A Predictable Regulatory Framework

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

Over the past 10 years, a remarkable event has occurred in the world’s political and financial capitals. Policy-makers embarked on a largely consistent agenda of regulatory reform to make derivatives markets more robust and resilient. That global reform initiative is now mostly in place, but there are a number of challenges on the horizon, including Brexit, which must be overcome before all the pieces fall into place.

A lot has been achieved in the 10 years since the collapse of Lehman Brothers. Regulators in the European Union (EU), the US and elsewhere moved fast to revamp their regulatory frameworks and strengthen their banks, based on a set of commitments agreed jointly by the Group-of-20 (G-20) nations.

The resulting national requirements are not identical, but they are comparable – they all achieve similar objectives of increasing transparency and mitigating systemic risk. Where we have fallen short is creating a framework that allows entities from two different jurisdictions that have applied comparable requirements to trade under a single set of rules. There has not been sufficient appreciation that complying with two sets of similar but not identical requirements is extremely difficult and costly.

The ability to trade across borders under a consistent and predictable regulatory framework is crucial for end users. Derivatives markets were developed to facilitate the transfer of capital from where it is to where it is needed. Without an effective process for recognizing comparable overseas rules, global liquidity will ultimately fragment into regional pools, increasing costs and complexity.

Fortunately, there has been recent progress on this front. The first was an agreement between the European Commission and the US Commodity Futures Trading Commission (CFTC) – the primary US regulator for derivatives – to recognize each other’s trading regimes. This means a firm in one jurisdiction can satisfy local trading requirements by trading on a venue in the other location. The second was a proposal by the CFTC chairman, J. Christopher Giancarlo, to revise the agency’s cross-border framework, which will defer more to overseas regulators and recognize rules that are broadly comparable in outcomes as equivalent. This would be a big step in reducing complexity, duplication and costs for end users.

Unfortunately, a number of forces are pushing in the other direction – a loss of faith in the benefits of globalization, regional rivalries, trade negotiations and Brexit. Not only has the uncertainty about Brexit raised tensions over the future of the cross-channel relationship, but dialogue between EU and US policy-makers has become heated over the framework for market infrastructure regulation, suggesting regulatory cooperation between the EU and US is being challenged as well.

Capital markets are used to managing economic risk, but tackling political risk or fragmentation as a result of regulation is a different challenge altogether. Markets want regulatory and legal certainty. What’s required to achieve this goal? Short-, medium- and long-term solutions are essential.

Short-term, UK and EU policy-makers, should take all necessary steps in advance of Brexit to avoid a disruptive hiatus by ensuring that mitigating actions take effect from the date when the UK leaves the EU, including by taking all available preparatory steps and, where possible, accepting applications and adopting advance formal decisions so they take effect on that date.

Medium-term, EU policy-makers will need to provide clarity on the process and standards for third-country regimes to gain access to the EU – not only the UK, but other countries like Australia, Canada, Hong Kong, Japan, Singapore and the US, where financial reforms based on the G-20 commitments are well established.

Long-term, these countries need to establish a consistent and transparent cross-border recognition regime that is comprehensive and covers both risk-based activities, such as capital and margin rules and central counterparty regulation, and non-risk related rules, like trading, public reporting, and various post-trade services. This cross-border equivalence regime should rely on overseas rules that are comparable in outcomes, and the regulatory review and approval process should be both consistent and certain.

Global derivatives markets enable firms to efficiently and cost-effectively raise financing and manage their risk. For this to work properly, we need regulatory consistency, trust, cooperation and recognition. Failure to achieve this will ultimately serve no one – not the firms looking to raise the capital and investment needed for economic growth, nor the entities that need to manage their risk.

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