Reval’s ceo and co-founder Jiro Okochi shares insight on how regulatory reform is progressing based on his participation in the GMAC meeting earlier this month. Read on for details on rules affecting end-users and collaboration between Europe and the US in defining those new regulatory rules
It’s a small world—especially the electronic trading world. That was the point made by Commissioner Bart Chilton, one of the five commissioners of the U.S. Commodity Futures Trading Commission (CFTC), at the October 5 meeting of its Global Markets Advisory Committee (GMAC). Commissioner Chilton used his new Omega watch—the same model used by US astronaut Neil Armstrong—to draw the analogy between Armstrong’s perspective of the world from the Moon and the world of trading represented in the room that day.
Indeed, a Who’s Who of market and regulatory executives were gathered to discuss harmonization of international rules for the global reform of the over-the-counter (OTC) derivatives market. In addition to major Swap Dealers, exchanges, clearing firms and, of course, Reval, representing corporate end-users, those in attendance included special guests Patrick Pearson from the European Commission (EC) and Chikahisa Sumi from the Japanese FSA. In this unusually light-hearted GMAC meeting, full of laughs, multiple Shakespearean quotes and a general feeling of “we are the world” in the approach towards the OTC derivative reform, rule makers and market representatives got down to business.
Between quips and quotes from Shakespeare, Mr. Pearson provided a very clever and interesting presentation on how the Dodd-Frank bill and the recently issued draft on OTC reform by the EC are, at the end of the day, very similar despite their different approaches. Perhaps it was gallows humor as those in the room seemed to realize the dramatic impact and hard road ahead to prepare for and actually implement the reform (readers can view the Webcast)
The EC proposal has many “rules” outlined in it that have yet to be defined by the regulators in the U.S. I asked how the CFTC will take into consideration these draft rules, and the response was that the Chairman has publicly stated the goal to make them converge where possible. For the end-user community, I read this to mean that the information thresholds and clearing thresholds prescribed by the EC would be used to capture Major Swap Participants (MSP).
In Dodd-Frank, most non-financial companies are exempted without any threshold requirements from being required to clear swaps, provided they can demonstrate that they are hedging commercial risk and can meet the financial obligations of the un-cleared swap. The U.S. bill also recognizes that unless the swap dealer is also relieved of clearing the swap sold to a non-financial end-user, then the swap dealer will be forced to seek margin from the non-financial end-user, thereby defeating the purpose of the exemption. Furthermore, the U.S. legislation proposes that consideration be given to some financial entities less than $10bn that are hedging their own commercial risks, cause no risk to the system, and have similar cost restraints to clear their basic, plain vanilla interest rate hedging.
Using thresholds may also drive unintended consequences and behavior that could cause volatility in the marketplace. For example, as companies approach the clearing threshold, they may be forced into unwinding existing derivatives that could impact their business or cause volatility in prices. Also, what would be the process if the clearing threshold is breached? Would entities have to post all existing un-cleared derivatives on their books to a CCP and face cumulative margin requirements? Would they be allowed to post trades that get them below the clearing threshold and then be allowed to unclear trades later if they fall below the threshold?
The threshold issue is a key difference between the two approaches, and the commissions can easily write this rule in to mirror the EC’s approach, as much as I dislike the approach, as the thresholds are not known, and it is a bright-line rule vs. a principle-based approach that could catch and keep a company in the MSP category should the end-user one year tip the threshold scale. It’s also a proactive burden on end-users to manage the reporting of this as no end-user wants to even breach the information threshold and make its activities that public.
Going into the session, I did see clear differences between the EC proposal and Dodd-Frank, but after listening to Mr. Pearson, I saw that the product will ultimately need to be very similar in order for implementation to work. The EC and Japan essentially have until the end of 2012 to come up with their final rules, a full year after watching the U.S. go through its exercise, which is mandated by law to be mostly completed by July 2011. The spirit of this particular meeting was a very clear sign that, despite their different timelines for going “live,” the major members of the G20 are striving to work more closely together than assumed.
Jiro Okochi writes a blog via www.savemyswaps.com