Regulators Poles Apart As They Fail to Swap Notes on Derivatives Rules

Terry Flanagan

European and Asian derivatives users are becoming more and more concerned about the international reach of new U.S. rules that are set to govern its over-the-counter derivatives markets.

With the G20 group of nations’ self-imposed end-of-year deadline fast approaching for regulators to introduce comprehensive new rules across all jurisdictions to monitor the previously opaque OTC derivatives markets, many market participants are fearful of the unintended consequences that the new U.S. regulations, in the form of the Dodd-Frank Act, may bring.

“The U.S. head start on the adoption of implementing rules means that a significant part of the U.S. regime could be in force in advance of the corresponding European Union rules,” said David Felsenthal, a partner at law firm Clifford Chance.

“There is a significant commonality of approaches between Emir [Europe’s attempt at regulating its derivatives markets] and Dodd-Frank in relation to the regulation of OTC derivatives markets, but there are also some significant differences.”

The sheer complexity and overlapping nature of the reforms are worrying many in the industry on both sides of the Atlantic as a one-size-fits-all approach appears to have not been adopted by either European or U.S. regulators, which are home to the main derivatives markets. Asia’s derivatives scene is less developed but its set of disparate national regulators are currently formulating rules to enact the G20 diktat.

“The Dodd-Frank statutes and proposed rules go well beyond the relatively modest objectives agreed to by the G20 in 2009,” said Christian Johnson, professor of law at the University of Utah.

“These efforts in the U.S. create a legal environment ripe for regulatory arbitrage and the isolation of U.S. OTC derivative markets.”

Johnson warns that many market users will “simply abandon U.S. markets because of overly aggressive U.S. regulation” and highlighted “concerns surrounding the extraterritorial powers given to the Commodity Futures Trading Commission to enforce these mandates”.

Earlier this week, overseas regulators set out their concerns to the CFTC in a meeting in Washington over the extraterritorial reach of Dodd-Frank. Previously, both regulators and senior politicians from both Europe and Asia had written to the CFTC appealing to the main U.S. swaps regulator to ease off on some of the new rules.

“The proposed approaches across the globe simply won’t work,” Patrick Pearson, head of the financial market infrastructure unit at the European Commission, told the meeting in Washington. “They won’t mesh. They won’t interact. They will cause conflicts.”

The Financial Stability Board, the G20’s regulatory arm, has also been monitoring the situation and it believes that a lack of clarity and international wrangling over the rules, which are aimed at reducing risk and increasing transparency in a market that was blamed for fueling the financial crisis in 2008, threaten to delay the deadline.

“Progress to date in cross-border discussions has been slow,” the FSB said in a report on October 31. “This risks delaying the full and timely implementation of the G20 objectives.”

In the meantime, firms outside of the U.S. are being warned that if they engage in swap trading with U.S. entities they should prepare themselves to comply with Dodd-Frank requirements for trade execution, clearing and real-time reporting. Foreign banks and other trading entities will have to undertake compliance for processing trades with U.S. entities by the end of this year. While substituted compliance will be allowed for swap data reporting and record keeping, as long as the CFTC is provided access to data held at the foreign trade repository.

“The regulatory structure for OTC derivatives has become more stringent following the financial crisis,” said Anshuman Jaswal, senior analyst with research consultancy Celent’s Securities and Investments Group. “For foreign banks and other swap trading entities, the task of identifying all swaps with U.S. counterparties is likely to be one of the main problems with regard to compliance with the new regulations.”

Legal experts, though, are warning that any U.S. attempt to enforce extraterritoriality rules on the rest of the world may prove difficult due to the basic hierarchy of rules, which may ultimately mean that you can only have one set of rules in each jurisdiction.

Although U.S. regulatory attempts to extend the reach of Dodd-Frank may indeed result in greater convergence of international regulations, but it remains doubtful that full harmonization is likely.

And it appears that Europe could be fighting back in the extraterritoriality debate with its new rules on short-selling as they are one of the first financial regulations laid out by Brussels that apply directly to U.S. markets.

All of this regulatory posturing, though, is likely to just cause more waves on either side of the Atlantic for market users.

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