CFTC, SEC Report on International Coordination of OTC Derivatives Reform

By Lene Powell, J.D., Commodity Futures Law Reporter.

The U.S. Commodity Futures Trading Commission and Securities and Exchange Commission have released a joint report on the regulation of swaps and derivatives in foreign jurisdictions. The report, which was required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, surveys the current state and future plans for regulation in jurisdictions with major derivatives markets, and identifies key areas needing harmonization efforts.

Like the Dodd-Frank Act (DFA) itself, the report was prompted by the financial crisis that began in 2008. With respect to over-the-counter (OTC) derivatives, the Group of 20 agreed in September 2009 that:

All standardised 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. We ask the FSB and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.

Although there is consistency in policy goals among jurisdictions with major OTC derivatives markets, the pace of reform varies. Among the major jurisdictions, only the United States and Japan have adopted reform legislation since the start of the crisis. In the United States, most regulations required under Title VII of the DFA have been proposed, and some regulations have been finalized. Similarly, the Japanese legislature adopted statutory amendments in May 2010, and full implementation is expected by November 2012.

European legislators are debating legislation on clearing and trade repositories that was proposed in September 2010. Technical standards for implementation are expected to be proposed by June 2012.

Other jurisdictions have not yet proposed or adopted statutory or regulatory changes, but have published consultation documents to gather public comment on the appropriate regulation of OTC derivatives.

In October 2010, the Financial Stability Board released a report containing 21 recommendations for authorities, which it summarized under four categories:

• Standardisation: Increase the proportion of the market that is standardised in order to further the G-20’s goals of increased central clearing and trading on organised platforms.

• Central clearing: Specify the factors that should be taken into account when determining whether a derivative contract is standardised and therefore suitable for clearing.

• Exchange or electronic platform trading: Identify what actions may be needed to fully achieve the G-20 commitment that all standardised products be traded on exchanges or electronic trading platforms, where appropriate.

• Reporting to trade repositories: Trade repository data must be comprehensive, uniform and reliable and, if from more than one source, provided in a form that facilitates aggregation on a global scale.

United States

The DFA and accompanying regulations address all of the agreed-upon goals:

Swaps that are required to be cleared must be submitted for clearing to a registered or exempt clearinghouse; whether a given swap must be cleared is determined by the appropriate Commission according to a defined process. End users, or non-financial entities using swaps to hedge commercial risk, are exempted from the clearing requirement.

Swaps subject to the mandatory clearing requirement must be executed by counterparties on an organized market or on a registered or exempt execution facility. However, this mandatory execution requirement does not apply if no market or execution facility makes the swap available to trade, or if the swap is subject to the end-user exception from clearing.

All swap transactions must be reported to a registered data repository or, if no such repository will accept the swap, to the appropriate Commission.

With regard to dealers and clearing members, the Act and regulations impose prudential regulatory requirements include requirements related to capital, margin, risk management, segregation, and liquidity.

European Union

The European Union has begun creating an EU-wide regulatory framework for OTC derivatives. The European Commission proposed legislation in 2010 called the European Market Infrastructure Regulation (EMIR). EMIR is being developed as a “regulation”, as opposed to an EU directive. This means that EMIR will become effective throughout the European Union upon adoption, and will not require separate implementation by EU member states.

Implementation of certain EMIR provisions will occur through technical standards proposed by the European Securities and Markets Authority (ESMA), along with the European Banking Authority (EBA), and then adopted by the EC. ESMA is expected to submit draft technical standards to the EC by June 30, 2012, for intended adoption by the end of 2012.

The EC also published two draft proposals relating to the Markets in Financial Instruments Directive (MiFID): the “Revised MiFID” and a new regulation entitled the Markets in Financial Instruments Regulation (MiFIR). The Revised MiFID and MiFIR cover financial instruments broadly, and set forth requirements for derivatives generally and for OTC derivatives specifically.

Under EMIR and accompanying technical standards, all OTC derivatives that have been declared subject to the clearing obligation would be required to be cleared through an authorized or recognized CCP.  Among other reporting requirements, all derivatives (centrally cleared or otherwise) would be reported by financial and non-financial counterparties no later than one business day following completion of the transaction to trade repositories, or to ESMA if there is no repository for a particular asset class.

As to mandatory trade execution, all OTC derivatives subject to mandatory clearing pursuant to EMIR and determined “sufficiently liquid” by ESMA would be required to trade on one of three types of trading venues. This obligation would be imposed on both financial and non-exempt non-financial counterparties over a certain size.

Hong Kong

The Hong Kong Authorities (Hong Kong Monetary Authority and Hong Kong Securities and Futures Commission) have proposed a mandatory reporting obligation in which specified OTC derivatives transactions must be reported to a trade repository to be operated by the HKMA. The repository will meet international standards consistent with CPSS-IOSCO on reporting and data format, which will facilitate the aggregation of global data.

Mandatory clearing is expected to cover certain interest-rate swaps and non-deliverable forwards initially, with subsequent consideration of extending the requirement to other types of products. The scope of mandatory clearing is under review, but Hong Kong currently plans to cover institutions holding positions that may pose systemic risk to the financial system.

Hong Kong has proposed regulation of major participants in its OTC derivatives market, in particular authorized institutions (AIs), licensed corporations (LCs), and large participants whose positions may pose a systemic risk. AIs and LCs that already are registered would not need a separate registration.

While the Hong Kong Authorities do not propose a mandatory trading obligation at the outset, the relevant statute will be amended to permit a trading requirement in the future. Legislative changes to give regulators power to impose trading requirements are anticipated to be completed in early 2012, but the timing of implementation remains under consideration. The Hong Kong Authorities will examine local market conditions after the introduction of mandatory reporting and clearing requirements and advise on how best to implement a mandatory trading obligation.

Areas of Inconsistency

The report noted a number of areas of concern.

Besides the United States, no other jurisdiction has proposed a thorough registration and regulation requirement for market participants. However, entities engaged in similar OTC derivatives activity may be otherwise regulated in their respective jurisdictions under existing law.

Relating to prudential requirements, participants in the OTC derivatives markets will need to monitor the minimum required capital requirements for each jurisdiction, and the scope of entities captured by these requirements, in order to determine the amount of capital they must hold. Given the importance of margin requirements to the overall reform of the derivatives markets and the current lack of uniform treatment of margin across jurisdictions, authorities are working together to establish consistent standards for margin for non-centrally cleared OTC derivatives transactions, with a draft consultation paper expected by June 2012.

The DFA includes the Push-Out Rule, which substantially limits non-hedging use of Swaps by depository institutions, and the Volcker Rule, which significantly limits the ability of banking entities to engage in proprietary trading, other than for hedging and other specified exceptions. However, other than in the United Kingdom, foreign regulators have not proposed rules similar to the Push-Out and Volcker Rules.

The scope of transactions potentially subject to mandatory clearing may differ between the United States and the European Union, involving differing exemptions for foreign exchange transactions (FX), intra-group trades, central bank transactions, and a temporary exemption for pension funds.

Both U.S. and EU legislation include a carve-out for end users that use OTC derivatives to hedge risk. The DFA provides an exemption by type of participant and transaction (non-financial entities that use Swaps to hedge their commercial risks with an exception from the clearing requirement, subject to certain conditions). The CFTC and SEC are required to consider whether certain small financial institutions (with assets of $10 billion or less) may be permitted to use the end-user exception. In contrast, EMIR would establish an as-yet- unspecified clearing threshold under which a non-financial entity would not be required to clear its OTC derivatives transactions. Until ESMA sets this threshold, it is not possible to assess whether the scope of relief is consistent with the DFA.

Recommendations

The report recommends that CFTC and SEC staff continue to monitor developments across jurisdictions and communicate with fellow regulators involved in efforts to regulate OTC derivatives. Further, staff should continue to participate in international fora, and actively contribute to initiatives that are designed to develop and establish global standards for OTC derivatives regulation.

Finally, staff should continue to engage in bilateral dialogues with regulatory staff in the European Union, Japan, Hong Kong, Singapore, and Canada, and should consider dialogues with additional jurisdictions as appropriate.

Dissent

CFTC Commissioner Scott O’Malia issued a dissent to the joint report. In the commissioner’s view, although there is coordination on general policy considerations, significant questions remain regarding the extraterritorial application of specific rulemakings currently underway at the SEC and CFTC.

According to the commissioner, the application of entity definitions proposed by the CFTC would subject U.S. entities to mandatory clearing and capital requirements even if they operate outside the U.S., while foreign competitors may not be so constrained.

In addition, a number of jurisdictions object to a DFA provision indemnifying swap data repositories and the CFTC, and have demanded that if change is not made, they will not cooperate with U.S. swaps data collection efforts. Staff has noted that a statutory change may be necessary to ensure that the U.S. is able to fully cooperate with international regulators to share critical information regarding global risk exposure and trade data.