Wednesday, May 25, 2011

House Hearings Reveal Concern with Regulatory Arbitrage in Derivatives Regulations

Since the US is expected to be the first nation to fully implement a comprehensive regulatory regime for the OTC derivatives markets, Congress is becoming increasingly concerned about the global coordination of derivatives regulations to ensure that the U.S. remains competitive in international markets and to achieve the objectives of reform to reduce systemic risk and enhance market stability and transparency. Testifying before the House Commodities and Risk Management subcommittee, CFTC Commissioner Jill Sommers noted that other jurisdictions are not as far along in their reform process, which may harm the global competitiveness of US businesses, and that there are some important substantive differences between derivatives reform in the US and other jurisdictions.

In Europe, legislation on clearing and reporting requirements for OTC derivatives, called the European Market Infrastructure Regulation, or EMIR, may not be finalized until the end of summer. Also, after adopting legislation, EMIR directs authorities to draft technical standards by June 30, 2012. Rules on mandatory trade execution and other provisions that are parallel to provisions in Dodd-Frank are being considered as part of a review of the EU’s Markets in Financial Instruments Directive (MiFID). However, formal legislation has not been proposed. Japan has passed its legislation and plans to implement reform by the end of 2012. Other jurisdictions such as Singapore, Australia, Hong Kong and Korea are also either providing or planning to provide clearing services.

Subcommittee Chair K. Michael Conaway (R-TX) said that ensuring a coordinated, international regulatory approach is crucial to marketplace stakeholders regardless of their respective size or role in the global financial system. By acting well ahead of other nations, he continued, the US needlessly risks creating serious disadvantages to its own markets by failing to understand and prepare for the substance of international proposals that are far behind. Ensuring that U.S. financial markets retain a competitive edge and are able to continue functioning in both an efficient and effective manner is a goal that cannot be ignored. Chairman Conaway emphasized that Congress must ensure that the assorted derivatives regulatory schemes carried out by the federal government work to promote economic growth, competitiveness, and innovation.

Regarding substantive differences, Commissioner Sommers noted that a provision in the EU’s proposed legislation on clearing and reporting of OTC derivatives would explicitly exempt multilateral development banks such as the International Bank for Reconstruction and Development, while such institutions are not exempt under any of the Commission’s proposed rules. Similarly, the EU is considering exempting pension funds from mandatory clearing of their swaps transactions, while Dodd-Frank does not contemplate any such exemption. Ms. Summers is Chair of the CFTC’s Global Markets Advisory Committee.

Differences also remain with respect to rules being considered at the CFTC and in Europe for the mandatory execution of swaps on a trading platform. According to the Commissioner, the CFTC’s proposed rule on swap execution facilities would create an inflexible model whereby all requests for quote must be submitted to, at a minimum, five swap dealers. The more flexible approach being considered in Europe and by the SEC would allow counterparties to submit a request for quote to a single dealer and still satisfy the trade execution requirement. This is another area where there is a potential for regulatory arbitrage, warned the CFTC Commissioner.

In other areas, such as capital and margin requirements for uncleared swaps, exemptions from mandatory clearing for inter-affiliate transactions, and ownership limits on market infrastructure, the extent of regulatory divergence may not be known for some time, she noted, while assuring that staff continues to work closely with international counterparts as rules develop.

There are also differences between the US and Europe in the approach to position limits, cautioned the Commissioner, adding that this is an area requiring that the regulations be harmonized to the maximum extent possible. The CFTC has for years imposed position limits in the agriculture commodity markets, she said, and proposes to impose position limits in the energy and metals markets. Regulators in the EU have historically not used position limits and, even under current proposals, may only mandate position limits in agricultural commodity markets.

Commissioner Sommers is also concerned that marketplace uncertainty is being creating by not addressing the application of Dodd-Frank to foreign entities and foreign transactions. Section 722(d) of Dodd-Frank explicitly states that the Act does not apply to activities outside the US unless those activities have a direct and significant connection with activities in, or effect on, commerce of the US or contravene rules that the Commission may promulgate to prevent evasion of the Dodd Frank Act. The Commission has not issued any formal guidance on what this section means in practice.

In the past, CFTC staff have relied on the assistance of foreign regulators for the supervision of entities located abroad so long as the foreign jurisdiction is found to have a comparable regulatory structure. But the CFTC has not proposed a mechanism to do this with respect to any of the rules being put forth under Dodd Frank which, said the Commissioner, has already created regulatory uncertainty for firms with global operations.

In his testimony, CFTC Commissioner Bart Chilton noted that, while the European legislation that is set forth in the European Markets Infrastructure Report (EMIR) and in the European securities laws (MiFID) are likely to be adopted later this year, thereby putting Europe somewhat behind the U.S. timeframe, this may have little substantive impact in practice since CFTC Chair Gary Gensler has indicated that the Commission will be pursuing a phased implementation in the U.S. In each jurisdiction, he emphasized, the key goal is to meet the end-2012 deadline set by the G-20.

Commission Chilton also noted the CFTC’s unprecedented coordination with European and Asian counterparts on all major issues relating to the implementation of OTC derivatives oversight regulation. While there are differences on some provisions of the respective laws, he said, the level of overall harmonization is substantial. In addition, he believes it to be fortuitous that many jurisdictions are developing regulations contemporaneously since this allows the CFTC to craft corresponding, standardized, conforming, or complementary rules as appropriate.

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