Critical Year Ahead for Trading Rules

Next year could end up largely determining how derivatives trade across borders. As the European Union (EU) puts the finishing touches to its revised Markets in Financial Instruments Directive (MIFID II) ahead of implementation on January 3, 2018, the need for regulators to consider whether the rules align with those in the US will become critical. Failure to find agreement could change the nature of the global derivatives market forever, transforming what was a single pool of liquidity into smaller, shallower, more fragmented pools.

This issue was very much front and centre at ISDA’s first ever trade execution conference last week, and our speakers gave some fascinating perspectives. Our first keynote speaker, Edwin Schooling Latter at the Financial Conduct Authority, stressed the importance of mutual equivalency, and argued that derivatives markets would be more liquid if European firms subject to the trading obligation can trade at the same venues as US firms subject to the swap execution facility (SEF) rules.

Our second keynote, the Commodity Futures Trading Commission’s (CFTC) J. Christopher Giancarlo, also warned about the risks of market fragmentation, and pointed out that liquidity pools have already divided between those in which US persons are able to participate and those in which they are not – a fact picked up in successive ISDA research reports.

The cause of this fragmentation in liquidity, he said, is “ill-designed rules and burdensome regulations”, and he called on the CFTC to revisit its SEF requirements. To get an idea of what those changes might be, it’s well worth looking back at Commissioner Giancarlo’s January 2015 whitepaper on the CFTC’s swaps trading rules.

We agree that targeted changes to certain elements of the SEF rules could help promote more trading and make cross-border equivalence and substituted compliance determinations more achievable. For example, in a petition that ISDA filed with the CFTC last year, we argued that the CFTC’s SEF rules – particularly an obligation for ‘required transactions’ to trade on an order book or a request-for-quote system where requests are sent to three participants – is unnecessarily restrictive and at odds with language in the Dodd-Frank Act, which merely requires trading to take place “by any means of interstate commerce”. The end result is a regime that discourages and restricts trading on SEFs, rather than encouraging it.

Emergence of further detail in the MIFID II rule-making would also be helpful to the goal of cross-border convergence. In particular, ISDA would like to see a high level of granularity in the setting of the trading obligation. This would ensure that firms have a clear and defined product list, and would avoid confusion about whether a particular product is in scope. It would also have the advantage of aligning Europe more closely with the US.

Even with changes such as these, however, US and European rules are unlikely to ever be identical. It’s therefore crucial that equivalence and substituted compliance decisions are based on broad outcomes.

The good news is, speakers at our trade execution conference recognized this point. Regulators and market participants on both sides of the Atlantic spoke about the importance of equivalence – and the need to make the necessary determinations based on outcomes. There was a broad consensus that the US and EU regimes are largely the same in in terms of objectives, even if the detail of the rules differ. That mirrors analysis ISDA conducted on the two regimes earlier this year.

This is positive news to end 2016. The challenge for 2017 will be to follow that through. The ability for derivatives users to trade safely, efficiently and cost-effectively by accessing a global liquidity pool depends on it.

Cross-border Overreach

Those of you who have come to an ISDA conference, read our comment letters or, indeed, read this blog over the past several years know that cross-border harmonization matters a lot to us and our members. The derivatives markets are global, and end users have been able to benefit from tapping into a single, global liquidity pool when putting on their hedges. Split that single pool into multiple liquidity puddles, each distinct from the other, and end users face less choice, higher costs, and a lower chance of executing large-sized trades, particularly in stressed markets.

Unfortunately, the global liquidity pool for certain instruments has shown clear signs of fragmenting over the past two years, caused by variations in the timing and substance of the derivatives regulations implemented in each jurisdiction. But a recent proposal from the US Commodity Futures Trading Commission (CFTC) threatens to drive a wedge into that fracture and force it even wider.

The proposed rule, published in October, expands the CFTC’s extraterritorial reach way beyond what was outlined in previous 2013 cross-border guidance, which set out which rules should apply when counterparties trade across borders. To be more specific, the proposed rule requires non-US affiliates that aren’t guaranteed by a US parent but are consolidated on its balance sheet for accounting purposes – so-called foreign consolidated subsidiaries (FCSs) – to meet CFTC threshold registration and external business conduct requirements when trading with non-US entities. The proposal also requires those non-US counterparties to count their trades with FCSs for the purposes of CFTC registration.

This is a change from what went before – the CFTC’s cross-border guidance specifically stated that Dodd-Frank requirements would not apply if a non-US, non-guaranteed affiliate of a US person trades with a non-US entity. There were good reasons for this. The US parent is not obliged to cover any losses that may be incurred by the affiliate – the result of the absence of a guarantee – and the non-US affiliate and non-US entity would be subject to overseas regulation anyway.

Without fully explaining the rationale for the change, the CFTC has decided that US requirements should apply after all, at a stroke exposing a whole new universe of non-US trades to duplicative and potentially inconsistent requirements. Absent a substituted compliance decision, trades conducted between an FCS and a non-US entity would need to comply with both US obligations and the requirements of the host regulator simultaneously.

So far, the proposed extension of extraterritorial reach only applies to a couple of Dodd-Frank requirements, but the CFTC says it will consider how other requirements, including trading, clearing and reporting mandates, should apply to FCSs in future.

The implications are severe. Non-US corporate end users that are classed as FCSs will find it difficult to trade with dealers based in the host country, as potential overseas counterparties will look to avoid being subject to multiple sets of rules, as well as potentially breaching a notional threshold of trades with US persons that would require them to register with the CFTC as swap dealers. US dealers will find their non-guaranteed, non-US FCSs are unable to compete overseas, for the same reason. Liquidity will suffer as a result, leading to increased transaction costs.

We feel this goes beyond the CFTC’s statutory remit. Congress was very specific in stating that the Dodd-Frank regulation should only apply to activities that have a “direct and significant effect” on commerce of the US. We don’t think a trade between a non-US, non-guaranteed FCS and a non-US entity meets that criterion. At any rate, the non-US affiliate would be regulated by local foreign-country regulators, and either is or soon will be subject to similar regularly requirements to Dodd-Frank, as per commitments made by the Group of 20 in 2009.

In short, we think this proposal to expand the CFTC’s extraterritorial reach should be shelved. It will impose significant additional compliance costs on FCSs and non-US entities. It will put FCSs at a massive disadvantage in overseas markets. And it will further fragment liquidity.

The fact is, the rules are converging. In the trade execution space, Europe is finalizing its rules for implementation in January 2018, and Japan already has a trade execution mandate in place. Rather than extend the reach of its rules even further, now is the time for the CFTC to work with overseas regulators to prepare the ground for substituted compliance determinations. Once that’s achieved, the CFTC can be sure that those activities that genuinely have a significant and direct connection to the US are covered by similar requirements, whether in the US, Europe, Japan or elsewhere. Those activities that have a remote connection to the US should not be under CFTC jurisdiction in the first place.

Just a quick PS: we’ll be discussing cross-border issues later this week at our first trade execution conference in London. Hope you can join us.