UNINTENDED CONSEQUENCES.

Be careful what you wish for warns Jannah Patchay, Director, Agora Global Consultants.

The history of regulatory change is littered with the shipwrecks and skeletons of unintended consequences. The first two instalments of the Basel rules incentivised the move to off-balance sheet transactions and helped drive the creation of opaque product structures, paving the way for the events of 2007. These events in turn created the regulatory environment of today, in which both global and national regulators are attempting to put in place a system of market oversight and governance designed to avoid a repeat of past calamities. However, the spirits of unintended consequences are ever lurking in the shadows, sometimes presenting themselves to great effect, as we shall see in the following examples.

Not all unintended consequences are negative. The first iteration of MiFID, while on the one hand leading to a proliferation of new trading venues and fragmentation of liquidity, also led to increased competition and ultimately to a more efficient, dynamic and innovative market. The piecemeal adoption of the Dodd-Frank Act for derivatives markets, on the other hand, has thrown up some very interesting conundrums that are at best viewable as temporary disturbances, which will ultimately settle down into a long-term equilibrium, and at worst as unforeseen ramifications causing widespread disruption to what were previously largely stable markets, such as FX and Rates.

Devil in the detail

Amongst Dodd-Frank’s many quirks is that the devil is often buried in the details of footnotes, rather than laid out in the actual regulatory guidance itself. This was manifested in Footnote 88 of the CFTC’s Core Principles and Guidance for Swap Execution Facilities (SEFs), the final version of which was published in June this year. Whilst the draft rules had excluded uncleared products from SEF execution rules, Footnote 88 in the final rule stated that all multilateral trading platforms are required to register as SEFs, regardless of whether or not the products traded on them are subject to the trade execution mandate.

Suddenly, a large number of ECNs and interdealer brokers found themselves scrambling to obtain temporary authorisation as SEFs, put in place the infrastructure to support SEF trading, and on-board their eligible participants to the new SEF legal entities before the 2nd October compliance deadline. On the other side of the fence, dealers, buyside and corporates were similarly scrambling to complete legal and technology on-boardings, in many cases to not one but multiple new SEFs.

And this was just the beginning. The entire SEF framework was envisaged as supporting the execution of transactions in cleared products. Little thought was given to the implications of imposing this model upon transactions in uncleared products (specifically, those for whom the Dodd-Frank clearing mandate has not yet taken effect, such as FX options and non-deliverable forwards). Therefore, whilst the requirement that transactions on SEFs be confirmed at the time of execution makes perfect sense in the world of standardised, cleared products, where a richer set of trade terms is known upfront, it becomes rather unwieldy when applied to transactions in previously OTC-executed, uncleared products, where the full trade terms are agreed as part of a post-trade exchange of bilateral information or industry-standard documentation.

A SEF does not hold this information. It was not ever intended to. It is an execution venue, not a repository of post-trade documentation. And yet now, as various industry groups co-ordinate initiatives between market participants and SEFs to develop a workable solution for presentation to and approval by the regulator, this scenario has become a real possibility.

Another example is that of the prime brokerage credit intermediation model, commonly practiced within rates, credit and FX businesses. A prime brokerage client arranges a deal with an executing broker and then gives it up to a prime broker for execution. The trade is never done between the client and the executing broker – the consequence is that the client faces off to a single or smaller number of counterparts, and the executing broker is assured of the credit status of its counterpart to the trade, namely the prime broker.

In a cleared world, the need for this model falls away entirely, as the prime broker can be replaced by a general clearing member (GCM) and the client never faces off to the executing broker directly as the trade is given up to the clearer. In the world of non-cleared SEF execution, however, what exactly happens when a trade is confirmed at the point of execution in a model that does not cater for prime brokerage? Is the resulting trade executed between the client and the executing broker, and legally binding as such? Uncertainty around this area, since the SEF confirmation requirement took effect, has resulted in many executing brokers refusing to do business with prime brokerage clients on a SEF.

Regulatory inconsistency

The advent of SEFs has also led to a (hopefully only temporary) split in liquidity pools between US entities forced to trade on-SEF, and non-US entities, which are often not able to participate on SEFs even if they so desired. This is caused by the inconsistencies across different regulatory regimes; whilst in the UK, a US-authorised platform is automatically recognised, under many other regimes such as the Asian jurisdictions, the regulator must first authorise the platform according to local rules. This process can take 3-12 months in some areas.

The latest instalment in the Dodd-Frank footnote saga has been that of Footnote 513 of the CFTC’s Cross-Border Guidance on Transaction-Level Requirements. Or, in short, the scenarios in which Dodd-Frank KYC, execution, clearing, reporting, and various other rules apply to non-US entities previously deemed to be out of scope. Recently published clarification of this footnote effectively dragged in all personnel of non-US dealers who are physically located in the US. Given that, for EU entities, EMIR KYC, clearing and reporting requirements apply to these same transactions as well, situations can arise in which the same trade must be reported or cleared under two conflicting regulations. As EU representatives noted with some surprise, this represented a 180 degree turn on the “Way Forward” agreed between the EU and US regulators earlier this year, aimed at ensuring consistent and coherent application of each jurisdiction’s rules globally.

These are (often unexpectedly) exciting times for those affected by or working to implement regulatory change, and it remains to be seen whether they will be merely temporary upheavals on the way to a new equilibrium in market structure, or whether they signal the start of something wider-ranging and less certain in its outcome.

©Best Execution 2014

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