An interview with Dan Gallagher, former SEC Commissioner
As part of our Kurtosys Insights series, we caught up with Dan to get his views on the effects of the DOL’s Fiduciary ruling, a potential Trump presidency, the UK’s “Brexit” and Blockchain technology. Here’s what he had to say:
Can you help us explain how the DOL legislation will affect how asset managers distribute investment products?
It’s a really interesting question because so much of it is yet to be seen. The rules came out of the U.S. Department of Labor (DOL) this year, but won’t go into effect for quite a while.
Asset managers who create and distribute product are trying to understand the contours of the rule. However, the real crux of this is more about regulating the activity of brokers who provide advice in connection with retirement accounts than it is about getting at asset managers who create and distribute product.
It may result in new product creation, meant specifically for brokers servicing Individual Retirement Accounts to comply with the rules, but also give them the ability to offer a choice to their clients. I think the impact on brokers is going to be huge.
How will any breaches in these regulations be discovered?
The rule gets at the provision of advice with respect to retirement accounts that operate under Employee Retirement Income Security Act (ERISA) standards. Before the rule, even right now before it’s effective, that field is dominated by the brokerage industry.
The new rule assumes a weakness in the current oversight structure for brokers, which is governed by the so-called “suitability” or “best interest” standards. These standards are enforced by the Financial Industry Regulatory Authority (FINRA), the self-regulatory organisation that oversees brokers. FINRA and the brokers themselves are both overseen by the Securities and Exchange Commission (SEC).
Right now the current enforcement mechanism is that both FINRA examiners and the SEC examiners review brokerage firms on a regular basis. If they find potential violations, they’ll refer these violations to the respective enforcement divisions of each of those entities and they will bring public enforcement cases. That’s how you see it happen today.
So your question is a good one in the context of a Labor rule. How will those breaches be discovered? And truth be told, I don’t think they’re going to be discovered generally by the government. The DOL does not have a serious examination or enforcement mechanism to oversee activities subject to the rule. I think that’s why they created expanded civil liability in the rule so that, effectively, plaintiff lawyers can be the enforcement mechanism.
And that, potentially, is going to be an absolute disaster for the industry and for investors because it’s only going to take a few major plaintiff lawsuits before folks move in the direction of not offering certain services. And that hurts the end investor.
What sort of penalties are likely to be levied for any breaches?
You usually talk about penalties in the context of government enforcement actions.
The SEC, theoretically, and FINRA will have no authority to enforce the DOL rule and so the penalties that they normally would impose in this context are irrelevant. Government agencies don’t have the authority to enforce the laws that Congress hasn’t given them the authority to enforce.
I think DOL penalties will be the exception, not the norm. I think the norm will be all sorts of plaintiff’s lawsuits being brought against firms and individual brokers for alleged breaches of this rule.
Will these regulations force additional costs onto the consumers?
Undoubtedly this rule will drive up costs for consumers.
One thing that the folks in Washington never seem to understand is that costs usually get passed down to end-users, and in this case the end-users are investors.
Because it’s so complicated, complying with this rule will add a layer of costs that will be passed on directly to consumers. To the extent that firms who provide services covered by the DOL rule are sued by plaintiff’s lawyers, the cost of defending those law suits and any pay outs will eventually be passed through.
I think it’s without a doubt that consumers who continue to have retirement accounts serviced in accordance with these new rules will pay more.
I should point out the worst possible cost, and certainly an unintended consequence of this rule, is that many investors will just simply have their accounts shut down at the firms that they’re at today. Because firms are going to make the choice depending on asset level in the account, or just depending on whether they want to hold retirement assets at all, if they are going to service certain customers.
To me that’s the ultimate cost, especially for low- to middle-income folks who need the advice the most, who need to be putting money away for retirement from an early age. They’re the ones most likely to have their accounts terminated and I think that’s a travesty.
Will these regulations force consumers to self-manage, thereby potentially increasing their risks inadvertently?
Yes, I think so. It’s likely going to cause more to self-manage and unfortunately I think for a lot that means that they won’t save when they would have.
There will be a certain level of self-management. You’ve heard a lot of talk about whether the robo-advice industry can dominate this field. It sounds great to me and I’m all for optionality and investment choices and choices among investment service providers. However, I think robo-advisors, just like human beings, are going to be susceptible to the civil liability that I talked about before.
It doesn’t matter if the advice is provided by a computer or a human being, if you’re going to get sued, you’re going to get sued. And if robo-advice means that a firm’s margins are very thin, it’s not going to be worth it to the firm at a low margin rate if it is still subject to litigation.
I do think it’s going to change the provision of retirement services in a number of ways, none of which I think are for the better.
What impact do you think a Trump presidency will have on the US financial industry?
I do think that this is election is going to be a watershed moment for the financial services industry, because I think that the candidates present two very different paradigms for financial services oversight.
Based on the platform and statements made to date, I would expect that Clinton’s Administration, if it were to happen, would largely follow what’s been happening over the last seven and a half years in the Obama Administration. It would finish implementation of Dodd-Frank, much of which is still yet to be implemented, at least at the SEC. I think you’ll have, as you’ve seen out of the DOJ and elsewhere, continued, massive penalties against financial institutions, and potentially a continuation of anti-Wall Street sentiment.
Donald Trump has been vocal about the negative economic impact of over-regulation and bad regulation, and that is very encouraging. And he is making those comments at the same time that Chairman Hensarling has released his CHOICE Act for financial reform, which I believe is incredibly thoughtful and critically needed. In the end, given the enormity of the U.S. administrative state, a lot of this comes down to who these candidates will pick to run the agencies and what their views are and how effective they will be.
You have a potentially very stark difference in how the agencies will be run, because you’re going to have such different potential candidates running the agencies – the SEC chairman, Commodity Futures Trading Commission (CFTC) chairman, Department of Treasury Secretary and other senior positions in Treasury, the Federal Reserve governors and it goes on and on.
So I think you’re just going to have very, very distinctly different potential outcomes for financial services regulation depending on which way it goes.
Many in the Asset Management industry believe that the bond market’s highly likely to be the epicentre of the next financial crisis. Is the SEC doing anything to get ahead of potential bond market problems?
This is a topic that I spoke about frequently when I was an SEC commissioner. There’s been a lot of infatuation at the SEC, in particular since the publication of Flash Boys, the Michael Lewis book, about high frequency trading. There’s been a lot of fascination about the equities market generally. Meanwhile, in a zero percent, or close to zero percent, interest rate environment, we’ve had record issuances of debt over the last 7-8 years, both municipal and corporate debt – both of which the SEC has oversight responsibility for.
Every year since the financial crisis, over a trillion dollars has been issued in debt and there is close to, depending on how you count, twelve trillion dollars outstanding in the debt markets as we sit here. That’s all happening while we have Basel standards going in place, the Volcker Rule, changes in risk management practices at the big dealers and all that has resulted in a lack of liquidity at the dealers, the traditional liquidity providers.
I do think that the asset management industry is right to worry because you see a lot of the flows, a lot of the debt is being purchased by asset managers. We’ve seen the fixed income funds growing hugely, that’s a buy-side transaction on behalf of the asset managers. But in the event they need to sell, they’re worried about where’s that liquidity going to come from, who’s going to buy? And I think that’s still a very unclear question: who’s going to be on the other end?
I’m hoping that we’ll see a new class of market participants arise, maybe smaller brokers, maybe hedge funds who will fill the void that’s been created due to the lack of liquidity on the balance sheets of the big dealers. I don’t think we’re quite there yet though and I do think that the liquidity mismatch does pose potentially significant risk. Hopefully it will never rise to a systemic risk but it certainly does have the potential to.
When I was a commissioner I spoke a lot about the fact that the SEC wasn’t paying enough attention to the issue. I often joked that if we were going to prioritize our agenda with Michael Lewis books, we should probably go back to his 1989 book about the fixed income markets, Liars Poker. They’re largely the same today as they were back then- except for a little bit of post-trade transparency that came along. It’s pretty much the same market today that it was back then.
I do think that it is a clear present danger that needs to be addressed, but I don’t think that it needs to be addressed by prescriptive regulation. I think that the asset managers, the dealers and the smaller firms all need to get together and come up with private sector solutions to this problem.
How big of an impact do you think that the UK’s “Brexit” will have on US funds over time?
You know, like the presidential election here, because it’s not in effect yet, there is so much that’s yet to be seen. I’m an optimist when it comes to freedom and I’d like to think that Brexit will do nothing except provide opportunity for the US financial services industry.
I know that for some of the big Wall Street firms that have major operations in London there will be a time of pain and I take that very seriously. But I think that over the years it will provide opportunity because London has always been such a great financial partner to the US – especially in dealing with the European continent and the continental regulators. I think that it will provide a lot of opportunity for the US and London to team up in financial services, hopefully for the betterment of both.
So I’m optimistic about it.
What’s your opinion on the rise of robo-advisors?
I think that optionality is a very good thing and if the rise of robo-advice means that investors have one more choice, not just for the best product but also for the service provider behind it – all the better.
I don’t see it though, as some folks do, as this panacea of “we don’t need to worry about about brokers or advisors anymore because we have algorithms.” I think there’s a lot of folly in that. I do think they can be a useful tool, maybe they can be used in coordination with human-based advice. But I don’t expect it to be the rise of the machines that will take over the industry.
I think it’s a positive development but not one that is going to be as transformative as folks think.
What are your views on blockchain technology in the funds industry?
I haven’t thought about blockchain in the context of funds, but I think blockchain generally is very exciting.
The potential for absolutely revolutionizing the clearance and settlement process and the back office processes, that are so critical to the US financial services industry, is just huge.
If you think through the process today by which the fund industry sells and manages mutual fund shares, there’s no doubt that blockchain could up-end a lot of archaic infrastructure that is in place today.
I do really think that blockchain can and should change the industry all for the better.
I think it can result in better risk management, cheaper transaction costs, and higher efficiency. That should be good for regulators, investors and the financial services industry itself. Hopefully I’m right and hopefully it’s a win-win-win across the board.
Where do you see the asset management industry in 5 years? Is it changing much? How so?
I think that in five years it will be interesting to look back and see if this shift towards passively managed funds, ETFs in particular and index funds, continues – which it looks like right now it will it – or whether, like any other cycle, things will revert a little bit and move back into more active asset management.
I’m guessing right now, especially with things like the DOL rule and other regulatory restrictions, that the inability of firms to charge fees like they have over the last several decades, will lead to a continued move into passively managed index funds, and ETFs in particular. It’s going to be fascinating to watch, because obviously today actively managed registered mutual fund shares are not traded on exchange. I actually think that this continued push into ETFs will change the secondary markets of the US and the practices and the business model of exchanges – because they’re going to see a rise in trading activity. This will continue the shift out of the actively managed asset management side and into the passively managed ETF space.
So when you talk about the trillions of dollars involved it’s a pretty massive evolution here, because even on a small percentage of the shift in assets from active to passive it’s still trillions of dollars.
I think that the industry is going to be fine and healthy and continue grow. I think that there will be some new regulation that the SEC has proposed over the last year or so, but hopefully that will not impair or impede the ability of the industry to grow and thrive and provide safe retirements and college savings and other types of savings products for American investors – because they need it.
Daniel M. Gallagher, Jr. served as a Commissioner of the Securities and Exchange Commission from 2011 until 2015. There, he focused on initiatives aimed at strengthening our capital markets and encouraging small business capital formation, including staunchly supporting the changes introduced by the JOBS Act. He also has been instrumental in educating the markets and investors about the shortcomings of the Dodd-Frank Act and the encroachment of bank regulatory measures and prudential regulators into the capital markets.
In the private sector, Commissioner Gallagher advised clients on broker-dealer regulatory issues and represented clients in SEC and SRO enforcement proceedings as a partner with the Washington, D.C. law firm WilmerHale, where he earlier began his career in private practice. Commissioner Gallagher also served as the General Counsel and Senior Vice President of Fiserv Securities, Inc., where he was responsible for managing all of the firm’s legal and regulatory matters. Commissioner Gallagher earned his JD degree, magna cum laude, from the Catholic University of America, where he was a member of the law review. He graduated from Georgetown University with a BA degree in English.
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