As financial markets become increasingly global and interconnected, hammering home country regulations that align with those abroad becomes more and more difficult. U.S. regulators and their counterparts in the European Union and elsewhere, for example, are increasingly at odds on a host of topics, including data privacy, antitrust, and accounting regulations, even as they increasingly work together on enforcement.
U. S. regulators, for example, are pushing for more stringent capital buffers at large banks than their regulatory counterparts in Europe. Even when international regulators are in general agreement, the devil lies in the details.
The current poster child for an international impasse is the battle over rules pertaining to international derivatives transactions. Europeans lament that the United States is trying to impose its regulations and guidance on their markets. Now, it is increasingly likely that the Commodity Futures Trading Commission may do an about face and walk way from some of its rulemaking.
CFTC Commissioner Christopher Giancarlo, who joined the agency at the beginning of this year, is a vocal proponent of a regulatory do-over, cracking back into its swaps rules and rethinking its interpretive guidance. Speaking at the Global Forum for Derivatives Markets in Switzerland in September, he warned of “a looming cross-Atlantic derivatives trade war,” that may be an unintended consequence of his agency’s past actions.
Giancarlo’s speech coincided with the fifth anniversary of the Pittsburgh G-20 Summit where global leaders agreed to work together to support economic recovery. They pledged to work together to “implement global standards” in financial markets and ensure that protectionism would not be the outcome, intentionally or otherwise.
Giancarlo fears this spirit of cooperation has long since evaporated. A specific concern is the “uncoordinated approach to swaps clearing” that has emerged. The CFTC, he explained, needed to meet requirements of the Dodd-Frank Act and was one of the first regulators of the G-20 to implement clearing mandates, patterning swaps clearing rules on existing rules for clearing futures. Those rules do not require that swaps clearing take place in the United States, even if the swap is in U.S. dollars. But, the CFTC does require that swaps clearing take place on a CFTC-registered and supervised central counterparty clearing house (CCP) that meets basic standards.
“What you have, unfortunately, is the CFTC implementing its rules and stating its view on cross-border application of those rules before regulators in other jurisdictions have had a chance to catch up with it.”
James Schwartz, Of Counsel, Morrison & Foerster
Critics, however, worry that the futures regime may not apply well to the much different swaps market. Another snag is that the European Commission has not recognized U.S. CCPs as equivalent under its European Market Infrastructure Regulation.
Giancarlo explains that if the EC does not recognize U.S. CCPs as equivalent they will be ineligible to clear contracts subject to the EU clearing mandate next year. “This outcome will be destructive to both U.S. and European economic interests and lead to further market fragmentation and contraction of liquidity, market disruption, and dislocation in the global derivatives markets,” he said.
Giancarlo opined that the “lack of coordination in swaps clearing does not exist in a vacuum” and the CFTC, “started the current rift in cross-Atlantic swaps cooperation” with guidance it issued in July 2013. It asserted that every single swap a U.S. individual or entity enters into, no matter where it is transacted, falls under CFTC transaction rules. Several months later, the CFTC issued a staff advisory declaring that, even if no U.S. person is a party to the trade, its trading rules apply if it is “arranged, negotiated, or executed” by personnel or agents of a non-U.S. swap dealer located in the United States.
“Taken together, these CFTC pronouncements say that CFTC trading rules apply anytime and anywhere a U.S. person is a party to a swaps trade or the trade is assisted from U.S. shores,” Giancarlo said. “Making things worse, the CFTC swaps trading rules contain a host of peculiar limitations based on practices in the U.S. futures markets that have not been adopted in the European Union or anywhere else.”
The following is an excerpt from a keynote address delivered by Commodities Futures Trading Commission member J. Christopher Giancarlo in September at the Global Forum for Derivatives Markets in Switzerland.
I believe my agency, the CFTC, started the current rift in cross-Atlantic swaps cooperation with its July 2013 “Interpretative Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations.” In essence, the Interpretative Guidance asserted that every single swap a U.S. Person enters into, no matter where it is transacted, has a direct and significant connection with activities in, and effect on, commerce of the United States that requires imposing transaction rules of the CFTC.
Several months later, the CFTC issued a “Staff Advisory” that declared that, even if no U.S. person is a party to the trade, CFTC trading rules apply if it is “arranged, negotiated, or executed” by personnel or agents of a non-US swap dealer located in the U.S.
Taken together, these CFTC pronouncements say that CFTC trading rules apply anytime and anywhere a U.S. Person is a party to a swaps trade or the trade is assisted from U.S. shores.
Making things worse, the CFTC swaps trading rules contain a host of peculiar limitations based on practices in the US futures markets that have not been adopted in the EU or anywhere else. Several of these peculiar CFTC swaps trading rules are contrary to common practice in global markets and are unlikely to be replicated by non-US regulators, including:
Trading only on order books and request for quote (RFQ) systems to TWO then THREE counterparties;
Exchange-certified “made available to trade” determinations;
Swap Execution Facility (SEF) position-limit maintenance and enforcement;
Limitations on counterparty transparency; and
Treating swaps not accepted for clearing as “void ab-initio.”
The combined effect of the CFTC’s Interpretative Guidance and Staff Advisory – neither of which are formally adopted CFTC rules – is to dictate that non-US market operators and participants must abide by the CFTC’s peculiar, one-size-fits-all swaps transaction-level rules for trades involving U.S. persons or supported by U.S. based personnel.
“On the ostensible grounds of ring-fencing the U.S. economy from harm, the CFTC purports to tell global swaps markets involving U.S. persons to adopt particular CFTC trading mechanics that do almost nothing to reduce counterparty risk,” he added. “This uncoordinated approach to the regulation of swaps execution has fragmented global markets.”
Back to the Drawing Board
Giancarlo called for “a reset” in the EU and CFTC cross-border regulatory relationship and made a case for deference to home country regulators “especially in matters of market practices, transparency, and price formation that have little to do with preventing global systemic risk.” That approach has gained support of Commissioner Mark Wetjen, and Chairman Timothy Massad said he is open to the idea.
How did the quest for effective cross-border regulations go from the optimism expressed in the 2013 “Path Forward” agreement between the United States and European Union to fears of a “trade war?” Part of the problem, experts say, is that the CFTC, under the leadership of former Chairman Gary Gensler, ripped through its Dodd-Frank Act mandates at breakneck speed. The rapid pace of rulemaking put the United States far ahead of the European Union in swaps regulations.
“The derivatives market has historically been a profoundly international market,” James Schwartz, of counsel for law firm Morrison & Foerster and former in-house counsel at a major derivatives dealer, says. “It hasn’t made much difference, historically speaking, if you are sitting in New York and your counterparty is in London, Toronto, or Japan. What you have now are governments in many of the G20 jurisdictions trying to implement reforms separately. What is lacking is a superstructure to align the different regulations.”
“Because the swaps market is very international, the CFTC has to say how it views the international application of its rules, otherwise, if it was just regulating strictly those within the U.S., and that doesn’t capture a large part of this market,” Schwartz says. “What you have, unfortunately, is the CFTC implementing its rules and stating its view on cross-border application of those rules before regulators in other jurisdictions have had a chance to catch up with it.”
Schwartz would also like to see greater transparency as international regulators move forward. “It is notable how little people outside the governments know about what discussions are going on,” he says. Those discussions must address the lack of any central organization to help the regulators harmonize. “The institutional framework to resolve any discrepancies among different regulations in different countries is not especially clear at this time,” he adds.
While Giancarlo’s comments may have been controversial in the United States, they may prove to be a breath of fresh air for Europeans. “It was a welcomed response from a CFTC commissioner because, for a long time, with the exception of Wetjen, and Scott O’Malia before he left, it seemed as though the commissioners were largely ignoring international concerns for wanting to get everything done to meet the U.S. timeline,” Carolyn Jackson, a London-based partner with the law firm Katten Muchin Rosenman, says. “It was really done at the expense of international cooperation.”
“What was particularly heartening about Giancarlo’s remarks was that he thinks non-U.S. trading platforms—the whole multilateral trading facilities issue—is not where you need dual regulation, and he even states that deference should be given to home country regulators,” Jackson says.
If the CFTC is willing to work closer with international regulators there is reason to be optimistic that rule harmonization will eventually work out, Richard Paulson, a managing director at PwC, says. “It is difficult and it will take some time, but I’m confident they are going to get there,” he says. “Like most complex political journeys, this one is messy. There is a lot of back and forth and everyone shouting out their concerns about the ultimate outcome and what will happen if they don’t get it right. At the end of the day, I think the goal is a harmonized set of regulations and a strong system of mutual recognition and substituted compliance.”
The impetus to get things right should inspire compromise. “Most of the swaps market is international and the transactions typically cross borders,” Paulson says. “The regulators know that if there are big divergences in the ultimate set of rules regarding things like clearing, margin, and exchange trading execution reporting that there will be an adverse outcome. The spirit of cooperation regulators have set out in their various papers on this topic, and with their actions, show they are working hard to get this done. I see a lot of traction, but we are not there yet.”