Quotes and Comments 2

Some quotes and comments in the first half of 2015.


Source: Kinzai | 22 June 2015

 Kinzai 22 June 2015

Smooth operator: Japan looks to ease into electronic trading

Author: Aaron Woolner
Source: Asia Risk | 17 June 2015
Categories: Regulation

Smooth operator: Japan looks to ease into electronic trading

Low CCP compression rates in Japan vex foreign banks

Author: Viren Vaghela
Source: Asia Risk | 04 June 2015
Categories: Derivatives, Risk Management
Low CCP compression rates in Japan vex foreign banks

Global Derivatives Regulatory Environment In The Second Half of 2013

Published in Kinzai on 6 January 2014

Japanese text: 2014-01-06 Kinzai Institute for Financial Affairs Article

Kinzai 6 January 2014


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[1] from most of the major Asian CCPs[2] and has undertaken a comparison of regulatory regimes across the world to determine their level of equivalence to the EU[3].  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[4] 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[5] and footnote 513[6].

US regulation and SEFs

SEFs are an entirely US concept, although there are alternatives planned for Japan (ETP)[7] 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[8] (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.”[9]


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 [10].  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.


[1] A CCP recognised by ESMA but outside the EU

[2] ESMA Document: ESMA/2013/1588 (6 November 2013)

[3]  http://www.esma.europa.eu/system/files/formal_request_for_technical_advice_on_equivalence.pdf

[4] http://www.cftc.gov/PressRoom/SpeechesTestimony/genslerstatement111213

[5] http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister051613b.pdf

[6]  http://www.cftc.gov/LawRegulation/FederalRegister/FinalRules/2013-17958

[7] Publication of draft proposals are anticipated shortly

[8] A DCO is a central counterparty regulated by the CFTC or exempted from regulation by the CFTC through substituted compliance

[9] http://www.cftc.gov/PressRoom/SpeechesTestimony/opaomalia-31

[10] http://assets.isda.org/media/f218f397/af17b509.pdf

Ripples from Western derivatives regulation spreading across Asia

Global Regulation of CCPs

Published in Kinzai on 26 August 2013

Japanese text: 2013-08-26 Kinzai Institute for Financial Affairs

Kinzai 2013.8.26 Front Cover


The financial crisis and the G20 Pittsburgh Summit

From their inception CCPs have faced a range of challenges. Before the 2008 Lehman’s crisis they were not considered to be the essential part of financial markets infrastructure that they are today.

Since the financial crisis which resulted in the collapse of Lehman Brothers in September 2008 and the subsequent leaders’ statement at the end of the G20 Pittsburgh Summit (24-25 September 2009), there has been a global move towards regulating the OTC derivatives markets.  The different directions that regulation has taken across the G20 has created some unique challenges for the existing CCPs clearing OTC derivatives, along with new market entrants, who are playing their role in fulfilling their countries’ commitments under the declaration.

The main section of the declaration relevant to OTC derivatives, as one would expect, contained a few specific items but much was left open to interpretation:

Improving over-the-counter derivatives markets: 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. We ask the FSB[1] and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.” [2]

There was a genuine consensus that the spectre of financial institutions which are considered “too big to fail” should be got rid of once and for all and the G20 members generally pressed hard to meet the deadlines, both through domestic regulation and global standards, such as the CPSS-IOSCO principles for financial market infrastructures (PFMI) and Basel III.

Global regulation

The commitment made by the G20 leaders has meant that the changes to the regulation of the OTC derivatives markets have been carried out in parallel in numerous jurisdictions; most notably Europe and the US.  Each regulatory body took its own interpretation of the required action away and as a result, the Dodd–Frank Wall Street Reform and Consumer Protection Act (DFA) was signed into law in the US on 21 July 2010 and the EU (which includes G20 members Germany, France, Italy and the United Kingdom) adopted the European Market Infrastructure Regulation (EMIR) on 4 July 2012.  These two pieces of legislation drove the rule makings in their respective jurisdictions, with the European Securities and Markets Authority (ESMA) Regulatory Technical Standards (RTS) coming into force on 15 March 2013 while the CFTC and SEC, along with other US regulators, have undertaken a rule making that is still on-going (“As of June 3, 2013, a total of 279 Dodd-Frank rulemaking requirement deadlines have passed. Of these 279 passed deadlines, 175 (62.7%) have been missed and 104 (37.3%) have been met with finalized rules.”[3]).

Adding to the complexity, the collapse of MF Global in October 2011 and other financial crises have caused regulators to expand the scope of their rules to cover emerging issues, as they might be expected to do in the normal course of events.

So now, looking from the outside, the situation with Europe and the US is increasingly difficult for CCPs; if they are to clear for European counterparties they must become a “recognised third country CCP”, under Article 25 of EMIR.  Equally, if they are to clear for US Persons and any Swap Dealer (SD) or Major Swap Participant (MSP) they need to become a Derivatives Clearing Organisation (DCO) regulated by the CFTC; not just recognised.  This creates a large number of potential legal and regulatory conflicts.

Although one might imagine that the European and US rules would not directly affect a CCP in a third jurisdiction, that is not the case; it has become a major burden for overseas CCPs.  The more obvious effects have been delays in making commercial decisions until particular elements of regulatory uncertainty have been resolved and being driven to make early changes that would not normally be that high up the list of priorities, from a commercial perspective.

Europe has set some significant challenges for global CCPs.  On the face of it, EMIR has resulted in a more principles-based set of regulations, less prescriptive than those of the CFTC.  However, these have broader implications and have been subject to a great deal of misunderstanding.  Even recently we have been hearing from CCPs who had thought that the rules only apply to the part of their business clearing OTC derivatives; each CCP is considered as a whole and must have submitted their application for recognition by 15 September 2013 or be precluded from clearing any contracts for any European counterparties.  From an individual participant’s point of view there may be ways of avoiding such consequences, but for some jurisdictions I am aware that certain participants consider that it may well be more cost effective to withdraw from that market entirely.

The process for applying to ESMA has also been a matter of some confusion.  The original impression given to CCPs, who were not able to directly engage with ESMA, was that they would have to demonstrate full compliance with the RTS and PFMI, applying partly directly and partly through their domestic regulator.  Simultaneously an assessment of regulatory equivalence was being undertaken by ESMA at the order of the European Commission (EC).  It was never quite clear how the two assessments would be combined.  However, within the last month, ESMA made it clear that they would take an alternative view and required that a CCP be in a country that qualifies under third-country regulatory equivalence and is certified by their domestic regulator as being compliant with their domestic regulation; a more easily understood approach, if the domestic regulator feels legally able to provide such certification.

Moving across the Atlantic, the CFTC issued draft extraterritorial guidance (a form of rule without a formal analysis of the cost of implementation) in July 2012.  It was far reaching, setting out a very broad definition of a “US Person” with the restrictions that go with that (e.g. a “US Person” is subject to the CFTC clearing mandate and is obliged to clear only through a DCO).  The draft guidance contained some apparent contradictions and was generally thought by the market to be unreasonably far reaching (i.e. a bank in another jurisdiction, which was designated a SD or MSP, trading with a counterparty in the same country would be required to clear only through a DCO).  As such, it was widely believed that the final text would be much more liberal.  The CFTC issued a time-limited Exemptive Order, which expired on 12 July this year.

The next step was hard to predict, never mind the final outcome, although some additional aspects may have been decided by the time this article is published.  For example, after testifying at a Senate Appropriations subcommittee in Washington, outgoing CFTC Chairman Garry Gensler was recently quoted as saying, “It means delay and I think we’ve had a year to do this. The American public should hold us to task if we can’t get this done by July 12. They should say, ‘Why does it take so long and are we doing too much to accommodate Wall Street?’”  There is however, a divided view amongst the four remaining CFTC Commissioners, with Commissioner Wetjen saying that it is “absolutely essential” that the interim final guidance gives the marketplace time to adjust.[4]

Motions to adopt both Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations (Cross-Border Final Guidance) and Exemptive Order Regarding Compliance with Certain Swap Regulations (Cross-Border Phase-In Exemptive Order) were passed on 12 July 2013, in a rush (the wording of the orders had to be amended over the weekend of 13-14 July) and following a debate, with strong representations against both orders by Commissioner O’Malia.  To summarise the outcome: the interpretation of the defined term “U.S. Person” has been revised to be in line with the EMIR equivalent terminology, the statement on Substituted Compliance is now accepted, and again is broadly in line with the European approach, market participants can continue to apply the definition of the term “U.S. Person” contained in the January Order, until 75 days after the Guidance is published in the Federal Register, relief from both Transaction Level and Entity level requirements has been clarified, particularly in respect of non-U.S. jurisdictions.

This demonstrates that generally U.S. and EU regulation is converging, both in content and timing of effect. There is still some way to go but to the global OTC market this is a massively reassuring step. Some particular details remain to be thrashed out; for example in respect of CCPs the regulatory approach to margin calculation needs some alignment.  Additionally, although two further No Action Letters have been issued to Eurex SA and LCH.Clearnet SA on the same basis as the one issued to the JSCC earlier this year, these all expire on 31 December 2013.  Commissioner Bart Chilton’s comments[5]best captured the issues at stake, that the world is looking for certainty and that “these are interconnected markets,” quoting from Hollywood “if you build it they will come,” and going on to explain that if the US and the EU harmonise their regulation then the rest of the world will follow which is “good for the world, good for consumers and good for our economies”.

Substituted compliance for Asia

The CFTC issued exemptive orders from the Dodd-Frank requirements, until 21 December 2013, for market participants in Hong Kong, Japan and Australia. However, the absence of Singapore from this substituted compliance regime has created uncertainty over how the branches of US banks in the city-state will be regulated.  The reason may be that, as at the time of writing, no entity in Singapore has applied to the CFTC to register either as a SD or a MSP. Therefore, it appeared that the jurisdiction did not need to be examined for substituted compliance purposes. This has left confusion over the treatment of the branches of foreign firms active in Singapore, who may be looking to register with the CFTC in the immediate future.

Additionally there is now uncertainty surrounding the CFTC’s transaction-level requirements, which apply to branches of SDs and MSPs. If a SD or MSP is located in Hong Kong, Japan or Australia, then they are able to get relief from certain CFTC rules. However, taking trade reporting as an example, it is unclear how the Singaporean branch of a US SD will deal with the application of conflicting rules from the Monetary Authority of Singapore (MAS) and the CFTC.

60 seconds

With the large number of new rules being issued in different jurisdictions, it is frequently unclear exactly what is required.  Initial reading may provide some comfort only for it to be discovered that there are other thoughts in the regulators’ minds that are not obvious.  For example, the real meaning behind this seemingly simple extract from the CFTC rules:

§ 39.12 Participant and product eligibility[6]: (7) Time frame for clearing. (i) Coordination with markets and clearing members. (B) Each derivatives clearing organization shall coordinate with each clearing member that is a futures commission merchant, swap dealer, or major swap participant to establish systems that enable the clearing member, or the derivatives clearing organization acting on its behalf, to accept or reject each trade submitted to the derivatives clearing organization for clearing by or for the clearing member or a customer of the clearing member as quickly as would be technologically practicable if fully automated systems were used.

This has given rise to what has become generally known as “the 60 second rule”.  The decision to set the time at sixty seconds was not unanimous amongst the CFTC Commissioners, with comment that although the rule had been adopted there was no intention of making it sixty seconds. That the time allowed is 60 seconds and precisely when the time begins and ends is unclear from the rule; it is only in light of various explanatory letters from the CFTC that the rule has become fully understood by all potential candidate DCOs.  What is more, although there are CCPs that could comply with the rule, without any major changes, SwapClear, for example, substantially changed their intra-day workflow and now provide tolerances (effectively short-term credit underwritten by additional clearing fund contributions[7]) to members to make compliance achievable.  It is an apparently elegant solution but may not work in other jurisdictions where a CCP may not be legally allowed to provide credit, or where there is no settlement infrastructure similar to LCH’s Protected Payment System (PPS).

The struggle to make it work

When one looks at the situation in Japan, there are some serious challenges that are coming to light.  The CFTC rules create an interesting ambiguity: they make a Swap Dealer trading an eligible swap with a US Person, subject to the clearing mandate requiring them to clear through a DCO.  If that swap dealer is a Japanese entity and the “US Person” is not a member of a DCO then there is a question of how that swap can be legally cleared prior to JSCC’s launch of client clearing in February 2014.  This is a relatively simple problem and, under most circumstances can be resolved, without the granting of “no action relief” or regulatory change, by the CFTC.  However, there is always the temptation for participants to withdraw from markets in which they are not very active in order to avoid committing the resource needed to keep up to date with overseas legal and regulatory change.

The uncertainty surrounding CCPs has created a further strain on the banks.  As many of the global CCPs are not in a position to understand the immediate implications of the rapidly emerging global regulation, their existing and potential participants are forced to make contingency plans to ensure their own protection.  Also, because the implications may be commercially or politically sensitive, some CCPs are not always willing to voice their concerns publically at an early enough stage to have the regulatory authorities in the various jurisdictions coordinate whatever interim relief might be required to prevent the worst-case scenario or simply to prevent duplication of effort across multiple institutions.

Looking forward

The challenge for CCPs has not been trying to comply with individual rule changes; it has been to deal with the fundamental change that the legislators and regulators have imposed on what has traditionally been a lightly regulated area of the global financial markets.  In particular, they have had to balance their own risk and commercial factors with those of their members and their clients.  For the larger CCPs with massive resources this has been challenge enough.  For the smaller, regional CCPs, it has been overwhelming.

A year ago, a poll of OTC market participants would probably have given the response that the main drive towards clearing was regulator-imposed clearing mandates (with Japan and the US being introduced first).  That situation has now changed and most would acknowledge that the Basel III[8] capital rules are becoming the main factor.  CRD IV[9] is coming into force in Europe, the Fed has published draft rules[10] and Japan has already laid out its implementation time line.

With regard to new regulation and compliance for CCPs, the situation remains fluid.  Europe will require applications from CCPs prior to 15 September 2013, only 10 working days after they announce the regulatory equivalence of the first-phase of countries (US and Japan) and two weeks before the announcement of the assessment of the second-phase countries[11].  It appears that most other global regulators are taking a fairly pragmatic, wait-and-see approach, not causing their domestic financial institutions any more issues than necessary.  It is notable that CCPs who have the committed support of their domestic regulators are faring far better than those that do not.

For CCPs in different jurisdictions there are a unique set of challenges in reconciling domestic regulation and law with the demands of the European and US regulators.  It is only with the support of well-informed domestic regulators who engage both with their CCPs and regulators in other jurisdictions that regional CCPs can hope to flourish in what is an increasingly global market place.

[1] Financial Stability Board

[2] http://www.g20.org/load/780988012

[3] http://www.davispolk.com/Dodd-Frank-Rulemaking-Progress-Report/

[4] Quotes from http://www.bloomberg.com/news/2013-06-25/gensler-rejects-cross-border-compromise-as-delay-for-wall-street.html

[5] http://www.youtube.com/watch?v=MlqkF_WzpcM&feature=youtu.be

[6] Title 17: Commodity and Securities Exchanges, PART 39—DERIVATIVES CLEARING ORGANIZATIONS, Subpart B—Compliance with Core Principles

[7] The “clearing fund” is a fund contributed to by all CCP members to cover mutualised risk

[8] http://www.bis.org/bcbs/basel3.htm

[9] http://ec.europa.eu/internal_market/bank/regcapital/legislation_in_force_en.htm

[10] http://www.federalreserve.gov/bankinforeg/basel/USImplementation.htm

[11] http://www.esma.europa.eu/system/files/2013_14_june_2013_letter_esma.pdf