Derivatives Regulation: Outlook for 2011 in the United States and Europe
17 January 2011
This article first appeared in a slightly different form in Derivatives Week, 17 January 2011.
The strict and ambitious 360-day timeline set by the Dodd-Frank Act for the CFTC and the SEC to complete their rulemaking will expire in mid-July. Once finalised, those rules will then come into force 60 days after the agencies adopt them.
This rulemaking process is already well under way. The CFTC has proposed more than 40 rules in each of the 30 key areas it initially identified. The CFTC should complete the final round of proposed rulemaking later this month, which will include much-anticipated rules on position limits for derivatives. The majority of the rules are still in the comment period; these include reporting requirements and the key definitions of swap, swap dealer and major swap participant. Industry groups and some lawmakers have already raised concerns that they are not being provided with sufficient time to consider these. It is not yet clear whether the agencies will exercise the discretion provided to them under the Act to address these concerns.
One of the most anticipated aspects of the rule-making process is the introduction of a new breed of “swap execution facilities”. The Dodd-Frank Act requires that all cleared derivatives transactions be executed either on an electronic exchange or on a swap execution facility. The CFTC announced initial proposals on swap execution facilities in December. These contemplated a range of systems, including electronic platforms and request-for-quote (RFQ) and order book models that can be limited to a minimum of five trading partners. The bulk of trades will likely be executed electronically, with voice brokers only being used for block trades or trades exempt from the clearing requirements.
Of most interest to corporate users of derivatives will be the rules relating to the exemption from derivative clearing requirements for “commercial end users”. The CFTC has recently published rules setting out the information that must be provided to a registered swap data repository and giving further guidance as to the circumstances in which a swap will be considered as “hedging commercial risk”. However, questions still remain as to whether the costs of derivatives trades for end-users will increase in 2011 as a result of the reforms. In particular, the agencies are yet to clarify whether they will take advantage of an issue left open in the Dodd-Frank Act and seek to impose margin requirements on end-users.
CCPs are the cornerstone of US derivatives reform and the success of the legislation at managing systemic risk will depend on the ability of these clearinghouses to establish effective platforms for different types of derivatives while meeting the strict capital and governance requirements set by the agencies. The recent withdrawal by Intercontinental Exchange Inc of its application to register its ICE Trust unit as a clearinghouse with the CFTC highlights the difficulties that entities face in developing their platforms before the rules have been finalised. Given the complexity of these rules, it seems unlikely that CCPs will dominate the OTC derivatives market in the US until well into 2012 at the earliest.
All these developments will take place amid a reshaped political landscape. Following the November midterms, the Republicans took control of the House of Representatives and made substantial gains in the Senate. As a result, a Republican now occupies the Chair of the powerful House Financial Services Committee (displacing Barney Frank, co-architect of the legislation). These developments may affect the pace and direction of derivatives reform. While a handful of Republican representatives have called for a full repeal of Dodd-Frank, the new Congress’s influence will more likely be limited to increased oversight of the agencies and, in particular, scrutiny over the proposed hefty budget increases necessary for them to perform their new roles.
The Commission's explanatory note for EMIR states that the draft regulation is "consistent with the recently adopted US legislation on OTC derivatives", and broadly speaking it is, with central clearing and the use of trade repositories as central tenets.
EMIR's approach to the types of derivatives that must be centrally cleared differs in that it has two different approaches: a “top-down” approach giving ESMA, (with help from the European Systemic Risk Board) power to require central clearing of selected derivative categories not already centrally cleared. And a “bottom-up” approach will allows these regulators to demand mandatory central clearing of categories of derivatives already to some extent centrally cleared.
The draft regulation also distinguishes between financial and non-financial derivatives counterparties, demanding that financial institutions centrally clear all ESMA-designated OTC derivatives categories. At the same time it will exempt non-financial counterparties from central clearing and/or notification to ESMA, unless non-hedging transaction volumes exceed certain, yet to be determined, thresholds.
Europe trails the US not only in passing framework legislation for OTC derivatives, but also in terms of the maturity of the regulatory authority charged with developing the detailed secondary rules. ESMA, constituted only at the start of 2011, has yet to appoint a chairman and executive director (with appointments anticipated for the spring), and presently has only around 45 staff. So, with the Council of Ministers and European Parliament still to debate and approve EMIR and the key players who will draft the detailed rules yet to take their seat at the table, the new world of derivatives regulation in Europe may not begin to take effect until 2012 or beyond.
Other regulatory developments scheduled for 2011 include a derivatives-orientated revamp of the Market Abuse Directive, with a proposal due in the spring. Changes here will likely involve beefing up and harmonising the powers of the regulators to deal with market abuse involving derivatives.
MiFID too has been promised a revisit with a 2011 review focussing on the oversight, organisation and transparency of OTC derivatives in conjunction with EMIR, and also with particular emphasis on the commodity derivatives markets.
The European Commission's 2010 proposed regulation on "Short Selling and certain aspects of Credit Default Swaps" will also likely make it into law. It aims to harmonise EU equity short selling rules as well as introduce disclosure requirements for sovereign CDS. In each case ESMA will have the power to intervene in these markets in emergency situations.