It’s been a busy summer for those who write the laws that govern the activities of financial service regulators around the world, and attention is rapidly shifting from legislation to implementation.
In the United States, the legislative phase ended with the July passage of the 2,300-page Dodd-Frank Wall Street Reform and Consumer Protection Act. The implementation phase arguably begins in earnest when the Financial Stability Oversight Council (FSOC) meets for the first time in September. Less publicly, industry participants are bombarding both the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) with advice on how to best convert the mandates given to them under Dodd-Frank into rules and regulations.
In the European Union, the process is a bit messier, due largely to the 27-nation block’s diffuse structure. Reforms are being implemented in and among individual member states, and also in and among various parts of the pan-European governing apparatus. Japan, meanwhile, has added over-the-counter (OTC) clearing to its list of long-stalled regulatory reforms.
"There are probably five big-picture issues in Europe’s drive towards regulatory reform, and the first one is how the member state regulatory authorities interface with the new European supervisory authorities," Futures and Options Association (FOA) CEO Anthony Belchambers says. "There are potentially some turf issues there, as well as supervisory issues and other complicating factors that need to be clarified."
The second big-picture European issue, he says, is the UK’s decision to overhaul the Financial Services Agency (see "The end of the FSA," at the end of this article). Then comes the debate over how to regulate banks (narrow versus universal and highly capitalized versus nimble and quick), followed by a growing tendency towards regulatory silos.
"This fourth issue is a paradox," he says. "It’s about communication: at the macro level, regulators have never communicated more on big picture policy objectives, but when you get down to the nitty-gritty, they’re bogged down in regional or national regulation and we need as a matter of urgency to re-engage on what should be the kind of criteria that would govern mutual regulatory recognition." But the headline issue is number five: the new global regulatory regime for swaps.
Regulating swaps
As in the United States, the EU has created a new entity aligned with its central bank to monitor systemic risk. Unlike the FSOC, however, the European Systemic Risk Board hasn’t yet been fully defined. Its final structure should be agreed on by September, just as the FSOC holds its first meeting. Based alongside the European Central Bank in Frankfurt, the ESRB will have three affiliates (for banking, insurance and financial markets) in different cities, with the agency that regulates financial markets likely based in London.
Regulators on both sides of the Atlantic are finally beginning to establish clear rules for pushing OTC derivatives into central clearing and regulating swaps in general, as well as determining who will be permitted to trade them.
In the United States, Dodd-Frank gives the SEC authority over "security-based" swaps (on single or narrow based securities) and gives the CFTC authority over all others. It then establishes guidelines to help whichever agency is responsible determine whether a swap has to be cleared or can simply be handled bilaterally.
As in futures, bona fide hedgers are exempt from certain regulations — and in this case, that means bona fide hedgers can choose whether to clear their swaps or simply do the trades bilaterally. This means that any swap can be exempted if one of the parties is a bona fide hedger and that any swap that is not explicitly exempt must be cleared.
What’s not clear is whether prop houses will have to register as swaps dealers under the new law. "There’s a danger that proprietary trading groups will fall into the definition of swap dealer but the reality is that their goal is not to have positions at the end of the day," Gary DeWaal, general counsel and head of legal and compliance at Newedge USA, says. "It’s not clear that they easily fit into the registration categories currently articulated by Congress and you can expect to see plenty of commentary offered by industry as the CFTC and SEC make their rules."
Assuming that commentary finds receptive ears, the U.S. legislation clearly paves the way for prop houses to deal in swaps without being subject to cumbersome capital requirements (and also mandates that larger firms run swaps trades through the business unit that handles futures).
That’s not necessarily the way it’s evolving in Europe. "Right now there are two clearing models," DeWaal says. "One is the CME/IDCG (International Derivatives Clearing Group) model, which is geared towards brokers, and the other is the ICE Trust and LCH SwapClear model, which is geared towards dealers. The first lets you trade through a futures-type arrangement and the second essentially maintains the current status and requires you to be a big player."
LCH.Clearnet is rolling out a futures-like service in the United States, and it’s by no means clear what shape European legislation will take once it passes SEC and CFTC: Boon or burden?
While no one is talking about unifying the CFTC and SEC these days, Dodd-Frank does force them to work together like never before (see "Gensler: Correcting the record on OTC regulation").
"The Act prescribes a shared scheme of regulation," William J. Sweet, Jr., Michael D. Dorum, and Joshua B. Warren write in "The Dodd-Frank Act: Commentary and Insights," published by Skadden, Arps, Slate, Meagher & Flom. "The CFTC and the SEC share the power to regulate derivatives clearing organizations, designated contract markets, and swap execution facilities based on the type of swap at issue." While the two must coordinate their activities, they also will have autonomy within their areas of jurisdiction. "Although the CFTC and SEC must treat functionally or economically similar products and entities in a similar manner, they need not treat them in an identical manner," the three attorneys write.
All of these new tasks have some asking if the agencies might become overburdened. "The question is, ‘Do the CFTC and SEC have the staff to write those rules and in what order are they going to be written and do they have the resources to actually implement them given the significant number of comments they’re going to get?’" John Fay, head of the Americas region for Newedge, says. CFTC Chairman Gary Gensler says he has the staff to write the rules but will need another 400 people to implement them a year down the road.
Japan’s "comprehensive exchange"
Not to be outdone, Japan has embedded OTC clearing in its long-stalled reform process. In May, Parliament passed a bill mandating the use of central counterparties (CCPs) for large-scale OTC derivatives transactions by November 2012, and even before that, the Tokyo Stock Exchange and the Tokyo Futures Exchange had begun building OTC platforms. The Tokyo Commodity Exchange (TOCOM), meanwhile, is researching a way to clear OTC commodity products such as metals and energy.
Neither is yet complete, however, and FIA Japan boss Mitch Fulscher says the door also is open to non-Japanese clearinghouses. "There has also been interest expressed by overseas clearing organizations to offer clearing of Japanese products," he says. "The question is whether this can be a profitable business. Although there is a volume of business in Japan in these products, it does not seem to me to be adequate to have more than one clearinghouse involved in clearing these products."
He points out that the move to clear OTC is part of a larger regulatory process that has been progressing slowly and haltingly for years, and believes the advent of OTC clearing could overcome inertia in that endeavor as well.
"This situation of having multiple exchanges and multiple clearinghouses is a result of the regulatory ‘silos’ that separate markets by product," he says. "However, the laws...now permit cross-over [which] should help to break down these silos and permit the exchanges and their clearinghouses to come together in a rational way to fully serve customers. This urgently needs to take place. The development of OTC clearing could be the opportunity for exchanges to meet together and begin the process of forming an integrated market."
The European process
Within Europe, reforms are progressing on several levels: within EU countries (see "The end of the FSA," below), among EU countries and at the commission level. On the OTC derivatives front, the European Commission received nearly 200 official comment letters by the time it had closed its "Public Consultation on Derivatives and Market Infrastructure" in July. Because the proposal won’t be ready until September, it’s not clear what form the Commission’s new derivatives directive will take.
On a broader level, the European Securities Markets Authority (ESMA, formerly the Committee of European Securities Regulators) has been granted new pan-European powers as of next year, and is now advising the European Commission on its proposed overhaul of the already-sweeping Markets in Financial Instruments Directive — a massive endeavor in its own right that came into effect in 2007 and was designed to forge a more unified capital market. Under proposals released in late July, ESMA wants EU member states to agree on a mandatory two-year deadline for making the continent’s fragmented markets work as one by mandating coordinated pricing of securities. If the states can’t coordinate their practices within that period of time, ESMA will look to do it for them.
ESMA is one of three committees that advise the European Commission on regulatory matters (the others are the Committee of European Banking Supervisors and the Committee of European Insurance and Occupational Pensions Committee) and the commission has proposed replacing all of them with something tentatively called the European System of Financial Supervisors, which Belchambers characterizes as "a central regulator of regulators."
"They will coordinate regulatory approaches across the member states, and they will have a number of roles in developing common standards of implementation enforcement and so forth, but direct supervision is likely to be limited to credit rating agencies and less likely clearing CCPs," Belchambers says. "The guts of supervision of the main markets and the main financial service providers will remain with the supervisory member state supervisor authority."
Many EU initiatives, such as the Alternative Investment Funds Directive (AIFD), have floundered in the wake of unresolved differences. The AIFD was designed to regulate hedge funds and private equity, but has stalled over the same turf wars that have hampered the EU since its inception: should fund managers be treated as members of a single market, or should they be subject to the regulations of the member state within which they reside?
"Some key players will take new prominence in the new world," DeWaal says. "The first player will be the professional trading groups, because they will take the role that currently is monopolized by the dealers and they will help to diversify liquidity sources." The second group, he says, is swap execution facilities, which are execution platforms for OTC derivatives. All of these changes will need to be somewhat normalized across the Atlantic to avoid jurisdictional shopping for regulatory weak spots once credit markets loosen up. Gensler (see "Gensler: Correcting the record on OTC regulation") was optimistic on this, saying, "Capital at risk knows no geographical boundary so it is very important to work with our international counterparts to get as consistent as possible."
The end of the FSA
No regulator has gone from hero to zero faster than the UK’s Financial Services Authority (FSA), which was cobbled together from several entities over the past quarter century and became the agency that most other European regulators — especially those of new member states — and a number of international authorities emulated when trying to walk the fine line between over-regulation and excessive lenience.
As a single regulator for banks, insurance, and financial services, the FSA was responsible for systemic risk, consumer protection, and law enforcement; and it oversaw a period of tremendous growth. It also advocated a "light touch" regulatory approach — one that came under fire as the market for credit-default swaps imploded two years ago. Indeed, as the crisis grew, the FSA reversed its previous strategy and became increasingly aggressive in pursuing sluggish bankers.
Pending approval by Parliament, its prudential regulatory structures and the oversight of systemically important institutions will be absorbed into a new Bank of England (BoE) subsidiary called the Prudential Regulatory Authority by the end of 2012. Its consumer protection, markets and remaining divisions will be folded into a new entity called the Consumer Protection and Markets Authority (CPMA), and its law enforcement structures will be folded into a new agency focused on white-collar crime.
"In general terms, I think we know where we are going, but the specifics of it haven’t really been addressed," says Futures and Options Association CEO Anthony Belchambers. "There are questions about scope between the Prudential Regulatory Authority and the CPMA. For example, it’s not clear what happens to the prudential regulation of non-systemically important, smaller, broker-dealers. Splitting out the regulation of CCPs will be a headache for those that are vertically integrated with exchanges." In late July, the UK Treasury published a consultation paper called "A New Approach to Financial Regulation: Judgment, Focus and Stability," which is available at www.bankofengland.co.uk and says the CPMA will essentially continue to follow FSA principles, but in two separate tracts.
