July 21, 2010, marked the signing into law of the Dodd-Frank Wall Street Reform and Consumer Protection Act — the most comprehensive piece of financial legislation since the Great Depression. Of particular interest to many individuals and entities worldwide was Title VII of Dodd-Frank (as the Act quickly became known), which addressed critical gaps in US financial regulation by imposing a comprehensive regulatory framework and regime on derivatives and market participants.
Today, more than five years after the launch of Dodd-Frank, many Title VII requirements have been implemented but, according to a recently released report by the International Swaps and Derivatives Association, there are still a number of outstanding issues that need to be addressed and resolved in order to achieve appropriate risk management that enables economic progress and growth on a global level. Eight of these areas of focus include:
1. Cross-Border Harmonization
Derivatives regulations in individual jurisdictions can be quite different in terms of both timing and substance. As a result, more and more derivatives users are choosing to trade with counterparties based in their own jurisdictions rather than having to potentially face multiple, inconsistent requirements.
However, this practice results in liquidity fragmentation along geographic lines, something that increases costs and reduces choice for end users. To avoid this outcome, regulators should aim to harmonize national rule sets to the greatest degree possible as well as implement a transparent process that can be used to determine equivalence based on broad outcomes.
Central counterparties, also known as clearinghouses, have become systemically important as a way of reducing the levels of counterparty risk previously found in over-the-counter (OTC) markets. Given their critical role, it is essential to ensure that these central counterparties are resilient.
One method for ensuring this resilience entails implementing minimum standards for stress tests and greater transparency on margin methodologies. It would also be helpful to have further regulatory input on such issues as acceptable recovery tools and resolution conditions that do not make use of public money.
3. Commercial End Users
Under Dodd-Frank, many efficient structures known as centralized treasury units (CTUs) are classified as financial entities. This means that, even though they may simply be affiliates of purely non-financial end-users, they are still subject to the same clearing requirements as financial entities like banks. To correct this confusion, further legislation is needed to clarify that end users that use CTUs to net and consolidate their hedging activities (a common practice) are eligible for a clearing exemption.
4. Trade Execution
To help facilitate cross-border harmonization and encourage more trading on Swap Execution Facilities (SEFs), it would be beneficial to introduce targeted amendments to certain US SEF rules, such as allowing execution methods to be more flexible in certain cases. Additional refinements would also help to eliminate other incongruities.
For example, regulators could remove the requirement that block trades cannot be executed on SEFs. Additionally, they could introduce a new mechanism that would allow an SEF or an SEF user, in the event of changing liquidity conditions, to petition for a “made available to trade” (MAT) determination to be removed.
Because reporting requirements are different both within and across borders, it is difficult for regulators to get an accurate picture of global risk exposures and possible concentrations. Regulators worldwide, therefore, need to identify and agree on what trade data is needed to fulfill supervisory responsibilities. Consistent reporting requirements can then be issued accordingly. Greater cross-border sharing of data would also be facilitated if the Dodd-Frank Swap Data Repository indemnification requirements were repealed.
6. Regulation of Swap Dealers (SDs) and Major Swap Participants (MSPs)
SDs and MSPs are the twin pillars of Dodd-Frank’s regulation of swaps, but despite the
requirement that all SDs and MSPs register as such with the Commodity Futures Trading Commission (CFTC), by the end of 2012, firms were only provisionally registered. Final registration is necessary in order to eliminate regulatory doubt regarding these firms’ status.
In order to maximize preparation time, it is important to quickly finalize non-cleared derivatives margin rules. Groups like the International Swaps and Derivatives Association (ISDA) have been working to develop a standard model for computing initial margin requirements.
The ISDA’s efforts would help reduce the potential for disputes, but certainty in the rules is necessary in order for these efforts to progress to an industry-wide level. Global consistency in rule sets is also critical in order to avoid certain institutions being subject to competitive disadvantages at the international level.
As with margin rules, global consistency in capital rules is necessary to prevent both financial institutions and non-financial corporates in particular jurisdictions from suffering competitive disadvantages. Regulation on this issue should be both comprehensible and suitable to the risk level of a given activity. To avoid high financing costs for borrowers, as well as increased hedging costs for end users, a comprehensive assessment of the various regulatory components and their cumulative impact is key.