ISDA CEO O’Malia Argues for Trading Rule Harmonization

ISDA CEO Scott O’Malia posted an opinion in ISDA’s on-line news publication “derivatiViews” titled “Trading Rules Need to Work Together”. In his commentary, Mr. O’Malia discusses the need for amendments to the U.S. swap execution facility (“SEF”) rules and for general trading rule harmonization.

The markets are fragmenting already, Mr. O’Malia stated. Until late 2013, trading between European and U.S. dealers comprised roughly a quarter of the euro interest rate swaps market. Now, he said, this market is traded almost exclusively between European dealers, with many U.S. entities locked out of this liquidity pool.

Mr. O’Malia blamed the start of this market fragmentation on the introduction of U.S. trading rules in October 2013. He explained that the launch of Europe’s own trade execution rules in 2017 via the revised Markets in Financial Instruments Directive could help mitigate the problem eventually but added that “there are significant differences between the existing SEF framework and the rules proposed by European regulators,” which could potentially exacerbate fragmentation.

Mr. O’Malia emphasized ISDA’s position that regulators should abide by some “high-level principles” when developing and implementing trade execution rules, some of which are set out in ISDA’s paper titled “Path Forward for Centralized Execution of Swaps.” Based on these principles, Mr. O’Malia stated, targeted amendments to the U.S. SEF rules are necessary, including changing the process for making mandatory trade execution determinations to ensure it is based on objective criteria and supported by data.

Mr. O’Malia stated that, generally, ISDA believes centralized trading venues provide a useful addition to derivatives market infrastructure, and can help provide greater transparency on liquid products that are suitable for this type of execution mechanism. However, he continued, the rules must be consistent globally and the U.S. SEF rules must be improved.

Lofchie Comment: It is becoming more and more apparent that the CFTC’s initial approach to rulemaking under Dodd-Frank has failed. Instead of maintaining its position as the world’s financial center, the United States has allowed the trading markets to separate into three sectors – North America, Europe and Asia – resulting in a diminution of America’s role in the world economy. European and Asian market participants, both sell-side and buy-side, are voting no with their trading wallets when it comes to CFTC-regulated markets. (Given the amount of trading data that it now collects, the CFTC should be able to verify or contradict this impression.) Some of the damage can be undone if the CFTC’s would be willing to rethink its approach to global markets. The longer it takes to correct this regulatory overstep, the less correctable the damage will be. As European and Asian markets become established and require less U.S. participation, the more difficult it will be for U.S. players to reclaim their role.

SIFMA, Clearing House Association and FSR Submit Comments to FRB on GSIB Surcharge

SIFMA, the Clearing House Association LLC, and the Financial Services Roundtable (“FSR”) (collectively, the “Associations”) submitted comments on a proposed rulemaking (the “Proposal”) by the Board of Governors of the Federal Reserve System (the “FRB”) that would impose additional capital requirements (the “GSIB surcharge”) on global systemically important bank holding companies (“GSIBs”) headquartered in the United States.

The Associations voiced support for the FRB’s determination that a properly structured GSIB surcharge could reduce systemic risk and that, under certain circumstances, reliance on short-term wholesale funding (“STWF”) could pose risks to individual institutions as well as the financial system as a whole. Even so, the Associations argued, the Proposal contains significant flaws that include the following:

  • The Proposal’s methodology does not account for reductions in systemic risk that have been caused by major developments in micro and macro-prudential regulation since 2011, including the Liquidity Coverage Ratio, the Net Stable Funding Ratio and the Enhanced Supplementary Leverage Ratio.
  • A lack of transparency vitiates the FRB’s explanations of the design, rationale and empirical foundation for certain key elements of the Proposal, such as the doubling of the systemic indicator score and the STWF factor.
  • The Proposal affords insufficient consideration of the costs and benefits of the GSIB surcharge on the GSIBs’ customers, the markets and the broader economy.
  • The Proposal fails to explain why the GSIB surcharge for U.S. GSIBs is significantly higher than it is required to be by international agreement.

In addition to offering the criticisms listed above, the Associations recommended that the FRB implement the Proposal’s “method 1” framework for calculating the GSIB surcharge (which reflects international consensus), with slight modifications:

  • The Proposal should utilize a rolling five-year average conversion factor to moderate the effects of FX rate volatility on the surcharge calculation;
  • The denominator of the surcharge calculation (which reflects the aggregate U.S. market for financial services) should be expanded to include the following non-GSIBs: (i) U.S. banking organizations that already report the information necessary for the systemic indicator calculation; (ii) central counterparties; and (iii) non-bank financial companies designated by the Financial Stability Oversight Council; and
  • The STWF factor should be revised to avoid imposing unnecessary costs on certain funding sources that are beneficial to all market participants, namely unsecured wholesale deposits, brokered deposits and secured funding transactions.

Lofchie Comment: The Associations’ most profound comment about the FRB’s rule proposal is that it is effectively a “black box.” The regulators put the name of a big bank into the box and it spits out a number, but the process by which it arrives at the number is not clear. This mysterious process is inconsistent with a regime that is supposed to be based on the “rule of law.”

”Streetwise Professor” Craig Pirrong Critiques the Options Clearing Corporation’s New Capital Plan

In a blog post titled, “BATS in the OCC’s Belfry? or The Perils of Natural Monopoly Regulation, CCP Edition,” University of Houston finance professor Craig Pirrong discussed the dispute surrounding the Options Clearing Corporation (“OCC”) new capital plan.

Pirrong states that BATS, other non-owner exchanges and market users are concerned that the capital plan “allows OCC’s owners to ‘monetize’ the rents accruing to its status as the monopoly clearer for options transactions in the U.S.” He explained that non-owner exchanges and market users believe that OCC will pay for dividends received from preferred stock by charging fees that will impair competition among exchanges and will burden market users.

Mr. Pirrong suggested that the situation would not likely be resolved in the near term because: (i) financial market utility pricing and governance is “inherently messy and controversial,” and (ii) when it comes to capitalizing, allocating, and pricing the systemic risks that central clearing counterparties bear, the problem becomes even more complicated.

Lofchie Comment: Professor Pirrong’s article focuses on the economics of the OCC. His observations have broad applicability to an increasing number of areas of financial services, particularly as Dodd-Frank imposes government-mandated structures on the provision of financial services. For example, Dodd-Frank mandates the central clearing of certain swaps. As to most (perhaps all) of the types of swaps that are centrally cleared, there will be a monopoly or near-monopoly clearing house (or at best a cartel) through which anyone wishing to trade in the relevant swap must transact.

Given the network benefits of trading through a clearing house with established volume, a monopoly power will be nearly impossible to challenge. Once a monopoly clearing house is established, a competitor will not be able to come in and win business on the basis of offering lower costs or better services. As a result, the clearing house, left to its own unregulated devices, would have the ability to: (i) charge high fees and (ii) undercapitalize itself from a risk standpoint. An important downside to mandated central clearing is that decisions of profitability and risk will be left in the hands of the government. It is ironic that the outcome of years of CFTC action intended to enhance competition in the swaps market may be simply to replace a dealer cartel with a clearing house cartel.

One cannot overlook the probability that such monopoly or cartel power may be extended to ancillary services such as trade reporting on swap data repositories (which are also mandated by Dodd-Frank). Clearing houses insist that such reporting be done through their captive SDRs and the CFTC has blessed this approach.

See: “BATS in the OCC’s Belfry? or The Perils of Natural Monopoly Regulation, CCP Edition,” by Craig Pirrong.

SEC Issues Investor Bulletin Regarding Public Company Bankruptcy

The SEC Office of Investor Education and Advocacy issued an investor bulletin, titled “Bankruptcy for a Public Company,” intended to help investors understand what happens when a publicly traded company declares bankruptcy. The investor bulletin explains that, regardless of the type of bankruptcy filed by a company under Chapter 7 or Chapter 11, any common stock in that bankrupt company is likely to be worthless, since the common stock is “the last in line to receive what’s available to be distributed in a bankruptcy proceeding.”