More haste, Less speed

By Jim Schwartz, Of Counsel, and PeterGreen, Partner, both at law firm Morrison Foerster

At the G20 summit in Pittsburgh in 2009, representativesof the G20 nations committed to fundamental reforms of the derivatives market, agreeingthat standardised derivative contracts should, by the end of 2012, be traded onexchanges or electronic trading platforms and be cleared through centralcounterparties. Now, however, almost six years after the summit, and fast approachingthe three-year anniversary of the year-end 2012 deadline, we are still some wayfrom full-scale implementation of this commitment and even further away from itbeing applied in a consistent and coordinated manner across differentjurisdictions.

It needed no clairvoyance to foresee therisks of derivatives market participants being subject to overlapping andinconsistent regulation. Almost from the time when regulators started to formulateproposals to implement the G20 reforms, commenters highlighted the potentialfor market fragmentation and substantially decreased liquidity. Unfortunately,although perhaps inevitably, given the complexity of the reforms, regulators haveprincipally focused more on the development of their own rules and less on howthose rules will work in a global context alongside the similar, but differentrules, of other jurisdictions. Almost a half-dozen years after the meeting inPittsburgh, regulators have yet to clarify among themselves whichjurisdiction’s rules will apply to a swap transaction between counterparties indifferent jurisdictions.

International bodies such as the FinancialStability Board (FSB) and the OTC Derivatives Regulators Group (ODRG) haverecently encouraged regulators in different jurisdictions mutually to recogniseeach other’s rules. These efforts, however, have come too late in the day toprevent major market fragmentation and a significant reduction in cross-borderliquidity. 

Of greatest concern have been the rulesrelevant to clearing and exchange trading in the US and the EU (see note 1), whichrepresent the most significant derivatives markets.  In the US, the Commodity Futures TradingCommission (CFTC) moved forward with the implementation of its rules for mandatoryclearing and trading on execution facilities for many swaps while, at the sametime, the EU authorities were still in the process of formulating their rules. Norwere the CFTC’s rules applicable only within the US. Rather, the CFTC set up acomplex web of requirements for those non-US institutions that might prove sufficientlybrave or foolhardy to wish to continue their traditional swap activities withUS institutions. The result was predictable: non-US parties in many products haveshunned their trading counterparts in the US in order not to become enmeshed inthe US rules. In the EU, meanwhile, the reforms continue at a more deliberatepace, although they will also have extra-territorial scope. It is expected thatmandatory clearing of certain interest rate swaps and index credit defaultswaps will commence by the end of 2015 or early 2016, with the exchange tradingrequirements of Mifir coming into force in early 2017. These timing mismatchesdo not help a coordinated cross-border approach.

Regulatory authorities in both the EU andthe US have the ability to permit “substituted compliance” with equivalent rulesin other jurisdictions rather than require compliance their own rules. The EUhas made equivalence determinations in relation to the clearing requirements andrecognition of central counterparties (CCPs) in Australia, Hong Kong, Japan andSingapore but not yet the US. It has justified the omission of the US on variousgrounds, including the fact that a CCP in a non-EU jurisdiction cannot qualifyfor recognition under Emir unless such jurisdiction has an effective equivalentsystem of recognition of clearinghouses located in the EU. The EU Commission hasstated its view that, even though certain clearing houses have long been duallyregistered in both the US and the EU, any requirement by another jurisdictionfor EU clearing houses to be registered in such jurisdiction falls foul of Emir.For its part, the CFTC has made substantial comparability determinations for entity-levelrequirements, but only a scattered few such determinations for transactionlevel requirements, and none at all in relation to clearing and swap execution.

As a result of the current impasseregarding CCPs, US-based CCPs do not currently qualify as “Qualifying CCPs” underthe EU Capital Requirements Regulation, meaning that European banks would incurprohibitive regulatory capital costs in clearing through US CCPs. The EU hasextended the relevant deadline to 15 December 2015 but this remains a key issueto be resolved. In addition, there has been criticism of the CFTC requirementthat multilateral trading facilities (MTFs) based outside the US and providing USpersons with the ability to trade or execute swaps must register as a SwapExecution Facility in the US; the fact that the Mifir exchange tradingobligation does not come into effect until 2017 is not helpful to finding aworkable solution. The CFTC has given “no action” relief to EU-based MTFs, butsubject to burdensome conditions, as a result of which no MTFs have takenadvantage of the “relief.”  Other aspectsof the CFTC’s cross-border guidance further complicate attempts at mutualdeference between the EU and US.

Not only have the regulators fragmented theswap market with their uncoordinated demands on its participants but, withrespect to the general lack of cross-border harmonisation, they have managed todo so with a bare minimum of sunlight shining into their closed door consultations.A pattern has emerged: there comes a carefully worded, impeccably anodynestatement assuring the credulous reader of progress; followed by months ofwaiting for some verification or substantiation of progress; followed by anotheranodyne statement of progress; followed by yet more months marked by little ifany actual, verifiable progress.

In a recent such statement, CFTC ChairmanTimothy Massad and his EU counterpart, EU Commissioner for Financial Stability,Financial Services and Capital Markets Union, Jonathan Hill, jointly assuredreaders that discussions were “constructive and continuing” and focusing on theability for both systems to defer to each other’s rules, with the aim offinalising an approach by the summer of 2015. Almost six years after the G20 meeting in Pittsburgh, however, the swapsmarket can be forgiven for not holding its collective breath waiting for these“constructive” discussions to bear fruit.

Note 1:  In the US, derivativesregulation is contained in Title VII of the Dodd-Frank Act (Dodd-Frank).  In the EU, the rules relating to centralclearing of derivatives are set out in European Market InfrastructureRegulation (Emir) and those relating to exchange trading of derivatives in theMarkets in Financial Instruments Regulation (Mifir).