Response to the Financial Crisis: Outlook for 2010
The financial crisis brought over-the-counter (OTC) derivatives to the forefront of regulatory attention. The default of Lehman Brothers, the near collapse of Bear Stearns and the bailout of AIG highlighted to all involved the significant role played by OTC products. Since then, regulators on both sides of the Atlantic have begun to look at how the derivatives market, or “weapons of mass destruction” as they have fashionably come to be known, can made safer. Although derivatives have been around for centuries, from the most basic contracts for the transfer of risk, the innovation within the sector has been fast and finding a solution to producing effective regulation from a policy-making point of view has not been easy.
The key criteria driving actions has been to bring more transparency to this seemingly unregulated area of the market. Action so far has focused on moving as many derivative trades onto exchanges and other platforms, standardising the OTC derivatives, introducing central counter party clearing (CCP), and increasing reporting to trade repositories. Invariably though with policy makers having taken the political initiative to regulate this particular area of the financial services industry, there will also be significant reviews of other areas too.
Public policy in 2009
The year 2009 was notable for the raft of proposals and indeed committed policy action taken by policy makers and regulators in seeking to prevent a repeat of the problems of the past years. If there were concerns that Governmental action to prevent the collapse of the system was not exactly coordinated, we have certainly seen more coordination in the regulatory response to prevent such events happening again.
One of the areas where we have seen relatively coherent policy to date has been on OTC derivatives. Indeed this has been largely driven by political reform coming from the G20 Communiqués of London and Pittsburgh.
Back in April the London G20 summit Communiqué notably included a commitment to:
“promote the standardisation and resilience of credit derivatives markets, in particular through the establishment of central clearing counterparties subject to effective regulation and supervision”.
The London Communiqué made explicit reference to the credit derivatives market, as post-Lehman Brothers et al. regulators saw a number of problems in the credit derivative market such as market concentration and risk mitigation. In fact, political action had been taken back in 2008 on this, with authorities pushing industry into clearing through central counterparties.
Most recently, the Pittsburgh summit made the following declaration that:
“All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”
These were strong commitments from the G20 leaders with a clear desire to bring more safety, transparency and reporting of transactions to this sector.
Policy in the US
The first sign of reform in the US on OTC derivatives came from Treasury Secretary Timothy Geithner who wrote a letter to Congress in May 2009 outlining specific proposals for comprehensive reform of the sector. In the letter, the Treasury Secretary laid out the steps he envisaged necessary to effectively regulate OTC derivatives markets. He focused on four broad objectives and looked to:
- Prevent activities in the OTC derivatives markets from posing risk to the financial system;
- Promote efficiency and transparency;
- Prevent market manipulation, fraud and other market abuses; and
- Ensure that OTC derivatives were not marketed inappropriately to unsophisticated parties.
The Obama Administration soon followed suit with the announcement of a blueprint to overhaul the US financial regulatory system launched in August. The proposal sought an ambitious plan to oversee the derivatives market and force many products onto regulated exchanges or electronic venues. The Obama blueprint did not differ much in this regard from that outlined by the Treasury Secretary.
As well as addressing market issues such as wanting to make prices and markets more transparent, dealing with issues related to CDS, and requiring standardised derivative contracts to be processed through clearinghouses, the Administration’s proposal also looked at what they saw as the fragmentation of the federal regulatory system (SEC, CFTC and banking regulators) and the need for a coordinated and coherent regulatory framework. Specifically on fragmentation, they proposed that the size of the OTC derivatives market required a harmonised framework for new and existing derivative products.
Proposals have now translated into a House of Representatives Bill finalised in December, the "Wall Street Reform and Consumer Protection Act", which includes the "Derivatives Act". It was based on the legislative proposals introduced by the Treasury Department as passed by the House Agriculture Committee and the House Financial Services Committee last year, and by and large conforms closely to the Treasury's proposals.
The Act will for the first time subject all OTC derivatives to comprehensive federal regulation under the new SEC-CFTC regime. The CFTC will be given authority over swaps, swap dealers and major market participants whilst the SEC will be given authority over security-based swaps, security-based swap dealers, and major security-based swap participants.
Also under the Act, swap dealers and major swap participants will be subject to a central clearing requirement. Swaps required to be cleared will also be traded on a regulated exchange or alternative trading platform.
Furthermore non-cleared swaps will need to be reported, with major participants and dealers also having to adhere to strengthened capital and margin requirements. The legislation however, as it currently stands, proposes to exempt commercial end-users from the clearing requirement.
There is also a requirement for record-keeping and reporting requirements, with swap dealers and major swap participants needing to maintain daily trading records, records of communications and a complete audit trail.
Lastly, the legislation has also looked to expand the CFTC's authority to establish position limits by directing the CTFC to set position limits for all physically deliverable commodities. Indeed, in the past week, we have had the CFTC undertake a hearing into position limits in the energy markets, as well as announcing its intention to consult on the applicability of these limits within the precious metal market too.
The EU has been a little behind the US in developing a comprehensive framework for OTC derivatives, but is taking its cue from the need for international consensus; its proposals are similar to those presented in the US.
The Commission called for a “paradigm shift” from the traditional view that derivatives are financial instruments for professional use towards an approach that puts the safety of the financial system first. The Commission is going for a comprehensive policy to cover the whole of the derivatives market in order to prevent, as much as possible, the structuring of transactions so as to exploit any regulatory arbitrage.
A key area for the Commission has been around the question of transparency; and in order to assure that all transactions are reported and well managed, the Commission is proposing that market participants will report transactions to repositories where regulators will have access. Furthermore on transparency, but for price and positions, the Commission is also looking to mandate the trading of standardised derivatives on exchanges and other organised trading venues.
The Commission is also focusing on counterparty risk in regards to where organisations using derivatives are exposed to many different counterparties, and is proposing the requirement of CCPs for OTC derivatives that are sufficiently standardised. The Commission though does not consider that all derivatives may suitable for central clearing, and for those derivative trades that remain outside CCPs stricter collateral requirements would apply.
Finally, the Commission is looking to strengthen market integrity and oversight through curbing insider dealing and market manipulation, as well as giving regulators the possibility to set position limits.
Derivatives in 2010 – differences in approach
Now in 2010, there is a considerable amount of headway to be made. It is expected that the Commission’s legislative proposal will be released mid-2010. However, and importantly for the future direction of policy, there will be a new Internal Market Commissioner in the form of French politician Michel Barnier, currently waiting to be voted in by the European Parliament. As Commissioner, he will have the authority to put his steer on the direction of travel. The Commission’s proposals have stated that they will look to ensure global consistency, and indeed it would seem foolish to see how the Commission could want not to ensure that the proposed legislation does that; but there is a worry that the Commission will not just want to be guided by what the US proposes. Commissioner Designate Barnier in his formal interview in front of the European Parliament’s Economic and Monetary Affairs Committee spoke on the importance of internationally consistent rules, as well as his commitment to regulate the derivatives market, and also desire to impose position limits on agricultural commodities.
In the US, we now have the House of Representatives Bill, but there is still the passage through the Senate to go. The texts, though, on both sides of the Atlantic do share common goals, but on closer inspection, and indeed what will make 2010 arguably the most important year for derivatives, there are differences in the detail. Notably, these relate to three main areas:
On centralised clearing, the EU is looking to push all standardised contracts onto CCPs. It does not seek to differentiate between standardised and CCP-eligible derivatives, which the US proposal does through the requirement that only eligible contracts will be centrally cleared by derivative clearing organisations, if both parties are dealers and/ or major swap participants, and also after the approval of both the SEC and CFTC.
Additionally, on standardisation there is a growing difference between public authorities, notably in the UK HM Treasury and FSA, and the US. In the US, it is considered that a trade will only be considered standardised if it is centrally cleared, whilst according to a recent Treasury/FSA paper clearing eligibility should not be based solely on whether a product is standardised.
The UK paper has also rejected the notion that standardised trades should be executed on organised trading platforms, and they have stated that they would not support proposals for mandating central clearing, as the clearing of all standardised derivatives could create a situation where a CCP was required to clear a product that it was not able to risk manage adequately. This is a clear difference in view from the EU and the US proposals. Also, a recent Federal Reserve Bank of New York study has questioned whether clearing houses would pose a systemic risk, calling the international regulatory standards for CCPs insufficient, and recommending that regulators ensure that a CCP’s risk management design and financial resources are robust enough to allow the CCP to withstand extreme but plausible loss scenarios.
The European Commission has attached a strong focus on the need for standardisation but has not yet sought to define this. The UK paper furthermore states its intention to push for the establishment of an international working group comprising regulators and industry participants, in order to find consensus on products that are eligible for central clearing. The Commission is looking to investigate this, too, through an internal working group.
- Capital charges
Legislative texts across both jurisdictions propose higher capital charges and margin requirements for non-centrally cleared contracts. The US legislation as recently passed, though, proposed exemptions for non-financial companies, certain banking products, and positions held for hedging or risk management. The Commission, on the other hand, is currently proposing to extend capital charges to everyone and margin requirements for non-financial companies using derivatives above a certain threshold. Indeed, on this point, with some preparatory involvement by representatives of banking institutions which prepare complex derivative instruments, a consortium of non-financial companies has written to the European Commission looking for an end-user exemption to continue to allow them to use OTC derivatives to hedge risk. They have argued that the consequences of the draft may threaten economic recovery by draining companies’ liquidity into mandatory collateralisation of contracts, reducing the amount of hedging, thereby increasing business risk, and raising costs for those prudently hedging their risks. They want any final legislation to preserve their ability to manage financial and market risk exposures by ensuring continued access to reasonably priced and customized OTC derivatives. It seems likely that there will be a change of direction on this, though, as Commission President José Manuel Barroso has said that he wants the passage of the derivatives legislation within the EU to carve out an exemption for companies to hedge risk. This was similar to a concern raised during the passage of the US legislation when an amendment was put forward to impose margin requirements on end users, but would allow them to use non-cash collateral – however this was rejected in light of industry concerns.
- Ownership Limits
Under the US Derivatives Act, ownership of interests in a clearing house will be limited to 20%. The limit is imposed as part of a set of rules designed to minimise conflicts of interest in the decision-making process. This has not been included within the EU proposals to date, and it is not known whether the Commission will opt for this, or seek to address this through strengthened corporate governance procedures. The concern from the US is that potentially conflicted CCPs may be hampered when deciding the accessibility of a derivative transaction to central clearing.
Interestingly, these divergences also raise a fourth difference - one of approach. Although the US proposals are more advanced than the European Commission’s, they are also more prescriptive in their scope whilst the Commission’s communications are more focused on guiding principles and on being consultative. This does raise the issue of whether the US rules could be stricter than those being drawn currently by the Commission, but with policy makers wanting to adhere to globally consistent rules the likelihood of any sort of regulatory arbitrage seems unlikely.
Where next? More transparent and secure markets
2010 will not just be the year of change to the OTC derivatives market. Regulatory attention is focused on financial services, and policy makers have stated their clear intention to look at every aspect of the industry. European Commissioner Designate Michel Barnier said during his European Parliament hearing that “no area of financial markets will go unregulated”, and if he seeks to be anywhere as driven as Gary Gensler, Chairman of the CFTC, who has arguably led the charge to bring real reform to the OTC derivatives market in the US, there could be further change in the way markets operate.
One area of the markets that has also come under the scrutiny of regulators in the EU and US is dark pools. Although dark pools have been round for several years, the worry now is that they are creating a two-tier market with the potential that users can exploit it at the detriment of the broader “lit” market. The US has been first to move on this, and the SEC has recently held a consultation outlining possible proposals to regulate them. The SEC consultation proposed three main amendments to current legislation. Firstly, the proposals look to require that indications of interest privately transmitted to market participants be treated as either “bids” or “offers”. Secondly, the SEC proposes a substantial lowering of the thresholds required to publicly display orders, bringing this down from 5% to 0.25%. Lastly, the SEC proposes for trades to be reported along with the identity of the dark pool immediately after the execution - currently only the trade data is made available and not the identity of the dark pool. The SEC, by adopting this approach, is looking to effectively outlaw the un-transparent aspects of dark pools.
In a similar fashion, the European Commission is also looking at dark pools, something it will review more concretely as part of its review of the Market in Financial Instruments Directive (MiFID). For the Commission, there are two main concerns: firstly, whether increased trading in dark pools has been affecting the overall efficiency of markets by undermining price formation and liquidity on lit markets; and secondly, why this specific kind of bilateral order-matching remains dark by default, due to legal reasons, and should not be required to apply for a formal waiver from a competent authority like regulated markets and MTFs. Indeed, the European Commission will be reviewing MiFID this year. Current thinking within the Commission, as outlined by Emil Paulis of the Commission, is that they will not be looking for radical change, and as suchone should not expect a “MiFID II” with overtly radical changes . The Commission is likely, though, to look at strengthening the quality of trade reports, as well as enshrining more detailed requirements on the format and content of reporting together with better measures for enforcement.
The proposals here, although different in their level of analysis and level of possible reform, do bring us back to the key criteria driving regulatory reform – transparency. It is clear that both US and EU regulators will seek to shine a light on all aspects of the market in order to level the playing field by enhancing transparency requirements.
Conclusion – the opportunity
There are a number of key principles here that will guide policy-making over the course of the next year - safety, transparency and reporting.
There are also some real concerns that unless international coordination is found on diverging issues, notably that of mandating central clearing, there is a worry from a US and EU perspective of damaging the model vis-à-vis other jurisdictions. The G20 roadmap will largely be played out through the dialogue between the US and EU, and if the regime is sound enough it will be used as a model by other markets that are currently reviewing their regulatory regimes.
However, when regulators do stall, this also provides an opportunity for the market. For the exchange community, the current direction of travel has the potential to improve market quality. The principles of greater transparency and reporting sit well with a model that can offer visibility of prices and execution to multiple parties. The important point, though, is for these solutions to be market led.
What regulatory change does highlight also is the importance of innovation and technology in the creation of these market-led solutions. Although regulators are seeing a need for intervention in markets where technological change has been so rapid, the same technological evolution can also seek to answer these concerns. Indeed, when the push is for more transparency and more detailed trade audits, for example, market platforms that are able to provide these to both those operating within the market and those seeking to regulate them, show the clear opportunity afforded by harnessing technology.
The regulatory environment for OTC and other areas of the market has still some way to go, and considered and international engagement from all sides should resolve the potential dangers of regulatory arbitrage. Clear recognition that there will be fairer and more transparent markets will hopefully deliver for industry and regulators alike a marketplace that will be safer for years to come.
About Edmund Lakin
Edmund works for Cicero Consulting, the leading financial services public policy consultancy. Based in London and Brussels, Cicero campaigns to meet the challenges of UK, European and international legislative and regulatory policy impacts.
He works across Cicero’s UK and EU operations providing strategic guidance on relations with policymakers and officials, engagement strategies, whilst also undertaking detailed research and analysis. He previously headed up the European desk as part of Cicero’s NovaRes arm, which provides financial services public policy monitoring and information services. Before joining Cicero he worked in the UK Parliament and has also worked at the Office of Fair Trading as a Public Affairs and Stakeholder Liaison Officer with responsibilities for Parliamentary and political guidance among senior officials.