This week marks the fifth anniversary of Dodd-Frank Act being signed into law by President Barack Obama. This incredibly ambitious, 848-page piece of legislation covered everything from derivatives clearing, reporting and trading, to bank resolution, consumer protection and financial market supervision.
Five years on, significant progress has been made in implementing the key elements of Dodd-Frank, particularly those covering reform of the derivatives market. Today, roughly three quarters of the interest rate derivatives average daily notional volume reported to US swap data repositories (SDRs) is cleared, according to data compiled by ISDA SwapsInfo.org. More than half of reported interest rate derivatives transactions are traded on a swap execution facility (SEF) each day. All swaps are now required to be reported to an SDR, providing more transparency in derivatives markets than ever before. US margin rules for non-cleared derivatives are close to finalization, and capital rules are being phased in.
All this was done in a very short time frame. Dodd-Frank was enacted less than a year after the Group-of-20 (G-20) nations agreed on a common set of objectives to overhaul derivatives markets. And the first detailed Dodd-Frank rule-makings from the Commodity Futures Trading Commission (CFTC) emerged shortly after that.
As a CFTC commissioner at the time, I remember all too well the work that went into developing these rules. The fact that so much was done so quickly speaks volumes about the dedication of the CFTC staff and the commitment of its former chairman, Gary Gensler. But I also remember that in the rush to complete the rules, there was an assumption there would be time to correct mistakes and review badly crafted rules.
I think the fifth anniversary of Dodd-Frank is a good opportunity to look at where problems exist and consider how best to resolve them, with the aim of making Dodd-Frank even more effective.
Cross-border harmonization is a prime example. In its 2009 communique, the G-20 leaders pledged to implement global standards consistently in a way that “ensures a level playing field and avoids fragmentation of markets, protectionism, and regulatory arbitrage”. That, unfortunately, hasn’t happened. The first-mover status of Dodd-Frank and lack of coordination with overseas regulators on the substance of the rules mean significant differences now exist in global rule sets. Rather than be subject to multiple, duplicative and potentially inconsistent rules, derivatives users are opting to trade with counterparties in their own jurisdictions where possible, leading to a fragmentation of liquidity.
This needs to be resolved so end users can continue to tap into global liquidity pools and avoid the higher costs that arise from a fragmentation of markets. Reconciling the rules on trading and clearing with those in other jurisdictions is a crucial step. US and European regulators have been engaged in long-running negotiations over whether US clearing house rules are equivalent to those in Europe, but discussions have stalled over technical differences in margin methodologies. A similar outcome may emerge for trading unless more is done to resolve differences in the trade execution rules. ISDA has contributed to this debate, and has proposed a set of targeted changes to US SEF rules that will encourage more trading on these venues and facilitate cross-border trading.
Cross-border issues also crop up in trade reporting. While regulators now have access to a huge amount of transaction data in their own jurisdictions, they are unable to gain a clear picture of global risk exposures and possible concentrations because of differences in reporting obligations within and across borders. Again, ISDA has proposed a series of specific fixes to improve regulatory transparency of derivatives reporting, which includes harmonization of regulatory requirements and the development and adoption of common reporting standards. A key recommendation is the repeal of the Dodd-Frank SDR indemnification requirement, which has restricted the ability of regulators to share data.
As well as greater harmonization in global rule sets, it’s important that equivalence or substituted compliance decisions are based on broad outcomes, rather than granular rule-by-rule comparisons. US regulators need to clearly articulate how substituted compliance decisions will be made in order to shed light on this process.
Other issues should also be reviewed. For example, Dodd-Frank made clear that commercial end users should be exempt from clearing requirements, but many firms opt to hedge through centralized treasury units (CTUs) in order to net and consolidate their hedging activities. Many of these CTUs classify as financial entities under Dodd-Frank, subjecting them to clearing requirements. While the CFTC has issued no-action relief, legislation clarifying that end users employing these efficient structures are exempt would provide greater certainty.
Consistency is also needed in margin requirements for non-cleared derivatives. Current proposals from US prudential regulators would subject transactions between affiliates of the same financial group to margin requirements, putting financial institutions that operate in the US at a competitive disadvantage internationally.
An objective review of these and other issues would make Dodd-Frank more effective, and would ensure end users can continue to hedge in a cost-effective and efficient way. A five-year anniversary is a good opportunity to reflect honestly on the successes and failures.
Listen to an audio webinar discussion on Dodd-Frank progress.
 ISDA SwapsInfo.org compiles data reported to the DTCC and Bloomberg SDRs