Long anticipated, US and European regulators reached a preliminary agreement in mid-October to recognize each other’s derivative rules, in anticipation of European rules going into effect in early January.
Although still just a proposal, progress towards equivalence determinations is important to minimize the fragmentation that results in the absence of an official equivalence determination. Fragmentation has already resulted from US rules for over-the-counter (OTC) swap trading and reporting taking effect before EU rules, as some non-US “persons” have stopped trading with US persons to avoid being pulled into US rules stemming from the Dodd-Frank Act.
“If the European Union (EU) recognizes US swap execution facilities (SEFs) as equivalent, and the US recognizes Europe’s multilateral trading facilities (MTFs) as equivalent, it should enable people to transact more easily across borders,” said Eric Juzenas, a director in Chatham Financial’s global regulatory team. “It should reduce fragmentation due to regulation, although there could be other reasons people choose to transact on one venue or another.”
The equivalence agreement is expected to be finalized in November, ahead of the EU’s MiFID II rules, which the CFTC states will dramatically overhaul the way stocks, bonds, commodities and derivatives are traded in the EU.
“Without any equivalence deal, US and European firms would not be able to trade derivatives between the two countries,” the Commodity Futures Trading Commission (CFTC) said in a statement.
The regulators have already made progress in that direction. Early this year, US and EU regulators recognized swap-clearing facilities as “equivalent,” thereby recognizing swaps as validly cleared in each other’s jurisdictions. And earlier in October, the two regulators agreed to recognize each other’s rules for the treatment of collateral posted against OTC derivatives, which are not processed by clearing houses. Corporates tend to use OTC derivatives because they’re more flexible and better meet their needs, although energy companies and other commodity-focused companies trade heavily in cleared derivatives.
The proposal to finalize equivalence for trading rules is an important next step in allowing substituted compliance across international boundaries.
“The commitment you see here today is a commitment to see this through to the end. I am confident we will resolve the remaining issues and finalize this before the January 3, deadline,” said CFTC Chairman Christopher Giancarlo at a briefing.
Mr. Juzenas said that determining equivalence for trading rules is critical because while trading rules’ linkages to risk may be less obvious than rules covering clearing or margin, they can significantly impact where swap dealers decide to make markets, and so where end users are able to execute swaps. Without that equivalence, he added, market fragmentation would likely continue. For example, said Mr. Juzenas, if a US corporate pursues a swap with an EU dealer, the dealer would face having to comply with more requirements in areas such as best execution, transparency and reporting, and it would have to potentially collect information from US clients, such as personal information about who had decision making-authority to execute the trade.
In September, the International Swaps and Derivatives Association published a white paper that sought to help harmonize regulatory regimes worldwide and ease the regulatory burden on swap market participants. The paper set out five risk-based principles to determine whether those regimes can be granted substituted compliance in full, so that market participants can apply one set of rules rather than both.