Are you ready for Dodd-Frank’s extraterritorial impact on derivatives?
Foreign swap dealers will need to register with US authorities, back up trades with more capital and collateral and comply with certain transactional regulations for swaps with US persons under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) from October 2012.
US swaps regulation under Dodd-Frank moved closer to being in final form over the past weeks, with the Commodity Futures Trading Commission (CFTC) issuing rules and guidance on a number of issues:
- joint final rules with the Securities and Exchange Commission, to further define key product definitions like “swap”, “security-based swap” and “mixed swap”
- no-action relief to allow swap dealers to delay compliance with certain reporting under the large trader rules for physical swaps and swaptions until 60 days after the swap dealer registration requirements come into force in October 2012
- a proposed rule to require that certain classes of interest rate swaps and credit default swaps be the first derivatives subject to mandatory central clearing.
For foreign swap dealers the CFTC issued proposed interpretive guidance giving an indication of how derivatives regulations under Dodd-Frank will be applied to non-US firms. Under Dodd-Frank, the CTFC is required to regulate, to some extent, swaps entered by any person (wherever located), with a counterparty that falls in the definition of a “US person”.
Foreign swap dealers that deal with US persons are required to register with the CFTC as swap dealers by October 2012, and comply with certain transactional requirements from that date. As part of the registration process, management has to identify all significant persons within the firm involved in swaps transactions. Aside from that the registration process should be a fairly straightforward information gathering exercise. Foreign based swap dealers appear to be able to use a different, and less onerous, test for registration versus their US counterparts.
Nevertheless, if a firm has to register, it will have to comply with tough external and internal business conduct requirements under Dodd-Frank. Even the task of identifying all swaps with US persons is likely to be burdensome (non-US firms involved in preparing for the US Foreign Account Tax Compliance Act (FATCA) have found identifying all their clients who are US persons a similarly difficult exercise).
US regulators expect all registered swap dealers and major swap participants to operate their global swap dealing business in a Dodd-Frank compliant manner. Foreign swap dealers can apply to have a 1-year grace period during which they would be able to just comply with their local compliance requirements (“substituted compliance”) rather than Dodd-Frank requirements. Foreign branches and affiliates of US firms may also request certain compliance delays for trades with foreign persons if they are operating in jurisdictions that are creating Dodd-Frank type rules. However even with this grace period, EU firms are likely to run up against challenges because the EU is unlikely to be fully equivalent in time as many EU trade reporting requirements will only come into force once MiFID II is implemented (around 2015).
Depending on the foreign swap dealing entity, its location, the nationality of its counterparties and the particular regulatory requirements, European firms and their affiliates may be in or out of scope for Dodd-Frank. In determining the relevance of this proposed guidance to their particular situation, foreign firms should start by keeping a number of questions in mind:
- where and out of which entities do I trade swaps with US persons?
- how and by whom are my US and non-US swaps regulated?
- which of my entities are or potentially could be swap dealers?
- do I have to comply with Dodd-Frank now, something comparable later or some combination thereof?
- if I can delay complying with certain aspects of Dodd-Frank, does it make business sense to do so?
Although each firm and group will need to do its own detailed analysis, our FS Regulatory Brief
offers general observations for firms to consider. It also provides a table assessing the projected regulatory impact on various types of entities/branches engaged in swap dealing activities.
Firms will also want to consider how the Dodd-Frank provisions will align with the forthcoming EU derivative regime. The main EU legislation on derivative regulation (EMIR and MiFID II) is still being negotiated and may change, particularly around trade reporting requirements. As a result, EU firms may be forced to design their compliance systems around Dodd-Frank and other international regulations and then adapt them when the EU regime comes into force. This timing disconnect is likely to make the change process much more costly and complex for firms.
Michel Barnier, the EU Commissioner for Internal Markets and Services, wants US authorities to delay certain elements of their derivatives regulation, fearing that confusion surrounding some of the provisions will harm EU banks operating in the US. Moreover, divergent approaches to regulations and rule application and uneven enforcement may mean that the resulting market structure will vary across instrument classes and by jurisdiction. Clearly, it’s important that regulators on both sides of the Atlantic increase their efforts to align their regimes. Ideally, all international markets would implement their G20-driven changes to derivatives regulation, but that appears extremely unlikely to happen, even across the major international markets.
IAIS finds reinsurance is unlikely to cause systemic risk
The International Association of Insurance Supervisors (IAIS) has found that reinsurance is not a source of systemic risk and is unlikely to amplify or cause a crisis in its recent report. Even for alternative risk transfers (ART), which include potentially risky activities such as the underwriting of credit default swaps (CDS), the IAIS said that in most cases this activity will “not undermine a larger credit pyramid” and is unlikely to affect other financial market participants or the economy.
The interconnected nature of the insurance industry may be a source of systemic risk if a large insurer were to fail. However, the intra-industry connectivity in insurance is distinctly different from banking, with several structural factors mitigating the affects of a negative shock. Firstly, the relationship in insurance is built on the original insurance contract, and contractual payments are strictly tied to the occurrence of an insured event. If those obligations are reinsured, the original insurer (cedant) remains responsible for its original contractual obligation with the original policyholder, regardless of whether or not the reinsurer passes some of its own risk to the capital markets through securitisation, so the cedant always has some “skin in the game”. Secondly, insurers do not engage in overnight lending and cash calls on demand facilities that could trigger a run on a reinsurer. Thirdly, unlike payments relating to banking transactions, large insurance claims are typically paid out on a staggered basis over a lengthy period. In contrast, if a customer decides to withdraw its bank deposit or defaults on a loan, the bank takes an immediate hit against its capital.
Recently, investment banks have started to offer longevity and pension services with risk transformation and risk transfer features similar to products offered by non life and life insurers. In light of this, the IAIS is calling on supervisors to strengthen cross-sector prudential supervision and surveillance, targeting systemically important products and activities.
The reinsurance industry has held up pretty well in the face of the financial crisis. AIG’s failure illustrated the dangers of engaging in non-insurance activities, such as underwriting CDS or collateralised debt obligations, without appropriate provisioning. If reinsurers stick to their ‘bread and butter’ activities, they should continue to grow without posing systemic risks. In contrast, IAIS noted that banks and shadow banks adopted originate-to-distribute business models during the 2000s with poorer risk governance and due diligence that ultimately spawned the sub-prime crisis.
EBA calls for wide regulatory net to cover market finance risks
A wide regulatory net should be cast to contain risks arising from “shadow banking”, according to the EBA’s opinion paper in response to the EC green paper on shadow banking. The EBA argues supervisors need “powers to prompt changes in the perimeters of regulation” in order to respond more quickly to risks in market finance.
The regulatory perimeter has two dimensions: regulation of entities and regulation of functions/activities. The EBA believes that a functional approach would work best; however, giving supervisors powers to shift regulatory boundaries unilaterally raises some fundamental questions. This approach would represent a significant departure from the current EU legislative framework, where the regulatory perimeters are established through directives, regulation or local laws in the Member States, with the regulators providing guidance to interpret the perimeter legislation. It goes against the grain of the principles of good regulation
-- as propagated by the Organisation for Economic Co-operation and Development. It would also inject a fresh dose of uncertainty into a market that provides much needed liquidity in the economy.
The shadow banking system needs prudential regulation because it harbours many risks, according to the EBA. Shadow banking entities, particularly if unregulated and unconsolidated, are potentially vulnerable to runs (withdrawal of deposit-like assets due to panic, early redemptions due to a confidence crisis) and/or liquidity problems (liquidation of assets at fire sale prices). Unlike banks, market finance intermediaries do not have access to central bank liquidity support, government guarantee programs or insured deposits.
Shadow banking entities are also highly interconnected and can, directly or indirectly, generate systemic risks through a contagion or domino effects between shadow entities. The EBA are also concerned by excessive leveraged positions set-up by market finance entities or instruments without any regulation to keep leverage in check.
With an adequate mandate and sufficient powers, the EBA believes that it is best positioned to regulate the shadow banking system given the information flows it receives from national supervisors. If politicians agree, we may see both the EBA’s regulatory powers and the regulatory perimeter expanding significantly.
CRD III’s procyclical impact
The European Commission (EC) surveyed national supervisors and found that a majority believe that risk-sensitive bank capital requirements under CRD III may amplify business cycle fluctuations.
The story goes that minimum capital requirements, like those in CRD III, are increasingly driven by the probability of default and therefore these inputs are likely to rise during an economic downturn. When borrowers’ creditworthiness deteriorates, banks are forced to increase their capital positions-- contracting the supply of credit in the economy and further exacerbating borrowers’ position (vicious circle). Similarly, during an economic upturn when prices steadily rise and defaults decrease, the apparent reduction in risk may reduce capital requirements. Then banks can increase lending, boosting the economy further (leading to overheating and the formation of bubble type conditions).
In a study based on Basel II minimum capital requirements and drawing from quantitative data on the Spanish banking sector (1987-2008), Repullo et al
. (2009) pointed to “very significant cyclical variation of the Basel II capital requirements when they are calculated with point-in-time default probabilities”. In 1993, at the worst point of the business cycle in the sample period, capital requirements would have been 11.9%, falling to 7.6% in 2006, a year of high GDP growth. The authors calculated that this “variability of 57% in Basel II capital requirements from peak to trough contrasts with the flat 8% requirements of Basel I”.
The EC, using different data, time periods and an underlying approach arrive at a different answer. Running their quantitative models, the EC estimated that the cyclical effects at portfolio level seem to be mitigated by the affects of the minimum capital requirements. These mitigations are likely to be primarily due to portfolio adjustments to the size and composition of banks’ overall portfolios.
The real answer is probably somewhere in between. Minimum capital requirements are procyclical by their very nature, however, it is difficult to mathematically model individual bank behaviour that may mitigate these effects.