Wednesday, April 20, 2011

New Democrats Caution SEC and CFTC to Avoid Regulatory Arbitrage in Implementing the Derivatives Provisions of Dodd-Frank

The New Democrat Coalition in Congress, whose 42 members wrote a number of the derivatives provisions of Dodd-Frank, have cautioned the SEC and CFTC that the new derivatives regulatory regime must be set up in such a way that it prevents regulatory arbitrage and limits unintended consequences that could increase systemic risk. In a letter to the Commissions, the New Democrats emphasized that international harmonization of the derivatives regulations should be a major priority during the rulemaking process. The interconnectedness of the markets and the large global role that derivatives play demand a coordinated approach with US global partners in order to provide a seamless flow of information and eliminate systemic problems at the outset.

Regarding the specter of regulatory arbitrage, the Coalition is especially concerned that the requirements for banks to push out their swap desks into separately capitalized entities may make it more challenging for US regulators to monitor swap activity and exposure at these financial institutions on a net basis, which could increase systemic risk and costs and, in turn, drive derivatives trading into less regulated global markets. This scenario would inevitably make it more difficult for US counterparties to manage risks in the swaps market. The New Democrats strongly urge the SEC and CFTC to consider these implications when constructing rules ensuring that the US market can operate on a level playing field.

An important goal of Dodd-Frank is to provide the SEC and CFTC with the detailed real time information they need to monitor swap activity. Dodd-Frank enhances real time information by encouraging as much trading activity as possible to occur on regulated transparent exchanges. However, Congress also recognized that there is not always sufficient liquidity in the exchanges to support all types of swaps. Thus, Congress designed swap execution facilities to act as an alternative mechanism for bringing transparency and disclosure to the derivatives markets. The Coalition said that SEC and CFTC rules implementing these provisions should provide swap execution facilities with the flexibility to operate distinctly from exchanges. The Coalition said that the SEC’s proposed rule on swap execution facilities is consistent with this goal and urged the CFTC to mirror its final rule with the SEC rule.

Real time reporting of swap transactions and block trades will also infuse transparency into the market, noted the Coalition, and provide regulators important data with which to monitor systemic risk. The market relies on data repositories to function without delay to ensure liquidity while allowing market participants to meet the requirements of the law. The Coalition said that the SEC and CFTC, when writing reporting rules, should protect market liquidity for businesses looking to hedge risk and ensure the infrastructure and technology is in place for the derivatives market to function without delay and at minimal cost.

Finally, the Coalition asked the SEC and CFTC to consider appropriately phasing-in the final rules and implementation guidelines to ensure minimal market disruptions. In this context, the sequencing of the rules is an important element to avoid market disruption and provide certainty that market participants can adjust their operations to meet the new requirements.

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