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09 February 2012

Mind the Gap: Dodd-Frank vs. the Rest of the World

The effort by U.S. regulators to coordinate derivatives regulations with their global counterparts is commendable but there are areas to watch. And what about Volcker?

Perhaps the worst kept secret in the whole Dodd-Frank discussion is that the law is U.S.-based law while derivatives trade in a global market. As market participants wrestle with a stream of rules from the Commodity Futures Trading Commission and Securities and Exchange Commission under Title VII, other regulators in other countries or jurisdictions are issuing their own rules. Or not.

At the end of January, the CFTC and SEC issued their Joint Report on International Swaps Regulation as required under Section 719(c) of the Dodd-Frank Act. In the report, the agencies recap most of their own rulemaking efforts and then catalog the efforts of Canada, Brazil, the EU, Japan, China, Hong Kong, Singapore, Australia and South Korea. Finally, the report identifies open issues and harmonization efforts and makes some recommendations.

Instead of looking at each jurisdiction’s proposed rules in isolation, it’s better to see how everyone deals with items of general interest and whether any differences in approach have a significant impact.

The first area of interest is in the types of market participants. The DFA creates four specific categories: dealers and major participants for both swaps and security-based swaps. To begin with, no other jurisdiction differentiates between swaps and security-based swaps, probably because they don’t have separate equivalents of the CFTC and SEC. All the other jurisdictions view derivatives dealers in the same light as dealers in other instruments, using the same registration and oversight mechanisms. Two Canadian provinces may institute separate registration for swaps dealers, but haven’t yet, and the EU, the largest non-U.S. market in the study, does not envision special registration requirements for either swap dealers or major participants.

The second area of interest is in the clearing mandate. Although the DFA envisions both a top-down and bottom-up process for applying a clearing mandate, the agencies have so far opted for the bottom-up approach, where central counterparties apply to the regulator for the clearing mandate. The European Union envisions a top-down process (in addition to the bottom-up process) where the European Commission could determine that certain derivatives must be cleared, even if no CCP has applied to clear them. Hong Kong also envisions a top-down process, but other jurisdictions have given no indication of their plans. It is not yet clear whether any of these jurisdictions will automatically accept CCPs domiciled (and regulated) outside their borders as satisfying their own clearing mandate.

The third area of interest is the execution mandate. The DFA requires that any derivative with mandatory clearing must be executed on one of the trading facilities (designated contract market or swap execution facility) unless it isn’t listed anywhere, or unless the trade is end-user-exempt or over the block threshold. Here, other jurisdictions are all over the lot, if they’ve indicated anything at all. Canada has not decided whether to require DCM/SEF execution for any swaps, the EU appears to have a liquidity threshold for required execution and the other jurisdictions have not indicated their plans.

The final area of interest is the reporting mandate. The DFA mandates reporting of all trades in derivatives, whether listed or OTC, and the agencies have required enhanced reporting for major participants and end users who are claiming an exemption. Every other jurisdiction has a similar requirement, that trades be reported to a trade repository. The difficulties may occur in 1) determining whether reporting to a TR in one jurisdiction satisfies the requirements in another jurisdiction and 2) what determines where a trade takes place so as to determine which TR to report to.

An area covered in the U.S. section of the report but not in every other jurisdiction is business conduct. The CFTC’s final rule in this area has several suitability requirements for swap dealers and major swap participants. The EU proposals appear to address risk management requirements but not necessarily suitability while other jurisdictions have nothing, or almost nothing, in this area.

The effort by the CFTC and SEC to coordinate their regulations with their global counterparts is certainly commendable and this report is a good start. It points out some areas where they are already coordinating, and some where more coordination is needed. There is however, a much bigger regulatory cloud on the global horizon.

No other jurisdiction has passed a version of the Volcker Rule and it’s very hard to coordinate with something that isn’t there. So maybe the regulators are looking at second base while the ball is going to first.

Spotlight-white-trans For more stories in the OTC Derivatives Reform Spotlight Series click here.

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