THE NEW NORMAL?

PJ Di Giammarino, founder and CEO of JWG Group asks how long will it be until we see the derivatives market’s new equilibrium?

With ESMA having declared the US to be ‘conditionally equivalent’ with the EU, what does this mean for your OTC trading business? And how does this fit with the recent trade reporting delay?

Before 2008, world leaders were in talks about how to align the rules for a global marketplace. Then the crisis hit. What followed was a rush to find agreement at the highest level, so that leaders could return to their countries and get the ball rolling on their national regimes. The next four years saw rules fragment, as differences emerged between jurisdictions in timing and approach. Today, in 2013, institutions are living on borrowed time, with delays and no-action letters often the only thing standing between them and non-compliance. So what barriers still stand between us and a functioning derivatives market?

Extraterritoriality

First of all, we have the issue of extraterritoriality. In a world where trading has no respect for borders, there is clearly going to be an issue with which set of rules to apply. Some requirements attach to the entity doing the trading and so can be differentiated, but others, such as dispute resolution in the EU, apply to the trade and so affect both parties. This is especially difficult where the rules conflict between two jurisdictions, putting institutions in a Catch-22, and so require some kind of mechanism (which we will come to later) to reconcile two sets of rules.

However, rule makers, in an effort to insulate their own jurisdictions from extraterritorial threats to market stability, have introduced additional extraterritoriality rules. The EU, for instance, have produced standards on OTCD contracts that have an effect in the Union, and so will be subject to EMIR’s requirements. As currently drafted, this applies to branches of and entities guaranteed by EU institutions. But entities can move over or under the guarantee threshold and it is not clear whether products such as CDSs count towards this threshold. Therefore, these rules greatly complicate compliance for third country firms as they will have to track their counterparties in order to know whether or not they should be playing by EU rules.

Mutual recognition

The only way to escape being subject to EMIR’s extraterritoriality rules is for your country to be deemed ‘equivalent’. Equivalence is a form of mutual recognition, whereby a host jurisdiction recognises foreign firms as compliant for complying with the rules of their home jurisdiction. For comparison, the US’ version is called ‘substituted compliance’. In an ideal world, once a country’s rules are recognised, firms from that jurisdiction should face no additional requirements when trading with the jurisdiction that recognised them.

But this has not proved to be the case. In fact, both the US and EU have created a whole new set of requirements for firms from other jurisdictions. In the US, the CFTC responded to the problem of cross-border trading by first extending the definition of US persons, in order to capture subsidiaries of US banks, but then limited the scope of entity and transaction-level requirements according to the status of the entity in question. The aim purportedly was to scope out non-US entities. However, a single footnote (513) then reverses a substantial part of this by declaring that US branches of non-US SDs/ MSPs (Swaps Dealers/Major Swap Participants) will still be subject to transaction-level requirements. Far from simplifying cross-border compliance, this could well be argued to further complicate the issue.

Similarly, the EU promised a simplification of the rules, stating that it would declare third countries equivalent on a ‘holistic’, country-by-country basis. However, they have yet to deliver on this promise. Not only have ESMA’s recommendations so far failed to provide clarity on whether a country is equivalent or not by instead taking a rule-by-rule approach to equivalence, but have also invented a third category of ‘conditional equivalence’. This means that firms and FMIs wanting to be considered for authorisation by ESMA will have to ‘top-up’ their current compliance efforts with select elements of EMIR, in effect creating a new set of rules for each non-EU country.

Furthermore, in spite of the confusion, regulators are pushing ahead with new requirements. For example, the CFTC refused to delay the 2 October SEF registration deadline, despite calls from the highest levels to do so, and had to issue a host of no-action letters in lieu. Similarly, it looks likely that the European Commission will refuse to delay exchange-traded derivatives reporting requirements, for which ESMA had hoped to be granted time to draft additional standards. Not only will this complicate EMIR compliance in the short term, but will also have knock-on effects for MiFID going into 2014.

In short, a new wave of regulatory protectionism seems to be trumping cross-border co-ordination. Temporary relief from rules does nothing to tie-up the global market; it only delays fragmentation. As Mark Carney (Governor of the Bank of England) wrote in the FT the other day, regulators need to set their differences aside before this stalemate affects volumes and the real economy. Unless that’s their intention of course…

©Best Execution 2013