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Europe’s OTF to Follow the US’s SEF?

By Henner Bruner, Capco
Originally published on TABB Forum

It is still probably too early to derive meaningful conclusions from the impact of Swap Execution Facilities on trading behavior. However, European regulators and counterparties can learn from the US experience as they implement the European equivalent of SEFs, Organized Trading Facilities, as part of the Markets in Financial Instruments Regulation.

Although central clearing provides counterparty credit risk mitigation, SEF trading – because it will not become mandatory until the ‘made available to trade’ (MAT) rules are effective – is creating uncertainty and onboarding complexity rather than immediate economic benefits.

Why the uncertainty? Potential regulatory arbitrage between the Commodities and Futures Commission (CFTC) and the Securities and Exchange Commission (SEC) is one factor. Then there’s confusion about implementing the SEF trading rules. In addition, the actual start date for mandatory SEF trading varies on the one hand between the official deadline of 18 December 2013 and the market consensus estimate of Q1 2014.

Then there’s the complexity of these new rules where pre-trade credit checking involves feeding credit limits into the SEFs systems. This can easily amount to a high 5-digit number of credit limits a day (intra-day).

Add to this the operational implementation of the direct push, ping or hub approach. This is burdensome, as is the legal and operational documentation, which buy-side participants and futures commission merchants (FCM) may struggle to complete on time.

Meanwhile, in Europe there are many implications for regulators and counterparties concerning the implementation of the still-to-be-defined OTF, while dealing with the widely cited "Footnote 88." The note states that all multi-lateral trading in all swaps, as defined by the CFTC, must occur on SEFs.

And, since the US is months, maybe years, ahead in shaping the future derivatives trading space, there is the risk (or even fear) that US rules are being imposed on European counterparties.

To sum up, the role of US and non-US persons interacting with SEFs is not clear. This is bad news for European regulators who dread a negative operational impact on foreign trading platforms in which US banks participate. Non-SEF platforms already discriminate against non-US branches of US banks by excluding non-US accounts with liquidity pools. Therefore, firms might shy away from trading in the US or on SEFs, to avoid being subject to US regulatory requirements.

First lessons learned:

~ Regulatory differences (EU versus US) currently dampen the road to substituted compliance regarding pre-trade transparency rules. As a result, OTF guiding rules might be altered in the process of implementing MiFIR.

~ The CFTC should grant dealers and SEF operators outside their direct regulatory reach a no-action relief period until OTF rules have been finalized.

~ Avoid confusion among market participants: establish concise guiding rules for OTFs, allowing sufficient time for technical and operational implementation, and avoid regulatory arbitrage between MiFIR and linked regulations (e.g., EMIR).

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Litigators Must Love the CFTC

By David B. Weiss, Aite Group
Originally published on Aite Blog

The usual legal industry of lobbying, commenting, advising, etc. that the CFTC and SEC have created aside, it sure does seem like the CFTC is driving a fair amount of business for litigators these days:

Sure makes it interesting for the spectator. Of course, not all market operators have taken that route. Some have just asked to be let off the rules for a while. Bloomberg is noted far more for being “sticky” then litigious, but when it decided to step up to the plate, it did so in a big way, choosing Eugene Scalia (and former governor of New York, Mario Cuomo) to make its case. Scalia has a pretty good record when it comes to these regulatory lawsuits, so it was pretty bold of the CME to make light of Bloomberg’s lawsuit, given their own track record, detailed above, against the CFTC. How ironic that, hours later, the DTCC would sue the CFTC in direct response to the favor it believes was shown to the CME (and ICE) on SDRs.If the CFTC and SEC felt overwhelmed by their new regulatory tasks stemming from Dodd-Frank, then these latest two regulatory arbitrage opportunities created by the CFTC were not the right steps to take. Now they’re being sued on two fairly substantive grounds.

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Can the SEC Save Civilization?

By Steven Wunsch, Progress Wunsch Auction Associates, LLC
Originally published on 
Tabb Forum

The disintegration of our stock market into chaotic fragmentation is paradigmatic of the disintegration of Western society generally. And the cacophony of market structure voices – as evidenced in the debates on TabbFORUM, the SEC's comment period debates, and similar debates around the world – is not likely to produce solutions any more than Stalin's five-year plans solved the Soviet Union’s problems. But we've got to start somewhere. 

Now comes the news that the SEC wants more money and authority. After all the money spent creating the current chaos, the Commission says it needs much more, presumably to do much more of the same.

High-frequency trading, and the plethora of new rules, technology and staff the SEC proposes to deal with it – the Large Trader Rule; the Consolidated Audit Trail; the Market Access Rule; the Midas computer system; Limit-Up/Limit-Down; the Systems, Compliance and Integrity Rule, etc. – may be mysteries to the world at large, but not to readers of TabbFORUM. HFT is a feature of the SEC's National Market System that didn't exist before, and it is growing more complex and confusing as the SEC creates new rules and policies to control it. The more the SEC intervenes, the worse the problem seems to get.

There are other examples where government-imposed fairness and redistribution are producing chaos, areas that on the surface may seem more amenable to understanding by the public and therefore more amenable to being addressed by policy changes. The gender fluidity that began with feminism, for example, now finds some parents chemically blocking their children's puberty until they can make decisions on a rapidly proliferating array of gender selection options, which are no longer just male or female, or even straight or gay; rather, if a child is gay, whether to undergo surgical gender modification or not, and which orientation to adopt or present to the world, in public or private. [The New Yorker, “About a Boy: Transgender surgery at sixteen,” Margaret Talbot, March 18, 2013]

That simple women's equality would transform into gender chaos was not expected. But such results are always unexpected, because they are bound to spin out of the control of their initially well-intentioned founders as conflicting claims erupt over civil rights or redistributions of the economic pie. Because of the heated emotions in such battles, these are unlikely places in which to begin to reel government back in.

High-frequency trading and the National Market System, on the other hand, are good places to begin. While the HFT issue may be visible in detail only to market structure types like those who read TabbFORUM, readers and non-readers alike can recognize the unseemly grasp for more power and money by the SEC. As a result, reining in the SEC may be more possible than we imagine, if for no other reason than that there are no generally recognizable civil rights or redistribution issues involved.

Regardless of one's market sophistication, it is easy enough to see that the SEC's National Market System created HFT and all the ancillary problems associated with it – the Flash Crash, the Facebook IPO, the Knightmare on Wall Street. It is also clear that before NMS, the US stock market provided average investors unparalleled opportunities to participate in the growth of American businesses, and that it provided those businesses and the technologies they introduced unparalleled opportunities to get funded and to get started. It no longer provides these benefits with anything remotely resembling its previous power.

In an age of deficits as far as the eye can see, it would be very unwise to give more money to the SEC. But beyond the money, granting government the power to reorder naturally evolved structures that have endured for decades, centuries or millennia, as stock markets have, is unwise beyond belief.

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Jurisdiction Battles Threaten Swaps Reform

By Colby Jenkins
Originally published on 
Tabb Forum

The Securities and Exchange Commission faces ideological differences with the CFTC and international regulators in implementing Dodd-Frank reforms. But the SEC’s slow, deliberate approach to rulemaking affords the global swaps market a safer transition from opaque to transparent.

If the Dodd-Frank Act is the cure for an unstable market, the anticipation over its implementation may be as painful as the shot. After years of missed deadlines and underwhelming progress, regulators are at a crossroads. This is the situation Mary Jo White will be walking into as the chair of the US Securities and Exchange Commission.

This past January, Elisse Walter, as chairman of the SEC, pointed to the issue of extraterritoriality as the agency’s top priority for 2013. In her words, a definitive position on cross-border regulation is “a critical linchpin” in establishing remaining Dodd-Frank compliance rules domestically and abroad. Charged with the responsibility of regulating the global market of security-based swaps, the SEC has a tremendous uphill climb in front of it -- but at least the Commission is on the right path.

Extraterritoriality is not the only jurisdictional issue facing the swaps market. In the US, Dodd-Frank regulatory responsibilities are split bilaterally between the SEC and the CFTC. This means that many market participants will need to register with both agencies. Thus, it is not surprising that recent industry-wide surveys indicate that financial institutions are not prepared -- or even taking the appropriate precautions -- to meet the requirements of impending swaps market overhaul. After all, in the face of dual-jurisdiction requirements and potentially disparate sets of compliance rules, where does one start?     

Where the CFTC has gone the route of issuing guidance with regard to cross-border regulation application (releasing this past December a final exemptive order that would afford certain global participants temporary relief from compliance obligations while the CFTC finalizes its cross-border guidance), the SEC has chosen the route of formalized rulemaking. This process will include extensive analysis as to how extraterritorial Dodd-Frank applications might affect economic factors globally and, most important, systemically  affect the U.S. financial system -- focusing in particular on the tremendous capital and margin requirements expected of a trillion-dollar industry that has previously been largely unregulated.

This slow process of regulatory overhaul is not unique to the States. Aspirations for a centrally cleared, transparent OTC marketplace are shared globally. Foreign resistance to the extraterritorial reach of the Dodd-Frank Act stems from disparities in regulatory timelines and issues of overlapping, duplicative regulation that might lead to a fragmented global market if implementation is not carried out within a framework of global coordination.

This trepidation is in many ways underscored by the blunt approach the CFTC has taken in giving global participants until May 2013 to prepare for finalized guidance on cross-border applications. On the other hand, the SEC’s approach of formally proposing rules for analysis and discussion before any regulation is finalized will likely extend an already drawn out regulatory process.

As of February 1, the SEC lagged behind the CFTC in terms of overall Dodd-Frank rulemaking progress (see Exhibit 1). With regard to Title VII progress specifically, the CFTC had finalized 35 rules and missed deadlines on eight others, while the SEC had finalized 10 rules and missed 19 deadlines (see Exhibit 2).

Exhibit 1: Overall Dodd-Frank Rulemaking Progress

Source: Davis Polk

Exhibit 2: Title VII Progress

Source: Davis Polk

While at face value the CFTC is considerably ahead of the SEC in terms of rulemaking, the progress has come at a cost. “The lawsuits and the ad-hoc barrage of exemptions point to a flawed rulemaking process that prioritized getting the rules done fast over getting them done right,” lamented CFTC commissioner Scott O’Malia, speaking at the 2013 TABB Group fixed income event.

Going forward, the CFTC will be hard pressed to thoughtfully address critical issues regarding SEFs and margin/capital requirements before the May 1 deadline. Issues such as SEF execution method flexibility, the potential for a variety of SEF platforms rather than mirror DCMs, and finalizing margin and capital rules for uncleared products that are consistent with standards set by the BCBS and IOSCO are at the top of the list.

Meanwhile, the SEC, which has 19 remaining Title VII proposals to finalize, has no such time constraint. While the idea of continued regulatory ambiguity and lethargy is certainly unappealing, creating responsible, globally reaching rules requires time for analysis, public discussion/feedback, and further refinement. When the dust settles, the SEC’s formal, stepwise approach to rulemaking will, in all likelihood, afford the global security-based swaps market a slower and safer transition from opaque to transparent.

Until then, as regulatory agencies grapple with the difficult task of internationally and domestically coordinated rulemaking, it seems the devil is in the lack of details.


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Davis Polk Dodd-Frank Progress Report Reveals 93 Deadlines Met, 144 Missed to Date

Davis Polk has released their latest progress report on Dodd-Frank, summarizing regulatory activity to date. According to the executive summary of the report:

In October 2012

  • No New Deadlines. No new rulemaking requirements were due in October.
  • 6 Requirements Met. The Federal Reserve, FDIC and OCC released final rules on stress testing.  The SEC released its final rule on clearing agency standards.  The CFTC released a final rule that incorporates swaps into existing regulations.
  • 4 Requirements Proposed. The SEC released a proposed rule on capital, margin and segregation requirements for swap dealers and major swap participants.  The FHFA released a proposed rule on stress testing. 

To date:

  • As of November 1, 2012, a total of 237 Dodd-Frank rulemaking requirement deadlines have passes. Of these 237 deadlines, 144 (61%) have been missed and 93 (39%) have been met with finalizing rules.
  • In addition, 133 (33.4%) of the 398 total required rulemakings have been finalized, while 132 (33.2%) rulemaking requirements have not yet been proposed.
  • Major rulemaking activity this month included the Federal Reserve, FDIC and OCC final rules on stress testing. Additionally, the SEC proposed a rule on capital, margin and segregation requirements for swaps dealers and major swap participants.

For the complete PDF of the Davis Polk Dodd-Frank Progress Report, click here.

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Swaps Definition Takes on the World

By David Dixon, Misys plc
Originally published on Tabb Forum

Earlier this month, the Securities and Exchange Commission and the Commodity Futures Trading Commission released the long-anticipated definition of a swap. As expected by the majority of industry participants, the SEC and CFTC sided with the wording in the Dodd-Frank Act.

Although there were no big surprises in the content of the announcement, banks and financial institutions still have a huge amount to contend with on the regulatory front – including registering themselves, complying with compensation rule changes, establishing living wills and of course determining changes to their business strategy – in addition to the newly outlined definition. It may seem that the software changes necessary for this one piece of Dodd-Frank are a small part of the overall picture. However, having the right technology in place plays a big role in being compliant and running an efficient business.

Industry Implications
The compliance clock started ticking on July 11, when the definition was announced to the public, but the onset of the regulations was realized long ago. From our experience, and speaking with our clients, the most difficult element of complying with the new definition is the short timeframe – just 60 days to implement in some cases – setting the deadlines as early as September.

Much of what banks and financial institutions need in terms of software solutions is available today. But to implement and test these systems takes more time than is currently at hand. In addition, there are elements of Dodd-Frank to come that will affect areas of the solution previously implemented, e.g., trade reporting will come into effect in September but the requirement to use legal entity identifiers (LEIs) will come at the end of the year. This adds additional pressure on firms and further complicates the software update process.

Prioritizing Updates
Over the next few months, there will be a huge scramble in the industry as many new regulations go into effect at different times before the end of the year. The process is akin to buying the latest computer and almost immediately a newer, faster version is available.

Similarly, deciding at what time to implement new compliance software when you know there are future regulations, bringing additional changes, adds a level of complexity to any decision. Firms have to draw the line somewhere and the ultimate decision will be made based on different implications at each organization.

In addition, as the deadline is fast approaching, short-term fixes have to be more tactical while strategic solutions will be implemented down the line. It’s not possible to get everything done at once and firms have their plates full.

Global Impact
Although the SEC and CFTC’s announcement concerns only Dodd-Frank and the U.S. market, the implications are global. As there is a general drive for regulatory harmonization across the world to avoid potential regulatory arbitrage, it would be safe to assume that the rules will look similar across the globe. Therefore, banks and financial institutions need to be prepared to handle similar regulations in other regions.

U.S. banks are well advanced in their planning and European organizations are close behind, however, in Asia, with its many different jurisdictions, regulations and deadlines are less certain. We still continue to see little interest regarding the SEC/CFTC definition from firms in Asia. This raises the issue of whether businesses will move to Asia as a consequence of less regulation in that area. A second concern is whether Asian firms are prepared for the U.S. regulations when they take effect.

These are big issues that banks will need to contend with over the next few months. But there is a third consideration.

Even before Dodd-Frank there was pressure to globally consolidate software systems; with Dodd-Frank this continues to get the benefits of consolidated reporting, increased globalization and to allow greater risk controls. If firms update to comply with this definition in a hurry, they risk ending up with ad-hoc systems to meet the requirements of various regions versus deploying a unified and efficient infrastructure.

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SEC Approves Final Rules on Key Derivatives Definitions under Dodd-Frank Act

Late last week, the SEC unanimously approved rules and interpretations on key derivatives product definitions.

According to a statement on the SEC website:

“The SEC rules and interpretations further define the terms “swap” and “security-based swap” and whether a particular instrument is a “swap” regulated by the Commodity Futures Trading Commission (CFTC) or a “security-based swap” regulated by the SEC. The SEC action also addresses “mixed swaps,” which are regulated by both agencies, and “security-based swap agreements,” which are regulated by the CFTC but over which the SEC has antifraud and other authority.”

According to the SEC, the final rule text and a fact sheet will be available once the CFTC adopts the final rules.

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SEC Adopts New Procedures for Reviewing Clearing Swaps under Dodd-Frank Act

The SEC finalized rules on Thursday, June 28th, that will help the agency determine clearing requirements for swaps. The SEC rules detail how clearing agencies will provide information to regulators about swaps submissions for clearing. The information will aid the SEC in determining whether such security-based swaps are required to be cleared.

In addition, the SEC approved another set of rules that define and describe “when clearinghouses deemed to be "systemically important" need to file certain advanced notices to regulators.”

According to a Reuters article on the rule-making:

“Those systemically important clearing agencies will need to let regulators know if they plan to make changes to their risk management processes, or changes that affect their core clearing and settlement functions.”

Following is a link to the SEC Final Rule and Fact Sheet: Procedures for Reviewing Clearing Submissions Under Dodd-Frank Act

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The Dangers of De Minimus

By George Bollenbacher
Originally published on Tabb Forum

Two weeks ago the Commodity Futures Trading Commission and Securities and Exchange Commission jointly approved a final rule on further definition of various entity categories including swap dealer (SD) and major swap participant (MSP). The final rule, published on the CFTC’s website, sets out the conditions under which a market participant must register as an SD or MSP. For our purposes, the SD registration requirement is the most important.

SD registration requires membership in the National Futures Association and imposes quite a few business conduct rules – among them requirements to determine if a counterparty is an eligible contract participant (ECP), to record and retain all electronic and voice communications with potential counterparties and for SDs to supply, at a counterparty’s request, the scenario analysis used to price a swap. And there are many other rules.

The rule says that SD means, among other things, anyone who “regularly enters into swaps with counterparties as an ordinary course of business for its own account” as long as the annual trading volume is above a de minimus threshold.

In the weeks leading up to the approval, there apparently was considerable debate within both agencies as to the threshold volume, and the final compromise was $8 billion notional amount for an introductory period, followed by a reduction to $3 billion, perhaps gradually.

What got almost no attention, from either the press or the Commissions, was a small section of the de minimus section that set a threshold of “an aggregate gross notional amount of no more than $25 million [where] the counterparty is a ‘special entity.’”

Special entities are defined as, among others, public bodies and employee benefit plans. Unfortunately, the de minimus definition says nothing about trades done on a swap execution facility, even those where the counterparties are blind to each other’s identity.

Thus any entity that regularly enters into swaps as part of its business could become a SD simply by doing a single large trade on a SEF, or even a series of smaller trades, with a special entity. In cases where the special entity is a client of an asset manager, their identity would only become known when a block trade is allocated, way too late for the putative SD to do anything about it. Further, if the entity did not know that its counterparty was a special entity, it could inadvertently fail to register as a SD.

The CFTC recognized its error after the rule was finalized and plans to issue supplementary guidance. Absent that guidance, the only way an active trader could ensure that it didn’t run afoul of this reverse loophole would be to require that any executing broker or asset manager exclude special entities from any trades that it does. Not exactly what the agencies had in mind when they passed the rule.

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Exemptions Are a Mirage – There’s No Escaping the Cost of Collateral

By Will Rhode and Paul Rowady
Originally published on Tabb Forum

One hundred million dollars to $8 billion – sounds like a big leap. In reality it makes no difference.

News that the Commodity Futures Trading Commission and the Securities and Exchange Commission have jointly agreed to allow firms to trade anywhere up to $8 billion in swaps each year, up from a paltry $100 million, before labelling them a “swaps dealer” is supposed to offer relief to large energy firms that use derivatives to hedge.

But the dealer exemption merely means energy companies will likely become classified as end users. As we discussed in our report Initial Margin for OTC Derivatives: The Burden of Opportunity Costs, the end-user exemption is a mirage. As long as the dealer side of an over-the-counter trade with an exempted party is obligated to clear, then the dealer will be on the hook for both the counterparties’ margin requirements (since the CCP cannot only clear one side). To offset these costs, dealers will price initial margin into the trade, mostly likely in the spread and fees.

OTC derivatives market designations may change compliance requirements – reporting, and such – for swaps dealers vs. major swap participants vs. others. Clearly the more active players are the more systematically important. But the collateral requirements will impact all. TABB Group believes there will be no two-tier OTC derivatives market with cleared and uncleared, except in very rare circumstances.

Extraterritoriality is also a mirage. Extraterritoriality represents the extension of the rules in one domain to entities based in another domain. Dodd-Frank includes rules that extend to entities outside the U.S.

But TABB Group believes that rules that apply to OTC derivatives in the G20 will eventually converge and therefore major swap participants will ultimately need to comply with similar rules in all regions. The window of time for the potential for regulatory arbitrage is uncertain – not likely to be lengthy – and the operational aspects to exploit such opportunities is non-trivial. Major swap participants will need to comply with the spirit of the rules as well as the letter.

According to our report European Credit & Rates Dealers 2011: Capital Clearing and Central Limit Order Books, 73 percent of European dealers said they expected to steal a march on their U.S. counterparts as a result of Dodd-Frank’s extraterritoriality rules. Rest assured, U.S. authorities will take a dim view of that. For those who hope to exploit the discrepancy, don’t plan on a trip into the U.S. markets any time soon without a very unwelcome reception waiting on the other side of the border.

Some European dealers say they will not seek out regulatory arbitrage opportunities for fear of angering U.S. authorities and may force clients to clear even though they will not be obligated to do so.

In essence, the G20 central clearing mandate means there is no escaping the burden of collateral costs. It doesn’t matter if you are a large energy company, a pension fund or a European regional bank – one way or another you will end up footing the collateral bill for the simple reason that dealers have no intention of paying for it.

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