International Regulation of Derivatives Markets

By David Oakes, Dauphin Financial Training Inc.

In 2009, the G20 countries committed to reform regulation of over-the-counter (OTC) derivatives markets in order to enhance transparency and reduce risk.  In the US, this is being implemented through the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (DF) and associated regulations.  In the EU, it is being implemented through the European Market Infrastructure Regulation (EMIR), the revised Markets in Financial Instruments Directive (MiFID II), and the Markets in Financial Instruments Regulation (MIFIR).  While these reforms are addressed primarily at market participants in the US and the EU, the global nature of the OTC derivatives business means that many transactions have a cross-border element, and many participants are active in more than one market.  As a result, global entities may be subject to overlapping but non-identical rules, while entities that are based neither in the US nor in the EU may find themselves subject to the extra-territorial reach of one or both sets of rules.

The Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC) share responsibility for implementing the DF reforms, with the CFTC having authority over swaps, swap dealers and major swap market participants, and the SEC having authority over security-based swaps, security-based swap dealers and major security-based swap market participants; the term swap is defined so as to include most types of derivative security.  Dealers and major market participants must register with the CFTC and the SEC, and many standard derivative products must now be centrally cleared.  The CFTC and the SEC decide which swaps or swap products are subject to this clearing obligation.  Transactions in contracts that are not subject to the clearing obligation must be reported to a trade repository; this trade-reporting obligation is already in effect.  Some of the swap products that are subject to the clearing obligation have been determined made available to trade (MAT).  These products must be traded on a designated contract market (DCM) or on a swap execution facility (SEF).  A DCM is an exchange, while a SEF is a trading system in which parties have the ability to execute or trade swaps by accepting bids or offers from multiple participants.  The intent of these reforms is to make OTC derivatives market more closely resemble exchange-traded derivatives markets.

European reforms distinguish between financial counterparties (FC) and non-financial counterparties (NFC).  FCs, as well as NFCs who exceed certain volume thresholds (known as NFC+s), must clear OTC derivatives with a central counterparty.  All trades must be reported to a trade repository.  Since the US reforms do not distinguish FCs from NFCs and have no volume thresholds, the same entity may face different obligations in the two cases.  Mandatory clearing is also being phased in over a longer period (up to three years) in the EU.  Derivatives that are sufficiently liquid and eligible for clearing will ultimately have to be traded on an organized trading facility (OTF) or a regulated market, but the OTF structure has not been finalized, so it is uncertain what adjustments a SEF might have to make to be recognized as an OTF.

By increasing transparency, these parallel reforms should help reduce systemic risk, but their complex cross-border nature and the subtle differences in the obligations they impose are likely to prove challenging to market participants for some time to come.