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Regulatory Watch

Adding Harmony to Swap Trading Rules

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September 28, 2017

ISDA issues whitepaper to facilitate harmonization of swap regulatory regimes.

Currency controlsWith major European Union financial regulations becoming effective January 3, 2018, the International Swaps and Derivatives Association (ISDA) recently published a whitepaper that seeks to help in efforts to harmonize regulatory regimes worldwide and ultimately ease the regulatory burden for swap market participants.

Titled “Cross-Border Harmonization of Derivatives Regulatory Regimes: A risk-based framework for substituted compliance via cross-border principles,” the paper sets out five risk-based principles to determine whether those regimes can be granted substituted compliance in full. Such compliance means derivative-market participants can apply one set of rules rather than both, greatly easing compliance.

Eric Juzenas, a director in Chatham Financial’s global regulatory solutions team, noted that US and European clearinghouse equivalence was reached last year, and the Basel capital accords have prompted equivalent or nearly equivalent rules in areas such as capital requirements, trade compression and margin requirements.

“However, there are a lot of unknowns about how equivalence for trading regimes will play out, Mr. Juzenas said, adding that trading requirements are more difficult because their linkages to risk are not as obvious, but they can significantly impact trading and may affect where [swap dealers] decide to make markets, and thus where end users are able to execute swaps.

“Until there is trading equivalence, we are likely to see further bifurcation of swaps markets,” he said. He added that ISDA’s whitepaper does not address trading requirements specifically beyond suggesting a general principle that equivalence determinations should be based on whether regulatory regimes are “comparable”, not “identical”.

ISDA’s framework is intended to apply to any derivatives regulatory regime.

The lack of trading-rule equivalence and the fact that US Dodd Frank rules are already in effect has already resulted in some market fragmentation, since any European entity transacting with a US-registered entity—referred to as a US “person”—must apply the Dodd-Frank rules. As a result some, European-based dealers and end users have chosen to avoid pursuing derivative transactions with US entities.

Once the European regulations---Markets in Financial Instruments Directive (MiFID) and Regulation on Markets in Financial Instruments (MiFIR)—are also in effect, then US end users may face a similar situation. For example, Mr. Juzenas said, Europe’s pre-trade transparency requirements for derivatives require greater disclosures than the US’s. If a US corporate is currently doing transactions with an EU dealer, probably in London, that dealer faces having to comply with more requirements around such things as best execution, transparency and reporting requirements. They’ll have to collect information from US clients, such as personal information about who had decision-making authority to execute the trade, and they may have privacy concerns and face their own requirements for safeguarding personal information. Or the dealer may prefer to do that trade through a US-based affiliate.

“So transactions with US [clients] that once may have been done in Europe may be now get done in the US with a dealer’s US entity until trading equivalence gets sorted out,” Mr. Juzenas said. “While that could have a meaningful impact on the market, end users will still be able to get deals done. Dealers are just going to have to weigh in which markets they will decide to provide liquidity.”

It may also change how US companies pursue transactions. For example, some electronic quote platforms are transitioning to becoming a multilateral trading facility, similar to a swap execution facility in the US. End-users that want to continue to get quotes through those platforms will have to register as users. For other quotes dealers may become systematic internalizers, similar to swap dealers in the US. Given that the rules and guidance are still evolving, it is difficult to say exactly how market structure will change, but end users should pay attention so they know if they are going to have to change their work flows, Mr. Juzenas said.

He added that J. Christopher Giancarlo, the recently appointed chairman of the Commodity Futures Trading Commission (CFTC), has expressed interest in recent speeches about achieving trading equivalence as soon as possible.

“I think that would be great for markets. When trading equivalence decisions can be reached, it prevents people from having to sort through duplicative and sometimes conflicting requirements and it minimizes market fragmentation,” Mr. Juzenas said. “The ISDA whitepaper addresses some important principles related to risk, but there is still a lot of work to be done to get to trading equivalence.”

The risk-based principles are:

  • Foreign regulations that require firms to establish capital and margin requirements pursuant to the G-20 commitments demonstrate comparability.
  • Foreign regulations that require firms to establish sound risk management policies to address risks posed by derivatives business demonstrate comparability.
  • Foreign regulations that require firms to maintain an effective and accurate system of records demonstrate comparability.
  • Foreign regulations that require firms to make swap data available to regulators demonstrate comparability.
  • Foreign jurisdictions that have clearing and settlement services that comply with the Bank for International Settlements/International Organization of Securities Commissions principles and that have similar clearing mandates should be deemed comparable.

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