Clarity Gap


Market participants’ first questions arose around the fall of 2008, when the collapse of Lehman Brothers and a close call with financial armageddon made it all-but-certain that the regulatory pendulum would swing back toward tautness.

Little was settled by 2010, when Dodd-Frank was signed into law in the U.S. and MiFID II gained traction in Europe. The initiatives cemented the notion that new and significant regulation was forthcoming, yet details were lacking and the timeframe of implementation remained a ways off.

Now, as the global financial crisis approaches its fourth anniversary, investors and traders remain vexed as much remains unknown. Rulemaking has moved forward, but only in fits and starts, and with delays; some specific codes such as the Volcker Rule are still up in the air; and political forces in a U.S. presidential-election year threaten to scrap Dodd-Frank in its entirety.

“Uncertainty is high whenever many regulations have not been translated into final rules,” said Max Dufour, principal at trading-technology provider SunGard Global Services. “It’s especially high when the proposed rules are complex, demanding and applied by multiple agencies, without the test of time to validate the process.”

(Uncertainty) is especially high when the proposed rules are complex, demanding and applied by multiple agencies. Max Dufour, principal at trading-technology provider SunGard Global Services

Market participants and financial regulators such as the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission have always had an uneasy co-existence. Over the past couple years, this tension seems to have ratcheted up, and market players consistently cite the lingering fog of the process as a sticking point. It’s almost as if the market would prefer strict, but clear and definitive, rules to an continually developing picture that leaves questions and uncertainty.

Dodd-Frank and Basel III in Europe are currently in the implementation process, and details of hundreds of rules still need to be written. Dodd-Frank, meant to take effect this July, is expected to be rolled out gradually over a period of months; regulators have said they’ll take longer to get it right rather than rush.

That view may be constructive for the market in the long term, but for now it remains unclear what, if any, restrictions will be placed on high-speed traders and dark pools; how much big banks will have to rein in or restructure trading operations; and how much of the OTC derivatives market will be brought onto exchanges.
“While regulators spend a lot of time trying to extract signals from noise, they have not yet had a chance to answer some of the fundamental questions raised by the regulations,” said Philippe Buhannic, chief executive of execution-management provider TradingScreen. “With basic questions about scope and jurisdiction still up for grabs, it’s doesn’t seem like we can expect clarity on the details of this regulation any time soon.”

Lots of Lapses
As of March 2012, 225 Dodd-Frank rulemaking deadlines had lapsed, according to Dufour of SunGard. Most of the Dodd-Frank Act’s provisions rely on analysis, interpretation, rulemaking and defining filing requirements by regulators.

“Once that process is completed, there is work left for the financial institutions and their advisors to build the technology, teams and business processes to support the requirements, as part of an integrated and holistic framework to avoid duplicated efforts or unnecessary work while keeping up with mandated timelines,” Dufour told Markets Media.

The expectation that rules would be in place by the middle of 2011 have since given way to a sense of frustration. Market participants say they are unable to invest or make strategic decisions comfortably without knowing what the playing field will look like in a few years, so often they just stand pat and potentially miss out on opportunities.
Derivatives reform is an area of focus for regulators, and by extension derivatives players are among the most in limbo.

“We have seen the timetable shift dramatically,” said Richard Baker, chief executive of Cleartrade Exchange, which handles trades in freight, iron ore, steel and fertilizer derivatives. “The critical definitions of swap, swap dealer, and (swap execution facilities) have been pushed back to the end of 2012. We’re left with huge uncertainty about which direction the rules will take.”

Uncertainty is affecting firms that have not traditionally been under regulatory oversight. “They will need to interpret the impact of the regulatory agenda and its impact on their business, technology and operations,” said Jeffrey Wallis, managing partner of SunGard Global Consulting Services. “This is particularly the case for swap dealers and major swap participants defined under Dodd-Frank’s Title VII and corresponding EMIR directives.”
The situation is exacerbated by an election cycle in the U.S. and attempts to synchronize the regulatory agenda across continents. “There are deadlines but these can be postponed, and I would expect that this will happen in Europe and the U.S.,” he said. “Given everything they have to do, it would be surprising if regulators were able to meet their deadlines.”

Financial services firms “are moving forward and considering how to implement the spirit of the rule filings with an expectation that adjustments will be made once the regulatory agencies catch up,” Wallis said.
In the U.S., the CFTC, which regulates futures markets, has the lion’s share of regulatory responsibility for implementing Title VII of Dodd-Frank.

“Most OTC swaps will be regulated by the CFTC under the authority of the Commodity Exchange Act,” said Kathryn Trkla, partner in Foley & Lardner’s securities, commodities and exchange regulation practice.

For credit derivatives, regulatory oversight will be split, with credit-default swap indices falling under the CFTC and single-name CDS handled by the SEC, Trkla noted. This roughly follows the jurisdictional framework for stock-index futures, where broad-based index futures are regulated by the CFTC, while single-name futures are jointly regulated by the SEC and CFTC.

“One area where it can get confusing with the construction of CDS indexes is that when a component defaults and drops out of the index, it could cause the index to flip from broad-based to narrow-based,” said Trkla.
Is Finalization Final?

Even where rules have been finalized, the manner in which they get implemented can generate uncertainty.
The CFTC, for example, has issued a final rule on reporting of swap transactions, called Part 43. Under this rule, responsibility for reporting swap transactions depends on whether the transaction takes place on an exchange/SEF, or bilaterally.

For transactions executed on a registered SEF or designated contract market, the SEF or DCM must report the swap transaction and pricing data to the appropriate registered swap data repository for public dissemination. For transactions executed bilaterally, the parties to the transaction report to the appropriate swap data repository for public dissemination according to the following rules: if only one party is a swap dealer or major swap participant, then the swap dealer or major swap participant should report to the registered swap data repository. Otherwise, the parties designate which party should report to the registered swap data repository.

We are seeing Asian jurisdictions, particularly Singapore and Hong Kong, making their positions clear. Richard Baker, chief executive of Cleartrade Exchange

“For off-exchange transactions, the reporting obligation is assigned to the swap counterparty that the CFTC views as the best-equipped to report,” said Gavin McConville, a regulatory expert at Lombard Risk.

Further, swap transactions and pricing must be reported to a registered swap data repository “as soon as technologically practicable” after execution of a publicly reportable swap transaction. This CFTC guideline “is subject to wide interpretation,” said McConville. “There’s a great deal of ambiguity.”

The CFTC has entered the crucial definitional phase of rule making under Dodd-Frank, upon which hinges all the other rules for regulating the OTC swaps market.

“The definitional level is where the real work happens,” said Wallis. “Historically, regulators have allowed regulatory reviews and fines to set the precedent. They will be forced to go a little further this time, due to the amount of regulatory synchronization required between the SEC, CFTC and EU.”

In March 2012, Nasdaq OMX Nordic postponed the introduction of competitive clearing in the Nordic cash equity markets, citing regulatory uncertainty.

“There is still uncertainty regarding the detailed requirements for interoperability even though there is a political agreement regarding EMIR,” said Hans-Ole Jochumsen, president of Nasdaq OMX Nordic, in a statement. “There needs to be clarity and a level playing field in this area, before we can introduce interoperability.”

Europe Picks Up Pace
In Europe, derivatives lawmaking is currently divided between EMIR, which deals with central clearing and trade repositories, and Markets in Financial Instruments Regulation (MiFIR), which deals with trade execution.
“Clarity is emerging very slowly around Dodd-Frank, but it seems the EU is picking up the pace with EMIR in particular,” said Wallis. “The EU is using the directive framework approach, which is fast-tracking the effort. This will help catch up to Dodd-Frank and potentially pass it depending on how the political agenda impacts Dodd-Frank.”

A text of EMIR has been agreed to by the Council of Ministers of the European Union and the European parliament. EMIR now gets handed off to the European Securities and Markets Authority, which is tasked with creating implementation rules, known as Level 2 in the regulatory process.

ESMA will need to have Level 2 rules in place by end of September to be approved by the European Commission by year-end.

The perception that the U.S. and Europe have been ahead of Asia on OTC reforms has sparked fears of regulatory arbitrage. But any gap may be closing, as regional authorities have in recent months churned out consultation papers and worked with the International Organization of Securities Commissions.

Cleartrade Exchange, which is regulated by Monetary Authority of Singapore, has been closely following regulatory developments in the Asia-Pacific region. “We are seeing Asian jurisdictions, particularly Singapore and Hong Kong, making their positions clear on how they will approach the G20 reforms,” said Baker of Cleartrade Exchange. “Regulators are doing a good job of communicating that there won’t be a ‘lighter touch’ regime in Asia, certainly not in the primary markets.”

The Monetary Authority of Singapore has proposed that regulatory oversight of commodity derivatives be transferred from the Commodity Trading Act to the Securities and Futures Act, so entities operating markets or clearing facilities for commodity derivatives and commodity futures will only need to seek authorization from one regime. MAS is also proposing to expand the regulatory scope of the SFA to include derivative contracts.

Of all the rules and regulations that have been proposed, none has generated more controversy than the Volcker Rule, which is intended to protect banks’ lending capacity by barring the banks from speculative trading. As with many other regulatory pieces, there is no shortage of moving parts.

The proposed rule implements exemptions for underwriting and market making-related activities. For each of these permitted activities, the proposed rule provides a number of requirements that must be met in order for a banking entity to rely on the applicable exemption.

“There are a number of activities that are effectively on ice while these regulations are being hashed out,” said Buhannic of TradingScreen. “Proprietary trading at banks is now on hold. Some banks are looking to get away from this business entirely, while others are spinning out their prop desks as hedge funds.”

At the same time, the rule permits banks to engage in trading activities that support ‘client-oriented’ financial services, which include underwriting, market making, and traditional asset-management services. That introduces a potential loophole through which prop trading could continue under the guise of legitimate market making or underwriting.

“A very fundamental issue is the definition of terms,” Buhannic said. “For example, the activities covered by the term ‘market making’– and the parties that might be engaged in it – are unclear.”

Demand Outlook
Regulations could drive demand for a range of market-data services for OTC-traded derivative instruments migrated to exchange-traded derivative markets, said Dominic Dowd, director of data delivery solutions at TMX Datalink.

These services, according to Dowd, include extensions to real time and historical data delivery formats/specifications to accommodate more complex OTC markets, more robust connectivity to trading venues as OTC instruments migrate to exchange-traded venues, and storage and access to detailed historical information to meet the requirements of the Office of Financial Research created under Dodd-Frank.

Additionally, new regulations are introducing requirements on what firms need to do with their data. “This impacts the entire firm,” said Joshua Walsky, chief technology officer at Broadway Technology. “What’s specifically of interest is what is going on in the front office at the point of execution.”

Walsky cited as an example the impact pre-trade regulations such as SEC rule 15c3-5 or customer production regulations like MiFID are having on transactional and order-execution systems.

“These regulations require a collapsing of data, and to meet these regulations, firms must now bring together different data from across the organizations,” he said. “This data used to be managed by separate systems and, in some cases, by separate departments like the front office versus the back office. Meeting new regulations will require bringing this data together in a single place in a single system.”

Another challenge for the front office is dealing with ill-structured or differently structured data. Dodd-Frank, for example, requires “formalizing a series of OTC contracts to allow greater transparency by mandating that these are transacted or recorded in open facilities—the SEFs,” said Walsky.

In deciding when and how to implement changes in software, market participants tend to fall into two categories: those who insist on complete clarity, and those who will tolerate a certain degree of ambiguity once the broad outlines have become clear.

Both approaches have risks, but the consensus seems to that it’s better to err on the side of being proactive rather than reactive.

“There will be more aggressive financial institutions that create utilities and industry consortiums that help manage the change and cost problem,” Wallis said. “Those types of institutions will gain a significant advantage in the new market structure that will emerge after 2014.”

More broadly, the pace of regulatory activity is expected to accelerate after the November presidential election in the U.S.

“It will happen towards the end of 2012 hopefully, and once a majority of the rules have been broken down into actionable items,” said Dufour of SunGard. “We will start seeing frameworks and methodologies emerge, which will help with understanding and implementing the rules, providing all parties which much-needed clarity.”

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