United States: Washington - We Have A Problem

The largely opaque nature of the G20 financial reform processes, together with the different time-frames for implementation, has resulted in confusion, uncertainty and an increasing demonstrable friction between national regulators.

June 2012 offered the first serious insight into how international regulators intended to apply their new derivatives regulatory regimes to cross-border issues. On 29th June 2012, the Commodity Futures Trading Commission (CFTC) published its proposed guidance on the extraterritorial application of key provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank").

Earlier the same week, the European Securities and Markets Authority (ESMA) published its consultation paper relating to the array of technical standards to be developed and implemented under the European Market Infrastructure Regulation ("EMIR"), including a summary of specific technical guidance that is being developed on the extraterritorial effect of EMIR.

In parallel, although on different time-frames, Japan, Australia, Canada, Hong Kong and Singapore (among others) are phasing in their own reforms to derivative markets. While several Dodd-Frank deadlines loom at year end, we still have no final guidance on cross-border issues from the CFTC. The comment periods for the CFTC guidance and the ESMA consultation paper both closed in August 2012. The largely opaque nature of these processes, together with the different time-frames for implementation, has resulted in confusion, uncertainty and an increasing demonstrable friction between national regulators.

This was evident in the Global Markets Advisory Committee (GMAC) meeting hosted by the CFTC on November 7th, 2012. Regulators from the EU, Japan, Hong Kong, Australia, Singapore and others raised a number of serious concerns and strong objections to the CFTC's approach to the implementation of Dodd- Frank's extraterritoriality provisions.

The unfolding regimes are imposing a number of challenges to both commodity market participants and regulators. Market participants are faced with having to negotiate through this multitude of overlapping and often inconsistent rules, many of which are not even final but require implementation now. The regulators are faced with increasing concerns as to how to maintain the functionality of the market as a whole, ensuring that the new regimes are rolled out internationally in a coordinated way and do not drive away participants and consequently hinder liquidity. The ability of regulators, particularly the CFTC and authorities in the EU, to resolve outstanding issues, and ensure the consistent application of derivatives rules, will be key to the orderly functioning and viability of derivatives markets going forward. The failure to do so to date is beginning to damage the market as a whole to the detriment of market participants and consumers alike.

It All Began in Pittsburgh ...

The commitment to derivatives markets reform sprang from the consensus among the G20 nations at the 2009 Pittsburgh summit. Given the global nature of these markets, it should be of no surprise that legislative initiatives towards such reforms taken by the US (in the form of Dodd-Frank) and the European Union (in the form of EMIR) create significant cross-border impact on the trading of derivatives.

The unfolding regimes are imposing a number of challenges to both commodity market participants and regulators

While Dodd-Frank and EMIR correlate to a large extent, there remain significant differences in the rules as they currently stand. This creates risks for industry participants and for the commodity sector in particular.

Separated at Birth: Dodd-Frank & EMIR

Given that the consensus among the G20 nations was for trading in derivatives to be given greater stability, Dodd-Frank and EMIR have complementary provisions in a number of areas. These include:

• Mandatory clearing obligations for OTC derivatives, subject to similar criteria that regulators must consider when determining if a particular type of contract should be cleared;
• Mandatory reporting obligations for OTC derivatives: under Dodd-Frank to registered swap data repositories, and under EMIR to registered trade repositories (or to the relevant national regulator in certain circumstances);
• Under Dodd-Frank, there is a clearing exemption for end-users that use swaps to hedge commercial risk and comply with certain formalities. Under EMIR, "non-financial" counterparties will generally not be required to clear transactions unless they exceed a certain "clearing threshold". If this clearing threshold is exceeded, then a clearing obligation will apply (with a carve-out for certain hedging activity);
• Requiring counterparties to put in place additional measures to ensure the stability of derivatives transactions that are not centrally cleared, for instance, capital, margin and collateral requirements; and
• Employing specific mechanisms to enable the consideration of compliance with third country regimes.

... some areas of the two sets of rules do not completely align, leaving substantial scope for compliance mismatches

However well-intended the US and EU legislators were when setting out to draft their initiatives on OTC derivatives regulation, inevitably some areas of the two sets of rules do not completely align, leaving substantial scope for compliance mismatches and practical difficulties in implementation where an entity may be subject to both regimes simultaneously. For instance:

• Applicability – Swaps versus OTC Derivatives: The Dodd-Frank definition of a swap includes any agreement, contract or transaction that is (or becomes) commonly known in the trade as a swap, including any transaction that depends upon the occurrence of a particular event. EMIR, however, is limited to bilateral OTC contracts which are not executed on a regulated market (or third country equivalent market) – thereby excluding derivatives traded on regulated markets (which are covered separately under the Markets in Financial Instruments Directive (MiFID)).
• Reporting: Although market participants will be required to report their derivatives trades under both Dodd-Frank and EMIR, the mechanics of reporting differ. Under Dodd-Frank, reporting of detailed transaction data will effectively need to be done in real time, whereas EMIR allows for a slight time lag in that details of transactions will not need to be reported until T+1. However, the EMIR rules arguably are stricter on what information is to be reported and how reporting occurs.
• Supervision of market participants: Entities that qualify as swap dealers or major swap participants under Dodd-Frank are required to register and will be subject to supervision and regulation by the CFTC. The CFTC has imposed capital and margin requirements on registered entities, as well as conduct of business rules. However, EMIR does not in and of itself impose any registration or supervision requirements on entities that would be required to register with the CFTC, although such entities may be required to be authorised to operate in the EU under MiFID or other local financial services regulation.
• Timing: Some requirements and regulations of Dodd-Frank are already in effect or are expected to be effective by the end of 2012. Although EMIR entered into force on 16 August 2012, various provisions will not be effective until the European Commission adopts technical standards (with the first set of such standards not expected to be finalised until the end of 2012).
• Extraterritorial Effect: Different methods of assessing when the rules of a regime apply to market participants based outside of a regulator's jurisdiction.

Failure by regulators to address these issues in a coordinated way opens the door to the risk of regulatory arbitrage or the departure of market participants, with an attendant increase in market concentration and, arguably, systemic risk.

Extraterritoriality

At first glance, it appears that Dodd-Frank and EMIR take a similar approach to the cross-border regulation of swaps, each providing for extraterritorial effect in circumstances where (broadly):

• the parties' arrangements are deemed to have a sufficiently significant impact on geographical areas within the remit of the rules; or
• it is deemed necessary for the legislation to apply in order to deter parties from concluding transactions intended to evade it.

Dodd-Frank applies to activities taking place outside of the US only if they either (i) have a direct and significant connection with activities in, or effect on, commerce in the US, or (ii) are in violation of CFTC rules aimed at preventing the evasion of Dodd-Frank requirements (s. 722(d)).

Under EMIR, where a contract is concluded between an EU based entity that is subject to the clearing requirement under EMIR and a non-EU entity that would have been subject to the clearing requirement if it was established in the EU, EMIR will apply. In addition to this, EMIR is intended to have extraterritorial effect where two non-EU counterparties enter into an 'eligible' contract and either: (i) the contract has a "direct, substantial and foreseeable effect" within the EU; or (ii) it is necessary or appropriate for EMIR to apply to their arrangements in order to prevent the evasion of any provision of EMIR.

Moreover, the broad extraterritorial powers in Dodd-Frank and EMIR are partially tempered by a number of indications that a harmonised approach to the regulation of trading in derivatives was envisaged by the legislators, evident through (i) specific provisions aimed at recognising compliance with comparable regimes and (ii) a number of areas of convergence between the two sets of rules in practice. However, as has become increasingly apparent, the broad drafting of the extraterritoriality provisions has left them open to an extremely generous interpretation, thereby giving the authorities considerable scope to impose their requirements more broadly than accepted principles of comity would support. Correspondingly, the perception remains among commodity market participants (and some regulators) that the level of coordination between regulators is simply not adequate.

Carve-Out For Equivalent Regimes

Each of Dodd-Frank and EMIR provide an explicit carve-out by which transactions that would theoretically be subject to the extraterritorial reach of the rules may be deemed to be compliant if they already adhere to the laws of a third country jurisdiction which have the same (or roughly similar) effect.

... the lack of coordination on a global scale has resulted in a disjointed implementation process

EMIR contains a 'mechanism to avoid duplicative or conflicting rules', by which the European Commission is required to monitor international rules and highlight provisions that could duplicate or conflict with EMIR. The provision also empowers the European Commission to adopt (and regularly review) implementing acts to declare that the legal, supervisory and enforcement arrangements of a third country are equivalent to EMIR if they:

Once an implementing act has been adopted with regards to a particular country, counterparties entering into a transaction subject to EMIR will automatically be deemed to have complied with the specific articles of EMIR set out above if at least one of them is established in the relevant third country.

The proposed guidance published by the CFTC pursuant to Dodd-Frank includes provisions for limited 'substituted compliance'. This is a mechanism by which non-US swap dealers and major swap participants can, in some circumstances, comply with entity level and transaction-level requirements (such as record keeping, data reporting, mandatory clearing, and margining) imposed by their home jurisdiction in lieu of those of the CFTC. Under the CFTC's proposed guidance, in order for this to be effective, the CFTC must carry out a rule by rule analysis and form a conclusion that, in each case, the non-US requirements adequately compare to requirements under the Commodity Exchange Act and CFTC regulations.

In contrast with EMIR, the initiative for a finding of substituted compliance will be made from the industry upwards; an entity (or a group of non-US persons from the same jurisdiction, or a foreign regulator on behalf of an entity) will need to make an application for this purpose. Further to considering such an application, the CFTC may also decide to enter into a memorandum of understanding or similar formal arrangement with the foreign supervisor. Similar problems exist with the CFTC's overly broad definitions of US person and its treatment of aggregation across affiliated entities.

Unintended Consequences – Undermining Commodity Markets

While the implantation of new regimes under Dodd-Frank and EMIR are intended to effect broadly the same outcome, the lack of coordination on a global scale has resulted in a disjointed implementation process. These systemic mismatches will impose a range of atomised requirements on commodity market participants active in multiple markets, who will be facing a number of new and unprecedented challenges. These include the high compliance costs imposed by dual (or multi) jurisdictional regulation, the lack of clarity regarding the requirement to register and the availability of substituted compliance, and the CFTC's asserted jurisdiction over third country counterparties.

The problems created by the disjointed implementation process are further complicated by the CFTC's decision to implement many of its requirements before all of the substantive requirements and extraterritorial aspects of Dodd-Frank are resolved. For example, the decision by the CFTC to move forward with its registration requirements even before it finalises the extraterritorial guidance, margin or capital requirements, has created substantial confusion among multinational institutions regarding how to structure their US derivatives business, which entities are required to (or should) register, and the costs of doing business going forward. The CFTC reliance on "substituted compliance" as an alternative form of compliance is equally problematic, given that substituted compliance is effectively unavailable at this point in time due to the lack of finality of non-US regulation such as EMIR – meaning that multinational institutions will have no practicable choice other than to become fully compliant with CFTC regulations until EMIR is finalised. These problems in turn are being felt by counterparties as well, who remain uncertain regarding exactly which institutions will be able to conduct business and the costs of continuing (or changing) those business relationships.

There has not been any suggestion that trading in commodities was to blame for the financial crisis, but the introduction of a plethora of new rules runs the serious risk of creating reduced liquidity, increasing concentration of trading activity within fewer market participants, and, ironically, creating systemic risk where none existed before. This will be the opposite effect to what was intended and has the potential to cause long term damage to the commodity markets.

There is an argument that both EU and (particularly) US legislators should strongly consider "resetting" the process now ...

The presence of numerous commodities markets players spread across the globe brings liquidity and efficiency to the commodities markets. Regulators must not underestimate the imminent harm caused by inconsistent or poorly coordinated regulations. The markets will respond to the regulatory uncertainty. The reforms are already leading to market changes such as the "futurisation" of contracts under which an increasingly large volume of swaps will be converted into futures and driven onto a limited number of exchanges. It seems unlikely that such a reallocation of risk in fewer trading venues, albeit well capitalised and highly regulated ones, would have been the goal of those framing the news rules, particularly with regard to the commodity markets.

There is an argument that both EU and (particularly) US legislators should strongly consider "resetting" the process now to avoid the need to revise and reverse elements of the provisions later and on a piecemeal basis, potentially in the face of a future crisis. In any event, it is imperative that legislators and regulators should, as far as possible, maintain a sharp focus on aligning their policies with other international reform measures. A critical first step in this process is for the CFTC to take to heart the recent admonition by an EU representative – "Washington We Have A Problem."

Previously published in COMMODITIES NOW, December 2010

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.