House Financial Services – Oversight of the SEC

House Committee on Financial Services

Oversight of the Securities and Exchange Commission

Tuesday, April 18, 2023

Topline

• Committee members questioned Gensler heavily on a wide range of SIFMA priorities including the SEC’s rulemaking process, equity market structure, open end fund liquidity, security-based swaps, SAB 121, private funds, e-delivery, and CAT.
• Other heavily questioned topics included digital assets and climate risk disclosure.

Witnesses

• The Honorable Gary Gensler, Chairman, Securities & Exchange Commission (SEC)

Opening Statements

Chairman Patrick McHenry (R-N.C.)

In his opening statement, McHenry touched on the SEC’s enforcement agenda against digital asset firms and highlighted the Commission’s overly aggressive and very expensive rulemaking agenda and the 53 new rules introduced at a breakneck pace at twice the number as under former-SEC Chairs Mary Jo White and Jay Clayton in the same period of time. He suggested the rulemaking process is being rushed, undermining the quality of our securities laws, and risking negative, unintended consequences, an issue raised by current SEC staff. He explained that Gensler has cut the public out of the rulemaking process through short comment periods, even with major rules like the climate risk proposal and equity market structure overhaul. He said Gensler failed to justify these significant rulemakings with thorough evidence, careful studies, and even cost-benefit analysis and added that the Commission is rushing to make dramatic changes to public markets based on paltry economic analysis and limited public input.

Ranking Member Maxine Waters (D-Calif.)

In her opening statement, Waters said Republicans are trying to harass the SEC in the hopes of impeding the agency’s work and joining industry’s efforts to delay overdue reforms. Waters commended the SEC for proposing rules to provide greater transparency for private equity and hedge funds, which she said are long overdue. Waters noted Republicans are eager to rush forward with measures to deregulate our capital markets and discussed the recent impact of the Trump-era banking deregulations, highlighting the collapse of Silicon Valley Bank. She said Congress should be adding more guardrails, not taking them off.  Waters lauded the SEC for going after crypto criminals, noting the agency nearly doubled the size of the unit protecting investors in crypto markets and from cyber threats.

Representative Ann Wagner (R-Mo.)

In her opening statement, Wagner called the Commission’s agenda overly aggressive, being rushed at a frenzied pace not seen since the 2008 financial crisis. She added that the agenda is not driven by congressional mandate or by widespread market failure and that it remains to be seen what actual deficiencies the agency seeks to address through its 53 regulations. She said the Commission’s half-baked economic analysis fails to consider the burden on retail investors, small business, and capital markets, the bread and butter of the U.S. She continued that these dramatic changes will cause a death by a thousand cuts to capital formation.

Representative Brad Sherman (D-Calif.)

In his opening statement, Sherman emphasized that investor protection is not the antithesis to capital formation, but rather it is the necessary antecedent. He concluded that if we do not protect investors, capital will go to other markets.

Testimony

Gary Gensler, Chair, Securities & Exchange Commission

In his testimony, Gensler said the U.S. has the deepest, most liquid, and most trusted capital markets in the world, but warned we can’t take this leadership for granted. Gensler cited the dramatic growth in the scale, size, and interconnectedness of capital markets, noting individual investors are participating more than ever before. He also discussed how other fast-growing economies may seek to supplant the U.S.  Gensler pointed to these challenges as proof we must regularly update the rules of the road. Gensler noted the SEC filed nearly 1,500 enforcement actions and conducted more than 6,000 examinations of registrants in the past two years. He cited existing proposals regarding securities lending, short sale disclosures, and large position reporting for securities-based swaps.

Gensler said it is appropriate for the SEC to freshen up its rules to promote efficiency and competition in the equity markets, noting private fund advisers and the funds they manage play an increasingly important role in our capital markets. Gensler added that private funds have surpassed the size of the entire $23 trillion American commercial banking system. He explained this is why the SEC proposed a rule to require private fund advisers to provide detailed reporting to investors of fees, expenses, performance, and preferential treatment, such as side letters. Gensler explained risk in one corner of the market can spill out and hurt regular folks and stressed the need for markets to serve investors and issuers alike.

Question & Answer

SEC Rulemaking Process

Rep. Frank Lucas (R-Okla.) said the volume and breath of SEC rulemaking is concerning, and that the implication of the SEC’s proposals is massive. He added that the proposed rules often affect the same or interconnected financial products and market sectors, noting that adverse consequences in one sector can bleed over into another, causing lasting economic harm. The SEC is following the same flawed path of rulemaking as the CFTC during Dodd Frank implementation, during which the CFTC’s process was rushed and chaotic, leading to poorly vetted rules and last-minute staff guidance to modify new, unworkable rules and circumventing the standard rulemaking process and lacking cost-benefit analysis. He added that the SEC’s proposed rules have a major impact on every major asset class in the SEC’s jurisdiction that could result in serious consequences for public companies, investors, and retirees. He recommended that the SEC take great care to analyze and consider the impact of draft rules in order to avoid the rush to fix the unintended problems created. Gensler said the proposals are put together carefully with input through public comment and that the Commission takes meetings with market participants seriously and considers their thoughts. Lucas followed up, noting the Commission has released twice as many rule proposals in his first two years as former-Chairs White and Clayton, noting concern from SEC staff over the pace of rulemaking.

Rep. Bill Foster (D-Ill.) expressed concern for the overload on both SEC staff and industry participants, citing the SEC’s economic analysis with multiple rulemakings coming in at once, and trying to understand how they interact with each other.

Rep. Josh Gottheimer (D-N.J.) discussed his concern with the unusually rushed rulemaking at the SEC that undermines the public’s ability to provide thoughtful feedback on the proposals of the Commission, and risks stressing an already tenuous economic climate. He also highlighted the SEC Office of Inspector General (OIG) report raising concerns with the SEC’s aggressive and rushed approach to rulemaking and noted that the SEC has staffing issues that may affect quality of rulemaking, given the short fuses. Gottheimer added that 27 of the Commission’s 53 comment periods have been unusually short – 45 days from the date the proposal was published in the Federal Register, adding that this strays from the historical practice of the SEC and that the proposals contain more than 4000 pages and more than 2500 questions. He continued to note that many stakeholders, including small businesses and small players in the space, have requested additional time to comment, citing the overlapping and rushed comment periods, and he expressed concern that limited stakeholder engagement from those without large regulatory teams to respond will lead to unintended consequences that will ultimately harm American consumers. He asked if Gensler is concerned about the possibility of hurting market participants through hasty rulemaking through short comment periods. Gensler said he is proud of what the Commission has done, including reopening proposals, adding that, on average, it has been more than 70 days from voting to the end of the comment period and that the Commission accepts comments after the deadlines. He also said the Commission takes meetings and engages actively with trade associations and market participants. Gottheimer countered that the appropriate measure is not when the proposal hits the SEC’s website; rather, the standard is when the proposal is published on the Federal Register. Gensler said people can read, start their analysis, and engage with staff or with their trade association members once the proposal hits the website. Gottheimer asked if there is a way for stakeholders to comment as soon as a proposal is posted on the website. Gensler said stakeholders want time to read what the SEC does and that the Commission makes the proposals transparent and often considers comments well beyond the deadline. He also said it takes an average of 15 months from proposal to adoption.

Rep. Warren Davidson (R-Ohio) commented on the pace of rulemaking, short comment periods, unworkable and unlawful environment, social, and governance (ESG) disclosure mandates on the market, unworkable proposals for overhauling equity market structure, a de-facto ban on crypto through SAB121, high staff turnover, and unhappy companies leaving our country. He then said he would introduce legislation to replace the SEC Chairmanship with an Executive Director position reporting to the Board, where all authority would reside.

Rep. Brittany Pettersen (D-Colo.) asked how Gensler could reassure the public that new rulemaking changes to the markets will not significantly impact their retirement savings accounts or children’s college funds. Gensler said the changes are about lowering the cost of markets in the middle.

Rep. Mike Lawler (R-N.Y.) discussed short comment periods and cited Gensler as saying he did not trust industry participants to provide honest feedback.

Rep. Ralph Norman (R-S.C.) also criticized the Commission’s cost benefit analysis and short comment periods.

Equity Market Structure

Wagner highlighted how the SEC’s equity market structure proposals completely upend equity markets and remake them from top to bottom. She added there is a strong possibility that the proposals could make those markets more costly, less efficient, and overall worse for retail investors. Wagner added that the SEC has made repeated admissions that it is uncertain of the impacts of the proposal and that it is unable to quantify or estimate the economic impacts of the proposals. She also said this uncertainty means that these proposals will likely make markets worse for retail investors. Wagner urged Gensler and the SEC to reconsider the proposals before putting millions of Americans’ hard-earned savings at risk. Wagner also asked if Gensler was aware that there is a process under existing rules to amend or change FINRA’s rules, including its current Best Execution (Best Ex) rule, and if he believed FINRA could adequately maintain and enforce its Best Ex rule. Gensler said yes and that Best Ex is an important rule to have at the Commission level. Wagner said an SEC Best Ex rule would be duplicative, onerous, and costly for firms.

Foster expressed concern for the overload on both SEC staff and industry participants, citing the SEC’s economic analysis with multiple rulemakings coming in at once, and trying to understand how they interact with each other. Foster said Rule 605 needs to be updated but expressed concern over a new complicated reporting requirement for all market participants. He added that there is one entity that has all the necessary data, the CAT, and said that running some standard, agreed upon version of the software would get that information in a clearer form. Foster asked about the technical implementation of measures of execution order quality. Gensler discussed the merits of updating Rule 605 to improve information quality and said the order routing proposal was meant to provide greater order competition. Foster said it’s not blindingly obvious that investors would get better pricing and that the current system already allows retail investors to ask market participants for the best price based on their lack of sophistication. Gensler said the average investor is pretty smart, but is only trading small amounts of stock, and that the challenge is to get competition for these small orders. Foster said the proposal might take away the ability to monetize the “sweetness” of small orders. Gensler said it is still only a proposal, and that comments still need to be considered. He noted that the proposal intends to provide greater competition by allowing the options of routing orders to a lit exchange, getting a mid-market half spread, and if not on a lit market, putting the order out for competition. Foster followed up by suggesting that the proposals changes be made through a pilot program before being exposed to the whole market.

Rep. Ritchie Torres (D-N.Y.) offered observations on the SEC’s private funds and equity market structure proposals, explaining that if a broker sends an order to an exchange, they would be in compliance with the rule, but not if they send to an off-exchange wholesaler, even if the wholesaler is offering a better price than the exchange.

Rep. William Timmons (R-S.C.) asked whether the SEC’s auction rule would allow legal front running with prices moving against retail investors. Gensler said it could instead benefit investors and that the SEC is building on and learning from similar systems in the options market. Timmons said it is shocking the SEC would issue its auction’s proposal, that the SEC should not move forward without a proper impact analysis, and that there is evidence that the SEC rushed this proposal without considering the real-world impact on the investing public.

Rep. Erin Houchin (R-Ind.) asked why the SEC did not collaborate with industry participants on the SEC’s equity market structure proposals, highlighting alarming public comment letters, and called the proposals untested experiments. Gensler said the SEC met with a lot of people in the markets before the proposals were made and that the goal is to drive greater efficiency and lower costs.

Open End Fund Liquidity

Wagner said the Liquidity Risk Management (LRM) rule would require funds to assume a worst-case scenario of a 10% sell off on the fund when classifying the liquidity of assets, and that asset managers informed her that a 10% run would be a magnitude higher than any that they have seen in a recent history. She asked what historical data the SEC used to justify the 10% and if it appropriate for the SEC to require funds to operate in a scenario that is five times worse than the historical standard. Gensler said this was just to define highly and middle liquid, and that the Commission laid out its data in its proposal.

Rep. Steven Horsford (D-Nev.) said a hard close component of the SEC’s open end fund liquidity proposal would require investors using intermediaries to submit orders hours before closing, causing them to miss out on today’s price, leading to a bifurcated market benefiting sophisticated investors over retail investors. Gensler said the SEC is trying to ensure funds are less reliant on extraordinary measures by our central bank and reduce systemic risk.

Rep. Dan Meuser (R-Penn.) said the open-end fund liquidity rule is a solution in search of a problem and asked if the SEC has discussed the proposal with the Department of Labor (DOL). Gensler said the SEC has not.

Rep. Zach Nunn (R-Iowa) asked why the SEC is picking winners and losers through its open-end fund liquidity proposal. Gensler said the SEC is trying to lower fund risk. Nunn discussed the limited use of swing pricing and asked why the SEC would mandate it. Gensler cited systemic risk issues.

Security Based Swaps

Lucas said there is a consensus among market participants that the SEC’s security-based swaps proposal to publicly disseminate large security-based swap positions would deeply harm liquidity, particularly in the credit market, and that a comparable regime at CFTC aggregates the applicable information anonymously, unlike under the SEC’s proposal. Lucas asked if the SEC would amend its proposal to address feedback from a bipartisan letter pointing out the risk of putting sensitive swap reporting information out on the market. Gensler said the SEC is taking the letter’s recommendations into consideration and that Congress intended for some information to be in the public domain.

Rep. Andrew Garbarino (R-N.Y.) asked about the SEC’s short sale and security-based swaps proposals and their economic analysis. Gensler said each proposal addresses separate information and that the swaps proposal authority was given separate from that of the short sale proposal.

Consolidated Audit Trail (CAT)

Reps. French Hill (R-Ark.) and Barry Loudermilk (R-Ga.) asked about the Consolidated Audit Trail, and Gensler said the SEC is still working on parts related to funding and data security filings, that CAT data is already being collected, and that encryption is part of data security. Gensler also said the CAT is important for surveilling the market and protecting against fraud, manipulation, and insider trading.

Staff Accounting Bulletin 121 (SAB 121)

Rep. Andy Barr (R-Ky.) explained that SAB121 is a shift in historical practice as custody assets have always been treated as off balance sheet. He was concerned that because banks cannot offer digital asset custody services at scale without significant balance sheet implications, they will simply not offer those services. He added this would lead to market participants not having bank-grade solutions to pick from, driving them to seek those services off-shore, like in the Bahamas. He concluded that this would diminish American competitiveness and compromise investor protection. Barr asked Gensler’s thoughts on the irony of pursuing SAB121, effectively precluding banks from offering customers the safety and security of segregated digital asset custody services, while no SEC employees noticed that FTX was allowed to comingle customer funds, trade, and settle assets without institutional grade custody. Gensler said he is proud of the staff who put out SAB121 because it says public companies, not just banks, need to put on their balance sheets that they custody crypto, and that in bankruptcy, investors often must stand in line. Barr asked if Gensler or his staff consulted with prudential regulators on SAB121 before or after issuance, given the ramifications that this effectively prevents banks from providing digital asset custody services.  Gensler said there was significant dialogue with Big 4 accounting firms.

Davidson said that qualified custodian banks would effectively be unable to provide crypto asset related custody because of punitive capital impact under the accounting provisions of SAB121 and asked if the bulletin should be amended. Gensler said the staff appropriately saw that crypto asset custody today should be appropriately put on public company financials.

Rep. Mike Flood (R-Neb.) asked whether Gensler consulted banking regulators before releasing SAB121 and how they responded. Gensler said putting crypto assets off balance sheet is bad for the financial system, that the SEC chief accountant was consulted, and that other regulators have their own authorities.

Private Funds

Barr asked what evidence the SEC is relying on when saying there is a need for greater competition in the private funds market. Gensler said limited partners mentioned they needed greater transparency about fees, performance, and side letters, including those in which private fund managers are cutting separate deals. He added that if private funds are registered, the SEC could look at their records, and that without registration, the SEC’s only tools are investigative.

Torres said that retirement systems are heavily invested in private funds, which have provided high returns, and that the SEC may be trying to fix something that is not broken. Gensler said there is not a level playing field with dark markets, which have different rules of the road that the Commission is trying to harmonize.

E-Delivery

Rep. Wiley Nickel (D-N.C.) Nickel expressed concern that the SEC’s equity market structure proposals could have unforeseen impacts on working families and expressed appreciation for proposals to update Rule 605. He then said academic studies show that two of the proposals would increase costs for everyday investors and that without the wholesale system, retail investors could lose one billion dollars in trading costs. He also expressed concern that commission-free trading would go away and asked if Gensler considered savers and how the proposals would increase costs for them. Gensler said zero commission trading does not mean zero cost, explained the proposals, and said the purpose is to make the markets more transparent and competitive for investors. Nickel emphasized the importance of engaging with stakeholders in this process.

Treasury Markets

Hill asked about Treasury purchasers being classified as dealers. Gensler said the applicable law is focused on parties that are facilitating buying and selling treasuries and making markets in treasuries to get them registered, whether they be high frequency traders or others who are active in the market.

Debt Limit

Reps. Emanuel Cleaver (D-Mo.) and Al Green (D-Texas) asked if the mere suggestion that the U.S. might default on its debt might create an economic problem. Gensler said the threat creates a dose of market uncertainty, which becomes more problematic as the debt ceiling x date approaches, undermining the base of our capital markets. He also said that closer to the x date, we will see fraying, less liquidity in the Treasury markets, higher costs to taxpayers, and a mess in capital markets, including equity and fixed income, and ripples into the banking system.

Regulation Best Interest

Wagner asked if Gensler still intends to not rewrite Regulation Best Interest (Reg BI), and Gensler said he does not and intends to vigorously enforce Reg BI.

Cybersecurity

Garbarino discussed the SEC’s cybersecurity proposals, said we must ensure that we are not driving talent out of the cybersecurity pipeline due to duplicative proposals, and asked how the SEC can harmonize its proposals. Gensler said the SEC has discussed cyber resiliency with the Cybersecurity and Infrastructure Security Agency (CISA). Garbarino asked if the SEC has analyzed how the two proposals would impact recently proposed rules from this year. Gensler noted the Commission reopened its investment advisor rule due to similar public comments.

Digital Assets

Reps. Tom Emmer (R-Minn.), Stephen Lynch (D-Mass.), Sherman, McHenry, Waters, Gottheimer and Foster questioned Gensler on digital assets. Gensler said all securities are commodities under the Commodity Exchange Act, noting a security can’t also be an excluded commodity, and added that “security” has more than 30 terms, one of which is an investment contract. He said the Supreme Court has addressed this multiple times and explained that if the public is putting their hard-earned funds with entrepreneurs and anticipating profit, that counts as a security. Gensler said the SEC has the authorities and laws that it needs to oversee crypto, noted the Commission could use more resources, and said the industry has chosen to be non-compliant, which undermines capital markets.

FTX

Reps. Bill Posey (R-Fla.) and Torres asked about FTX. Gensler said he has had a general concern about the crypto field’s non-compliance and comingling. Posey asked if Gensler directed his staff to look into FTX. Gensler said he directed his staff to look into a wide range of crypto intermediaries.

Climate-Risk Disclosure

Reps. Bill Huizenga (R-Mich.), Joyce Beatty (D-Ohio), Sean Casten (D-Ill.), Ayanna Pressley (D-Mass.), Rep. Roger Williams (R-Texas), and Rep. Alex Mooney (R-W.V.) asked or commented on climate risk disclosure. Gensler said the SEC put out an analysis in their proposal last year and noted the SEC is not a climate regulator and that the SEC’s proposal only applies to public companies and does not place any obligations on non-public companies, like small businesses. Gensler also said thousands of investors have told the SEC that clear disclosures would be beneficial and that investors have said they want better consistency, including estimates about the supply chain.

Mortgage Market

Reps. Scott Fitzgerald (R-Wisc.), Young Kim (R-Calif.), and Luetkemeyer asked about the mortgage market. Gensler said the SEC released a proposal that said if someone is doing asset securitizations, they cannot effectively trade against their investor clients.

Executive Compensation

Rep. Nydia Velazquez (D-N.Y.) asked about executive compensation. Gensler said the SEC completed two mandates from Congress in this area, one of which stated that executive compensation needs to be clawed back if it is built upon erroneous financials. He also noted the agency also took up a mandate regarding how insiders sell their stock.

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