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A common position has now been reached on the European Market Infrastructure Regulation (EMIR),1 which is the European Commission's proposal to comply with the Basel Committee on Banking Supervision's commitment to increase transparency and reduce risk in the over-the-counter (OTC) derivatives market by the end of 2012 at the latest. The U.S. is implementing similar proposals in the Dodd-Frank Wall Street Reform and Consumer Protection Act in line with its G20 commitment.2 Now that a common position has been reached in the European Council of Ministers, it will go forward to the "triologue" negotiations between the Council, the European Parliament and the Commission, and should be adopted shortly. If the regulations are not adopted within the next month, ESMA is likely to miss its tight July deadline for producing the detailed implementing rules and the regulations will be in danger of not being implemented in line with the G20 commitment. This means that both the EU and the U.S. are now moving to the implementation stage.
Both the EMIR proposals and the Dodd-Frank Act require the clearing of standardised OTC derivative contracts through central counterparties (CCPs) and for all derivative contracts to be reported to trade repositories as required under the G20 commitment. However, while the proposals are agreed at a high level, there are potential gaps and overlaps in the implementation of the proposal. It is clear that the U.S. and Europe have been looking closely at what the other is doing in order to ensure, as far as possible, a uniform approach which would prevent regulatory arbitration from occurring. It is also hoped that any gaps and overlaps will be ironed out. Both sets of regulations have extra-territorial reach, and it will be very difficult for cross-border operations to structure themselves to comply with both regimes if the detail is not uniform. Failure to create a uniform approach will lead to the stifling of cross-border operations, increased costs and complex supervisory oversight. It could also result in market fragmentation, protectionism and regulatory arbitration – all issues the G20 are fighting against in their G20 commitment. Essentially, global businesses need harmonised and consistent regimes, level playing fields and mutual recognition regimes and this is what the regulators should be concentrating on at the implementation stage. Otherwise, clients will need a multiple booking model, with the disadvantages of clients needing a relationship with multiple entities, increased costs, multiple supervisors, multiple trading venues and repositories, sub-optimal netting and risk management, sub-optimal use of capital, fragmented regulatory oversight, fragmented resolution procedures and uncertainty around the treatment of intra-group risk transfers. Regulators should not lose sight of the fact that the objective is to clear standardised OTC derivative contracts, not to force all OTC derivative contracts down this route, and to create more transparency. They should also bear in mind the Financial Stability Board's statement that regulators should only mandate clearing if to do so meets the G20’s objective of reducing systemic risk.3 Issues that need to be addressed in Europe include the fact that those who need to enter into a bilateral trade for hedging purposes, because a standardised contract does not fulfil the risks they need to cover, should not be penalised for doing so or be pushed towards a standardised contract that does not sufficiently cover the risks. The same clearing and reporting obligations should apply to exchange- and platform-traded contracts as OTC contracts to create a level playing field. More detail needs to be provided on the clearing threshold requirement to provide certainty to non-financial companies caught by the regulations. In addition, contracts should not be forced on exchange and electronic platforms. Some inconsistencies are unlikely to be removed between the U.S. and Europe, such as the U.S. "push out" of derivatives trading into separately capitalised non-bank affiliates,4 the Dodd Frank swap dealer registration requirements and the UK's unilateral proposal to ring fence banks.5 However, it should be possible to reach agreement on what should be cleared and what exemptions should apply. There should also be agreement on which entities are caught by the requirements and which entities should be exempt, and there should be a consistent implementation period. In addition, the treatment of uncleared derivatives trades and the position of intra-group derivatives trades should be uniform. It should also be possible for the U.S. to remove its mandatory requirement to trade standardised contracts on exchange or on platforms, for an agreement to be reached on position limits and for there to be agreement on the mutual recognition of CCPs and trade repositories. Likewise, in order for the transparency commitment to be effective in reducing systemic risk, there needs to be agreement in both the U.S. and in Europe as to what information needs to be provided to the trade repositories and in what format. In addition, there must be a commitment to share the information between repositories and regulators.
It is still early stages, but the key with all international regulatory reforms, is that they must be implemented in a consistent, uniform and timely manner. It is comforting that the regulators are aware of this and the danger of regulatory arbitrage. There is hope for cross-border operations that we will end up with harmonised and consistent regimes, level playing fields and mutual recognition regimes. However, time will tell whether harmonisation and financial stability can both be achieved.
Jacqui Hatfield heads up Reed Smith LLP's financial services advisory group. She has a wealth of experience across the broad spectrum of the FSA regulated community. Her clients range from asset managers, brokers, energy traders and corporate finance boutiques. She provides regulatory advice to both the buy side and sell side and covers both retail and wholesale business. Typical work includes advising on issues relating to authorisation, structuring energy trading, the regulation of derivatives, outsourcing, systems and controls, conduct of business, financial resources, market abuse, EU directives, promotion and distribution of investments, and money laundering. Telephone: +44 (0) 20 3116 2971; E-mail: email@example.com.
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