Published in Kinzai on 6 January 2014
Japanese text: 2014-01-06 Kinzai Institute for Financial Affairs Article
Global regulation in the second half of 2013
Since August this year, when I wrote for Kinzai regarding the impact of global regulation on Japan, there have been significant developments. ESMA, the European regulator, has accepted applications for recognition as a Third Country CCP from most of the major Asian CCPs and has undertaken a comparison of regulatory regimes across the world to determine their level of equivalence to the EU. While in the US, Gary Gensler is stepping down as the Chairman of the Commodity Futures Trading Commission (CFTC) at the end of the year and, in the meantime, has been pushing ahead with new rules and guidance; in particular, the rules relating to the use of Swap Execution Facilities (SEFs). The final SEF rules came into effect during the recent US government shutdown which has resulted in substantial argument over interpretation; most compliance officers in financial institutions will be familiar with references to footnote 88 and footnote 513.
US regulation and SEFs
SEFs are an entirely US concept, although there are alternatives planned for Japan (ETP) and the EU. A SEF is specifically a trading venue regulated by the CFTC, which may be electronic or voice brokered; the majority of OTC swaps trades executed on SEFs are voice brokered. The CFTC has mandated the use of SEFs by US Persons, Swap Dealers (SD) and Major Swap Participants (MSP) for executing trades in a range of swaps. SEFs have to follow rules regarding transparency of pricing, minimum numbers of quotes and order book management. These rules have been promulgated through a number of rulemakings, followed by additional interpretive guidance. In understanding the rules it is essential to not just read the rules themselves but also the discussions surrounding the draft rules and the footnotes to those discussions. For example, footnote 88 states that any trading venue that acts like a SEF for any instruments should be considered a SEF and therefore follow the SEF rules for all instruments, irrespective of whether or not they are mandated for execution on a SEF.
SEFs have an impact in two key areas: avoidance of de minimis thresholds for non-US Persons and price transparency.
The de minimis threshold for Interest Rate Swaps, as set by the CFTC, is currently 8 billion USD; once a financial institution (including a foreign institution) has traded swaps with an aggregate value above that threshold they must register as a SD, regulated by the CFTC. This is a significant burden and has created a split in the market with Japanese banks unwilling to trade with US banks or their affiliates. One of the SEF rules requires that any trades executed on a SEF which are subject to the CFTC clearing mandate be submitted to a Derivatives Clearing Organization (DCO) for clearing. Such trades are deemed not to count towards the de minimis threshold which one would expect will allow the market to reintegrate. However, the early introduction of mandated trading on a SEF and clearing through a DCO has led to significant legal and regulatory incompatibilities between Japan and the US. For example, there will be no client clearing service available for JPY OTC IRS in Japan until JSCC launches its service in early 2014.
Price transparency is generally a good thing in markets, creating a level playing field and increasing liquidity. However, the way that the SEF rules have been implemented has created some challenges. When the rules were published it was believed that a market participant would only be able to see those prices that they could trade. However, subsequent guidance from the CFTC states that they must be able to see all prices. For many of the SEFs this consolidated price information is an asset that they would formerly have sold on to the market (directly or via one of the market data vendors).
Individually the SEF rules may not appear to be difficult to implement but in conjunction with the massive amount of new regulation coming from multiple jurisdictions simultaneously, with relatively little notice and unpredictable interpretations, they are creating yet another challenge for banks’ already overstretched compliance and IT departments.
A clear indication of the pressure to avoid the immediate impact of the SEF regulations was an interpretation of footnote 513 used by some institutions to justify trading outside SEFs in the event that the trade was booked outside the US; subsequent clarification by the CFTC, although not explicit, has made it clear that the original interpretation was not aligned with the CFTC’s own. Still further confusion has been generated with CFTC Commissioner Scott O’Malia’s statement regarding CFTC regulation of foreign derivatives deals “Let me be clear –it is time to end this regulatory insanity.”
The European approach to regulation has been to look for parallels in foreign laws and regulation and use those as the basis of recognition of third country CCP and other financial market infrastructures. The European rules, known as the Regulatory Technical Standards (RTS), are based on the CPSS-IOSCO Principles for Financial Market Infrastructures which have been used as the basis for much of the swaps regulation globally and have been adopted in Japan. On the instruction of the European Commission (EC), ESMA has undertaken an in-depth evaluation of the laws and regulatory regimes across the globe. These have been published in a number of stages and are awaiting adoption by the EC. In the meantime a large number of third country CCPs have applied to be recognised by ESMA, stretching their resources. The list of applicants, which includes all of the Japanese CCPs, has been published on the ESMA web site. Completion of the assessment process is expected in the second half of 2014.
Looking into 2014
With the resignation of Commissioner Bart Chilton, the CFTC will go into 2014 with only two of the usual five commissioners. President Obama’s nominee to chair the Commission, the Treasury Department’s Timothy Massad, will still be awaiting approval. In addition, concerns have been voiced in the market over whether or not the CFTC has followed the correct procedures in the issuance of its interpretive guidance for several rules, raising the spectre of legal challenges, the first of which has been launched by SIFMA, ISDA and the IIB, challenging the CFTC’s cross-border guidance . In the meantime, ESMA will be awaiting the acceptance of their third country equivalence assessments by the European Commission. Globally regulators have set themselves a very heavy workload for 2014 and an already stretched financial services sector will face still further demands, with continued uncertainty over new regulation and how it fits into the global tapestry.
 A CCP recognised by ESMA but outside the EU
 ESMA Document: ESMA/2013/1588 (6 November 2013)
 Publication of draft proposals are anticipated shortly
 A DCO is a central counterparty regulated by the CFTC or exempted from regulation by the CFTC through substituted compliance