High Frequency Regulation: The Emergence of Structural Tensions

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By George Gilligan, UNSW

Last week I posted an analysis article on the CLMR portal that characterised the current debate in the US regarding possible increased supervisory requirements for Money Market Funds (MMFs) as an example of rubber hitting the road, when the public interest priorities of a multi-lateral actor such as the International Organisation of Securities Commissions (IOSCO) meet the hard surface of economic self-interest, in that case the commercial interests of MMFs in the US.  This paper considers the current regulatory proposals by the US Commodity Futures Trading Commission (CFTC) regarding over-the-counter (OTC) derivatives, and ponders what road they may drive down in terms of the relationship between US financial regulators and some of their international counterparts.  These developments are playing out against the backdrop of national regulators around the world seeking to progress the G20 post-Global Financial Crisis (GFC) reform process in global financial markets, in particular for the purposes of this analysis regarding the clearing and standardisation of OTC derivatives contracts.

In June 2012 the CFTC released its Proposed Guidance on Cross-Border Application of Certain Swap Provisions of the Commodity Exchange Act (CFTC Proposed Guidance) which will be enacted mainly through Title VII of the Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).  The major effects of the CFTC’s Proposed Guidance will be that US registration and regulatory obligations will apply to non-US institutions carrying out derivatives transactions with US persons, (or in specific situations where US persons are acting as guarantors for non-US clients), although in certain contexts the CFTC will allow “substituted compliance” via home jurisdiction regulatory obligations in place of the US requirements.

The reaction by a number of Asia-Pacific financial regulatory actors to The CFTC’s Proposed Guidance has highlighted the structural tensions that permeate relations between national financial regulators.  These tensions were given more prominence by the public release of two letters in August 2012 to Mr Gary Gensler, Chairman of the CFTC.  The first dated 13 August 2012, was from Mr Masamichi Kono, Vice Commissioner for International Affairs at Japan’s Financial Service Agency (JFSA) and Mr Hideo Hayakawa, Executive Director of the Bank of Japan. It is interesting to note that Mr Kono is also currently Chairman of IOSCO and so he is acutely aware of the structural dilemmas and tensions that may be prevalent when trying to secure international regulatory cooperation and outcomes in financial markets.  The second letter dated 27 August 2012 was signed by: Belinda Gibson, Deputy Chairman of the Australian Securities and Investments Commission (ASIC); Malcom Edey, Assistant Governor (Financial System) Reserve Bank of Australia; Arthur Yuen, Deputy Chief Executive of the Hong King Monetary Authority; Keith Lui, Executive Director Supervision of Markets, Securities and Futures Commission, Hong Kong; and Teo Swee Lian, Deputy Managing Director (Financial Supervision) Monetary Authority of Singapore.

Japan, Australia, Hong Kong and Singapore are all significant finance centres and together constitute a substantial segment of the Asia-Pacific finance sector.  It is highly unusual for national regulators to go public in this concerted way, especially to criticise, (albeit implicitly), a US regulator.  Although the text of the two letters was different and the relevant issues may be perceived by some as technical, the signatories to the separate letters were singing from the same song sheet, because both letters expressed genuine alarm at the extra-territorial implications of the CFTC’s Proposed Guidance.  Also, both letters stressed the commitment of their organisations to effectively and swiftly progress G20-agreed reforms regarding OTC derivatives markets.

The “overarching concerns” from Japan centred on “avoidance of overlapping or conflicting regulation” and the “need for international coordination in cross-border regulation”.  Mr Kono and Mr Hayakawa made three specific requests: 1) further extension of substituted compliance processes with greater specificity on issues of due process and timing; 2) deferral of the application of CFTC regulations regarding non-US persons; and 3) exclusion of certain transactions from the calculation of swap thresholds to establish the de-minimis threshold for non-US persons, (for example, transactions between non-US affiliates of non-US persons under common control [e.g. by a Japanese financial institution] and US persons.

The Australian, Hong Kong and Singapore regulators label the CFTC Proposed Guidance as “a useful first step”.   However, their general concerns centred on possible unintended consequences including increasing market fragmentation, compliance costs and potential systemic risk whilst reducing market liquidity, and they were critical of the “lack of clarity and specificity in a number of areas of the Proposed Guidance”.  The joint letter specifically requests the CFTC to: 1) re-assess the scope and timing for implementation of the Proposed Guidance, not with the current proposed emphasis on “a rule-by-rule or case-by-case approach”, but one which instead emphasises “substantive regulatory outcomes”; 2) provide more clarity and guidance on the processes of defining a US person and assessing substituted compliance, (for example, giving due credit regarding how a foreign regime complies with international standard setting bodies such as the Committee on Payment and Settlement Systems [CPSS], the Basel Committee on Banking Supervision [BCBS], and IOSCO; 3) “consider more flexible transitional arrangements”; 4) consider the potential conflicts between the Proposed Guidance and domestic requirements in some jurisdictions, for example regarding privacy laws and so delay registration requirements until such issues are clarified; and 5) consider a “proportional regulatory approach” especially with regard to Central CounterParties (CCPs) that operate in non-US jurisdictions with relatively small OTC derivatives markets.

Commentators both inside and outside of the CFTC have been critical of the CFTC Proposed Guidance.  An internal critic is CFTC Commissioner Scott D. O’Malia.  First on what he perceives as the CFTC’s propensity to a regulatory expansive approach: “Moreover, the Commission’s interpretation of CEA section 2(i) is overly broad to the point where the extent of the Commission’s jurisdiction is virtually endless.”  Commissioner O’Malia goes on to criticise what he sees as: “..the CFTC’s loose consideration of the principles of international comity..” arguing that: “..the CFTC should engage in real and meaningful cooperation with foreign and domestic regulators that honors these principles in order to respect the legitimate interests of other sovereign nations”.  Commissioner O’Malia also fears that the CFTC: “..is engaging in what amounts to high-frequency regulation.  I am very critical of this regulatory approach because it generally results in regulatory uncertainty and unintended, adverse consequences. In my view, failure to achieve real and meaningful harmonization of the implementation and application of swaps and security-based swaps rules will result in inconsistencies and added compliance challenges and costs for market participants.”

Some of Commissioner O’Malia’s opinions resonate with the observations expressed by the Asia-Pacific regulators in their letters to CFTC Chairman Gensler discussed above.  It remains to be seen what influence the views of those Asia-Pacific regulators and Commissioner O’Malia will have in shaping future CFTC policy in this area.  An external commentator Nicolas Breteau is even more strident in his criticism: “The CFTC’s disregard of non-US regulators and regulations smacks of imperialism at a time when international co-ordination is ever more necessary…. Just as there is no longer a place in the world for economic colonialism by nations, there is no longer a place in the world for colonialism by regulators.”

It may not be justified to label the CFTC as a regulatory imperialist, but it is almost inevitable that the economic and political reality of the US being the largest and most significant global finance centre imbues its key regulators such as the CFTC with more influence than other national regulators.  Whether, how and when, regulators such as the CFTC choose to flex that greater influence in the rough and tumble of multi-lateral regulatory praxis is a moot point.  The CFTC Proposed Guidance seems to be an occasion when the CFTC has decided to flex its regulatory muscle in the international regulatory ring as it were, at least for a round or two!  It is not insignificant that so many Asian regulatory actors have combined in order to counter the greater bulk and reach of the CFTC.  They have politely elected to challenge some of the propositions of The Proposed Guidance, by requesting the CFTC to delay and reconsider the potential consequences of such unilateral action.  One cannot be sure whether agreement will quickly materialise, whether there will be more gentle sparring on these issues, or whether a more bruising encounter will ensue.  The levels of consensus and international cooperation that can be generated, especially regarding the thorny issue of extra-territoriality, will be crucial in determining how cohesive, confused, or colonial, regulatory innovation on swaps provisions will be.

As a final point, it seems ironic that whereas regarding increasing multi-lateral supervisory requirements for MMFs, (see Gilligan’s IOSCO III analysis piece), some US regulatory figures are bemoaning the lack of regulatory consultation before a proposed guidance that has implications within the US is issued by an international regulatory actor (i.e.IOSCO); in the case of The CFTC Proposed Guidance we have international regulatory actors criticising the extra-territorial implications of a US proposal and clamouring for increased international regulatory consultation with the aim of modifying its implications outside the US.   Such ironies are seemingly inevitable in the “push-me pull-you” environment that constitutes regulation of international finance.  However, given that the G20 is committed to standardisation and clearing of OTC derivatives contracts by the end of 2012, there may not be too much time within which the pushing and pulling around the CFTC Proposed Guidance can occur.  Regarding OTC derivative standardisation and clearing issues it will be interesting to see if the Financial Stability Board (FSB) allocates red, amber or green traffic lights at the levels of both global policy development, and national/international policy implementation, at the next G20 summit.

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