Different roads to a common end

Different roads to a common end

Can regulators reconcile their differences over OTC clearing?

At the Pittsburgh Summit in September 2009, leaders of the G-20 nations committed to key reforms of the over-the-counter (OTC) derivatives markets, stipulating that by the end of 2012 at the latest, standardised OTC derivatives (including certain interest rate and credit default swap products) would be traded on exchange or exchange-like platforms, cleared through central counterparties (CCPs) and reported to trade repositories, while non-centrally cleared contracts would be subject to mandatory margin requirements.

Subsequent financial market reform has focused on enhancing transparency through increased reporting obligations, and reducing systemic risk through closer regulatory scrutiny and oversight of a wider range of markets participants and transaction types. It has had an impact on all aspects of OTC derivatives business from trading, risk management and compliance procedures to reporting of all swap counterparties in the US and the EU and their counterparties located elsewhere around the globe.

US and EU regulatory responses

The US took a head start on Europe in G-20 reform implementation. The Securities and Exchange Commission (SEC) and the US Commodities and Futures Trading Commission (CFTC) translated G-20 commitments into rules in connection with the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 (Dodd-Frank). Under Title VIII of Dodd-Frank, the first wave of mandatory clearing for certain interest rate swaps and certain credit default swaps for the largest users of swaps began in March 2013, and from June 2013 the rules will be extended to cover most buy-side firms. Many market participants in Europe and the US were, however, already centrally clearing USD billions of certain standardised IRS and CDS transactions.

Europe’s response to the G-20 OTC derivative mandate is the European Markets Infrastructure Reform (EMIR – see page 5), which came into force in August 2012. The European Securities and Markets Authority (ESMA) and European Banking Authority (EBA) produced Regulatory Technical Standards for EMIR (RTS), which were adopted by the European Commission in December 2012 and are now in the process of adoption by the European Parliament and Council prior to implementation, which is set for 2014.

Where they differ

Although there are broad conceptual similarities between the US and the EU regimes, there are some significant differences in the range and scope of application.

While many market participants agree with the need for increased regulatory scrutiny and greater transparency, many also believe that the lack of geographical coordination amongst legislators and regulators is failing to recognise the interconnectedness of the global financial markets and economy, particularly the cross-border nature of the swaps markets.

This has the potential to prove particularly problematic for cross-border transactions where one counterparty is domiciled outside the US or EU and/or has a branch or subsidiary in the US or EU, or breaches specified trading thresholds under Dodd-Frank rules. London-based brokers and law firms are reporting that clients in Europe, Asia and Latin America are reducing business with US entities and investigating trading alternatives to keep them outside the US$ 8 billion threshold triggering US compliance obligations under Dodd-Frank.

In Europe, how far the scope of the obligations under EMIR will extend depends upon how broadly or narrowly ESMA chooses to interpret contracts with direct, substantial and foreseeable effect within the EU.

There is a current lack of clarity and certainty under both regimes on how to resolve conflicts between the two systems where an entity is caught under both sets of rules or where a counterparty previously outside the EU or US regulatory regimes now finds itself subject to one of them in conflict with their home state rules.

Both US and EU regulators are aware of the need to find workable solutions to these potentially complex cross-border issues. In January 2013, the CFTC issued further guidance on the concept of extraterritoriality and relief for cross-border swaps; however, this is seen by many as a temporary solution extending the grace period for qualification for some market participants in specific circum-stances rather than clarifying the nature and scope of the rules applying to cross-border derivative transactions.

Approaches to cross-border conflict

The US preferred approach to conflicts of cross-border rules is “substituted compliance”, advocated by former long-standing SEC Chairman, Elisse B. Walter in a recent address to the Australian Securities and Investments Commission (ASIC) Forum on 24 March 2013. This, she explained, “recognises comparable foreign regulation to the maximum extent possible consistent with domestic policy goals...the domestic regulator would continue to have the ability to apply certain key policy requirements of local law when foreign law does not impose comparable requirements or provide com- parable protections.” In practice, this would mean that US provisions prevail in the event of a conflict or gap in regulatory provision and apply to non-US entities.

"Substituted compliance recognises comparable foreign regulation to the maximum extent possible consistent with domestic policy goals."

Elisse B. Walter

In contrast, the EU approach to resolving conflicts arising out of the extraterritorial application of its rules is to rely on the equivalency approach. As set out in international law firm Clifford Chance’s comprehensive comparison of EU and US initiatives (Sea of Change – Regulatory reforms – Charting a new course, September 2012), a transaction is deemed to have complied with EU rules, “where at least one of the counterparties is established in a non-EU jurisdiction that the European Commission has determined to have an equivalent regulatory regime which is applied in an equitable and non-distortive manner.”

ESMA is currently in the process of preparing equivalence proposals to be delivered to the EU Commission by 15 June for the US and Japan (these were postponed from April), and by 15 July for Switzerland, Australia, Dubai, India, Singapore and Hong Kong.

Many see the US approach as more aggressive than the EU solution. Divergence in approach between the US and the EU, delays to the determination of equivalence proposals, coupled with market uncertainty over the regulatory treatment of cross-border derivatives with non-EU or non-US counter- parties transacting with entities within those jurisdictions as well as the potential negative impact on the global swaps markets prompt- ed a public call by the major derivatives market industry bodies to the International Organisation of Securities Commissions Organisation (IOSCO) on 19 March 2013, “to energise the dialogue on mutual regulatory recognition.”

IOSCO responded at their board meeting held in Sydney on 21-22 March 2013 by agreeing to establish a task force on cross-border regulation and to develop, “a tool-box of measures in regulating securities markets activities that cross borders. If appropriate, it will then develop principles to guide the coordinated use of these tools... intended to help policy makers and member regulators in addressing the challenges they face in regulating cross-border activity” (IOSCO Media Release – 1 April 2013).

" It doesn’t make sense for anyone to have a fragmented set of rules at the global level which distort capital flows and result in sub-optimal economic welfare, but everybody has to see that and behind that is politics." 

David Wright

IOSCO Secretary General, David Wright embraces this complex challenge. “There is always a solution, but everybody has to see the common interest,” he says. “It doesn’t make sense for anyone to have a fragmented set of rules at the global level which distort capital flows and result in sub-optimal economic welfare, but everybody has to see that and behind that is politics.”

Put simply global issues are best resolved by global solutions. “We are trying to build frameworks at the global level that will help facilitate the resolution of these problems,” says Wright. IOSCO are also currently working with the Basel Committee on Banking Supervision (BCBS) on initial margin requirements for non-centrally cleared swaps. In 2002 they developed and launched a Multilateral Memorandum of Understanding to facilitate cross-border exchange of information among its members representing the regulators of 100 jurisdictions. It was recently used to exchange information used in the bank LIBOR-fixing investigations.

Regulators in both the EU and US have shown their awareness of industry opinion. In early April, the US Treasury Secretary, Jacob J Lew and the European Commissioner, Michel Barnier met in Brussels and agreed on “strong co-operation” over the framework for regulating OTC derivatives markets to avoid situations where EU and US entities have to comply with both Dodd- Frank and EMIR.

Although the meeting marked a very positive shift in the direction of regulatory harmonisation in light of common G-20 founding Regulation principles, it is not clear whether ESMA will determine the US or other jurisdictions as equivalent for the purposes of EMIR.

In spite of this uncertainty, there is clear hope in some quarters that agreement between the EU and the US can be realistically achieved – a sentiment reinforced by a Commission statement confirming that US and EU authorities had agreed to work together actively to strengthen their respective financial markets.

A large contributing factor to global regulatory uncertainty has been that not all of the G-20 countries have begun implementing the 2009 OTC derivative pledges. “As long as you have jurisdictions moving at different speeds, there will inevitably be clashes and conflicts of law,” says Wright. “While these issues are not going to be resolved quickly, what we are trying to do is persuade every- one to approach it in a similar way.”

IOSCO’s international influence was again evident on 21 April 2013. The Japanese FSA released a ministerial-level letter it had issued to the SEC, expressing concerns at emerging fragmentation in the international swaps markets as a result of regulatory uncertainty and lack of coordination and calling for common agreement on the basic principles for cross-border rules. The letter also set out some proposals for achieving this, including commonly agreed principles for determining substituted compliance and outcomes-based equivalence assessments.

Interesting times ahead

“Trade associations have been calling for a cost-benefit analysis of regulation for some time so that the unintended consequences can be minimised,” says Heinrich Siegmann, Financial Markets International at the Swiss Bankers Association and a signatory of the letter to IOSCO. “If heeded, this may avoid or at least minimise some of the fragmentation we may see in the market.”

A wide range of European market participants from agency brokers to clearing houses and industry associations have made similar suggestions. The International Swaps and Derivatives Association, Inc (ISDA), in particular, has lobbied ESMA, the EU Com- mission, the SEC and CFTC. Despite the public global commitment to finding consensus in OTC derivatives regulation, it remains to be seen how these and other G-20 regulators will respond in practical terms to calls for harmonisation and what effects the implementation of their varying provisions have on the global market place.

"Trade associations have been calling for a cost-benefit analysis of regulation for some time so that the unintended consequences minimised."

Heinrich Siegmann
Swiss Bankers Association