When Senator Carter Glass and Congressman Henry Steagall pushed through the Glass-Steagall Act in 1933, they experienced little in the way of pushback from the financial sector — largely because everyone got something they wanted: Investment banks loved the elimination of competition from commercial banks; commercial banks loved the ban on interest-paying demand accounts and over-the-counter derivatives hadn’t been invented yet.
The same can’t be said for the 2300-page legislation that Senator Chris Dodd and Congressman Barney Frank pushed through last July. The Dodd–Frank Wall Street Reform and Consumer Protection Act is designed to both reinstate some of the provisions of Glass-Steagall and to add new provisions designed to protect us from systemic risk, fraud and predatory lending. Chief among the provisions aimed at systemic risk are the migration of over-the-counter (OTC) derivatives transactions to exchanges and swap execution facilities (SEFs), the imposition of position limits on any derivatives positions that aren’t bona fide hedging and mandatory clearing for standardized products.
The law also requires that hedge funds with more than $100 million under management register with the Securities and Exchange Commission (SEC) as financial advisors, and those with more than $150 million report certain information — such as their positions, gearing and counterparty risk — to the Financial Stability Oversight Council (FSOC) on a regular basis. That law covers less than 20% of all hedge funds, according to Lipper TASS, but it should capture those large enough to do damage if they go belly-up.
Beyond that, it gets a bit fuzzy. Both the CFTC and SEC have delayed by as much as six months the July 16 deadline for coming up with rules on OTC derivatives, and no one can really agree on what an SEF is or how transparent it has to be.
As July approached, even early champions of the Act said things were moving too fast. In April, the Commodity Futures Trading Commission’s (CFTC) own inspector general issued a report criticizing the CFTC for relying too much on its legal team and not enough on its economic team when conducting a cost-benefit analysis of new rules.
"While we offer no opinion on the cost-benefit analyses for the four rules, we note that similar economic analyses in the context of federal rulemaking have proved perilous for financial market regulators," the report says. "At this stage in the process, staff indicated the overriding concern was meeting the rule-making deadline under Dodd-Frank."
Most participants greeted the six-month extension with relief — although many fear that the break will be used to roll back the reforms rather than to get them right.
However, not everyone is in a holding pattern; Fannie Mae and Freddie Mac already have begun clearing some of their OTC interest rate swaps. The two government-sponsored enterprises (GSEs) roughly hold a combined $1.3 trillion in plain vanilla interest rate swaps. Marti Tirinnanzi, chairman of the clearinghouse working group of the Federal Housing Finance Agency (FHFA), says that in October 2010 Fannie and Freddie began clearing a small portion of their interest rate swaps at CME Group. FHFA is the regulator and conservator for Fannie and Freddie.
While it is only a first step and Tirinnanzi says most trades still are executed the old OTC way, it can and is being done.
Stop the world!
Major banks that control the bulk of the $600 trillion OTC derivatives market and its shadow banking system have long opposed the reforms. They’ve also taken much of the heat for slowing down the pace of implementation — generally because they argue that most of the products trading OTC don’t lend themselves to exchange trading.
"They’ve been saying this for years, and lawmakers generally listen because it’s not their area of expertise," says Christian Baum, a London-based derivatives consultant and former Eurex product developer. "The fact is that 90% of these allegedly complex swaps are fairly commoditized at their core and easily can be moved on-exchange — or at least cleared."
That contention may be open to debate, but there’s no denying the value to major investment banks of keeping these products in the shadow economy. JP Morgan CEO Jamie Dimon, for example, has told shareholders that the new rules could cost his bank $2 billion per year.
The big banks, however, are far from alone in holding up the implementation of Dodd-Frank. Even exchanges and clearinghouses — which stand to win big as business migrates to their platforms — fear a shift from principles-based regulation to rules-based regulation at the CFTC. Others warn that we risk running out of synch with the European Union, which is at least a year behind the U.S. regulation (see ""). Asian regulators — most notably in Hong Kong and Singapore — have talked of creating friendlier regulatory environments, prompting House Financial Services Committee Chairman Spencer Bachus to warn that we’d only be sending business overseas by implementing a strong regulatory regime.
Finally — and shockingly — a new report called "Interest Rate Derivatives 2011: Collateral Damage in the Duration Market," published by the TABB Group, shows that participants just have begun to realize the impact that new capital requirements will have on their bottom line as Dodd-Frank, Basel III and European regulations kick in.
"Nearly 50% of [interest] rate traders believe that financial regulatory reform will be the leading force of change in their markets over the next year," the report says. "If implemented in its current form, and mimicked by similar efforts in Europe, UK and other major currency centers, (Dodd-Frank) could have impacts far beyond the hedging of interest rate risks."
Another report, "Expansion of Central Clearing," published by the Bank for International Settlements (BIS), concluded that the world’s 14 largest derivatives dealers (G14) had more than enough money to meet initial margin requirements, but they might need to free up billions within a day if volatility spikes.
"These margin calls could represent as much as 13% of a G14 dealer’s current holdings of cash and cash equivalents in the case of interest rate swaps," they wrote — a fact that underlines the importance of a robust clearing system.
For as long as there have been OTC derivatives, there have been exchange executives calling for their regulation. Dodd-Frank answered that call, but it’s not the answer many initially believed it to be.
First, Dodd-Frank left the default treatment of OTC derivatives uncleared, but imposed massive capital requirements on any practitioners who weren’t using a clearing facility. Then, it called for the "Commission" (the SEC and CFTC) to review periodically the types of derivatives that are required to be cleared centrally.
It also created something called a Swap Data Repository (SDR), which is to keep track of all swaps.
The CFTC immediately incurred pushback from clearinghouses when it proposed imposing higher capital requirements on clearinghouses that it deemed "systemically important" than on those that aren’t, as well as a new regime for segregation of customer assets for swap clearing.
CME Group Executive Chairman Terry Duffy — long a proponent of mandatory clearing and settlement — was one of several to criticize these and other proposals on May 25, while testifying before a U.S. Senate subcommittee on banking.
"A focus of Dodd-Frank is to bring the OTC swaps market into a regulatory scheme similar to that which allowed the futures markets to function flawlessly throughout the financial crisis," said Duffy. "If the CFTC and the SEC are to meet the goals of Dodd-Frank to transition from the world of unregulated, uncleared OTC trading to a world more nearly approximating the highly successful futures clearing model, they should adhere to the principles [that] have proven already effective in the management of risk."
He argued that imposing lower capital requirements on non-systemically important clearinghouses would make it possible for them to lure business by offering lower clearing costs.
He proposed instead subjecting systemically important clearinghouses to more frequent stress tests, but added that his argument is not about specific rules that the CFTC has proposed, but about whether the CFTC has overreached by proposing those rules.
"Although Dodd-Frank granted the CFTC the authority to adopt regulations with respect to core principles, it did not direct the CFTC to eliminate principles-based regulation," he said. "Rather, Dodd-Frank made clear that (clearinghouses) were granted reasonable discretion in establishing the manner in which they comply with the core principles."
He added that the CFTC seemed to be moving from its time-tested role as a principles-based regulator to a new role of a rules-based regulator.
"The rigid rules being proposed by the CFTC with respect to risk management are unnecessary and destructive of innovation and competition," he said. "Risk management is not an assembly-line type of process that can be commoditized, codified and deployed in such a way as to ensure that risk management regimes of (clearinghouses) remain prudent and agile."
Futures Industry Association (FIA) President John Damgard agrees and says, essentially, that the good guys are being painted with the same brush as the bad guys."The regulated exchanges and clearinghouses performed well through all this turmoil," he says. "They’ve basically shown they know how to get the job done through self-regulation, and that they do a better job through self-regulation than they would under a more restrictive regime, so it makes no sense to subject them to the same rules that you would subject to people who didn’t get the job done."
Don Thompson, managing director and associate general counsel of JPMorgan Chase, took a different tack.
"Central counterparties do not eliminate credit and market risk arising from derivatives," he said. "They simply concentrate it in a single location in significant volume."
He warned that the concentration of risk could be offset only by more regulation.
Over the next few months, Democrats and exchange bosses will be working hard to agree on rules they all can live with, while opponents will try to delay implementation until after the 2012 elections.
That’s a far cry from the way Glass-Steagall began. In the early years after implementation, it was strengthened and expanded — and partly credited with supporting one of the more stable periods in U.S. banking history.
Europeans move at their own speed BY STEVE ZWICK
In early June, European Union Financial Markets Commissioner Michel Barnier garnered headlines when he implied that stalled efforts to implement the Dodd-Frank Act in the United States could make Europe think twice about its own efforts to reel in systemic risk flowing from the global shadow economy — and warned that regimes looking to capitalize on regulatory arbitrage could spark a repeat of 2008.
A week later, U.S. Treasury Secretary Timothy Geithner said virtually the same thing, but with a different slant.
"Just as we have global minimum standards for bank capital expressed in a tangible international agreement, we need global minimum standards for margins on uncleared derivatives trades," he said. "A global approach to margin will help prevent regulatory arbitrage and a ‘race to the bottom.’"
While not mentioning Asian regulators by name, he clearly was targeting Hong Kong and Singapore — both of which aim to become OTC derivatives hubs. European regulators agreed with Geithner’s call for the creation of a global standard, but objected to his veiled implication that the United States was moving forward while others were lagging. The grumbling was prevalent enough for Futures and Options Association (FOA) Chief Executive Anthony Belchambers to issue a call for more productive rhetoric.
"The high policy debate is going in the wrong direction right now," he said at the FOA’s annual Derivatives Week meeting in London. "We need to get close together and we need to stop sound bites floating across the water in the way they do from both sides."
You can’t blame the Europeans for being upset. After all, they’ve been developing a coordinated regulatory apparatus for years, and within a structure that is more fragmented than the United States.
The Markets in Financial Instruments Directive (MiFID) predates Dodd-Frank by several years (See "MiFID is coming," August 2006), while the European Market Infrastructure Regulation (EMIR) was formalized in December 2010. EMIR’s roots, however, go back to the 1990s, when Alexandre Lamfalussy launched the Lamfalussy Process for incrementally unifying Europe’s markets.
For evolutionary reasons, MiFID covers trading while EMIR covers clearing and settlement. The two processes are designed to converge in a system that’s similar to the one being developed in the United States.
It’s not clear, however, that U.S. and EU rules will match up, something that the International Swaps and Derivatives Association (ISDA) warns could gunk up the system.
Instead of SEFs, for example, Europe offers Organized Trading Facilities, which include everything from trade-matching platforms to ledgers where transactions are recorded.
OTC swaps move to clearinghouses ahead of schedule
BY DANIEL P. COLLINS
Marti Tirinnanzi, chairman of the clearinghouse working group of the Federal Housing Finance Agency (FHFA), created quite a stir speaking at the Futures Industry Association conference in Boca Raton in March of 2010. It was there that she told the audience of futures industry executives that FHFA planned to begin moving the over-the-counter (OTC) swaps books of Fannie Mae and Freddie Mac into a clearinghouse structure before there was a government mandate to do so.
True to her word, Fannie Mae and Freddie Mac already have begun clearing some of their OTC interest rate swaps. The two government-sponsored enterprises (GSEs) roughly hold a combined $1.3 trillion in plain vanilla interest rate swaps and Tirinnanzi says that in October 2010 Fannie and Freddie began clearing a small portion of their interest rate swaps at CME Group. FHFA is the regulator and conservator for Fannie and Freddie.
“In October we initiated several interest rate swaps; Bank of America and Deutsche Bank served as the futures commission merchant, they also were the initiator of the trade (as there is no swap execution facility at this point) and we centrally cleared a number of trades on the CME,” Tirrananzi says. “That was the initiation of their central clearing project. They continue to work towards moving more trades towards central clearing but mostly on a beta test. Most of their business is conducted the old OTC way.”
Everything that has been cleared to date has been new trades according to Tirannanzi.
A year and a half ago there was an expectation that these trades would be cleared through multiple clearinghouses, but to date they have only gone through the CME clearinghouse.
“We have had a good deal of cooperation with Bank of America, but other counter parties are similarly working with us on customer agreements and we are in a good spot right now,” Tirinnanzi says. “[We are] negotiating customer agreements so that we will be able to diversify our counterparty exposure among several different futures commission merchants, which makes a lot of sense from a business stand point and a safety and soundness standpoint.”
While central counterparty clearing usually is credited with eliminating counterparty risk, Tirannanzi says that is not necessarily true.
“You still have counterpart y risk as these institutions are going to be holding a great deal of your collateral and will need to be relied on in managing collateral and working on a day to day basis….There is an operational risk that needs to be considered as well as the financial liability of the company and its ability to manage multiple accounts also to segregate collateral per our expectation. There is still a lot there, it would be naïve to assume the risk goes away just because you are centrally clearing.”
Tirannanzi says clearing OTC swaps will it be easier once Swap Execution Facilities (SEFs) are in place. “The market is still very much evolving, it is a huge change in landscape for derivatives. There are a lot of new players, a lot of entrepreneurial talent and it is coming together but a little more slowly than was expected.
She says that the industry is cooperating in the process despite delays in implementing rules. “We are seeing a lot of cooperation in the marketplace. It is inevitable that the rules will come out and we are [having] a lot of good conversations with a variety of different market participants right now. The writing is on the wall, we are definitely working towards an end goal and the CFTC and SEC will decide when precisely that will be. It is not going to be in the too distant future.”
But while the market waits on the regulators, or perhaps attempts to impede them, there are OTC swaps being cleared.