The escalating tension among global regulators has left central counterparties (CCPs) in the U.S. and Europe nervously awaiting a resolution to what has become the most daunting hurdle yet for the newly mandated regulatory regime in the worldwide clearing of over-the-counter (OTC) derivatives.
Worse yet, regulators in Europe are facing a mid-December deadline to resolve these issues, which center on regulatory equivalence and mutual recognition, and many worry that failure to meet that deadline could leave CCPs, exchanges, buyside firms, banks and investment houses on both sides of the Atlantic in limbo as to how to clear cross-border swaps, futures and other derivative products.
The biggest nightmare would be that CCPs will not recognize each others products, said University of Houston finance Professor Craig Pirrong.
The U.S. is already up and running with its clearing mandate, and market participants are feeling the full effect of that, Prof. Pirrong explained. But Europes clearing oversight rules dont go into effect until 2016. Until then-whether the European Union (EU) likes it or not-the U.S. Commodity Futures Trading Commission (CFTC), which has oversight of much of the US OTC derivative market and does have fully finalized and implemented rules for clearing OTC derivatives, is the point of the spear for OTC derivative regulation right now. Europe is very afraid of being dragooned into the U.S. regulatory system, said Pirrong. And some European derivative players say the simplest solution is to not have a U.S. counterparty.
Many market observers worry that such an unresolved and jagged schism between the U.S. and Europe in the trading, clearing and settlement of OTC derivatives could be enormously disruptive to the $700 trillion market.
Roots of the Problem
The roots of this dispute can be traced to the David L. Lawrence Convention Center in Pittsburgh in 2009. There, at the meeting of the G20, member countries resolved to have all governments mandate clearing of many derivative securities, which at that time were being heavily blamed for causing much of the chaotic market meltdown that led to the then-ongoing financial crisis.
After that, U.S. lawmakers created and passed the Dodd-Frank Act in 2010, which outlined an OTC derivative clearing regime that largely went into effect last year. As per the G20 agreement, the new US regulations used CCPs for clearing instead of allowing bilateral swaps between two parties and voluntary clearing, which regulators and legislators believed carried much more systemic risk. In Europe, lawmakers debated longer, eventually coming up with the European Market Infrastructure Regulation plan (EMIR) in 2012, which will see its OTC derivatives clearing regulations go into effect in 2016.
Into that regulatory gap plunged the CFTC, which was worried that with U.S. regulations finalized and most foreign regulatory bodies still mapping out their rules, a two-tiered system would evolve-one regulated and one not-that would greatly disadvantage the US derivatives market. Also, the CFTC feared regulatory arbitrage would emerge as market participants, even U.S.-based ones, would begin gravitating toward the countries with the least rules. So, the CFTC starting offering regulatory guidance, including interpretive guidance released in mid-2012 relating to extraterritorial issues and cross-border swaps. European regulators and others immediately accused the CFTC of regulatory overreach.
This is all part of the ongoing turf war between the regulators that has been sparked by what Europe considers to be extraterritorial overstepping on the part of the CFTC, said Virginie O’Shea, senior analyst at Aite Group. OShea explained that there is a lack of equivalence between the US and Europe in terms of both regulatory requirements and in recognition of CCPs for clearing. Additionally, there are ongoing disputes between the CFTC and the European Commission (the executive branch of the EU) and the European Securities and Markets Authority (ESMA) about minimum standards for risk, client collateral and margin requirements. The ongoing dispute has resulted in a stalemate of sorts over these issues, with each regulatory regime refusing to budge. The European Commission has already recognized a number of other countries for regulatory equivalence, but it has yet to agree with the CFTC on the U.S., OShea noted.
Indeed, this bad blood and bruised feelings among global regulators has resulted in occasional flare-ups. In a June 10 speech at the Futures Industry Associations IDX conference in London, Ananda Radhakrishnan, director in the CFTCs division of clearing and risk, said he was tired of providing exemptions to European-based CCPs and suggested instead that those CCPs move their clearing contracts to their US units and under CFTC oversight.
Two weeks later, the European Commission announced it would recognize the regulatory regimes of several more countries, including India and Australia, but pointedly would not yet recognize the U.S. In a tersely worded statement accompanying the announcement, Michel Barnier, the EU commissioner in charge of financial services, said the CFTC needed to recognize and defer to the strong and rigorous rules in jurisdictions such as the EU.
Real World Effects
Because the ongoing dispute involves finding acceptable equivalent standards on a myriad of complex and detailed regulatory issues, real world examples are as diverse as the problems themselves. For example, one major conflicting issue is that the EU has linked its banking capital ratios to the new clearing rules in order to give EU banks incentive to use clearing firms. If this dispute remains unresolved, however, those European banks would have to dramatically raise capital requirements if using those unrecognized US-based CCPs, making them a less attractive alternative.
Chicago-based CME Clearing, which clears the lions share of euro-dollar interest rate swaps, could feel the crushing impact of that development. Regulators and the industry are after the same thing, we want a level playing field across futures and swaps regulation and to avoid market disruption, said Suzanne Sprague, executive director of collateral and risk for CME Clearing, a unit of CME Group.
However, that has been complicated by this dispute, she added. The determination of regulatory equivalence across jurisdictions was supposed to be based on a holistic assessment without a line-by-line comparison of regulations given the structural differences of markets across the globe, Sprague said.
While there is a clear imbalance between the US and EU on futures regulation, she explained that the CFTC has worked to create an open door for foreign trading markets and has taken steps to defer primary regulatory oversight to the EU in certain cases. However, she said it is the EU that is cherry picking line-item regulations to impose on other jurisdictions without regard to recognizing weaknesses in its own rules.
One problematic part of this, Sprague explained, is that the EU is requiring that all CCPs that want to be qualified to clear OTC derivative products in Europe must re-apply for recognition as a domestic or third-country CCP with ESMA, despite the fact that the major CCPs across the globe are already registered in the EU as CCPs. This re-application process has consumed a significant amount of time and resources, she said, adding that the EU has tied qualified CCP status to this reauthorization process-but the U.S. has not.
The result is that European CCPs do not have to newly register with the CFTC, but U.S. CCPs must be reauthorized by the EU. Worse yet for US CCPs, the EU, as part of the reauthorization process, must regard the CCPs home jurisdiction as having EU-equivalent regulatory standards-something the EU does not yet recognize with the US.
Again, a seemingly fixable problem, but one-if left undone-that could mean a massive global headache for many of the firms involved, especially if the December 15 deadline for ESMA to recognize US-based CCPs under the EUs Capital Requirements Directive (CRD IV) is missed. Although there is no clear deal yet, we are working with regulators on both sides of the pond to resolve outstanding differences that will allow CME Inc. to be recognized in Europe and secure qualified CCP status, Sprague said.
Another example and one that the CFTCs Radhakrishnan outlined in his speech involves the regulatory quandary faced by the Nodal Exchange, a US-based exchange which trades futures contracts on North American power markets. Nodal clears its futures contracts with LCH.Clearnet, a London-based CCP. But because its a US-based exchange, its trades are required to clear through regulated futures commission merchants (FCMs) that have to follow the CFTCs rules on segregation of client assets.
However, because Nodal uses a European CCP for clearing, it will be subject to a different set of asset segregation rules established by the EU. The specific snag involves requirements under EMIR that allow for individually segregated client accounts, while CFTC-registered FCMs are not allowed to use individual segregation. It was this kind of conflict that Radhakrishnan said could be avoided if LCH.Clearnet simply moved the clearing of Nodals contracts to LCHs U.S. subsidiary.
Indeed, all such examples appear to boil down to one unfortunate conclusion: even the smallest detail in the most obscure of rules-and one that could seemingly be easily resolved-remains a deal-breaker that could upend an entire market segment if the two governing sides are not willing to compromise… or even talk.
To that end, Timothy Massad, who took over as new head of the CFTC in June, has said publicly he is committed to finding a timely solution for this dispute, and wants to work out a harmonious relationship that gives appropriate deference to other countries. While that may give the derivatives markets some hope-and Massad is regarded as having a much gentler touch than that of his predecessor Gary Gensler-until the problems of mutual recognition and regulatory equivalence are resolved, many CCPs, banks and investment firms with skin in the derivatives clearing game can only watch, very nervously.
This is a rather unseemly fight between Europeans and Americans over this issue, said Prof. Pirrong. And they will have to come up with something as a solution, but right now there is just a lot of posturing.