Summer Reading

We always like to pack a few good yarns to enjoy while on vacation in August…and this one is at the top of the list. It’s a tale of vanishing trades, shadow banking and international intrigue.

Kind of like The Da Vinci Code meets Wall Street.

Except…the trades in question did not vanish (the article admits as much, despite the scary lead) and nothing was done in the shadows.

The fact is, derivatives trades are required to be reported to trade repositories to ensure regulatory transparency, whether they are executed in the European Union or US. And a large proportion (approximately 75% of interest rate derivatives) is centrally cleared globally.

So why all the fuss?

The root of the issue lies in the need for greater cross-border harmonization of derivatives regulations – an issue that we’ve regularly flagged in research reports, magazine articles, speeches and testimonies.

The article claims US banks are shifting derivatives trades overseas in order to benefit from “weaker” regulation in Europe and elsewhere. It doesn’t mention that all trades with a counterparty classified as a US person have to comply with Dodd-Frank, irrespective of whether those trades reside at a US bank or an offshore affiliate.

The crux of the issue, then, is those trades conducted by US banks with non-US counterparties. These clients have to comply with their own country’s rules, and often prefer to trade with counterparties in their own jurisdiction to avoid the compliance burden of meeting multiple sets of regulations simultaneously (ie, their home rules and the regulations of their counterparty’s jurisdiction). Many banks have therefore organized their operations in order to serve those clients. As a result, some trades with non-US clients are being conducted through non-guaranteed, non-US affiliates. (The obligations of a non-guaranteed affiliate are not guaranteed by the parent company.)

It’s important to note that the trades in question are subject to the regulatory requirements of the location in which they and the affiliate are based. The affiliates are also subject to the regulatory and capital mandates of their host jurisdictions.

Critics, however, believe this is merely an attempt to avoid Dodd-Frank regulatory requirements and instead benefit from weaker regulation overseas.

Now, the article doesn’t actually give any specific examples of how the regulatory framework on one side of the Atlantic is ‘weaker’ or ‘stronger’ than the other. Both jurisdictions have implemented, or are in the process of implementing, the commitments made by the Group of 20 nations in 2009 to reform derivatives markets. Both have introduced regulatory trade reporting requirements. Both have committed to mandatory clearing of standardized derivatives. Both jurisdictions have passed bank recovery and resolution legislation to ensure troubled banks can be wound down in an orderly way without resorting to public funds. And stricter capital and margin rules have been developed at a global level and are intended to apply to all banks. Our recent report on progress in regulatory reform details the advances that have been made.

If there is a problem here, it’s the need to ensure regulatory frameworks are consistent across borders to support deep, liquid global markets. Global regulators have determined that their respective rules are equivalent in some areas, which would allow a counterparty to trade with an overseas entity and comply with equivalent overseas rules, without the need to also comply with its home regulations. However, equivalence/substituted compliance determinations have stalled in some cases because of technical, highly granular differences in the two sets of rules.

ISDA believes greater harmonization on the detail of the rules would help. But these equivalence decisions should be based on broad outcomes, rather than word-by-word comparisons of two sets of rules. Only then will the incentive for a fragmentation of liquidity pools be removed.

We know that story isn’t exactly a summer blockbuster. But non-fiction rarely is.

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