In 2010, US President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) into US law. Five years later, the International Swaps and Derivatives Association (ISDA) released a report evaluating the progress of the implementation of the rushed reforms, leaving many market participants reeling as they scurried to understand the implications of the new rules.
Banks now have more capital, yet access to credit remains a challenge for consumers.
Under Dodd-Frank’s Title VII, US derivatives markets saw a number of fundamental changes, namely: the introduction of clearing of standardized derivatives products; the trading of mandated derivatives products on a regulated exchange or swap execution facility (SEF); all swap transactions are required by the CFTC to be reported to a swap data repository (SDR); and the regulation of swap dealers (SDs) and major swap participants (MSPs), which mandated margins for non-cleared derivatives and imposed capital rules.
The ripples of the reform have been felt globally, particularly in Europe where the European Securities and Markets Authority (ESMA) has subsequently introduced regulation on derivatives (EMIR), with reporting, clearing and risk management requirements in line with Dodd-Frank.
Five years on, despite some initial teething problems, much of the framework envisaged by Dodd-Frank is in place. Banks now have more capital, yet access to credit remains a challenge for consumers.
Since 2013, the responsible regulators in the US, namely, the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC), have been able to mandate clearing for specific derivatives classes.
Central clearing is now well established, with approximately 75% of interest rate derivatives (IRD) and credit default swap (CDS) index average daily notional volume now cleared, according to data submitted to US swap data repositories (SDRs).
Consequently, there is now recognition of the systemic importance of central counterparties. Going forward, the report highlights the need to ensure they are resilient – for example, through greater transparency on margin methodologies and minimum standards for stress tests.
Since 2014, cleared derivatives have been required to be traded on a regulated exchange or a so-called swap execution facility (SEF).
The report finds that approximately 55% of IRD and 65% of CDS index average daily notional volume is now traded on SEFs.
However, rigid regulation may be preventing higher rates of trading on these venues and hampering cross-border harmonization. ISDA therefore recommends targeted amendments of US SEF rules.
Differing reporting requirements across jurisdictions mean regulators are unable to gain a clear picture of global risk exposures and possible concentrations.
Dodd-Frank also requires all swap transactions involving a US person to be reported to a SDR, allowing regulators to access and aggregate data to analyze trends that may pose systemic risk.
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However, due to differing reporting requirements across jurisdictions, regulators are unable to gain a clear picture of global risk exposures and possible concentrations. ISDA therefore suggests that “regulators across the globe need to identify and agree on the trade data they need to fulfil their supervisory responsibilities, and then issue consistent reporting requirements.”
Although similar legislation has been passed across the Atlantic, Dodd-Frank remains US-specific. Consequently, divergences in rules and implementation schedules across jurisdictions have caused a fragmentation of liquidity pools, which ultimately reduces choice and increases costs for end users.
To highlight this, ISDA research shows that “87.7% of regional European interdealer volume in euro interest rate swaps was traded between European dealers in the fourth quarter of 2014, compared with 73.4% in the third quarter of 2013.”
US entities are unable to access the most liquid pool for euro interest rate swaps, which is centred in Europe.
“The change in trading behaviour coincided with the introduction of US SEF rules, which encouraged non-US entities to avoid trading mandated products with US counterparties, so as not to be required to trade on a CFTC-registered SEF that offers restrictive methods of execution for these instruments. US entities, conversely, are unable to access the most liquid pool for euro interest rate swaps, which is centred in Europe, away from SEFs.”
As such, it is imperative that cross-border harmonization of regulation proceeds.
ISDA recommends the following targeted amendments with regards to cross-border harmonization:
- Regulators should work to harmonize rule sets as far as possible. Transparent, clearly articulated substituted compliance determinations based on broad outcomes would maximize the potential for cross-border harmonization.
- Regulators should identify and agree on the trade data they need to fulfil their supervisory responsibilities, and then issue consistent reporting requirements on a global basis. Further work is also needed by the industry and regulators to develop and adopt standardized product and transaction identifiers, as well as reporting formats.
Finance Magnates recently reported that such initiatives to improve data quality and standardization across jurisdictions are already underway.
ISDA announced on June 15 that a group of eleven industry associations have endorsed a set of principles seeking to improve consistency in regulatory reporting standards for derivatives.
It is imperative that cross-border harmonization of regulation proceeds.
Such calls for cooperation are echoed in the recent release of the Fair and Effective Markets Review, which was jointly produced by the Bank of England, the UK Treasury and the Financial Conduct Authority (FCA). The review emphasizes the need for coordinated international action, including “agreeing on a single global FX code providing a comprehensive set of principles to govern trading practices around market integrity, information handling, treatment of counterparties and standards for venue – as well as stronger mechanisms to ensure market participants adhere to that code.”
Reflecting such calls for greater collective responsibility around data and information harmonization, the Depository Trust & Clearing Corporation (DTCC) announced their recommendations for global data harmonization in June.
Thus, while substantial progress may have been made with regards to Dodd-Frank, regulators across the globe are still tuning their instruments so that end users can benefit from a harmonized regulatory environment, which will ultimately increase the effectiveness of markets and reduce complexity and cost.