The new commissioner of the Commodity Futures Trading Commission has pledged to replace existing regulation with more cross-border friendly rules. Will it be enough to reverse the fragmentation of the global market? 

Five years after the Pittsburgh G20 summit, a newly sworn in Commodity Futures Trading Commission (CFTC) commissioner has pledged to push for a rewrite of the CFTC swap execution rules, in a bid to avert a trade war between the US and Europe over derivatives clearing. In his keynote address at the Global Forum for Derivatives Markets, 35th Annual Burgenstock Conference, held in Geneva in September, CFTC commissioner J Christopher Giancarlo outlined what he called "the looming cross-Atlantic derivatives trade war: a return to Smoot-Hawley", and stressed the need for greater co-operation between regulators.

The issue stems, in part, from the European Commission's (EC) failure to recognise US-based central counterparties (CCPs) as equivalent to their European equivalent under the European Market Infrastructure Regulation (EMIR), as it reportedly plans to do for CCPs in India, Japan, Hong Kong, Australia and elsewhere. The omission is threatening to cause chaos in the industry.

But, as Mr Giancarlo points out, the EC's position was preceded by "an uncoordinated approach to regulation of swaps trading", which prescribed one-size-fits-all rules for non-US market operators and participants engaging in trades involving US parties. Mr Giancarlo pointed the finger squarely at the CFTC for inadvertently starting the trade war, which is fast threatening to become a stalemate. In an attempt to rectify the situation, Mr Giancarlo has pledged to seek the withdrawal of a CFTC staff advisory and interpretative guidance, and replace it with better rules for non-US regulatory regimes.

Waiting game

Mr Giancarlo believes that last July’s interpretive guidance on cross-border compliance and its far-reaching definition on who must comply with US regulations has caused the rift that is now spilling into the derivatives clearing debate, and that the subsequent CFTC staff’s November 2013 advisory, that spelled out the reach of transaction-level requirements to non-US persons, made matters worse and contradicts the conceptual underpinnings of the CFTC’s interpretive guidance.

Final rules to enable cross-Atlantic swaps clearing have not yet been published, but the European Securities and Markets Authority (ESMA) has performed initial work, giving technical advice on third-country equivalence, in which it indicates that the US clearing obligations are equivalent to their European counterparts. The EC has not yet adopted ESMA's technical advice in making formal decisions on ‘equivalence’.

It is not currently clear how equivalence will apply to funds that are not established in the US but are subject to the Dodd-Frank Act by virtue of being ‘US persons’, such as a Cayman Islands fund that is majority owned by US persons or has its principal place of business in the US.

Mr Giancarlo said: “The combined effect of the CFTC’s interpretative guidance and staff advisory – neither of which are formally adopted CFTC rules – is to dictate that non-US market operators and participants must abide by the CFTC’s peculiar, one-size-fits-all swaps transaction-level rules for trades involving US persons or supported by US based personnel.”

Creating a rift

Volumes between European and US dealers have declined 77% since the introduction of the US Swap Execution Facility (SEF) regime and the uncoordinated approach to the regulation of swaps execution has fragmented global markets into separate trading and liquidity pools for US and non-US persons. Mr Giancarlo said that users of swaps are choosing to do business with global financial institutions based more on the institution’s regulatory jurisdiction than traditional factors, wreaking the kind of global economic damage caused by the infamous Smoot-Hawley Tariff Act of 1930, widely considered to have contributed to the depth and length of the subsequent Great Depression.

He said: “With the CFTC’s SEF regime dividing trading in global swaps markets between US persons and non-US persons, can we risk further dividing US and European markets in derivatives clearing? That would be the effect if the EU does not recognise US CCPs as equivalent under EMIR.”

Mr Giancarlo used his keynote speech to call for a reset in the EU and CFTC cross-border regulatory relationship in the spirit of the Pittsburgh G20 accord to avoid a harmful trade war similar to that which worsened the US's Great Depression in 1930. “By Balkanising global swaps liquidity, the CFTC’s interpretative guidance is actually increasing the systemic risk that it was predicated on reducing,” he said.

Furthermore, Mr Giancarlo believes that EU markets and exchanges cannot afford to jeopardise US business. “Denying equivalence to US CCPs will not cure Europe’s stagnant economic growth – it will worsen it,” he said.

A united front

The CFTC has already issued an advance notice of proposed rule-making seeking comment on three different approaches to the cross-border application of CFTC rules for margin for uncleared swaps. Furthermore, Mr Giancarlo pledged to do everything he could to encourage the CFTC to replace its cross-border interpretative guidance with a formal rule-making that recognises outcomes-based substituted compliance for competent non-US regulatory regimes.

“As part of that effort, I will seek the withdrawal of the CFTC staff’s November 2013 advisory that fails not only the letter and spirit of the 'path forward', but also contradicts the conceptual underpinnings of the CFTC’s interpretive guidance.”

Going forward, Mr Giancarlo said that the best route to regulating the trading of swaps in global markets is deference to home country regulators within the Pittsburgh G20 framework, but that this will require flexibility and co-operation among regulators on both sides of the Atlantic in order to strike the right regulatory balance. It will also require a redoubling of efforts to craft a workable basis for the EC to issue its equivalence determination for the US.

He added that work continues on both sides to establish a sound and practical basis for regulatory and supervisory co-operation and those discussions have recently focused on exploring ways to achieve greater streamlining and harmonisation of regulatory requirements for CCPs that are registered by both the CFTC and a European regulatory authority.

“This is key to advancing our shared goal of promoting clearing through CCPs that are subject to a workable legal and supervisory framework that will promote financial strength and stability in the global swaps markets,” he said.

Furthermore, Mr Giancarlo believes that the current CFTC is more mindful of the regulatory concerns of its European counterparts. He said that the CFTC is prepared to maintain and expand the scope of its current policy, which takes into account whether the regulatory objectives of financial integrity and risk management can be met through different approaches under the regulation and oversight of the European regulatory authority, as well as exploring ways to enhance existing co-operation in the joint supervision of dual registrants.

Averting war

Mr Giancarlo concluded: “I sincerely hope that we can fulfil the important goals that the G20 set for us in Pittsburgh and avoid falling into a misguided global trade war over regulation of derivative financial products. A global economy that is just starting to show signs of recovering from the ‘Great Recession’ cannot bear the reduction in trade and fragmented financial markets that is a looming possibility.”

Meanwhile, delays still threaten to hinder progress towards swaps clearing. ESMA has submitted its final draft regulatory technical standards for the clearing of interest rate swaps to the EC, setting in motion the implementation of mandatory clearing in Europe. Expected to come into force in February, ESMA proposes a long phase-in period for mandatory clearing, delaying the central clearing requirement for buy-side firms until January 2016 and with non-financial institutions not coming on board until 2018.

Within days, BNY Mellon announced the closure of its European derivatives clearing business specifying the delay of EMIR mandatory clearing as the reason behind the decision as it delayed the expected expansion of the over-the-counter clearing business, which was a key element of the custodian’s derivatives clearing strategy.

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