The Rustle About the Russell

The upcoming annual Russell reconstitution is undoubtedly a frequent topic of conversation and concern for smaller public banks. For these institutions and potentially many others, recent regulatory updates provide a viable alternative.

On an annual basis, a team at FTSE Russell evaluates the composition of their indices and rebalances the portfolio of the top 3,000 companies. This “annual reconstitution” can produce an unfortunate side effect: smaller companies on the lower end of an index’s minimum market capitalization threshold may find that they no longer qualify for inclusion when the threshold increases. These firms can experience a semi-annual whipsaw — sometimes they make the cut, other times they don’t.

When a company is removed from “The Russell,” index fund managers no longer hold shares in that company. In fact, a Russell Index mutual fund manager would be in violation of several rules from the Securities and Exchange Commission if they trade in a ticker that no longer included in an index that they market themselves as tracking.

In simplest terms, when a company is bounced from the Russell, it’s bounced from the $11 trillion pool of index-fund portfolios. For smaller companies that tend to be otherwise thinly traded, this can be a major problem. Many banks that were removed from the Russell at the last re-balance saw a decrease of 30% in their stock, virtually overnight.

The One-Two Punch
Russell indices have a long list of securities they exclude. It is probably easier for most people to think of the composition of Russell’s US-based indices as including only public securities that are “listed” on an exchange, like the New York Stock Exchange and Nasdaq.

Maintaining an exchange listing can be a major ongoing commitment of a firm’s time and money. U.S. exchange listing fees are based on a bank’s market capitalization and total shares outstanding; listing additional shares and corporate actions incur added costs for banks.

So what happens when a listed company gets bounced from the Russell? Share prices drop because index funds begin selling positions en masse, and liquidity dries up as index funds buyers disappear. But the firm remains listed on the exchange, footing the bill for the related ongoing compliance overhead or face a de-listing. In turn, the firm ends up incurring all of the costs and reaps none of the benefits. 

Where to go from here?
Some estimates suggest that the minimum qualification criteria for some of Russell’s most popular indices will increase the minimum market cap from $250 million to about $299 million. For banks, this generally means over $2 billion in assets. This is an unfortunate fate for listed banks that may find themselves in the crosshairs; for dozens of others, it may mean further postponing plans for an IPO.

But an alternative does exist that smaller banks can uniquely benefit from. Recent overhauling of SEC Rule 15c2-11 positions the OTCQX Market as a regulated public market solution for U.S. regional and community banks. The market provides a cost-effective alternative that leverages bank regulatory reporting standards and can save banks around $500,000 a year compared to listing on an exchange.

Many of the banks that trade on OTCQX are under $350 million in market cap and can choose to provide liquidity for their shareholders through a network of recognized broker-dealers and market makers.

One key takeaway for management teams is that unless an institution can qualify for inclusion in the Russell and grow rapidly enough to keep up with annual reconstitutions, it may be time for them to re-evaluate the value of trading on listed exchanges.

Banking Blockchain: Making Virtual Currencies a Reality for Your Bank


blockchain-10-17-17.pngBlockchain-based virtual currencies are gaining in popularity and evolving quickly. Blockchain currencies often are described as disruptive, but also have the potential to radically revolutionize the banking industry in a positive manner. The reality is that blockchain currencies may develop into a useful tool for banks. Their acceptance, however, is hindered by their own innovative nature as regulators attempt to keep pace with the technological developments. Potential blockchain currency users struggle to understand their utility. Despite these hurdles, many banks are embracing opportunities to further develop blockchain currencies to make them work for their customers.

What Are Virtual Currencies and Blockchain?
Virtual currencies, also referred to as “digital currencies,” are generally described as a digital, unregulated form of money accepted by a community of users. Currently, blockchain currencies are not centrally regulated in the United States. For example, the federal government’s Financial Crimes Enforcement Network (FinCEN) and the Securities and Exchange Commission view blockchain currencies as money, the Commodities Futures Trading Commission sees them as a commodity, and the Internal Revenue Service calls them property. The IRS has attempted to define virtual currency as:

a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value [and] does not have legal tender status in any jurisdiction.

FinCEN, the agency with the most developed guidance regarding virtual currency, regards it in a more practical fashion as a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency. Whatever the regulatory definition, virtual currencies need more certainty in form and function before their use becomes commonplace.

Blockchain technology brings benefits to payment systems and other transactions that are quite revolutionary. Blockchain technology is essentially a decentralized virtual ledger (aka, distributed ledger), utilizing a comprehensive set of algorithms that records virtual currencies chronologically and publicly.

Some examples of blockchain currencies currently in use are Bitcoin, Dash, Ether, Litecoin and Ripple. These currencies are constantly evolving and are being developed by individuals, technology-based peer groups or financial institutions. In August 2016, a consortium of banks, led by UBS, Deutsche Bank, Santander and BNY Mellon, announced the development of the “utility settlement coin” or USC. The USC is meant to allow banks to transact payments in real time without the use of an intermediary. It is expected to go live in 2018.

Blockchain Currency Opportunities for Banks
Despite their reputation for being tools of illicit trade, blockchain currencies may be useful to banks in a variety of ways and can achieve certain benefits. Blockchain currencies could:

  • actually reduce fraud, including hacking or theft attempts, because the technology makes every step of the blockchain transparent.
  • reduce costs and risks associated with know-your-customer (KYC) programs because blockchain has the ability to store KYC information.
  • allow a financial institution to establish a new trading platform for exchange that eliminates intermediaries.
  • potentially could transform the payments industry. An obvious example is the USC, which permits payments to be made in real time, without the use of intermediaries; and strengthens the confidence in the authenticity of the transaction. Banks that are either able to establish a blockchain currency or adapt a proven technology for their operations will generate operational efficiencies and obtain a significant competitive advantage.

What Are the Regulatory Challenges?
Blockchain currencies currently are not centrally regulated in the United States. As discussed above, the lack of a uniform definition is a fundamental issue. FinCEN has classified any person or entity involved in the transfer of blockchain currencies as a money transmitter under money services business regulations.

As blockchain currencies continue to evolve, however, additional federal laws and regulations must be drafted to address the most substantial areas of risk. Some states are weighing in on the topic as well. For example, the Illinois Department of Financial and Professional Regulation recently issued guidance on the use of virtual currency in which the Department views virtual currency through the lens of the Illinois’ Transmitters of Money Act.

Additionally, the Uniform Law Commission is developing regulations that would, among other things, create a statutory structure (for each state that adopts it) to regulate the use of virtual currency in consumer and business transactions. Regardless whether the federal government or the states enact legislation affecting blockchain currencies, a more uniform regulatory approach would greatly aid their development and utility.

Conclusion
Blockchain currencies, and the laws and regulations governing them, are in a promising state of development. As new technologies emerge and existing technologies continue to evolve, banks are presented with real opportunities for innovation by successfully adapting blockchain for use by their customers. Those that figure it out are poised for real success.