As of March 11, 2013, swap dealers, major swap participants and private funds active in the swaps market are required to begin clearing five swap classes including index credit default swaps (CDS) and interest rate swaps that they entered into on or after March 11, 2013.

The clearing requirement applies to newly executed swaps, as well as changes in the ownership of a swap. Non-financial entities hedging commercial risk are eligible to elect an exception from clearing.  CFTC Chairman Gensler referred to this implementation as “one of the most significant Dodd-Frank reforms . . . [which] lowers the risk of the highly interconnected financial system.”

Lofchie Comment: The CFTC press release asserts that central clearing eliminates the need for market participants to individually determine counterparty credit risk, as clearinghouses now stand between buyers and sellers.  To me, this seems overly optimistic. 

Market participants should be aware of the credit risk that remains, or perhaps more accurately, the new credit risk that has replaced the pre-existing credit risk.  The FCMs that are responsible for clearing swaps have credit exposure to their customers.  On the other hand, customers to swaps that are cleared by FCMs should be concerned about the credit risk of exposure to their FCMs (e.g., MF Global or Peregrine), unless they feel comfortable that CFTC regulation has wholly eliminated such risks going forward.

As a practical matter, most market participants will continue to be concerned with credit risk relating to swaps.  Ultimately, credit risk is not so easy to wholly eliminate. 

Click here to view notice in full (links externally to CFTC website).
Click here to see a description of the five swap classes subject to mandatory clearing.

The SEC charged the State of Illinois with securities fraud for misleading municipal bond investors about the State’s approach to funding its pension obligations. According to the SEC, Illinois took multiple steps beginning in 2009 to correct process deficiencies and enhance its pension disclosures. The State issued significantly improved disclosures in the pension section of its bonds offering documents, retained disclosure counsel, and instituted written policies and procedures as well as implemented disclosure controls and training programs. The State designated a disclosure committee to assemble and evaluate pension disclosures. In reaching a settlement, the Commission considered these and other remedial acts by Illinois and its cooperation with SEC staff during the investigation. Without admitting or denying the findings, Illinois consented to the SEC’s order to cease and desist from committing or causing any violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933.

Much of the discussion in the release concerns not the alleged violation, but the fact that the Illinois’ pension plans are so underfunded – according to the release underfunded by $83 billion dollars as of 2011.

Lofchie Comment:  This is a significant case that has implications even beyond its materiality in the securities markets.  Will municipalities be required to make disclosures along the lines suggested by the SEC release?  Will disclosure of the type suggested by the SEC release make it more difficult for governmental entities to obtain funding?

View Order in full here (links externally to SEC website).
See also: Press Release.

The International Organization of Securities Commissions (“IOSCO”) published comments received in response to its report on financial benchmarks today. The European Central Bank (“ECB”) favored IOSCO’s call for greater regulation in the production of benchmark rates. The ECB stated, however, that the principles IOSCO adopts must be commensurate with the risk associated with producing the benchmark to prevent imposing unnecessary burdens on rate contributors. The ECB also stated that, in order for regulatory reform to be effective, the rules must be uniformly applied internationally to prevent regulatory arbitrage. The ECB agreed with IOSCO’s principle that benchmark rates should be tied, where possible, to observable arm’s length transactions.

Finally, the ECB suggested that any transition in rate calculations needed to be transparent, with contingency plans in place in the event a benchmark rate becomes unviable.

As of March 11, the following public comments were received by IOSCO on the “Financial Benchmarks – Consultation Report“:

• ACT – Association of Corporate Treasurers
• AFMA, Australian Financial Markets Association
• Amundi
• Argus Media
• Association Francaise des Investisseurs Institucionnels AF2i
• Association Française de la Gestion Financière AFG
• Baltic Exchange
• Barclays, London
• BlackRock
• Bourse Africa Limited – Ms Bopelokgale Soko
• California Public Employees’ Retirement System
• CFA Institute, London
• CME Group, Chicago
• Colorado Public Employees’ Retirement Association
• Depository Trust & Clearing Corporation DTCC
• EDHEC-Risk Institute
• Eurex, Frankfurt
• Euribor-EBF, Brussels
• European Central Bank
• European Federation of Energy Traders, Brussels
• European Structured Investment Products Association Eusipa, Brussels
• Federation of European Securities Exchanges, Brussels
• Financial Services Board, South Africa
• German Banking Industry Committee (sent their response to ESMA)
• Global Financial Markets Association GFMA
• Hong Kong Monetary Authority HKMA
• ICAP
• ICE Futures Europe/ICE Clear Europe Ltd
• ICIS, London
• IEA-IEF-OPEC
• Index Industry Association IIA
• ING
• Institute of Chartered Accountants in England and Wales ICAEW
• International Capital Market Association, London
• International Swaps and Derivatives Association ISDA
• Investment Company Institute and ICI Global
• Investment Management Association, London
• IPD, London
• Japanese Bankers Association, Tokyo
• Johannesburg Stock Exchange
• LCH Clearnet, London
• London Stock Exchange Group, London
• Markit, London
• MSCI Inc
• Nasdaq OMX
• Platts
• Prof. Rosa Abrantes & Metz NYU
• Rate Validation Services
• Russel Investments, Seattle
• S&P Dow-Jones
• Standard Chartered Bank
• STOXX Ltd
• Thomson Reuters
• Vanguard Asset Management, Ltd, London
• VDP – Association of German Pfandbrief Banks, Berlin
• Wholesale Market Brokers Association & London Energy Brokers Association

Lofchie Comment:  I note that many of the commenters raised what seemed very reasonable objections to requiring that all benchmarks be based entirely on actual transactions applied in a mechanistic fashion.   These objections seemed most significant in respect of benchmarks where there is a limited volume of trading.  Hopefully, the regulators will take note of these objections, which were raised by both sell- and buy-side firms or groups of firms.

Click here to view announcement in full (links externally to IOSCO website).
Related News Story: IOSCO Report on Financial Benchmarks; e.g., LIBOR.

On March 6, 2013, Senators Hagan (D-NC), Toomey (R-PA), Warner (D-VA) and Johanns (R-NE) introduced a bill to amend Section 716 of the Dodd-Frank Act, known as the “Lincoln Amendment.” The bill, S. 474, would extend to U.S. branches and agencies of foreign banks the same exemptions and transition periods afforded to “insured depository institutions,” and would grant an exemption for a broad range of swaps dealing activities, but with limitations on swaps entered into in connection with structured arrangements. A companion bill, H.R. 992, was introduced in the House by Representatives Hultgren (R-IL), Hudson (R-NC), Himes (D-CT) and Maloney (D-NY). The legislation is substantially identical to a bill that died last year before reaching a vote before the full House (H.R. 1838), although the current bills lack certain provisions limiting the extraterritorial reach of Section 716 that existed in last year’s bill.

See also: SIFMA Applauds Introduction of Swaps Push-out Reform Legislation

The SEC unanimously proposed new rules to require certain key market participants to have in place comprehensive policies and procedures surrounding their technology. The SEC’s proposal, which is called “Regulation SCI,” would replace the current voluntary compliance program with rules whose violation may be the subject of enforcement actions.

SROs, certain alternative trading systems, plan processors, and certain exempt clearing agencies would be required to design, develop, test, maintain, and survey their key systems. The proposed rules would require them to ensure that their core technology met certain standards, to conduct business continuity testing, and to provide certain notifications in the event of systems disruptions and other events.

Lofchie Comment:  The new rule requirement will present real challenges for compliance professionals and particularly for a firm’s Chief Compliance Officer, who is responsible for the creation and enforcement of reasonable supervisory procedures.  Determining that a firm has adequate procedures for implementing and maintaining various types of technology is not a routine compliance skill set.  I wonder if the job of establishing appropriate compliance as to technology, at least at larger firms, requires a specialized skill set in the same way that serving as “FINOP” requires a specialized skill set.  (See movie clip from YouTube.)

See: SEC Fact Sheet.

SEC Chairman Elisse Walter delivered an opening speech in which she discussed how rules for market-wide circuit breakers, and a new limit-up/limit-down mechanism to pause trading when markets move too far too fast, are already in place. Furthermore, the SEC clarified when erroneous trades are to be broken and prohibited stub quotes and naked access to the market. However, Walter stated that she believes that improved quality assurance is needed through more careful design, testing and monitoring.

See: Chairman Walter’s Opening Statement.
See also: Commissioner Daniel M. Gallagher’s Opening Statement and Commissioner Luis A. Aguilar’s Remarks entitled “Developing Solutions to Ensure That the Automated Systems of Our Marketplace Are Secure, Robust, and Reliable.”

SEC Commissioner Daniel Gallagher recently spoke at the Gulf Cooperation Council Regulators’ Summit in Qatar.  Gallagher focused his remarks on the globalization of financial markets and the resulting regulatory challenges.  Specifically, the speech acknowledged that requiring market participants to comply with the regulatory requirements of multiple jurisdictions can be costly, confusing, and cumbersome.  Gallagher asserted that any attempt at cross-border regulatory “harmonization” would be futile and impractical; he favors instead an approach of voluntary regulatory deference. 

Under this favored approach, each country would defer to others’ regulatory schemes for the regulation of certain products, services or transactions.  In support of this approach, Gallagher cited a November 2012 joint statement issued by twelve international regulators (linked below) agreeing to explore approaches in which each would recognize the sufficiency of another jurisdiction’s regulation of cross-border over-the-counter derivatives traders and transactions.  While noting that regulatory deference policies would require consensus and compromise, Gallagher stated that such policies were necessary to reduce regulatory burdens and foster efficient markets.

Lofchie Comment:  There is a very wide gap between the SEC’s approach to international regulation (which has put greater emphasis on cooperation) and the CFTC’s approach (which has put greater emphasis on expanding U.S. jurisdiction).   It is hard to see how the two commissions will be able to justify in the long term maintaining their opposing approaches, given the fact that the products that they regulate are so closely entangled.  Ultimately, I expect that the SEC approach will have to be one which the U.S. regulators adopt, as I don’t believe that the rest of the world is likely to submit to the CFTC’s approach; that expansive approach seems more likely to result in retalation by non-U.S. regualators against U.S. financial institutions.  See, e.g., European Commissioner Barnier on U.S.-EU Cooperation [or the Lack Thereof]

Click here to view speech in full (links externally to SEC website).
See also:  Joint Press Statement of Leaders on Operating Principles and Areas of Exploration in the Regulation of the Cross-Border OTC Derivatives Market (cited in the Gallagher speech).

SIFMA released a statement from Kenneth E. Bentsen, Jr., acting president and CEO, after legislation was introduced to amend Dodd-Frank Section 716 (”Prohibition against Federal Government bailouts of swaps entities”), which would force financial institutions to “push-out” their derivatives operations from banks into a separate entity. The Swaps Regulatory Improvement Act (numbered as HR 992 and S 474) was introduced in both houses of Congress by Senator Kay Hagan (D-NC) and Representative Randy Hultgren (R-IL). The bill also has a number of co-sponsors.

In the statement, Bentsen asserted that adoption of the legislation will “forestall a misguided action that would force swaps to migrate to other entities that are not subject to prudential regulation, and could likely increase systemic risk instead of reducing it.”

Lofchie Comment: Section 716 of Dodd-Frank, otherwise known as the Lincoln Amendment, is, I think, ill-conceived. “Swaps dealing” activities are fundamentally credit transactions, and forcing credit transactions to be effected outside of banks is a policy decision that has all kinds of bad results, including preventing banks from being able to net all of their credit exposures to one party in the bank, thus increasing the likelihood that the bank will suffer credit losses on the failure of that counterparty. While Section 716 was amended to allow banks to continue to engage in swaps where the reference asset is bank-eligible or for hedging purposes, the Lincoln Amendment would still require push-out of dealing activities involving non-bank eligible swaps (e.g., involving commodities, equity, and non-investment grade debt), and would require U.S. branches of foreign banks to push out ALL swaps. Significantly, the effective date for push-out by U.S. branches of foreign banks is much earlier than for US banks, and goes into effect this July.

Leaving aside that Lincoln is wrong-headed as a policy matter, many foreign banks may be wholly unable to comply with its requirements should it come into effect on schedule. Foreign banks and their counterparties are simply too overwhelmed by all of the other requirements of Dodd-Frank to be able to move the hundreds of thousands of contracts that would be required to be moved if Lincoln were to go live on schedule. If Lincoln were to go into effect as scheduled, U.S. markets would not stop, but they would get awfully slow (and move even faster offshore).

Click here to view statement in full (links externally to SIFMA website).