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.
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").