The Dodd-Frank Wall Street Reform and Consumer Protection Act includes provisions that could extend its reach extraterritorially to Asia, Europe, and beyond. Participants in the over-the-counter (OTC) derivatives market in these regions are assessing the potential cross-border compliance obligations. Two key areas of focus are the US Commodity Futures Trading Commission (CFTC) rules relating to the definitions of “swap dealer,” “major swap participant,” and “US person,” and the requirement to register as a commodity pool operator (CPO) or commodity trading advisor (CTA), unless one of the exemption provisions is applicable.
The many cross-border compliance obligations are not trivial. Apart from new rules on moving trades to regulated exchanges or electronic trading platforms, the use of central counterparty clearing, and timely disclosure of trade data to a centralized depository, such obligations presumably include various new rules and regulations relating to capital, trading, clearing, margining, collateral, netting, accounting, reporting, and taxes. As my colleague Beth Kaiser, CFA, CIPM, director of capital markets policy for CFA Institute, recently asked in a blog post: Is the CFTC’s Cross-Border Swaps Proposal Over-Reaching, Inviting Regulatory Arbitrage, or Just Right?
For a while, the lobby for restricting Dodd-Frank’s extraterritorial reach was quite vocal and gaining momentum. JPMorgan’s multibillion trading losses at its chief investment office earlier this year (i.e., the London Whale incident) shed a lot of light on this issue and may have contributed to shifting the political will to implement tight grips on extraterritorial OTC derivatives activities that could have systemic impact on the US financial system. In addition, there is growing recognition that a global approach is important in order for OTC derivative regulation to be effective.
While the CFTC has jurisdiction over “swaps” — broadly understood to include derivatives based on currencies, interest rates, fixed-income instruments, commodities, and broad-based securities and CDS indexes — the US Securities and Exchange Commission (SEC) regulates “security-based swaps,” which include CDSs and other derivatives based on a single security or loan, or a narrow-based security index. In this way, unlike its European counterparts, the US regulatory regime is bilateral.
The Global Will to Reform the OTC Derivative Market
In 2009, the G20 nations came to an agreement at the Pittsburgh Summit, and the leaders’ statement included the following: “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.” A new global Legal Entity Identifier (LEI) system, recommended by the Financial Stability Board (FSB) and endorsed by the G20, is also in the process of being implemented, effectively enabling regulatory authorities to uniquely identify market participants and readily trace and review in aggregate all of their financial transactions. (Read “Global LEI System: Fingerprint for Firms Managing OTC Derivatives” for more commentary.)
The importance of having a global framework of regulatory cooperation has been a much discussed issue. A recent Notre Dame Law Review article, “Regulating the Invisible: The Case of Over-the-Counter Derivatives,” investigated how a system of public-private partnership could be used to coordinate regulation of OTC derivatives internationally. The FSB progress reports on OTC derivatives market reforms highlight the global efforts twice a year. Appendix IX of the October 2012 report includes summary tables on the progress of various countries.
The United States as First Mover in the Reform Movement
The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010. The law and the ancillary regulations needed to implement it, as well as related initiatives in other countries, have been more than two years in the making, giving rise to some 400 different rules in more than 9,000 pages, resulting from more than 85 different studies by regulators in various jurisdictions. Yet, most regulatory authorities have completed only a fraction of the preparatory work for implementation — the CFTC, for example, is said to have merely completed about one-third of what is necessary to date. The CFTC has identified 32 areas for rule-making and has been actively making public consultations. As of early November 2012, the CFTC has finalized 41 final rules and 8 final orders.
It is interesting to note that regulators and industry participants in the United States have been wary of the systemic risk of OTC derivatives since the 1990s. SEC Commissioner J. Carter Beese, Jr., provided guidance and encouragement on a research project with results documented in a commentary piece, “OTC Derivatives and Systemic Risk: Innovative Finance or the Dance into the Abyss?,” published in the American University Law Review. In 1999 E. Gerald Corrigan, a former president of the New York Fed, became chairman of the Counterparty Risk Management Policy Group (CRMPG), a financial industry policy group for promoting enhanced practices in counterparty credit risk and market risk management. The CRMPG published “Containing Systemic Risk: The Road to Reform” in August 2008, just prior to the Lehman incident.
Local Regulatory OTC Derivatives Reform in Asia-Pacific and Europe
Many countries in the Asia-Pacific region and Europe are also in the process of putting through regulatory reform locally. While less than 10% of the US$440 trillion in global OTC derivatives notional value outstanding is attributed to the Asia-Pacific, several countries have been active in taking up the reform challenge. In Australia, there were several public consultations, and a draft bill was issued by the Treasury in July. In Japan, the Cabinet Ordinance on Regulation of OTC Transactions of Derivatives was issued in July; reforms have been focused on central clearing, trade reporting, and electronic trading. In Hong Kong and Singapore, public consultations have been rather extensive, and the reform agenda is relatively ambitious and comprehensive, covering trade reporting, clearing, and trade matching. (CFA Institute has submitted comments to the Hong Kong consultation and the Singapore consultation.) The reform efforts in China, India, and Korea have been more limited, focusing mainly on central clearing.
Reference materials on the EU’s official website provide a convenient summary update. The European Securities Markets Association (ESMA), “an independent EU Authority that contributes to safeguarding the stability of the European Union’s financial system by ensuring the integrity, transparency, efficiency and orderly functioning of securities markets, as well as enhancing investor protection,” was formed to play a major role in the reform. CFA Institute submitted a comment letter to Europe’s OTC derivatives reform consultation. In September ESMA published the technical standards for European Market Infrastructures Regulation (EMIR), which is scheduled to be approved by year-end.
Wait and See, or Get Ready?
While some market participants have opted to take a wait-and-see attitude and have done little preparatory work, others have started due diligence early and appear eager to get ready and adjust their business operations and infrastructure to accommodate the dawn of the “new ecosystem.” This regulatory tsunami could significantly affect hedge funds, broker-dealers, banks, corporate treasuries, insurance companies, pension funds, sovereign wealth funds, exchange reserve funds, and other entities that participate in the OTC derivatives market.
Once the assessment is complete, the next step would likely involve sorting out the impact of the pertinent regulatory requirements on several key areas, where necessary, such as:
- Trading and clearing
- Collateral and margin
- Accounting and reporting
- Compliance and taxes
According to a recent document released by the CFTC, the effective date for these changes will be in December 2012. Two trends appear likely to continue: The regulatory landscape will keep getting more complex, and the timing of implementation will remain fluid.
Register for a live webinar hosted by CFA Institute on 20 November 2012 covering the latest legal and regulatory developments relating to OTC derivatives.
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