Views on improving the integrity of global capital markets
19 July 2013

U.S.-EU Cross-Border Derivatives Compromise: Who is the Real Winner?

The recent announcement by the U.S. Commodity Futures Trading Commission (CFTC) that it would recognise certain EU derivatives rules as being equivalent to its own seemingly brought to an end a lengthy and contentious debate over the extraterritorial nature of swaps regulation. On the surface, at least, it appears like a victory for the EU, which has for some time been chastised by the U.S. for its slow pace of regulatory reform. The “victory” comes by virtue of the climb-down by the CFTC over its previous insistence that foreign market participants (derivatives counterparties or swap dealers, depending on your regulatory parlance) abide by the prescriptions of the Dodd-Frank Act when dealing with U.S. counterparties. But look beneath the surface and this victory is perhaps not quite what it seems.

First, the details of the accord. Under the landmark agreement, foreign branches of U.S. swap dealers can comply with U.S. rules through “substituted compliance”; that is, the CFTC will recognise certain requirements in the EU as being “comparable and as comprehensive as in the U.S.” The agreement also recognises trading venues that are regulated and supervised in the EU as being acceptable venues for fulfilling the swaps trading requirements of the U.S. Dodd-Frank Act, provided these EU venues are operationally comparable to U.S. “swap execution facilities” (SEFs). This is a crucial aspect of the agreement as it facilitates cross-border derivatives trades between foreign counterparties, thereby allowing EU derivatives trading venues to compete for business with U.S. SEFs.

But this is also where the catch lies.

Because European legislators are still thrashing out an agreement over EU trading rules under revisions to the Markets in Financial Instruments Directive, or MiFID (almost two years after the draft legislation was proposed by the European Commission), the precise transparency requirements for derivatives trading have yet to be determined. Unlike in the U.S., where pre-trade and post-trade transparency requirements have been specified for SEFs. To claim equivalence (or “no action relief” in the CFTC’s language), EU venues will have to adopt “a sufficient level of pre- and post-trade price transparency, non-discriminatory access by market participants, and an appropriate level of oversight”. This raises the spectre of EU venues having to meet U.S. standards before EU trading rules are finalised.

Moreover, the ultimate structure of EU derivatives trading venues remains unclear as the Council (representing EU member states) and Parliament (representing citizens) haggle over the final requirements for “organised trading facilities” (OTFs), a new category of trading venue being created under MiFID that is ostensibly the closest EU construct to the U.S. SEF.

As the CFTC announcement acknowledges, “While important EU rules on mandatory trade execution and trading platforms under the Markets in Financial Instruments Directive and Regulation are almost complete, we are working collaboratively to share ideas and ensure harmonization to the maximum extent possible.”

The word “harmonization” is key here. Although the principles of price transparency and non-discriminatory access are well accepted under the MiFID reforms, the fact remains that EU rules are yet to be passed into law, meaning that the development of technical standards by the European Securities and Markets Authority (the pan-EU regulator) to implement the MiFID reforms will lag the U.S. Asynchronous rulemaking is an oxymoron for “harmonization”. With the U.S. having first-mover advantage, the pressure for alignment must surely be felt more keenly by European policymakers than their U.S. counterparts.

Regarding central clearing requirements for derivatives trades, central counterparties (CCPs) clearing cross-border business will have to register with authorities in both the U.S. and EU. This is perhaps not surprising given that the interposition of CCPs in derivatives trades is seen as a key systemic risk-mitigation mechanism. Clearly, both jurisdictions want to retain oversight of these infrastructures given their central role in financial system stability.

With regard to the clearing obligation itself — specifically to which contracts and counterparties it applies — the agreement specifies that for cross-border trades where one jurisdiction has an exemption from clearing but the other does not, deference is given to the jurisdiction without the exemption. That is, the stricter rule applies. This is a victory for market integrity as it ensures that both jurisdictions will have to meet the higher standard.

For non-cleared swaps, the CFTC will issue “no-action relief” to allow counterparties to comply with only EU rules on risk mitigation. Under the European Market Infrastructure Regulation (EMIR), risk mitigation techniques include portfolio reconciliation and compression, marking-to-market and marking-to-model, and collateral and capital requirements to cover the exposures arising from OTC derivatives not cleared by a CCP. These measures are seen by the CFTC as essentially identical to their own requirements, hence the deference to the EU.

Other matters remain unresolved, mostly notably regarding access to trade repositories and the reporting of data, though discussions are ongoing.

Although this deal is an important step forward in global derivatives regulation, it belies the tensions and turf wars between these two key jurisdictions over financial supervision. Indeed, beneath the glossy façade of international cooperation lies an altogether murkier picture. Don’t expect the debate to end here.

Photo credit: ©

About the Author(s)
Rhodri Preece, CFA

Rhodri Preece, CFA, is Senior Head of Industry Research for CFA Institute. He is responsible for building and maintaining the global research function at CFA Institute, including leading the planning, coordination, and creation of research content across CFA Institute research platforms, which include the Future of Finance, the CFA Institute Research Foundation, the Financial Analysts Journal, and the Enterprising Investor blog. Preece formerly served as head of capital markets policy EMEA at CFA Institute, where he was responsible for leading capital markets policy activities in the Europe, Middle East, and Africa region. Preece is a former member (2014-2018) of the Group of Economic Advisers of the European Securities and Markets Authority (ESMA) Committee on Economic and Markets Analysis. Prior to joining CFA Institute, Preece was a manager at PricewaterhouseCoopers LLP where he specialized in investment funds.

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