FT Alphaville " American swap regulation: a class apart Take a moment to imagine what it must be like to be an American regulator. There are plenty to imagine being: the OCC, the Fed, the CFTC, SEC, FDIC, and that thrift one, until it subsumed into the OCC. Got one? So there you are, playing the game, doing more or less badly, being more or less under-resourced, and a crisis strikes. For awhile, it's hella busy as everyone tries to figure out what's going on and if there's anything to do about it, clear up the dead banks and look after their depositors, etc. Then, when the dust has begun to settle, several shotgun weddings and failures later, comes the mother of all homework assignments: the Dodd-Frank Act. Dodd-Frank isn't all rule-making in order to act the legislation - it's also about actual homework assignments, like that assigned by Section 719 (c) which: ...requires the Commissions jointly to conduct a study ("Study") and then to report to Congress ("Report") on how swaps and security-based swaps (collectively "Swaps," unless otherwise indicated) are regulated in the United States, Asia, and Europe and to identify areas of regulation that are similar and other areas of regulation that could be harmonized. The above is from the introduction to the 153-page study itself - just published on January 31st and which gives an exhaustive amount of detail on existing regulatory frameworks and proposals for swap regulation. In the incredibly dry report, "Section III. A. Open Issues" is where it gets interesting. It basically has a nice summary of all the things coming out of the US that frighten people in the rest of the world, because it is that much different. PYOA - Pick Your Own Acronym From the report: The DFA [Dodd Frank Act] created four new categories of market participants and generally requires registration of market participants that fall within the definitions of the terms SD [swap dealer], SBSD [security-based swap dealers], MSP [major swap participants], and MSBSP [major security-based swap participants]. ... No other jurisdiction has yet proposed to similarly register and regulate entities as a result of the types of activities that require registration pursuant to the DFA. However, entities engaged in similar OTC derivatives activity may be otherwise regulated in their respective jurisdictions under existing law. It's not that financial entities that meet one (or more) of these classifications aren't going to be regulated outside the US, it's just that no other country has taken the tack that the US has of registering and regulating activities. It creates another layer of regulations that institutions will need to adhere to. Part of this is a reaction to the opacity of certain over-the-counter derivatives markets and probably a fair amount of it is blowback from AIG, but more discussion on that later. Perhaps the most bizarre thing about it from the non-US perspective, though, is that there is this separation between the fiefdoms of the CFTC (non-security based swaps) and the SEC (security based swaps) - something that pops up in these classifications, but also in plenty of other places. Just imagine if all the FTEs spent figuring out which swap is which, and attempting to communicate across the void between American regulators, was actually spent ensuring, say, financial stability? Or as Risk put it: Derivatives lawyers have attacked proposed Dodd-Frank Act swap product definitions as "irrational," claiming the delineation of supervision between the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) will seriously impede the ability of market participants to hedge their positions. And separately, also from Risk: The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have failed to produce uniformly consistent definitions of "swaps," "security-based swaps" and other products in their joint rule-making. ... The proposed definitions run to more than 300 pages and have taken more than 10 months to agree, a time-lag that CFTC chairman Gary Gensler attributed to "issues around where the line is between the SEC and the CFTC. That took us a few extra months to draw those jurisdictional lines without creating gaps in the regulatory oversight. The prop trading ban Back to the report: The DFA includes the Push-Out Rule, which substantially limits non-hedging use of Swaps by depository institutions, and the Volcker Rule, which significantly limits the ability of banking entities to engage in proprietary trading, other than for hedging and other specified exceptions. Foreign regulators, other than in the United Kingdom, have not proposed rules similar to the Push-Out and Volcker Rules.428 It's been discussed and argued far and wide how the Volcker Rule will put US firms at a disadvantage relative to their foreign peers because of the ban on prop trading. More recently, the lobbying discussion has focused on the effect it may have on the liquidity of certain markets, like European sovereign bonds. Oh, and that UK thing just applies to ring-fenced retail banking entities. We're pretty sure it's going to be possible to work around that one. The clearing eligible question Clearing Requirement. The scope of transactions potentially subject to mandatory clearing may differ between the United States and the European Union. The U.S. Treasury has proposed an exemption from DFA clearing and trading requirements for FX swaps and forwards (although such transactions would remain subject to reporting and other requirements). The division over FX is but one example, but it happens to be the most obvious one. It has been proposed that FX derivatives are carved out in the US because it is said that the main risk is around settlement. Exactly which contracts are mandated for clearing will no doubt vary, at a micro level, once the new regs kick in - that's the potentially bigger thing. For example, a particular credit default swap may be mandated to clear in Europe but not in the US, ditto interest rate swaps and all other manner of over-the-counter derivatives. That is, unless regulators engage in an unprecedented amount of coordination. Things are done differently in Japan CCP Location. Neither the DFA nor current versions of EMIR would require OTC derivatives to be cleared in CCPs located in any particular jurisdiction. However, Japanese law requires certain OTC derivatives on Japanese underlying assets to be cleared on a CCP located in Japan. This locational requirement will be further specified through Cabinet Ordinance. That's a bit protectionist, no? The above are just a handful of examples where regulations aren't anywhere near harmonised; the report has plenty more. There are issues around end-user exemptions, execution requirements, disclosure of data, the segregation of client collateral, etc. To emphasize again, though, it isn't just that different jurisdictions are going at different paces, or heading down different routes, it's also that the situation is fragmented in the US with so many different regulators. The registration requirements for certain swap activities is by far the most revealing. From this one reads: 1) The agencies don't trust each other. It's not that AIG, or Fannie and Freddie, didn't have regulators. It's that certain segments of those businesses weren't being properly examined. Rather than empower their regulators, it's being deemed necessary to reach into their charges to regulate specific activities that proved harmful in this past crisis. 2) Some entities are going to be left unregulated, it's only that some of their activities may become regulated, e.g. hedge funds. We are willing to be so daring as to guess that the farther into the distance the crisis goes, the less time, resources, and energy will be spent on harmonisation efforts. And the banks may pipe down too... if they find a way to water down or arbitrage regs. Related links: The Volcker Rule riddle - FT Alphaville "Too early" to spot gaps in global regulation - FT Joint Report on International Swap Regulation - CFTC/SEC The Volcker Rule's impact on infrastructure (pdf) - Deloitte This entry was posted by Lisa Pollack on Wednesday, February 8th, 2012 at 19:43 and is filed under Capital markets. Tagged with cftc, derivatives, Dodd-Frank, OTC, sec, swaps.