Now that the dust is beginning to settle, regulators are softening their tone. Lynn Strongin Dodds reports
It was never going to be easy to agree on the best way to monitor the sizeable $700 trn global derivatives market but the US and Europe have been at loggerheads for months over the details particularly regarding the regulation of clearinghouses. There does seem to be a thaw in relations with the arrival and more conciliatory tone of Timothy Massad, the new chairman of the US Commodity Futures Trading Commission (CFTC). However, it will not happen overnight.
As Sassan Danesh, partner at etrading software and co-chair of the OTC products committee of the FIX Trading Community, put it, “It is definitely going to happen as the economic stakes are too high. The big question though is how long will it take? I think the change in management will definitely make a difference.”
Despite a shared vision, there have been several stumbling blocks including differing interpretations of global standards, new regulatory regimes as well as different timelines. “The US is much more advanced and has adhered to more stringent timelines whereas in Europe, mandatory central clearing has not even begun, “says Nick Chaudhry, head of OTC client clearing at Commerzbank. “The deadline has kept being extended from the end of 2014 to the end of this year due to the systematic reviews.”
Luke Zubrod, director, risk and regulatory advisory, Chatham Financial, agrees adding, “In order for there to be equivalence under the current framework there needs to be a comparable legislative framework in place and that is not the case today. Europe has been catching up quickly but Asia and other markets are farther behind in implementing their regimes, as they are essentially adopting a fast follower strategy.
The other problem is philosophical differences and the ire that the rest of the world has felt from the US’ expansionary approach. The result of the disjointed rules is that companies prefer to transact within their domestic markets to avoid having to understand and comply with foreign rules. Some have called this the Balkanisation of the derivatives market because instead of having a market that is fluid and global, regulation could increasingly break it up into pieces.
Balkanisation is not a new phenomenon but first was coined in the early 1930s regarding the fractious relations between the world largest economies following the passage of the “Smoot-Hawley” Tariff Act, which imposed levies on imported goods. In today’s world, it has been applied by some to the CFTC’s overterritorial reach and US centric approach to implementing rules under Dodd Frank in recent years.
However, while the US regulator has been forthright in its views, the Europeans have not been shrinking violets and both believe that their regime is the most robust. For example, under Dodd-Frank, the financial law prohibits the CFTC from recognising European clearinghouses as operating under equivalent rules. The only way they can conduct business is if they are registered with the US watchdog which would provide their customers with important protections under the country’s bankruptcy law.
European officials, which require two days of margin to the US’ one day, are adamant though that their method of calculating margin requirements is more stringent. In addition, they have taken a harder line and linked the clearing rules to the new banking capital ratios under the Capital Requirements Directive IV which is the region’s interpretation of Basel III. In doing so, banks using qualified clearinghouses may subject their trades to a 2% risk-weighted capital charge which soars to as much as 50% if the EU doesn’t recognise the clearinghouse.
The CME Group, the world’s largest futures exchange, estimates that the amount could jump in excess of 30 times current levels for some deals which would be too onerous for European banks to continue to do business in the US. The result is that American operators, which process significant volumes of cross-border derivatives that European firms enter into, could lose valuable business if there is no mutual recognition.
“Each region has a formula of how initial margins are calculated,” says Zubrod. “If one is lower than the other than there is an incentive for market participants to go to the cheaper place, so long as each is deemed by market participants to be fundamentally safe. Each country though has competitive concerns and they do not want to make their domestic players uncompetitive.”
The arguments came to a head early last year when the CFTC declined to grant full equivalence to European trading platforms for swaps and insisted European clearinghouses must comply with US rules when operating in America, rather than relying on their home regulator’s rules. European policymakers took umbrage and retaliated by refusing to deem US clearing regulations as “equivalent,” as it had with Japan, Hong Kong, India and other countries with much smaller clearinghouses.
Not surprisingly, the deadlock was not in anyone’s interest and tensions have eased somewhat over the past few months. Late last year, the European Commission formally delayed until June 2015 from December 2014 a requirement that European banks face significantly higher capital charges unless they move derivatives trades away from clearinghouses based in the US and other countries that operate under rules that haven’t been deemed “equivalent” to those in Europe. This gives them and their American counterparts more breathing space to try and reach a compromise.
The CFTC is also being more amenable. At a Futures Industry Association’s 2015 conference held in mid March, Massad stated that the agency might amend its uncleared swaps margin rules, bringing it more in line with overseas jurisdictions. This could see the country’s asset managers and corporations being required to post more margin to back swaps that would not be processed by clearinghouses, than what the industry has expected.
He pointed out that proposed US rules on margin requirements for swaps were lower than similar planned standards in Europe and Japan and that the CFTC should harmonise those even if it meant an increase to their requirements. The expectation is that the rules could be finalised by the summer.
As for Asia, Japan and Singapore are the most advanced. The former was the first country in the region, and the second in the world, to mandate central clearing while Singapore Exchange Derivatives Clearing (SGX DC) is the only Asian CCP that has successfully obtained the Derivatives Clearing Organisation (DCO) status in the US. Meanwhile, the HKEx Group in Hong Kong chose to build a new CCP dedicated to OTC swaps – OTC Clearing Hong Kong Limited which was launched in November 2013.
However, there are many other markets in the region that are progressing much more slowly. One reason is that financial regulators in Asia have argued for a more proportional approach to the implementation of the G20 reforms, particularly those relating to OTC derivatives. This is mainly because the region lacks the necessary infrastructure to comply with global standards.
Equally as important, “from an Asian perspective, Dodd Frank and EMIR (the European Market Infrastructure Regulation) do not reflect the market realities outside of the US and Europe,” says, Karl Egbert, Hong Kong based partner at law firm Dechert. “Many Asian regulators are in the process of developing their own approaches because the markets here are at the nascent stages. If you have global rules forcing all kinds of contracts to be pushed into central clearing then what you really need is the volume and liquidity to do so which is not the case in Asia.”
Egbert adds, “This is why I think the idea of equivalency is illusory and that achieving harmonisation across regions will be difficult. Regimes may be similar but they are not equivalent.”
