It was a banner week for the Commodity Futures Trading Commission (CFTC) last week with another three rules passed in its long journey towards total implementation of the weighty Dodd–Frank Act.
Of chief importance to the buy-side, the CFTC adopted new rules preventing dealers and their clients using a controversial standardised clearing system proposed last June by the International Swaps and Derivatives Association (ISDA) and the Futures Industry Association (FIA).
Dubbed the ‘give-up agreement’, ISDA had asserted the system mitigated the risk executed trades failed to clear. Under the measures, futures commission merchants (FCMs) were able to make clients disclose the dealer counterparty’s identity to them.
The result of the give-up agreement, the buy-side complained, could be that FCMs might restrict the number of dealer counterparties a client could use, and steer the buy-side towards their own desks. With its new rules, the CFTC has categorically denounced such a system.
Michael Cosgrove, managing director of strategic initiatives in commodities and energy at GFI Group – an inter-dealer broker specialising in OTC derivatives – said the CFTC has essentially passed a rule that enables buy-side customers greater power to access both central clearing houses as well as a broader range of market counterparties in addition to preserving the confidentiality of their transactions.
“This is a very interesting development which began with market participants asking ISDA for a solution to a central clearing house failing to accept an OTC swap for clearing. ISDA created an annex to their basic swap agreement that provided solutions to this problem that certain major buy-siders felt compromised their anonymity as well as their fair access to a broad range of market counterparties and central clearing houses” said Cosgrove. “The buy-side should be very happy that trilateral agreements have been banned.”
In the past few months, the CFTC and other US regulatory agencies have made significant progress on Dodd-Frank implementation but they are still far behind schedule on the vast majority of the act. According to law firm Davis Polk, as of 1 March, a total of 225 Dodd-Frank rule-making requirement deadlines had passed – some 56% of the 400 total rule-making requirements. Of these 225 passed deadlines, 158 (70.2%) have been missed and 67 (29.8%) have been met with finalised rules. Davis Polk says regulators have not yet released proposals for 24 of the 158 missed rules.
“The CFTC in the past was moving towards a more principles-based regulatory framework, however, with Dodd-Frank comes a more rules-based and prescriptive approach,” said Cosgrove. “They are moving ahead on a lot of rules at a relatively impressive pace, given their size and the volume of changes.”
New to the fold
Even with so many missed deadlines, so fast is the pace of some changes, that many buy-siders have struggled to keep up. Mark Israel, vice president of the business consulting and investment management practice at services provider Sapient Global Markets, said the firm’s alternative investment house and hedge fund clients had already registered with the SEC ahead of the Dodd-Frank-mandated 30 March deadline.
For the first time, Dodd-Frank requires advisers managing more than US$150 million in alternative investments to register with the SEC. And many of these buy-siders must now also reveal to the SEC the breakdown of their assets. ‘Form PF’ (private fund) needs to be filed by SEC-registered investment advisers on a quarterly or annual basis.
Alternative investment houses need to submit their first Form PF by 29 June. But Israel said many alternative investment houses were behind in their preparation of the new requirement.
“The form requires firms to reclassify their exposure to 47 regulatory categories of risk. This requires looking at their exposures in a completely different way than firms are used to,” said Israel. “While we knew this was coming last year it has proven an onerous task. For the initial filing, many firms are approaching it as a manual process, but the long-term goal would be to create a new classification scheme for their assets and automate the system. It comes down to being able to put your exposures into each bucket but every firm measures risk differently from the way the SEC categorises it.”
Sapient Global Markets is also helping firms face Dodd-Frank’s new clearing and collateral management requirements, working to understand the effects of collateral, and deal with that in performance attribution.
“We’re putting collateral management requirements into the same strategy as a trade and tracking it, whereas in the past, people kept collateral separate,” said Israel. “If an asset manager engages in an interest rate swap and hits big, that will cost a great deal in collateral. We’ve seen that as the cost of collateral is going up, firms want to track it more closely, as well as track the cost of that drag on the rest of the portfolio. These issues are being discussed more and more in the front office, at the portfolio management and trading level. Firms need to know whether it can be offset or net, or whether they can work with the same counterparty to offset it. Firms need to consider how this will impact their systems, from Excel to OMS.”
Sapient Global Markets is working with investment firms to solve both the reporting problem and new collateral challenges, but research shows many buy-siders do not yet realise how much needs to be done to prepare for the sweeping changes Dodd-Frank will bring.
Show me the money
Perhaps no better evidence of the dramatic changes about to hit the buy-side are regulators’ own preparations for its implementation. CFTC chairman Gary Gensler, appearing before the US House Appropriations Subcommittee on Agriculture in Washington DC on Thursday, asked for US$308 million to meet its Dodd-Frank Act obligations.
“Just as if the current number of [National Football League] NFL’s referees were called upon to monitor more than a hundred games in a weekend, we need the resources to protect the players, promote fair competition and ultimately ensure the integrity of the markets for the American people,” he told Congress.
The commissioner said effective oversight of the swaps markets depended on adequate funding for the agency’s expanded mission.
The CFTC is 10% larger than at its peak in the 1990s but since then the futures market has grown to approximately US$37 trillion notional, with Congress adding oversight of the US$300 trillion swaps market, which is far more complex than the futures market.
Along with the request for an appropriation of US$308 million – approximately 50% increase in funding – the agency Thursday also asked the US House Appropriations Committee for a further 1,015 full-time equivalent employees.
“We’re being asked to oversee the swaps markets, which is eight times the size of the futures markets. And we need more referees to protect the players, promote fair competition and ultimately ensure the integrity of the markets,” Gensler said. “It takes human beings to watch for market manipulation and abuses.”
Meet the new neighbours
The CFTC is gearing up for a busy couple of years. During 2012, the agency believes it will see the registration of an unprecedented number of new market participants, as well as reviews of new instruments for both the clearing mandate trading mandate.
The agency told the House last week more than 200 entities may seek CFTC registration within the next year. Under Dodd-Frank, market participants which will now need to register with the CFTC include four new clearinghouses seeking to register as derivatives clearing organisations to join the existing 16 DCOs, and five additions to the current 16 designated contract market (DCM) trading platforms which list futures and options and likely will start listing swaps.
The CFTC expects by 2013, a total of 28 foreign board of trades (FBOTs) will seek registration with the agency. FBOTs are trading platforms in other countries generally equivalent to DCMs. Since Dodd-Frank’s FBOT rule became effective in February, the CFTC said already two have filed formal applications.
Four new record-keeping facilities created by Dodd-Frank to bring transparency to the swaps market – known as swap data repositories (SDRs) – have already filed with the CFTC, and by 2013 an additional two SDRs are expected to seek registration.
Presently, the CFTC believes some 20 to 30 entities may request to become swap execution facilities (SEFs) – the new trading platform for swaps created by Dodd-Frank.
But the biggest group of soon-to-be CFTC-regulated firms under Dodd-Frank, are swap dealers. A rule finalised in January requires swap dealers to register with the National Futures Association (NFA) and agency staff reckon somewhere between 100 and 150 swap dealers will request registration with the NFA – of which the CFTC oversees the registration process.
Gensler told the House committee Thursday that while the CFTC has a system for provisional registration in place, market participants want the certainty of final registration.
The agency will also be responsible for reviewing which swaps will be subject to Dodd-Frank’s new clearing mandate. Gensler said unless Congress provided more funding for the CFTC, market participants would see a backlog in registrations, responses to inquiries, and product review because the CFTC “won’t have personnel sufficient to review their submissions in a timely and complete manner”.
In addition, the CFTC has asked Congress for US$87.8 million and 270 more full-time staff for surveillance, data acquisition, and analytics.
“The Dodd-Frank swaps market transparency rules mean a major increase in the amount of incoming data for the CFTC to aggregate and analyse,” said Gensler.
In 2013, the agency will have access to market participants’ ownership and control information for trading accounts to help it better detect intra-day position limit violations and analyse high frequency trading – responsibilities it now has under Dodd-Frank.
The CFTC also will be monitoring for compliance with rules on aggregate position limits for both futures and swaps in energy and other physical commodities.
“Market participants depend on the credibility and transparency of well-regulated US futures and swaps markets,” said Gensler. “Without sufficient funding for the CFTC, their businesses – and the nation – cannot be assured that the agency can adequately oversee these markets.”
Buy-siders beware. If the CFTC’s estimates are anything to go on, thanks to Dodd-Frank, the industry has a few very busy years ahead.