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Securities and Commodities Industry Question SEC and CFTC Dodd-Frank Derivatives Rulemaking at House Hearing

By Jim Hamilton

Securities and commodities industry representatives told the House Financial Services Committee that CFTC and SEC rulemaking implementing the derivatives provisions (Title VII) of Dodd-Frank go beyond what the legislation requires and are not harmonized with international derivatives regulatory efforts. They are also concerned that the regulations will decrease liquidity in the derivatives markets. More broadly, Terrence Duffy, Executive Chairman of the CME Group, Inc. was concerned that many of the rulemakings to date would unnecessarily convert the regulatory system for the futures markets from the highly successful principles-based regime that has permitted U.S. futures markets to prosper to a restrictive prescription-based regime that will stifle growth and innovation.

Regarding the negative impact on liquidity, Don Thompson, testifying on behalf of SIFMA, noted that the CFTC?s minimum five quote requirement in the request-for-quote aspect of the Swap Execution Facility rule will inhibit the willingness of liquidity providers to quote aggressively in response to requests because their quotes will be displayed to the entire market. Another area of concern in the rulemakings is the extent to which the Swap Execution Facility definition fundamentally changes the protocols currently in place for market participants. Currently less than ten percent of trades in the OTC markets are executed electronically. Requiring changes to the existing platforms that serve this market, as required by the CFTC proposal, said SIFMA, would add an additional level of complication to the already complex and difficult transition to electronic markets.

Without care, emphasized SIFMA, there is a real risk that the current proposals will drive liquidity out of US markets and increase the cost of managing risk, if not eliminate altogether the ability to do so by making it prohibitively expensive, inflexible or burdensome.

SIFMA is also concerned about the competitive harm to US companies resulting from differences in final regulations, the gap in implementation dates in Europe and other jurisdictions. While there has been significant transatlantic dialogue on areas of agreement in regulating OTC derivatives, conceded SIFMA, the final shape of regulations in Europe is still unknown. The European Union is in the process of developing its European Market Infrastructure Regulation (EMIR) and MiFID (Markets in Financial Instruments Directive) proposals.

MiFID revision is now at the consultation stage and not expected to be implemented across the EU until late 2013.. EMIR, which covers clearing and reporting requirements, will come into effect early in 2012. In SIFMA?s view, this gap has provided a significant competitive opportunity for European institutions that are basing marketing campaigns on US institutions? compliance with Dodd-Frank. This problem should be addressed by a simple clarification of the intended extraterritorial reach of the Act and by harmonizing the implementation timetables between the US and the EU.

Echoing these comments, Mr. Duffy said that the regulations being considered are not in harmony with international regulators such as the EU, which are far from adopting an approach as prescriptive. This creates an incentive for market participants to move their business to international exchanges where they may be subject to less prescriptive regimes. He urged the Commissions not to adopt restrictions that would tilt the competitive playing field in favor of overseas markets. For example, if heavy restrictions in areas such as position limits on traders in the U.S are imposed they are likely to move to overseas markets.

Returning to liquidity issues, SIFMA noted that Title VII authorizes the agencies to adopt position limit rules relating to OTC derivatives. The CFTC-proposed position limit rule has several aspects that, if adopted, would materially harm liquidity in US markets and thus impose additional risks and costs on all market participants, including end users.

Given that non-US jurisdictions are years away from imposing similar regimes, if they do so at all, it is likely that liquidity will migrate outside the US and this will adversely affect the competitive position of US entities. In particular, the proposed rule does not allow netting of physical delivery and cash settled contracts for purposes of determining compliance with aggregate and single month limits. SIFMA reminded that netting is critical to preserving liquidity in each market and presenting an accurate picture of market positions

According to SIFMA, extraterritorial application of Title VII goes beyond Congressional intent and harms the competitiveness of US financial institutions with global businesses. One area of concern is the potential application of the Section 716 pushout rules to foreign branches of US banks, said SIFMA, which was not the Congressional intent of Title VII. Section 716 restricts derivatives trading in entities that qualify for federal assistance (such as Federal Deposit Insurance).

Section 716 should not be applied to foreign branches of US banks or foreign subsidiaries of US banks, said SIFMA, because those entities do not qualify for Federal Deposit Insurance and thus do not pose any risk to the US taxpayer. Similarly, application of other provisions of Title VII, such as the mandatory clearing and swap execution facility execution provisions, to foreign branches of US banks or foreign subsidiaries of US banks is not warranted because those activities do not have a direct and significant effect on US commerce.

Full post as published by Jim Hamilton's World of Securities Regulation on February 17, 2011 (boomark / email).