On Thursday 13 October, the Chairman of the Commodity Futures Trading Commission (the "CFTC"), Gary Gensler, spoke on the topic of "Global Reform for Derivatives Markets" at the London School of Economics.
The Chairman discussed the causes of the global financial crisis, as well as how regulatory developments being brought about in the US under the Dodd–Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") and in the European Union ("EU") were framed to change the playing field in order to ensure that swaps would never again be in a position where they could cause such significant damage to the financial system.
The prevailing theme of the Chairman's address was the need for harmonisation between US and EU derivatives reforms. In particular he noted that:
- EU reform should reflect US reform in requiring transparency and clearing for all standardised swaps.
- The CFTC should work closely with the EU and other international organisations to determine common capital and margin requirements for swap dealers.
- Dodd-Frank enables the CFTC to recognise the rules of foreign regimes which are comprehensive and comparable to the US regulatory framework.
- Dodd-Frank will apply to any activity outside of the US which has a direct and significant effect on commerce in, or on the commerce of, the US. Public consultation on the effect of this rule will be sought next year.
Some of the key points of his speech are set out in more detail below.
The Problem
The Chairman restated his view that unregulated swaps, combined with increased leverage, played a central role in the financial crisis as they resulted in a concentration of risk beyond the level that the financial system could safely absorb. Also making a contribution to the economic crisis was the widespread perception that certain systemically important institutions were "too big to fail" and "too interconnected to fail".
The Solution
The Chairman spent much of his address focusing on what he considers to be the three critical components of Dodd-Frank, while at times comparing and contrasting it with developments in the EU. Some of his thoughts and reflections are summarised below:
- Promoting Transparency
The Chairman emphasised that markets worked best when they were transparent, open and competitive. However, since the introduction of swap transactions in the 1980s, financial institutions had consistently enjoyed an advantage over the public by virtue of their superior access to market information. One of the primary functions of Dodd-Frank was to address this asymmetry by requiring all swaps transactions, whether cleared or bilateral, to be reported as soon as is practicable after the swap has been executed. In the EU, the European Commission would address the issue of information asymmetry through its own regulatory enactment process1, but in recognition of the fact that the US is currently ahead of the EU on this issue, the Chairman suggested that EU reform should reflect US reform in requiring transparency for standardised swaps.
The Chairman also noted that Dodd-Frank would provide increased transparency for the regulators themselves by giving them a window on the risks present in markets and a greater ability to police for fraud and market abuse. The EU will provide for similar measures in the proposed revision of the Market Abuse Directive ("MAD II") and the recently adopted Regulation on Market Integrity and Transparency ("REMIT"). - Lowering Risk through Central Clearing
The Chairman then moved on to examine the clearing requirement that will be introduced by Dodd-Frank, and stressed the important role that clearing plays in preventing bank defaults and in protecting banks from the risk of other banks failing. He contrasted the current position in the US with the ongoing debate in the EU on whether to impose clearing requirements on all standardised swaps, and commented that he was encouraged by the work of the European Council in this regard. - Regulating the Dealers
On the third key issue of dealer regulation, the Chairman commented that although EMIR was organised differently to Dodd-Frank, EMIR should include some of the key highlights of Dodd- Frank on dealer regulation, including the introduction of capital and margin requirements, risk mitigation techniques, and business conduct rules. He emphasised that it was important for the CFTC to work with the EU and other organisations, such as the International Organization Of Securities Commissions and the Basel Committee on Banking Supervision, on the harmonisation of capital and margin requirements.
Building an international consensus
The Chairman once again stressed the importance of international co-ordination on derivatives reform, and highlighted the CFTC's efforts to consult and co-operate with international regulators. In the EU, the Chairman has met with a number of officials, in particular Michel Barnier of the European Commission, and a weekly staff call has been set up between the CFTC, the Securities and Exchange Commission, the European Commission and the European Securities and Markets Authority. The CFTC is planning to work on a number of memoranda of understanding with foreign regulators, and Dodd-Frank enables the CFTC to recognise the rules of foreign regimes which are comprehensive and comparable to the US regulatory framework.
The Chairman concluded his speech by reflecting on the degree of interconnectedness between the US and European financial systems, giving the example of the crisis in Europe not only affecting European sovereigns and banks, but also being of great concern to US institutions. He insisted that that the only way that effective reform of the derivatives market could take place was through international co-operation and consensus, especially between the US and Europe as these venues host the majority of the world's swaps markets.
Extraterritoriality under Dodd-Frank
Amongst the many queries posed in a lively question and answer session, the Chairman was asked to provide guidance on the timeframes for the implementation of the Dodd-Frank rules on extra-territoriality (s. 722(d)). The Chairman stressed that Dodd-Frank would not cover activities which did not have a direct and significant effect on commerce in, or on the commerce of, the United States. He explained that he felt that this requirement was clear in itself, but confirmed that public comment would be sought on it, hopefully later next year. In terms of what types of transactions could enter into the scope of this rule, the Chairman explained that it would probably not cover transactions between foreign entities in foreign countries, but that it was foreseeable that it could touch on transactions between US entities outside of the US, particularly if an entity is guaranteed by a US parent.
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