Danger Ahead: Cross-Border Swaps Rules Further Fracture Market

By Sol Steinberg, OTC Partners

Originally published on TABB Forum 

Even as the CFTC moves to finalize rules governing foreign-based swap clearinghouses and swap execution facilities, the harmonization of global swaps regulations remains a challenge, threatening to further fragment the trading process. 

With more than 50% of global swaps transactions occurring across borders, harmonizing international rules has been a point of contention throughout the overhaul of the global financial framework. Last week, the Global Markets Advisory Committee (GMAC) of the Commodity Futures Trading Commission (CFTC) met to discuss international regulatory requirements. The two-part meeting focused on issues related to the regulatory treatment of foreign-based swap clearinghouses and swap execution facilities (SEFs). However, it seemed more like a game of tit-for-tat, as U.S officials and their foreign counterparts took turns criticizing each other for not doing enough to facilitate cross-border swaps clearing and trading by harmonizing standards.

Foreign-Based Swap Clearinghouses 

Regarding foreign-based swap clearinghouses, the CFTC has almost completed a proposal that would exempt foreign designated clearing organizations (DCOs) from compliance with CFTC requirements, provided the DCOs in question are subject to comparable and comprehensive regulation and supervision in their home jurisdictions. Exemptions would be based on a DCO’s ability to meet the international standards spelled out in the CPSS-IOSCO Principles for Financial Market Infrastructures.

However, officials from Europe and Japan were quick to point out that there are important differences between international swaps clearing rules that could preclude DCOs from meeting the “comparable and comprehensive regulation and supervision” criteria. Consequently, they urged the CFTC to evaluate the various regulatory regimes based on the intended outcomes of the rules, not the actual details. They also implored the Commission to consider granting jurisdictional exemptions rather than individual ones.

That argument lost a bit of its impact when U.S. panelists, including CFTC Commissioner Scott O’Malia, pointed out that the EU does not appear to be making a sufficient effort to grant similar authorizations to non-EU clearinghouses, which must demonstrate equivalence with EU clearing rules by Dec. 15, 2014. In fact, non-European firms are already suffering competitively due to the threat of potential, significant economic disincentives that would go into effect in less than seven months. 

The other important issue raised by market participants on both sides of the Atlantic is that DCOs exempted under the CFTC’s proposal would only be permitted to provide clearing services to U.S. persons or institutions. They could not, however, provide clearing services to the customers of those institutions. According to critics, such a stipulation runs counter to the Commission’s calls for reciprocity between regulatory regimes and would violate the principle of fair and open access contemplated by CPSS-IOSCO.

In its defense, the CFTC said the rule is necessary to ensure that U.S. citizens are protected under U.S. bankruptcy law. Additionally, other proponents argued that the limitation would prevent large portions of the U.S. dollar-denominated swap and foreign exchange markets from moving beyond the oversight of U.S. regulatory authorities.

Even with the exemptions, qualifying DCOs would still be required to file a variety of daily, monthly and event-specific reports with the CFTC, highlighting everything from initial and variation margin on deposit for U.S. clients, to U.S. person aggregate clearing volume and average open interest, to U.S. clearing members, to changes in licenses or home country regulatory requirements, to disciplinary actions, to defaults by futures commission merchants (FCMs).

Swap Execution Facilities 

While the CFTC’s proposal for foreign-based swap clearinghouses is almost complete, much more needs to be done in the area of swap execution facilities. In the U.S., all swaps trading is conducted via SEF; however, at present there are no comparable foreign trading platforms for swaps that even can be assessed for equivalence. This has caused substantial fragmentation of the market, with participants tending to trade only on local venues. It also precludes any possibility of a mutual recognition approach.

As an interim step, the CFTC is offering temporary relief for multilateral trading facilities (MTFs) during the transition to the new regulatory regime established under the Markets in Financial Instruments Directive. However, none have yet requested such relief, so this step is widely considered a failure.

Making matters worse, there is no long-term solution to this problem. According to CFTC officials, the Commission is working on a more permanent solution; however, at this point it is only being described as a “term sheet.” Although there were no details, foreign officials suggested that differences in market practices necessitate an exemption approach for foreign trading venues like the one being proposed for foreign-based swaps clearinghouses.

The lack of a long-term solution sets up a dangerous situation. It only perpetuates further fragmentation of the trading process, which sets the stage for even more disastrous outcomes during market crises. Moreover, it has aroused concern that some swap dealers may be removing parent company guarantees on foreign affiliates so that they can trade through those affiliates without exposing themselves to CFTC authority.

Despite the gravity of the situation and repeated requests that it move more quickly to address the problem, the Commission said it would likely continue relying on an interim solution, rather than finalizing a long-term trading venue exemption. It also vowed to look into any questionable practices regarding parent company guarantees.