Regulators in the US and Europe recently decided to deem equivalent each other’s rules related to clearing derivatives, enabling market participants to substitute one set of rules for the other rather than having to comply with both. The move doesn’t directly impact corporate swap end users, which are exempt from clearing, but it does lessen the likelihood of swap market “balkanization” and the higher costs that implies.
“Our agreement is critical to ensuring that our global derivatives markets remain robust, while keeping our financial system as stable and resilient as possible. It is a significant milestone in harmonizing regulation of these markets,” said Commodity Futures Trading Commission Chairman Timothy Massad in a statement.
The agreement was a long time in coming, taking three years of at times heated negotiations, during which European Commission (EC) reached several similar equivalence agreements with regulators of other countries. One of the obstacles holding up progress, noted CFTC Commissioner J. Christopher Giancarlo in a statement, was the CFTC’s broad definition of “persons” that essentially extended its regulatory reach to overseas markets. Under Mr. Massad, the CFTC scaled back the reach of is derivative rules, leading to the dispute’s end.
Failing to find each other’s derivative clearinghouse rules equivalent could have contributed to a balkanized derivative market, since it would have become more expensive to transact with foreign clearinghouses and prompted derivative users to rely on their domestic markets. Such a scenario could split the currently global derivative market into less liquid regional markets.
A European bank seeking to hedge a derivative exposure to a European corporate, for example, may do that most effectively using eurodollar futures. Eurodollar futures, however, are primarily traded and cleared at the Chicago Mercantile Exchange (CME), requiring the European bank to hold significantly more capital against the US futures positions. That could cause the European bank to explore using less expensive domestic contracts that may be less liquid and that carry higher initial margin requirements.
“The ultimate outcome is the banks would pass higher costs on to end users,” said Luke Zubrod, director of risk and regulatory advisory at Chatham Financial, adding that European rules impose much higher capital requirements on banks clearing transactions through clearinghouses subject to non-equivalent rules.
The EC plans to adopt shortly an equivalence decision with respect to CFTC requirements for US central clearing counterparties (CCPs), allowing the European Securities and Market Authority (ESMA) to recognize US CCPs and enabling them to continue to provide services in the European Union. CFTC staff will propose a “determination of comparability” to allow European CCPs to provide services to US clearing members and clients while complying with EU requirements.
Besides reducing the likelihood of the derivative market becoming balkanized and increasing costs for swap market participants, including end users, said Mr. Zubrod, the decision may kick off a spirit of cooperation in terms of reaching equivalence determinations on numerous other derivative-related rules. He added that equivalence is a “spectacularly complicated process for several reasons,” one of which is that regulators must compare each of the numerous rules in their counterparts’ derivative rule regimes to determine if they’re equivalent. In addition, they must do that for each jurisdiction.
Mr. Zubrod said the substituted compliance decisions are anticipated to play out over the course of years, and starting with a “note of discord” between the US and Europe had cast a pall over the process, especially considering the majority of derivative activity takes place in those jurisdictions.
“But now that that log jam is broken and having worked through a very challenging negotiation, one would hope it creates an atmosphere of cooperation that pays dividends for other equivalence decisions,” Mr. Zubrod said.