A Risk of Regulatory Arbitrage in Derivatives

Sources:
FT: US and Europe Divisions Emerge on Derivatives; Traders Seek Answers on US Derivatives Reform; US Banks Plead to Limit Range of Swap Rules; Fault Line on OTC Rules Emerging
Economist: Unlucky for Some

Last July, the U.S. Congress passed a historic financial reform bill, the Dodd-Frank Wall Street Reform and Consumer Protection Act. Title VII of the Act deals with regulating the previously unregulated, over-the-counter (OTC) derivatives market which “played a central role” in the global financial crisis in 2008. The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) are in charge of writing detailed rules and they have been trying to make the derivatives market “transparent, open and competitive.” However, as the EU’s approach to derivatives reform seems to be more lenient and the US is moving faster than Europe in finalizing the rules, there could be a risk of "enormous regulatory arbitrage" where market participants move to the place with more favorable rules, warned Jill Sommers, a commissioner at the CFTC. “Effective reform cannot be accomplished by one nation alone. It will require a comprehensive, international response,” said Gary Gensler, chairman of the CFTC before the European Parliament on Tuesday.

Both the US and Europe aim to require more market participants to trade on exchanges and electronic platforms and use clearing houses in processing derivatives contracts in order to increase transparency and lower risks. However, the differences between the US and Europe emerge over the following three areas: 1) how to define trading platforms; 2) ownership of clearing houses; and 3) brokers' access to membership of clearing houses to deal with OTC derivatives on behalf of their customers.

First, in the case of trading platforms, the US suggested new trading platforms called "swap execution facilities" (SEF) where dealers would be required to display prices publicly. The European Commission (EC), however, defines their new platforms, "organized trading facilities," more loosely so that dealers could continue to trade through private and bilateral deals. "Our idea is not to disturb existing business models for trading of OTC derivatives," said Maria Velentza, head of the securities market unit at the EC. Also, while the US plans to put limits on the ownership of clearing houses, the EC is not suggesting any limits. Lastly, unlike the EC, the US regulators have suggested reducing derivatives clearing house capital requirements to $50 million from $5 billion to give small brokers access to membership of clearing houses.

In addition, Europe and the US have different schedules to finalize their derivatives regulations, which could also increase the risk of regulatory arbitrage. While the CFTC and the SEC are scheduled to provide rules by July 2011, Europe will not finalize its rules until 2012.