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06 December 2017
Refinement of margin requirements
US and international regulatory harmonisation
Capital treatment in support of central clearing
End-user issues and other clarifications
Trading market infrastructure
Supervision and use of financial market utilities
Regulatory structure and process
On October 6 2017 the US Department of the Treasury released its second in a series of four reports (Capital Markets Report)(1) evaluating the US financial regulatory system.(2) This report follows on the heels of Treasury's first report on the US banking system(3) and addresses the US capital markets, including debt, equity, commodities and derivatives markets, central clearing and supervision of financial market utilities.
This update focuses on the recommendations relating to the derivatives markets.(4) In many cases, these recommendations reflect concerns identified by market participants in recent years, but do not propose fundamental changes in the overall post-Dodd-Frank Act derivatives regulatory structure. Most of the recommendations could be implemented through agency rulemaking, although a few would require congressional approval. The report also emphasises reconsideration of certain existing rulemakings in order to streamline regulation, generally without offering specific modifications or proposing a specific result.
Treasury breaks up its recommendations for the derivatives markets into several broad categories, including refinement of margin requirements, regulatory harmonisation, capital treatment of derivatives, end-user issues and market infrastructure. Treasury also provides recommendations on the supervision and use of financial market utilities (FMUs) and the structure and process of regulatory agencies.
The report makes several recommendations concerning margin requirements for uncleared swaps which have been implemented in the United States and other jurisdictions beginning in 2016. These requirements marked a significant change in practice for many market participants and involved significant compliance efforts. The proposals reflect certain concerns that the margin requirements are too restrictive or may disadvantage US market participants when compared to their international counterparts. The recommendations include the following:
Under the Dodd-Frank Act, the swaps and security-based swaps markets were placed under the jurisdiction of the CFTC and the SEC, respectively. The Capital Markets Report urges greater harmonisation and coordination between these regulatory regimes. Specifically, Treasury recommends that:
Further, Treasury generally advocates for more cross-border harmonisation between US and international regulators, with the goal of avoiding market fragmentation, redundancies, undue complexity and conflicts of law. For example, Treasury recommends that:
As expressed in the Banking Report, and consistent with criticisms from market participants, the Capital Markets Report reaffirms Treasury's concerns with the treatment of initial margin for cleared derivatives under the supplementary leverage ratio in the bank capital rules. The existing treatment of initial margin under the supplementary leverage ratio results in futures commission merchants incurring higher capital charges in their clearing services, which in turn may disincentivise the business of clearing derivatives and would run counter to the goals of the Dodd-Frank reforms. To address this issue in the short-term, the Capital Markets Report recommends deducting initial margin for centrally cleared derivatives from the supplementary leverage ratio.
In the longer term, Treasury recommends that regulatory capital requirements transition from calculating derivatives capital requirements from the Current Exposure Method presently being used to the Basel Committee's more recent Standardised Approach for Counterparty Credit Risk. The latter provides clearer offset for initial margin and recognition of appropriate netting sets and hedged positions. In addition, Treasury recommends that the US banking regulators frequently conduct assessments to see how capital requirements affect the incentives to centrally clear derivatives.
Treasury makes several recommendations directed at facilitating swaps trading activity by end users (ie, non-dealers) by easing burdensome regulatory requirements and providing regulatory clarity.
Specifically, Treasury recommends an amendment to Section 2(h)(7) of the Commodity Exchange Act(8) that would provide the CFTC with rulemaking authority to modify and clarify the scope of the financial entity definition. This authority would facilitate exemptions from the swaps clearing requirements for end users engaged in bona fide hedging or risk management and would provide the CFTC the flexibility to codify existing no-action relief.
The report also recommends that the CFTC maintain the $8 billion swap dealer de minimis registration threshold, which was at the time of the report scheduled to be lowered to $3 billion at the end of 2018.(9)
Additionally, Treasury recommends that the CFTC finalise its long-delayed position limit rule amendments,(10) taking into consideration hedging exemptions, manipulation risks and deliverable supply.
In terms of trading market infrastructure, the Capital Markets Report recommends as follows:
The report acknowledges the significant role that FMUs play in financial markets and argues that their smooth operation is integral for maintaining a robust economy. Due to the interconnectedness of the systemically important FMUs (SIFMUs) designated by the Financial Stability Oversight Council, and the potentially dire consequences if one were to fail, the report supports enhanced risk management of SIFMUs. Accordingly, it recommends that:
In addition, Treasury recommends additional work on planning for liquidation and resolution of SIFMUs, which reflects a concern that strategies to date have been subject to only limited stress testing related to credit risk and certain default-related liquidity risks. The report recommends that:
The report contains several recommendations to make the regulatory process more flexible and advance the goals of stimulating economic opportunity and providing greater clarity to market participants:
As it relates to the derivatives markets, the Capital Markets Report does not advocate fundamental changes in the regulatory framework but suggests a change in regulatory emphasis. The report makes a series of specific recommendations that broadly would make incremental improvements suggested by market participants. Many of these changes could be made through agency action, and in some cases the relevant regulators have indicated that they are considering the same or similar proposals. Market participants should continue to monitor how the US federal regulatory agencies will respond in light of this report.
For further information on this topic please contact Donna M Parisi, Geoffrey B Goldman, Azam H Aziz or Nicholas Emguschowa at Shearman & Sterling LLP by telephone (+1 212 848 4000) or email (email@example.com, firstname.lastname@example.org, email@example.com or nicholas.emguschowa
(1) The Capital Markets Report is available here.
(2) The Treasury review is intended to align with the Executive Branch's Core Principles for Regulating the United States Financial System, as set out in Executive Order 13772, available here.
(3) The Banking Report is available here.
(4) This update supplements our previous overview of the entire Capital Markets Report, available here.
(5) Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker Dealers, 77 Fed Reg 70213 (November 23 2012), available here.
(6) Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants, 81 Fed Reg 29959 (May 13 2016), available here; and Regulation SBSR – Reporting and Dissemination of Security-Based Swap Information, 81 Fed Reg 53545 (August 12 2016), available here.
(7) The CFTC's proposed rule, Cross-Border Application of the Registration Thresholds and External Business Conduct Standards Applicable to Swap Dealers and Major Swap Participants, 81 Fed Reg 71946 (October 18 2016), is available here; and the SEC's proposed rule, Security-Based Swap Transactions Connected With a Non-US Person's Dealing Activity that are Arranged, Negotiated, or Executed by Personnel Located in a US Branch or Office or in a US Branch or Office of an Agent; Security-Based Swap Dealer De Minimis Exception, 81 Fed Reg 8597 (February 19 2016), is available here.
(9) Shortly after the Capital Markets Report was published, the CFTC issued an order delaying the scheduled lowering of the de minimis threshold from December 31 2018 to December 31 2019, available here.
(10) Position Limits for Futures and Swaps, 76 Fed Reg 71626 (November 18 2011), available here.
(11) More information regarding the CFTC's Roadmap to Achieve High Quality Swaps Data is available here.
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