Legal and technical issues still muddle regulatory compliance with derivatives regulation despite looming deadlines for both trading via SEFs in the US and trade reporting via TRs in Europe. Rob Daly explores these issues and what lies ahead for 2014.
Although February is expected to mark the start of mandated trading of certain contracts on swap exchange facilities (SEFs) in the US and the reporting of Over-the-Counter (OTC) and exchange-traded derivative (ETD) trades in the EU, not all outstanding legal and technical issues are done and dusted for these looming deadlines.
“There remain a number of legal issues and ambiguities that may be problematic when the use of SEFs becomes mandatory this year,” says Gabriel Rosenberg, an associate at law firm Davis Polk & Wardell.
He traces many of these issues to the use of approximately 70 no-action letters by the US Commodity Futures Trading Commission (CFTC) to build much of the regulatory regime throughout 2013 as well as some of the guidance given by the regulator.
One example he cites, is treating a SEF-based trades that fails to clear as ab initio (or void from the beginning), which surprised many market participants.
It would be useful if the regulators would issue the no-action letters further in advance of the problem, which they are meant to solve, he suggests.
“The CFTC has been accommodating in issuing of no-action letters in 2013,” agrees Jack Mulcahy, COO at SEF-operator Javelin Capital Markets. “Will it continue? It probably will.”
However, Christian Martin, co-founder and CEO of rival SEF TeraExchange expects to see fewer no-action letters issued this year. “Most of the 2013 no-action letters issued by the CFTC dealt with phasing in existing regulations, most of which should be completed in 2014.”
Going to the MAT
Unless the CFTC surprises the US OTC derivatives market by delaying the enforcement of its made available to trade (MAT) requirements, mandatory trading of the most liquid interest rate and credit index swap contracts should commence in mid-February and continue into March.
This would be the latest that this trading could commence by law, according to Javelin Capital Markets’ Mulcahy.
The clock started ticking on September 30 when Javelin submitted a list of interest rate swaps, which it wanted designated to be made available to trade, to the CFTC. Over the following two months rival SEF operators MarketAxess, Bloomberg, TrueEx and Tradeweb submitted their own lists to the regulator. At press time, the CFTC has certified 59 interest rate and 29 credit index products, which eventually trade only on SEFs or designated contract markets (DCMs). More information
Keeping track of which instruments are subject to mandatory SEF-based trading and central clearing, may prove difficult for those firms who lacked the funding or bandwidth to prepare for the switchover, says Davis Polk & Wardell’s Rosenberg. “Although a number of SEFs registered last year, their use has not been mandatory.”
“A firm’s preparedness for this new trading environment is less about the firm’s size and more about its management,” adds Mulcahy. “Some of the larger firms have had their hands in their pockets waiting and hoping things would not change.”
Like with the launch of elected SEF-based trading on October 2, 2013, TeraExchange’s Marin downplays the impact of “big bang” that the new mandatory electronic trading will have on the derivatives market.
“After living through a number of ‘big bangs’ in my 25 years in the industry, seldom do they have that lightning bolt moment,” he says. “They rather signal the start of adopting new practices and we will live through that come February.”
Meanwhile in the EU, the buy side, sell side and trade repositories (TRs) have a few weeks left to prepare for the February 12 deadline for reporting all OTC and ETD derivatives trades by each trade counterparty, which was set by European Securities and Markets Authority (ESMA).
Unlike the CFTC’s implementation of trade reporting in 2013, the ESMA trade-reporting requirement does not include a phased hierarchical approach that would have more active market participant reporting trades before less-active participants.
According to regulatory officials, there will be no reprieve from this deadline in any shape or form, explains Steven French, product strategy director at market-infrastructure provider Traiana. “The regulators may change their minds at the 11th hour, but there is a feeling that there might be a lessing of who may have to report instead of removing certain instruments from the reporting mandate. However, that is the unofficial word.”
Under the new trade-reporting regulations, buy-side firms may take advantage of delegated reporting services, where a sell-side firm may report the trade on a client’s behalf.
Such offerings are optional and may not offer buy-side organizations a complete reprieve from their trade-reporting responsibilities.
Many tier-1 banks are willing to offer trade reporting, yet not as many tier-2 banks have made the decision to offer the service, according to French. “This means if I’m a buy-side firm with 10 counterparties, unless they do all the reporting on my behalf, I will still have to do a certain level of reporting.”
French expects that in the coming weeks many buy-side legal teams will continue to push as much of the total ownership of trade reporting to the sell side as possible while the sell-side legal teams pushes it back. “And they have ESMA on their side,” he adds.
The Rest of 2014
After a busy first quarter of implementation on both sides of the Atlantic, the rest of year will return to rule making and international rule harmonization.
ESMA could release its draft regulatory technical standards (RTS) for the central clearing of interest rates swaps as early as May, but it likely will happen later in the summer, according to Traiana’s French.
Once released, the draft RTS needs to be endorsed by the European Commission, which has up to three months to make a decision, and then not object by the European Parliament or European Council, which both also have three months to make their respective decisions. More information
“Technically, it cannot be later than March 2015, which happens if all parties take the maximum allotted time to endorse the RTS,” explains French.
ESMA officials included in the draft RTS that they expect use a phased implementation based on the type of counterparty.
French doubts that the European regulator would seek to start mandating the trading of OTC derivatives on organized trading facilities (OTFs) concurrently with the central clearing of those trades. Yet one never knows, he adds.
For the US domestic market, TeraExchange’s Martin expects that a lot of analysis and introspection will go into the harmonization of international rules. “It likely will match the energy and angst levels experienced in the US domestic market in 2011, 2012 and 2013,” he estimates.
The CFTC took a step to improve cross-border rule harmonization in late December 2013 by approving substitute compliance for non-US swap dealers and major swap participants based in Australia, Canada, the European Union, Japan and Switzerland.
This decision allows those affected to replace certain CFTC entity-level requirements with their local regulatory counterparts.
Those who fall under EU jurisdiction are also able to substitute certain CFTC transaction-level requirements (Regulation 23.501, 23.502, 23.503 and certain parts of 23.202 and 23.504) with their local counterparts. Similarly, if they fall under Japan’s Financial Service Agency (FSA), they may substitute local regulation for CFTC Regulations 23.202 and 23.504. More information
These determinations will likely not be the only substitutions the CFTC will approve. As other non-US regulators strengthen their rule regimes, the CFTC will examine if the local requirements are comparable and comprehensive as those under the US Commodity and Exchange Act (CEA) and CFTC regulations and potentially eligible for substitution, according to CFTC staff.
