January 26, 2010
The latest developments in US and European OTC derivatives regulation initiatives.
The main provisions of the various regulatory and legislative initiatives on both sides of the Atlantic are summarized in the table below. Check back regularly for updates.
Sweeping ReformTitle VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), signed into law on July 21, 2010, mandates comprehensive changes to the U.S. over-the-counter (OTC) derivatives market.
The official effective date of Title VII of the Dodd-Frank Act—the part of the new law that concerns the OTC derivatives market—was July 16, 2011, but the two regulatory agencies charged with implementing the lion’s share of Title VII, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), have indicated that they will not come close to meeting that deadline. Moreover, many key provisions in Title VII permit the regulators to specify the actual effective dates and compliance deadlines.
Here are a few highlights of the House and Senate’s versions of the US bill’s provisions:
Transparency and accountability for derivatives
As advertised, the new bill still seeks to bring transparency and accountability to the derivatives market. This includes a central clearing and exchange trading for derivatives that can be cleared and provides a role for both regulators and clearing houses to determine which contracts should be cleared. For corporates, the pain may be in dealing with banks, which will see the biggest impact from the bill. That’s because banks would have to spin out to an affiliate certain derivative transactions (see IT story here).
The measure was watered down somewhat after House Agriculture Committee Chairman Collin Peterson brokered a compromise on what kind of derivatives can and cannot be retained by banks. What can be retained are interest-rate swaps, foreign exchanges, credit derivatives relative to investment grade entities that are cleared, gold and silver and hedging for the bank’s own risk. But what would be required to be spun out would be cleared and non-cleared commodities, energies and metals and all equities and any non-cleared credit default swaps.
To guard against “irresponsible practices and excessive risk-taking” that the above could engender, the bill will give the SEC and CFTC the authority to regulate OTC derivatives. For their part the clearing houses or swap repositories will be requires to collect and publish transaction data to improve market transparency and “provide regulators important tools for monitoring and responding to risks.”
Other parts of the derivatives measure:
- “Financial safeguards: Adds safeguards to system by ensuring dealers and major swap participants have adequate financial resources to meet responsibilities. Provides regulators the authority to impose capital and margin requirements on swap dealers and major swap participants, not end users.”
- “Higher standard of conduct: Establishes a code of conduct for all registered swap dealers and major swap participants when advising a swap entity. When acting as counterparties to a pension fund, endowment fund, or state or local government, dealers are to have a reasonable basis to believe that the fund or governmental entity has an independent representative advising them.”
Table: OTC Derivatives Legislation Update (Comparing the US and European Approach)
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US Approach |
European Approach |
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Status
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- On July 21, 2010, President Obama
signed the Dodd-Frank Wall Street
Reform and Consumer Protection Act
- Regulators have 365 days from date of signing to complete rule making.
- Title VII of the Dodd-Frank Act
amended the CEA to establish a
comprehensive new regulatory framework for swaps and security-based swaps.
- SEC and CFTC will share rule-making duties.
- Security-based swaps will be subject to the jurisdiction of the SEC. All other swaps will be under jurisdiction of CFTC.
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- Proposed EU Regulation applies to a broad class of OTC derivatives but is limited to derivatives on specified underlyings.
- EU definition doesn’t cover spot foreign exchange transactions and the European Commission (EC) has interpreted the relevant EU definition to exclude commercial forward foreign exchange transactions.
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Scope
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- EC: Applies to both financial and nonfinancial derivatives users, although in April the EC indicated that it would consider a corporate exemption
- UK: Applies to both financial and nonfinancial derivatives users, but supports some commercial hedging exemption
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Exemptions
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- Allows non-financial end-user exemption in most cases.
- Now a question of who is exempt, who is a swap dealer.
- CFTC/SEC define swap dealers. Current proposed rules are near match of those contained in the Dodd-Frank Act. The rules define the term “swap dealer” as any person who:–holds itself out as a dealer in swaps,
makes a market in swaps,
–regularly enters into swaps with counterparties as an ordinary course of business for its own account, or
–engages in activity causing itself to be commonly known in the trade as a dealer or market- maker in swaps.
- See below for further explanation.
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- EC: Commercial hedging exemption; may become subject to the mandatory clearing obligation (and have to notify the relevant regulator) if its positions (excluding certain hedges) exceed a clearing threshold (to be set by regulatory standards).
- UK: Commercial hedging exemption
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Central
Clearing
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- Requires regulators to make a determination as to which OTC derivatives are subject to the clearing obligation, although the evaluation criteria differ from the EU (e.g. the US regulators are required to take into account the effect on competition, including clearing costs). The US regulators can also take action even if no CCP currently clears the contract (e.g. to restrict trading in such a contract) and can also stay the application of the clearing obligation.
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Un-cleared swaps will be subject to margin requirements and swap dealers and major swap participants will be subject to capital requirements.
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- EC: The proposed EU Regulation requires the European Securities and Markets
Authority (ESMA) to make a determination as to which OTC derivatives are subject to the clearing obligation, although the evaluation criteria differ from the US. ESMA can also identify contracts for clearing even if no CCP currently clears the contract (but the proposed EU Regulation does not specify any related powers).
- UK: Some instruments will be centrally cleared; this depends on a host of factors that determine whether they can be risk managed adequately by the clearinghouse, not just whether they are standardized or not
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Exchange Trading
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- Requires central clearing and exchange trading for derivatives that can be cleared and provides a role for both regulators and clearing houses to determine which contracts should be cleared.
- Requires the SEC and the CFTC to pre-approve contracts before clearing houses can clear them.
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- EC: Standardized and cleared derivatives must be traded on organized trading venues
- UK: Opposes mandating that standardized instruments be traded on exchanges
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Margin/
Capital
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- CFTC Chair Gensler recently indicated his belief that Dodd-Frank gives the CFTC authority to impose margin requirements on end-user transactions.
- Requires margin for un-cleared trades in order to offset the risk they pose to the financial system and encourage more trading to take place in transparent, regulated markets.
- Swap dealers and major swap participants will be subject to capital requirements.
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- EU: Higher collateral requirements for bilaterally cleared nonstandard contracts
- EU: Higher capital requirements for bilaterally cleared nonstandard contracts
- UK: opposes blanket margin requirements for nonfinancial hedgers
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Position
Limits
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- House-Senate conference report calls for aggregate position limits and strong anti-manipulation tools
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- EU: Being considered
- UK: Opposes position limits
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Reporting
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- EU and UK: Reporting requirements will be strengthened
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