Progress, of a sort

Eight months on from the much-heralded “path forward” agreement that set a roadmap for how US and European regulators would deal with cross-border regulatory issues, the fruits of the new cooperative approach have started to emerge. In February, the Commodity Futures Trading Commission (CFTC) issued conditional no-action relief allowing US entities to continue trading on European multilateral trading facilities that haven’t registered as swap execution facilities, so long as those platforms meet requirements that are identical to those applied in the US.

It may not have been exactly what some European venues were hoping for, but this represented notable progress. At one point last November, following two clarifications by the CFTC that seemed to extend US rules further than ever before, it looked like the path forward would become a road less traveled.

There’s still a huge number of cross-border issues that need to be tackled – among the most urgent, Europe’s equivalence determinations for US central counterparties (CCPs). Under the European Market Infrastructure Regulation (EMIR), European banks would not be allowed to act as clearing members of any CCP in a non-equivalent jurisdiction, while Europe’s Capital Requirements Regulation prevents them from applying the lowest possible 2% risk-weight for cleared exposures at those venues. Together, these rules could have a devastating impact on the business of any non-equivalent clearing houses.

A comparison between US and European clearing rules throws up a number of seemingly intractable inconsistencies – for instance, a one-day margin period for futures contracts under US rules less onerous than the two days required under EMIR. Nonetheless, some have speculated that the new-found spirit of cooperation between US and European regulators may allow a compromise to be reached.

That doesn’t answer what happens elsewhere, though. Trades conducted between US and European entities account for a large portion of the cross-border universe, but there are plenty of transactions involving counterparties from other jurisdictions too – Australia, Hong Kong, Japan, to name but three. Some regulators have set out broad parameters for equivalence or substitutability determinations, but these are imprecise and lacking in detail.

Generally, regulators agree that foreign rules should be deemed equivalent if they pursue the same outcome. But beyond a pretty clear global consensus on central clearing and reporting – both key Group of 20 (G-20) objectives and initiatives supported by ISDA and the derivatives market – the desired outcomes differ from jurisdiction to jurisdiction. Dodd-Frank, for instance, covers everything from trading, clearing, reporting and business conduct rules to broader bankruptcy and resolution proceedings. EMIR covers clearing and reporting, with trade execution covered by the revised Markets in Financial Instruments Directive, but many other countries with smaller derivatives markets have opted to tackle clearing and reporting only.

The risk is that some national regulators will approach each outcomes-based equivalence determination as a broad, like-for-like comparison of their own regulatory and legislative framework. That tactic would likely doom any equivalence process to failure. Rather, regulators need to focus on whether the core objectives set by the G-20 are being met, taking foreign legal regimes and local market practices into account.

The trouble is getting to this point, as well as having a mechanism in place to deal with any disputes. The International Organization of Securities Commissions has suggested it may be able to play a role here, drawing up a set of principles – perhaps similar to those published by ISDA last year – and intermediating in equivalence determinations. This could involve peer reviews, colleges of supervisors and regulatory visits, comparable to what the Basel Committee on Banking Supervision has in place for Basel III. It seems like a good idea, and could do much to resolve potential problems and ensure the global derivatives market continues to be just that: global.

Market fragmentation is becoming a reality

fragmentation

The global nature of the derivatives market has long enabled users to manage their risk efficiently. This is something ISDA has championed throughout its history, and it’s been our single biggest concern over the past few years. Thankfully, the Group of 20 (G-20) nations shared this concern when setting their roadmap for derivatives reform in September 2009.

Nonetheless, derivatives users have been warning for some months now that the rollout of the US swap execution facility (SEF) regime, and the extraterritorial reach of those rules, would lead to market fragmentation, with separate pools of liquidity emerging for US and non-US persons. Evidence is now emerging that this is indeed the case.

Research published by ISDA clearly shows that European dealers have been opting to trade euro-denominated interest rate swaps with other European counterparties since the start of the SEF regime on October 2, 2013. Based on the volume of trades cleared at LCH.Clearnet, approximately 90% of European interdealer activity in euro interest rate swaps is now being traded with other European firms, up from roughly 75% before October. That tallies with an earlier survey published by ISDA in December, which found 68% of respondents had reduced or ceased trading activity with US persons since the SEF rules came into effect, while 60% had noticed a fragmentation of liquidity.

So, why are these rules affecting the trading habits of European dealers? It can all be traced back to the last-minute inclusion of footnote 88 within the final SEF rules, agreed by the Commodity Futures Trading Commission (CFTC) last May. That footnote essentially required all multiple-to-multiple trading platforms to register as SEFs, even if the products they offer aren’t subject to a trade execution mandate – an inclusion that sent a number of venues scrambling to submit their applications before the October 2 deadline. Combined with that was uncertainty about final interpretive guidance on the cross-border application of Dodd-Frank, published in the Federal Register on July 26. While the treatment of SEFs wasn’t explicitly covered, a number of non-US electronic trading platforms interpreted the guidance to mean they would need to register with the CFTC if any US person – including foreign branches of US banks – traded directly or indirectly on their venue.

Given the complex registration process, and the need for SEF customers to sign lengthy end-user agreements, a number of non-US platforms decided it was simply easier to ask US participants to stop trading on their platforms, or to split their businesses between US and non-US liquidity pools. The latest ISDA research shows this has become a reality.

Less clear is how this has affected over-the-counter derivatives markets. A fragmentation of liquidity could lead to less efficient pricing in certain markets, as well as greater volatility – something the G-20 stated it wanted to avoid in September 2009. According to the December ISDA survey, 46% of respondents said the fragmentation had led to different prices for similar types of transactions, but this trend may become more pronounced over the next month. While trading platforms have had to register as SEFs since October, US derivatives users haven’t been obliged to use them – they could continue to trade by phone or via single-dealer platforms. That will change on February 15, when the first trade execution mandates come into force. From that point, US participants will be required to trade those interest rate derivatives subject to made-available-to-trade determinations on registered SEFs or designated contract markets. Non-US entities won’t – and will probably continue not to want to.

Global regulators have talked a lot about the need for cooperation to ensure a consistent application of the new regulatory framework, and to avoid fragmentation and less efficient markets. This latest evidence suggests fragmentation is happening, and that can’t be a good thing.

New Slang

Cross border guidance, extraterritoriality, and third country issues. Mutual recognition and substituted compliance.

In the OTC derivatives world, these terms have replaced old favorites like day count fractions, credit events and calculation periods as topics for discussion and debate.

Comments flooded into the CFTC from industry and regulator alike on the long-awaited CFTC guidance on the cross border application of its rules (as the Commission refers to them) or to third country issues related to extraterroriality (as Europe refers to them).   Regulators are struggling over the mutual recognition of another country’s regulatory regime, or a system of substituted compliance, where one country’s rules can take the place of another’s in order to achieve compliance.

All this back-and-forth is driven by the 2012 year-end deadline to comply with the G20 commitment on clearing, execution, reporting and capital for OTC derivatives. Where do the US and Europe stand in achieving those goals? What are the differences between approaches? And how significant are those differences?

To assist our membership in understanding both the similarities and the differences, we have worked with the Clifford Chance law firm to produce a comparison of rulemaking on critical issues in both the United States and Europe. This is version 2.0, as we produced an earlier version almost two years ago. And with the regulations still evolving, don’t be surprised if there is a version 3.0.

What the comparison shows is that there is significant commonality in the approaches to issues in the United States and Europe.

But there are also some important differences. Treatment of end-users, the notion of major swap participant in the United States and the so-called “push out” rule are among those differences.

There are also differences in the timing of certain rules, driven largely by the fact that trade execution and pre- and post-trade transparency in Europe are part of the revisions to the Markets in Financial Instruments Directive (MiFiD), which is still working its way through the European process. We are not likely to have clarity on those issues until late this year or some time into 2013.

The comparison has a helpful summary chart indicating which rules (clearing, reporting, margin, capital, registration) apply to which entities (dealers, other financial counterparties, non-financial counterparties). From there, a reader can drill down to all the details.

As with any language, there are several levels of comprehension. One can learn the words, then the grammar, but true understanding comes when you know the subtle nuances of a native speaker. Think of the comparison we have produced with Clifford Chance as your Rosetta Stone for being able to be bilingual in the new world of derivativese.