By Pam Brown, Chatham Financial
Regulators globally face a host of challenges in harmonizing OTC regulatory reform.
“All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”
— G20 Leader’s Statement,
The Pittsburgh Summit (September 25, 2009)
Almost two years since the G-20 agreed on a set of directives for reforming the over-the-counter (OTC) derivatives markets, challenges to harmonizing OTC derivatives regulatory reform are emerging, particularly in the US and Europe where efforts to create new derivatives regulatory regimes are well underway. Although the US has yet to finalize its rules and the EU is still hammering out the details of its legislative proposals, there is growing concern among US lawmakers, regulators, and market participants that divergences between the American and the European approaches to OTC derivatives reform could create an uneven global playing field. What follows is a comparison of the similarities and differences on three key issues.
Issue #1: Margin Requirement
Although the EU is still months away from promulgating any specific rules, it appears that the EU and the US are taking different paths with regards to margin requirements for end users. In the US, bank prudential regulators proposed in April to impose margin requirements on all non-cleared swaps, including those involving financial and non-financial end users, which fall within their purview (i.e., swaps involving at least one swap dealer or major swap participant that is regulated by one of the prudential regulators). Specifically, the proposed rule would require dealers to collect initial and variation margin from certain end users. The rule would allow for thresholds below which some classes of end users—namely non-financial and low-risk financial end users—may be able to avoid having to post initial margin, but those thresholds could be subject to approval or review by the prudential regulators. In other words, even though the proposed rule draws a distinction between different classes of end users (financial vs. non-financial; low-risk financial vs. high-risk financial), all end users—including those that currently do not have to post any collateral to their counterparties—face the possibility of having to post margin under the new regulatory regime.
By contrast, the EU does not appear to be pursuing a similar course of action. The current version of European Market Infrastructure Regulation (EMIR) calls for either dealer capital requirement or margin requirement, which would mean that a non-cleared swap would not require margin so long as the dealer holds a sufficient amount of capital. It is definitely possible that the EU changes its policy stand on this issue between now and whenever its rules are finalized, especially if the US succeeds in convincing EU lawmakers and regulators to follow its lead. If the EU doesn’t change its policy, however, then US firms could be at a disadvantage compared to their European competitors that will not be subject to similar margin requirements.
Issue #2: Foreign Exchange
A second area to watch is the regulation of foreign exchange products. In late April, the Treasury Department proposed to exempt FX forwards and FX swaps from the definition of “swap,” which would effectively insulate them from many of Dodd-Frank’s regulatory requirements. If the current proposal is finalized, European regulators would be pressured to follow suit and take a more stringent approach towards the massive FX market. This of course would put financial centers in the EU at a considerable competitive disadvantage.
Issue #3: Entity Classification
Both the US and the EU draw a bright line between financial and non-financial entities, and both will subject financial entities—even those that use swaps only to hedge—to more regulatory requirements, including the central clearing
requirement.
Non-financial end-users in the US that do not hold “substantial” swap exposures and use swaps to hedge commercial risk are explicitly exempted from the clearing requirement. Similarly, non-financial end users in Europe would be subject to the clearing requirement if their OTC derivatives position exceeds a “clearing threshold” for a continuous period of one month. Under the European proposal, once a non-financial end user is required to clear, it will have to clear all swaps, including those that are hedging transactions. A key question is whether regulators in Europe will set the clearing thresholds at points similar to those proposed by regulators in the US.
A key difference, however, stems from how firms are classified as “financial.” For example, under Dodd-Frank, pension plans that fall under the Employee Retirement Income Security Act (ERISA) in the US will be considered financial entities and thus subject to the clearing and trading requirements. In Europe, however, pension plans appear to have won a reprieve from the clearing requirement, at least temporarily. In late May, the European Parliament’s Economic and Monetary Affairs Committee (ECON) expressed its support for a “special regime” for pension funds which would exempt them from having to centrally clear swaps for at least three years.
Regulatory Arbitrage potential
Aside from the three issues highlighted above, there are a number of other issues related to OTC derivatives regulation on which the US and Europe appear to be divided, and reconciling the differences is already proving difficult.
A recent letter dated 14 June 2011 from a Member of the European Parliament to the US Treasury Secretary Timothy Geithner highlights the growing tension between the two sides. In the letter, Dr. Werner Langen, the key negotiator on the proposed EMIR, which addresses issues related to central clearing, central counterparties, and trade repositories warned Secretary Geithner that the European Parliament will not back Geithner’s support of a proposal by some members of the European Council to include exchange-traded derivatives in the central clearing mandate under EMIR. “In case the ECOFIN ministers [in the European Council] will propose to extend the scope of the regulation beyond [OTC derivatives],” Langen writes, “there is risk that there will be no European legislation at all. This is certainly not what we want and I assume that this is not in your interest either.”
Werner’s warning to Secretary Geithner is just one indication of the challenges of harmonizing derivatives regulatory reform between the US and the EU. Even if the US and EU end up falling largely in line with one another, there is still the question of Asia. Although Japan, Singapore, Hong Kong and South Korea are a ways behind the US and Europe in their respective processes toward implementing reform, there are indications that they will not necessarily follow the US’s lead. If they don’t, end users could face a very uneven playing field in the world of OTC derivatives.