Consider it regulatory kismet. Independently, on Feb. 10, the Securities and Exchange Commission and Commodity Futures Trading Commission finalized long-lingering rules and agreements intended to resolve concerns with the international marketplace for derivatives deals.
The SEC’s new rules cover foreign swaps dealers who maintain trading desks in the U.S. and their cross-border transactions. First proposed in 2013 and modified over the years, it clarifies who should register as a security-based swap dealer under U.S. law, closing a perceived loophole that banks and others in the financial services industry could use to bypass domestic rules. Meanwhile, the CFTC took a giant step toward resolving a long-simmering impasse between it and European regulators. Both efforts are being hailed as “milestones” by both regulators and outside observers.
Nearly half of North American trading activity in credit default swaps occurs between U.S. counterparties and parties based abroad; approximately 40 percent occurs between non-U.S. counterparties, many of them foreign affiliates of a U.S. financial group. The SEC’s new rules apply to non-U.S. companies that use personnel located in a U.S. branch or office to arrange, negotiate, or execute a security-based swap transaction. Any dealer that exceeds an $8 billion notional threshold, including any of its dealing activity in the U.S., would need to register with the SEC as a security-based swap dealer (the Commission retains flexibility to revise the level).
The rules would help ensure that both U.S. and foreign dealers are subject to Title VII of the Dodd Frank Act when they engage in security-based swap dealing activity in the U.S. The legislation gave the SEC regulatory authority over security-based swaps and certain key players in that market, including security-based swap dealers and major security-based swap participants.
Chairman Mary Jo White called the 3-0 vote “a key milestone in the completion” of its regime for overseeing swaps dealers. Finalizing “ground rules” for U.S. activity allows the SEC to proceed with rules for how they conduct business with counterparties and how they use capital, margin, and asset segregation to maintain their financial strength and protect counterparties, she said.
Commissioner Kara Stein stressed the importance of such oversight by recalling oversights that contributed to the financial crisis. During just a few days in 2008, insurance giant AIG, a major participant in the global trade of derivatives, furthered a growing loss of confidence in the U.S. and global financial markets. “As AIG’s own credit-worthiness came into question, a drumbeat of collateral calls questioned AIG’s ability to make good on its promises,” she said. “The shortfall was growing by billions of dollars each day, and AIG simply couldn’t pay.”
“The concentration of swap dealing activity amongst a few financial firms, as well as the opacity of the CDS market, contributed to the threat of a daisy chain of failures,” Stein added. “This resulted in the government having to bail out companies no one had ever dreamed would be risky. Moreover, the global nature of swaps allowed the crisis to spread quickly around the world. As a result, the bailouts and other effects of the crisis spilled across international borders.”
“It has been a long, drawn-out process, but it was important that it be done. It’s a very important step in putting together a global regulatory regime and making sure the markets continue to operate as a global marketplace.”
Willa Cohen Bruckner, Partner, Alston & Bird
While the SEC was finalizing its new rules, elsewhere in Washington D.C. the CFTC was hammering out a new “common approach” for central clearing counterparties with European officials. After three years of discussions, it reached agreement with the European Commission on a framework to recognize that the other continent’s clearinghouses are subject to equivalent regulatory oversight.
CCPs guarantee the obligations of all counterparties to a transaction, typically with high-quality asset holdings. If a counterparty to a transaction goes into default before settling its obligations, its other counterparties are protected by collateral held by the CCP that is calculated and collected on a daily basis.
Without such a determination, a U.S. clearinghouse could not be deemed a “qualifying CCP” under EU law and European banks carrying positions here would be subject to penalty capital charges. As part of the agreement, domestic clearinghouses seeking recognition in the EU must demonstrate compliance with new requirements that are not currently required for all U.S. CCPs, including collecting initial margins sufficient to cover a two-day liquidation process and sufficient resources to cover the default of the two members with the largest exposure to them. The margins requirement will not apply to domestically traded agriculture derivatives.
A COMMON APPROACH
On Feb. 10, European Commissioner for Financial Stability, Financial Services and Capital Markets Union Jonathan Hill, and U.S. Commodity Futures Trading Commission Chairman Timothy Massad announced a common approach regarding requirements for central clearing counterparties. Key elements of the approach:
The European Commission will shortly propose for adoption an equivalence decision in respect of U.S. CCPs. Equivalence is necessary so that ESMA can recognize US CCPs wanting to serve EU markets. Once recognized by ESMA, a U.S. CCP may continue to provide services in the EU by complying with US requirements. It will also become a qualifying CCP for the purpose of the EU Capital Requirements Regulation, lowering costs for EU banks and their subsidiaries.
The proposed determination of equivalence is based on the condition that CFTC-registered U.S. CCPs seeking recognition in the EU confirm that their internal rules and procedures ensure:
For clearing members' proprietary positions in exchange traded derivatives, the collection of initial margins that are sufficient to take into account a two-day liquidation period.
That initial margin models include measures to mitigate the risk of procyclicality.
The maintenance of 'cover 2' default resources.
The conditions will not apply with respect to US agricultural commodity derivatives traded and cleared domestically within the U.S. This takes account of the significant nexus of these US contracts with the U.S. economy, the importance of these contracts to U.S. farmers and ranchers and recognizes the low degree of systemic interconnectedness of these markets with the rest of the financial system.
In addition, the European Commission will shortly propose the adoption of an equivalence decision under EMIR to determine that U.S. trading venues are equivalent to regulated markets in the EU, providing a level playing field between EU and U.S. trading venues for the purposes of the MIFID I framework.
CFTC substituted compliance
The CFTC staff will propose a determination of comparability, concluding that a majority of EU requirements are comparable to CFTC requirements. This determination will provide a basis for both EU CCPs already registered with the CFTC as derivatives clearing organizations and those seeking registration to meet certain CFTC requirements by complying with the corresponding requirements as set forth in EMIR. In addition, the CFTC staff will propose to streamline the registration process for EU CCPs wishing to register with it, reflecting these similar requirements.A c
This process will be completed within the same timeframe as the process for EU equivalence and recognition of CFTC-registered U.S. CCPs.
A statement from the European Commission praises the agreement as an important step to ensure that both EU and U.S. CCPs operate “to the same high standards,” while alleviating regulatory burdens by allowing compliance with only one set of rules.
Pending steps to implement the common approach include the CFTC finalizing a substituted compliance regime for EU CCPs, the EC adopting an equivalence decision, and an authorizing vote by EU member states.
CFTC Commissioner J. Christopher Giancarlo chalked the inability to reach an agreement sooner to an arrogance displayed by past members and proposals that “had little to do with insulating U.S. markets from systemic risk and more to do with increasing the regulatory jurisdiction of the CFTC.” European regulators “rightly viewed these requirements as a massive regulatory overreach,” he says.
The framework is intended “to prevent the cleared swap market from fragmenting along jurisdictional lines,” says James Schwartz, an attorney with Morrison Foerster and chairman of the SEC sub-committee of the Futures and Derivatives Committee of the New York City Bar Association. “They have reached this agreement that, assuming everything goes according to plan, will mean that someone in the U.S. can use a European CCP and someone in Europe can use a U.S. CCP without being unduly penalized.”
Schwartz characterizes the holdup in simple terms: “What the Europeans do might make perfect sense to them, and what U.S. regulators do might make perfect sense to them, but that doesn’t mean they are the same. You can take a general concept and skin it any number of different ways.”
“What happened here is that the European and U.S. regulators had different views as to the regulation of clearing houses,” he says. “In particular they had different views as to the calculation of margin that clearing houses should be required to have in order to ensure that they will meet their obligations. That’s been the primary issue and it appears that they have managed to reach an agreement.”
“It has been a long, drawn-out process, but it was important that it be done” says Willa Cohen Bruckner, a partner in law firm Alston & Bird’s financial services and products group. “It’s a very important step in putting together a global regulatory regime and making sure the markets continue to operate as a global marketplace.”
Bruckner agrees that a major sticking point was the initial margin calculations. “It wasn’t just an ego thing,” she says. “There were some real substantive issues they had differences on.”
What likely helped break the impasse are new European clearing requirements that are effective in June, but retroactive to trades entered into as of Feb. 21. “Consider a European bank with a transaction cleared in the U.S. If you haven’t got an equivalence determination, that bank is now not in compliance with the European requirement,” she says. “If they didn’t get this done very quickly there was the potential for European banks to pull back from using U.S. clearing entities, and vice versa.”