotes/nls/agnc AGNC +0.21%  and Newcastle Investment Corp. /quotes/zigman/299237/quotes/nls/nct NCT +1.95%  , while top money-market fund providers include Federated Investors /quotes/zigman/217607/quotes/nls/fii FII +0.17%  , Charles Schwab /quotes/zigman/240465/quotes/nls/schw SCHW +0.30%  and Goldman Sachs .

Donald Lamson, a former Office of the Comptroller of the Currency assistant director who now a partner at Shearman & Sterling in Washington, said the council has taken a particular interest in reforms to the $2.7 trillion money-market fund industry and it will continue to do so in the report.

The council is considering a formal recommendation that the Securities and Exchange Commission take action to impose tougher rules on money-funds. The recommendation may be having its intended effect: Under pressure from the council, top SEC officials say reform of the industry -- considered by many to be systemically risky -- is at the top of their agenda.

Marcus Stanley, policy director at the left-leaning advocacy group Americans for Financial Reform, said the report is likely to focus this year on concerns that financial institutions are having a tough time managing risk in today’s low-interest rate environment.

Stanley said the low interest rate environment gives firms an incentive to reach further for yields and get into more exotic products. He expects the report to take a closer look at riskier products such as high-yield bonds, leveraged loans and mortgage REITs.

The report may look at the exit strategy for institutions when interest rates finally do rise.

“How will they sell off bonds in a way that you don’t see bond prices drop across the board, driving a disorderly rush for the exit in the bond market,” he asked.

Report provides guidance on post-Lehman rules

Lamson added that there is a possibility that the council will also designate some firms other than banks that are systemically risky, noting that the members of the group designated eight so-called financial market utilities as systemically risky last year on the same day it released its 2012 annual report to Congress.

Observers have been hotly awaiting the release of the names of these institutions, which will be subject to gradually increasing capital levels, lower leverage limits and more liquidity. Some possible designated firms include GE Financial, a unit of General Electric /quotes/zigman/227468/quotes/nls/ge GE +2.14%  , Prudential /quotes/zigman/294774/quotes/nls/pru PRU +0.69%  , American International Group /quotes/zigman/557836/quotes/nls/aig AIG +2.41%  and MetLife /quotes/zigman/252112/quotes/nls/met MET +1.54%  , as well as BlackRock /quotes/zigman/249424/quotes/nls/blk BLK -0.31%  and Pimco, a unit of Allianz /quotes/zigman/143088 DE:ALV +1.01%  .

He added that the report will also likely review the issue of whether U.S. banks also should hold a form of so-called “contingent capital,” a special kind of capital that would act like a bond in good times but convert automatically into loss-mitigating common equity in a crisis.

The form of capital is also known as “bail-in capital” because it would force the institution to give itself an injection of common equity in a crisis, thereby potentially avoiding the need for a taxpayer funded capital infusion. The council last year recommended that the Fed and other regulators continue to look at the issue and study the “advantages and disadvantages” of the bail-in instruments.