Regulatory Divergence Rattles Markets

Terry Flanagan

The emergence of multiple regulatory regimes for OTC derivatives runs counter to the spirit of reforms agreed to by the G-20 in 2009, market participants say.

Legislators and regulators globally are devising separate laws and rules to cover the G-20 commitments, which could result in a multitude of clearinghouses and trade repositories, overlapping jurisdictional claims, and a host of market structure issues that have little, if anything, to do with safety and soundness.

“The more that policymakers focus on interconnectedness as a source of risk, they are less inclined to favor standards that foster cross-border market integration.,” Barbara Matthews, managing director at BCM International Regulatory Analytics, told Markets Media. “They want to protect domestic financial stability; they choose to do that through policy choices that fragment markets and liquidity.”

In Sept. 2009, leaders of the G20 agreed on commitments to strengthen the international financial regulatory system in the wake of the crisis, including stricter rules on transparency, capital, counterparty risk (through central clearing), and trading of derivatives contracts.

“As we observe regulatory reform around the world, it leads us to ask, “Do we face the prospect of a less global, more fragmented marketplace?” Unfortunately, the answer is that we might,” said Robert Pickel, executive vice chairman of the International Swaps and Derivatives Association.

The G20 also undertook to take action at the national and international level to implement standards in a way that ensures a level playing field and avoids fragmentation of markets, protectionism, and regulatory arbitrage.

However, the emergence of the Dodd-Frank Act and European markets Infrastructure Regulation (EMIR) threaten to undercut those objectives, according to ISDA.

In the United States, the SEC and CFTC are deep into the process of implementing derivates rules under FinReg, while in Europe, the European Parliament has temporarily applied the brakes legislation on CCPs, derivatives, and market structure, known as European Markets Infrastructure Regulation (EMIR).

That means that European regulations will not be in place until 2012 at the earliest, well after rules have been implemented in the United States.

The EU has taken a bifurcated approach with different laws addressing execution and clearing. Under the EU approach, the EMIR proposals cover clearing requirements and trade repositories, while MIFID II covers trading.

As proposed, EMIR would only apply to OTC derivatives, which would be defined as derivatives not executed on a regulated market as defined under MIFID. Therefore, derivatives transacted on trading platforms governed by MIFID would not be covered by EMIR and would not be subject to clearing.

“Regulations in different G20 jurisdictions may be creating conditions which will lead to harmful results,” said a letter from ISDA and other industry associations sent to Michel Barnier, commissioner for internal market and services at the European Commission, and Treasury Secretary Tim Geithner.

“Specifically, in the United States and Europe, we believe that both sets of rules, as proposed in the U.S. and as currently being debated in the EU, leave the global derivatives business with ambiguity and problematic extraterritorial challenges and issues of legal uncertainty,” the associations said

Examples of extraterritorial concerns include rules for CCPs trade repositories, and margin requirements.

In the case of margin requirements, non-U.S. subsidiaries, branches or affiliates of U.S. financial institutions will face dual and conflicting regulatory requirements, as opposed to local competitors who will have to comply only with the local regulatory regimes.

As for CCPs, conflicting clearing requirements would be impossible to comply with if the rules of each of two different jurisdictions require a trade to be cleared in its jurisdiction.

On trade repositories, Dodd-Frank’s requirement that U.S.-based swap data repositories (SDRs) obtain indemnification from foreign regulators as a pre-condition to data sharing undermines the ability of trade repositories to provide coherent information on risk in the derivatives business to regulators, according to eh derivatives industry.

Likewise, pre-conditions to recognition of third-country repositories in EU regulations are best drafted in cooperation with regulators in those third countries.

The associations noted the recent establishment of a trans-Atlantic working group to address differences between EU and U.S. regulator on derivatives, and urged regulators to redouble efforts limit the damaging effects of divergence as well as seek input from associations and market participants engaged in multiple jurisdictions.


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