Since the beginning of the financial crisis in 2008, Group of 20 governments have sought to extend their regulation of the financial markets — to avoid letting “Main Street pay for a failure on Wall Street.”The leaders’ statement issued at the G-20 summit in Pittsburgh in 2009 set the stage for a global move to regulate over-the-counter derivatives markets. The different directions the regulatory drive has taken across the G-20 has created unique challenges for financial institutions, central counterparties (or CCPs) that clear over-the-counter derivatives and other market infrastructure organizations, all of which play key roles in fulfilling their countries’ commitments under the declaration. Nowhere has this been felt as much as in Asia.In the U.S., the Dodd-Frank Wall Street Reform and Consumer Protection Act took effect in 2010 and has been followed by a series of rules from the Commodity Futures Trading Commission and the Securities Exchange Commission. In Europe, the European Commission passed the European Market Infrastructure Regulation, which came into force in 2012 and has been followed by rules from the European Securities and Markets Authority. In Japan, the Financial Instruments and Exchange Act has been amended. Other Asia-Pacific countries have taken their own approaches to making laws and rules.In parallel, the Bank for International Settlements has been publishing its Basel III rules, which dictate risk mitigation and capital requirements for financial institutions and other market participants.To put this into context, the global markets impacted by these new regulations are massive. The interest rate swaps market, for instance, has a gross value of $17 trillion, with $370 trillion in outstanding contracts.
Conflicts, contradictions and confusion
In the U.S., most of the swaps market is regulated by the CFTC under Chairman Garry Gensler, whose term of office draws to a close at the end of this year. The commission has taken a proscriptive approach to implementing the Dodd-Frank act, which focuses on swaps. As of Nov. 1, the CFTC had attempted to meet the act’s 398 rulemaking requirements with 162 finalized rules and 121 proposed ones, with a further 115 to go. The rules have been extremely complex, prone to error and subject to interpretation. In many cases, they have required no-action relief, a mechanism by which the commission can offer a temporary reprieve from some or all aspects of a rule.
Dodd-Frank is distinct in that it stipulates that U.S. rules must apply to foreign markets that “can significantly impact the financial system of the United States.” This element is driven by declarations known as “interpretive guidance.”
Meanwhile, Europe has been implementing its market infrastructure regulations through something called the Regulatory Technical Standards. These standards look to recognize equivalent regulatory regimes outside Europe. An initial assessment has already taken place and is awaiting adoption by the European Commission. It is notable that the standards cover all financial instruments, not just swaps.
On their own, the American and European rules pose a number of challenges for foreign market participants and organizations, particularly where there are legal conflicts. To give one example, Hong Kong’s confidentiality provisions were incompatible with the U.S. and European transparency requirements.
The European market authority’s assessment of foreign regulatory regimes has resulted in the granting of varying degrees of equivalence to Japan, Hong Kong, Singapore, Australia, India and South Korea. Where CCPs are based, there is a clear path to recognition, with temporary relief during the application process.
The CFTC rules and interpretive guidance, however, have had a much more dramatic impact.
The U.S. commission has operated by publishing a draft rule for public comment, and then publishing the comments and final rule. The published comments are typically accompanied by further interpretation by the CFTC, some of it in the form of footnotes. These are then often followed by further interpretative guidance.
The potential for gaps in understanding is illustrated by a rule on acceptance or rejection for clearing. In April 2012, the commission said action should be taken “as quickly as would be technologically practicable if fully automated systems were used.” That October, interpretative guidance defined the time period as 60 seconds. This past September, the period was shorted to a mere 10 seconds, presenting an unexpected and significant operational challenge to many market participants.
Another issue is uncertainty over the definition of a “U.S. person,” which generally refers to an organization rather than an individual. This was initially defined in guidance drafted in mid-2012, complete with several contradictions. The definition is important because it triggers various trade volume metrics, which determine whether or not an overseas organization is subject to direct CFTC regulation and reporting requirements. The thresholds are relatively low, and the consequences of being regulated by the CFTC can be extremely burdensome.
As a result, across most of Asia, there has been a withdrawal from swaps trading with the U.S. and a migration toward Europe. Even the foreign subsidiaries of U.S. banks have suffered where it is believed that they might be considered guaranteed by their U.S. parent. In other words, caution has resulted in a realignment of the market.
The final guidance was not issued until July of this year. It offered some clarification and opportunities to avoid being caught in the CFTC’s net, but again, there are contradictions and new conflicts have been created.
Other aspects of the CFTC regulations, such as a requirement to clear through a Derivatives Clearing Organization (a CFTC-registered CCP), have caused further fragmentation. In some cases, U.S. banks have come to consider withdrawal from certain Asian markets as their only viable option.
Generally, Asian regulators have done their utmost to fulfill their governments’ G-20 commitments. It is in nobody’s interest to disrupt global markets, and there has been a push toward embracing international standards and regulatory changes spearheaded by Europe and the U.S. Yet legal incompatibilities and contradictions remain.
The world’s regulatory framework is in a state of flux. Many of the consequences are, as yet, unknown. However, it is clear that only through closer cooperation can nations avoid further undesirable effects.
Michael Steinbeck-Reeves is an expert in OTC clearing. He has a deep understanding of Central Counterparty clearing, including global regulation, risk methods and operational workflows. As a consultant for Catalyst Development, he has worked closely with a the Japan Securities Clearing Corp., advising them on the design of their interest rate swap clearing service.