By Jim Schwartz, Of Counsel, and Peter Green, Partner, both at law firm Morrison Foerster
At the G20 summit in Pittsburgh in 2009, representatives of the G20 nations committed to fundamental reforms of the derivatives market, agreeing that standardised derivative contracts should, by the end of 2012, be traded on exchanges or electronic trading platforms and be cleared through central counterparties. Now, however, almost six years after the summit, and fast approaching the three-year anniversary of the year-end 2012 deadline, we are still some way from full-scale implementation of this commitment and even further away from it being applied in a consistent and coordinated manner across different jurisdictions.
It needed no clairvoyance to foresee the risks of derivatives market participants being subject to overlapping and inconsistent regulation. Almost from the time when regulators started to formulate proposals to implement the G20 reforms, commenters highlighted the potential for market fragmentation and substantially decreased liquidity. Unfortunately, although perhaps inevitably, given the complexity of the reforms, regulators have principally focused more on the development of their own rules and less on how those rules will work in a global context alongside the similar, but different rules, of other jurisdictions. Almost a half-dozen years after the meeting in Pittsburgh, regulators have yet to clarify among themselves which jurisdiction’s rules will apply to a swap transaction between counterparties in different jurisdictions.
International bodies such as the Financial Stability Board (FSB) and the OTC Derivatives Regulators Group (ODRG) have recently encouraged regulators in different jurisdictions mutually to recognise each other’s rules. These efforts, however, have come too late in the day to prevent major market fragmentation and a significant reduction in cross-border liquidity.
Of greatest concern have been the rules relevant to clearing and exchange trading in the US and the EU (see note 1), which represent the most significant derivatives markets. In the US, the Commodity Futures Trading Commission (CFTC) moved forward with the implementation of its rules for mandatory clearing and trading on execution facilities for many swaps while, at the same time, the EU authorities were still in the process of formulating their rules. Nor were the CFTC’s rules applicable only within the US. Rather, the CFTC set up a complex web of requirements for those non-US institutions that might prove sufficiently brave or foolhardy to wish to continue their traditional swap activities with US institutions. The result was predictable: non-US parties in many products have shunned their trading counterparts in the US in order not to become enmeshed in the US rules. In the EU, meanwhile, the reforms continue at a more deliberate pace, although they will also have extra-territorial scope. It is expected that mandatory clearing of certain interest rate swaps and index credit default swaps will commence by the end of 2015 or early 2016, with the exchange trading requirements of Mifir coming into force in early 2017. These timing mismatches do not help a coordinated cross-border approach.
Regulatory authorities in both the EU and the US have the ability to permit “substituted compliance” with equivalent rules in other jurisdictions rather than require compliance their own rules. The EU has made equivalence determinations in relation to the clearing requirements and recognition of central counterparties (CCPs) in Australia, Hong Kong, Japan and Singapore but not yet the US. It has justified the omission of the US on various grounds, including the fact that a CCP in a non-EU jurisdiction cannot qualify for recognition under Emir unless such jurisdiction has an effective equivalent system of recognition of clearinghouses located in the EU. The EU Commission has stated its view that, even though certain clearing houses have long been dually registered in both the US and the EU, any requirement by another jurisdiction for 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-level requirements, but only a scattered few such determinations for transaction level requirements, and none at all in relation to clearing and swap execution.
As a result of the current impasse regarding CCPs, US-based CCPs do not currently qualify as “Qualifying CCPs” under the EU Capital Requirements Regulation, meaning that European banks would incur prohibitive regulatory capital costs in clearing through US CCPs. The EU has extended the relevant deadline to 15 December 2015 but this remains a key issue to be resolved. In addition, there has been criticism of the CFTC requirement that multilateral trading facilities (MTFs) based outside the US and providing US persons with the ability to trade or execute swaps must register as a Swap Execution Facility in the US; the fact that the Mifir exchange trading obligation does not come into effect until 2017 is not helpful to finding a workable solution. The CFTC has given “no action” relief to EU-based MTFs, but subject to burdensome conditions, as a result of which no MTFs have taken advantage of the “relief.” Other aspects of the CFTC’s cross-border guidance further complicate attempts at mutual deference between the EU and US.
Not only have the regulators fragmented the swap market with their uncoordinated demands on its participants but, with respect to the general lack of cross-border harmonisation, they have managed to do so with a bare minimum of sunlight shining into their closed door consultations. A pattern has emerged: there comes a carefully worded, impeccably anodyne statement assuring the credulous reader of progress; followed by months of waiting for some verification or substantiation of progress; followed by another anodyne statement of progress; followed by yet more months marked by little if any actual, verifiable progress.
In a recent such statement, CFTC Chairman Timothy Massad and his EU counterpart, EU Commissioner for Financial Stability, Financial Services and Capital Markets Union, Jonathan Hill, jointly assured readers that discussions were “constructive and continuing” and focusing on the ability for both systems to defer to each other’s rules, with the aim of finalising an approach by the summer of 2015. Almost six years after the G20 meeting in Pittsburgh, however, the swaps market can be forgiven for not holding its collective breath waiting for these “constructive” discussions to bear fruit.
Note 1: In the US, derivatives regulation is contained in Title VII of the Dodd-Frank Act (Dodd-Frank). In the EU, the rules relating to central clearing of derivatives are set out in European Market Infrastructure Regulation (Emir) and those relating to exchange trading of derivatives in the Markets in Financial Instruments Regulation (Mifir).