New rules on US swaps trading definitions pose potential conflicts between regulatory bodies, but the buy-side must instead focus on solidifying agreements with clearers and monitoring impending execution rules.
Recent attention has focused on harmonising divergent definitions of swaps dealers and major swaps participants recently unveiled by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).
But market participants have advised buy-siders to turn their attention to changes in derivatives execution rules and reaching agreements with central counterparties (CCPs) on clearing and collateral across multiple instruments.
The wave of derivatives regulation is part of sweeping Dodd Frank reforms seeking to establish clarity in financial markets after the 2008 crisis, with over-the-counter derivatives to be centrally cleared and traded via swap execution facilities (SEFs).
Adjusting execution
While there are no exact implementation dates, some of the rules have been finalised and the remainder are expected to be set in stone in the first half of next year. As a whole, they will constitute the most rigorous changes to derivatives trading in recent times, and buy-side firms and will be forced to significantly alter their swaps trading business.
“While much of the focus thus far has been on regulatory compliance, firms will ultimately need to re-evaluate how they approach their business to capitalise on the new market structure,” said Sean Owens, director of fixed income and research at US consulting firm Woodbine.
As the SEC and CFTC finalise their respective lists for the asset classes will trade on SEFs, the minimum number of quotes investors must source before they can execute trades remains undecided. The SEC will deal with security-based swaps, defined as derivatives based on a single security, loan, narrow-based group or index of securities or event relating to a single issuer of securities in a narrow based security index. By comparison the CFTC will cover swaps based on interest rates, commodities and currencies. The final rules governing SEFs are expected in November, after the US presidential election.
“The SEC has indicated you will only need to send one request for quote out to the market, while the CFTC want multiple quotes,” said Owens, adding that the final execution requirements will be key for the buy-side in order to finalise agreements with multiple CCPs and alter their internal systems so they are regulatory compliant.
The difficulty in finalising rules for the US$648 trillion swaps market are manifold, with the number of quotes sourced by users of SEFs determined on a per-instrument basis, depending on current liquidity profiles.
According to Bradley Wood, a partner at capital markets consultancy GreySpark Partners, the delay in determining execution rules stem from difficulties encountered by the CFTC and SEC in dividing swaps products responsibilities.
“The lines can be blurred over who has authority over a specific transaction. Issuing quotes for a CDX credit default swap (CDS) index, with an index underlier will be regulated by the CFTC, however for an individual CDS, it will be the SEC, which has a vanilla bond underlier. Ideally those rules should be in sync, but that might not always be the case,” Wood said. Divergent use of terminology between the two agencies had also pushed back deadlines for both bodies, and left the door ajar for increased lobbying, which in turn fuelled further delays.
Shifting definitions
Under Dodd-Frank, the SEC and CFTC must impose margin and capital requirements to ensure the soundness of swap dealers and major swap participants, however these definitions have caused uncertainty, leading to last-minute changes.
On 12 October, the CFTC delayed reporting for swaps under the new guidelines until 31 December. The regulator plans to reassess its definitions, which would have included some asset managers in the same group as banks in their present form, creating uneven reporting and compliance issues.
“In the long term we’re expecting these definitions to converge. At the moment there’s problems on the major swaps participant definition, so we may see the swap dealer definition finalised first,” said Mark Israel, vice president of the business consulting and investment management practice at services provider Sapient Global Markets.
In particular, understanding how electronic clearing of derivatives will work, getting more services from CCPs and managing collateral across more instruments will be key for buy-siders looking capitalise on these changes.
“Asset managers see total transaction costs going down, but collateral costs going up, which will happen whether it’s exchange-traded or OTC. Buy-sides will also use consistent systems across instruments to have the same workflow for commodities, futures trading and derivatives trading as well as interest and credit derivatives,” said Israel.