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January 21, 2012 2:24 am
More than two years into the process of dealing with a wave of regulations aimed at reshaping the over-the-counter (OTC) derivatives markets, Craig Donohue, chief executive of CME Group, recently described how he felt.
“I feel I am being waterboarded by regulation,” he said, in a reference to the tough interrogation practice used by the US military in the Iraq war that sparked such controversy.
His remark will have resonance among many in the industry, which continues to face a wave of rules that are supposed to lay out how asset managers, banks, clearing houses and others are to comply with post-2008 crisis reforms such as the US Dodd-Frank act and its equivalent regulations in Europe.
Indeed this month seven associations representing exchanges, clearing houses and derivatives dealers wrote to European Union commissioner Michel Barnier, the finance minister of Denmark – current holder of the rotating presidency of the EU – and to Sharon Bowles, chair of the European Parliament’s economic and monetary affairs committee, complaining of “acute challenges” associated with the phase regulators now face in drafting detailed technical rules.
In effect, more than two years into the process of implementing the G20 reforms that created Dodd-Frank, the derivatives industry is struggling to keep up with the detail. At the same time regulators – and in particular the Commodity Futures Trading Commission, the US watchdog charged with implementing vast chunks of Dodd-Frank – is also struggling with a huge workload and a budget under threat.
According to Davis Polk, a US law firm, the CFTC has passed 21 rules but has missed the deadline for approving the same number of rules that have reached proposal stage. The agency has also missed the deadline for three rules that it has yet to propose.
However, it notes that the CFTC has still done more than any other federal regulator on implementing Dodd-Frank.
In Europe, there are concerns that new supervisory authorities, such as the European Securities and Markets Authority, do not have enough time to come up with detailed technical rules on clearing, short-selling and credit default swaps without jeopardising “high quality and credible regulation”.
Some of the criticism can be attributed to a general backlash against the new regulations as dealers attempt to defend their existing business models. In the US they have been emboldened by a Republican-controlled House of Representatives and hopes that the US presidential election will distract from the implementation process.
In spite of this, a clear trend is emerging: key players in the derivatives industry are moving to embrace the new market structures mandated by Dodd-Frank and, in Europe, the yet-to-be-finalised European Market Infrastructure Regulation (Emir) and Markets in Financial Instruments Directive (Mifid).
Key among them are that OTC derivatives that are “standardised” be traded on exchanges or new platforms to be established for OTC derivatives called “swap execution facilities” (SEFs), and that derivatives eligible for clearing should be processed through clearing houses or central counterparties (CCPs).
Large asset managers are starting to use clearing for their OTC derivatives transactions, and banks that are to act as brokers between derivatives users – such as the buyside – and CCPs say they are signing up customers in anticipation of clearing.
Dale Braithwait, global head of credit clearing at JPMorgan, says the adoption of clearing by large asset managers “has created a bit of a tipping point in the way other people are thinking about this”.
Christopher Perkins, global head of derivatives clearing at Citi, agrees. “It’s got very real for us, it’s no longer ceremonial,” he says, adding that Citi expects the second quarter will be “key” in terms of customers awarding the banks clearing mandates.
In the latest sign Robeco, a Dutch asset manager, this month said it had started clearing its derivatives through LCH.Clearnet, the Anglo-French clearer, saying it was “convinced that doing so will improve the mitigation of counterparty and systematic risk from bilateral collateral agreements”.
One factor driving the trend is the realisation that capital requirements – both applied to banks and on the collateral that must be applied to non-clearable derivatives – are forcing asset managers and pension funds to think about clearing. The amount of capital that must be held against uncleared derivatives trades is set to go up under proposed new Basel rules on bank capital, enshrined in a legislative package known as CRD4.
That said, considerable uncertainties remain. A big concern is how the myriad rules will be applied globally. Specifically there are worries over certain extraterritoriality provisions in Dodd-Frank and “third country provisions” in Emir.
Banks, so-called buyside institutions, exchanges and clearing houses are concerned over requirements that financial services businesses in non-EU countries be recognised on the basis of their home country’s “equivalence” with EU regulations – as laid out in Emir and Mifid.
Equally, it is unclear whether a non-EU bank would have to set up a branch in the EU if it wanted to become a member of a clearing house based in the region.
There is also confusion over how financial institutions operating globally would comply with Dodd-Frank, Emir, Mifid and legislation in Asia.
Davis Polk notes that although the CFTC’s proposed swap dealer registration rule had requested comment on the extraterritorial application of the swap entity registration requirements, the CFTC did not address this “critical issue” in its final rule recently. “This leaves many internationally active swap entities in a state of uncertainty regarding the implications of swap entity registration for their global operations,” Davis Polk says.
In addition the CFTC has yet to finalise how SEFs will operate. Lee Olesky, chief executive of Tradeweb Markets, operator of electronic trading platforms for fixed income and derivatives, says: “End users need to be clear on which trading platforms they are able to trade swaps on, using which protocols, following the various implementation dates. At this stage, that is not the case.”
Meanwhile efforts are underway to ensure that global regulators are co-ordinating their approaches. However, the industry remains sceptical.
Rick McVey, chief executive of MarketAxess, a corporate and government bond trading platform that is, like Tradeweb, expected to register as an SEF, says: “We are still very interested in seeing consistency of rules between the US and Europe. But I don’t know if it’s feasible.”
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