In a letter to the SEC, the hedge fund industry set forth a roadmap for a prioritized and gradual phase-in of Dodd-Frank derivatives regulations using voluntary compliance efforts, in preference to a big bang approach. In a letter to the SEC, the Managed Funds Association assured the Commission that the industry is not out to delay implementation of the derivatives regulations. On the contrary, the MFA believes that it is possible to modify the process and move expeditiously by properly ordering priorities and establishing a series of defined milestones. In this way, the OTC derivatives market could achieve substantial progress towards key regulatory reforms, including central clearing, sooner rather than later
The MFA cautioned that the reform process currently underway runs the risk of stalling because many of the proposed regulations are too focused on achieving 100 percent reform, and because there is no clear blueprint of interim milestones for industry participants to meet the key reform objectives.
The SEC was urged to avoid a big bang approach to implementation where all rules would go into effect simultaneously and almost immediately after adoption. In the view of MFA, this approach could strain the structure and resources of the financial markets, overwhelm the staff and financial resources of regulators, become a barrier to overall progress on reform.
The hedge fund association urged regulators to take the phase-in road under which the first two priorities would be expanding the use of central clearing for liquid clearable contracts and having trade repositories receive data on both cleared and bilateral swaps. These changes would provide substantial benefits to the markets by enhancing price transparency and competition for the most liquid swap transactions. In addition, reforms such as broad industry clearing and trade repository data will lay the groundwork for future reforms, such as electronic trading and trade transparency, that will provide regulators the data they need on liquidity and pricing to promulgate effective rules, oversee the markets and monitor for market risks.
Regarding central clearing, the MFA would expect derivatives clearing organizations to make the most liquid and standardized classes of products available for clearing first. At the time that a class of products is ready for clearing, all market participants should be permitted, not required, to clear those products, while confirming that they intend to be operationally ready to comply with the mandate when it comes into force. Then, there should be a phase-in period before clearing of that product becomes mandatory to give market participants time to resolve outstanding documentation or structural issues and for the infrastructure to prove that it is ready for clearing at scale.
The MFA emphasized that, with this approach, there will need to be a phase-in period for each class of products. The MFA would expect that, with respect to each category of rulemaking, the markets for more liquid and standardized classes of products, such as interest rate swaps and the most liquid credit default swaps instruments, will develop faster than illiquid classes of products. The MFA further expects that this staggered development will be the case for clearing, exchange trading and reporting.
The MFA set forth a regulatory roadmap timeline for adoption and implementation of all rules related to OTC derivatives reform as well as a timeline that articulates clear, practical, measurable milestones for all stakeholders to move clearing forward decisively. The approach is to establish milestones for clearing access and voluntary clearing with a phase-in period before clearing becomes mandatory. The MFA recommended regular meetings that include buy-side firms, sell-side firms, clearinghouses and regulators to ensure that timely progress is being made.
Most hedge funds are ready, willing and able to clear both current and future clearable swaps once certain basic impediments are addressed. However, there are currently substantial structural and economic barriers to full buy-side participation in central clearing. If implemented effectively, recently proposed Dodd-Frank rulemakings promise to address many of these barriers. In addition, if all parties work together, within a matter of months, voluntary clearing by buy-sides firms could expand substantially in both the broad-based index credit default swaps and interest rate markets.
During the voluntary phase, progressively higher targets for all buy-side firms could be met as traditional asset managers and other end-users resolve their unique implementation issues, and over time, all remaining assets classes could also move towards increased central clearing. The MFA’s recommendations come against the backdrop of press reports that one-fourth of hedge funds are currently clearing swaps.
The MFA’s recommended roadmap also envisions that rules requiring the use of swap execution facilities would come before real-time reporting because these facilities will assist regulators with crafting market ready real-time reporting rules. In addition, swap execution facilities can be an efficient mechanism to facilitate real-time reporting. Also, block trade levels should initially be set low, until regulators have data to determine what levels are appropriate. Also, prior to adopting many rules that are intended to increase transparency, regulators should obtain more market data, such as the reporting of swaps data to swap data repositories.