Derivatives Trading & Clearing Rule-making

Derivatives Trading And Clearing Rule-making

Derivatives acquired an especially dark reputation during and after the financial crisis, primarily because most people (including those on the Wall Street and that includes some sitting in the corner offices) did not understand the derivatives business and then, the market process for trading and clearing the derivatives was completely private and the public and the regulators had no visibility into how that process worked and what exactly was going wrong in that area of the markets.

Dodd-Frank’s huge push for consumer education and consumer protection may or may not help ease the first part of the problem but the second part, open platforms for trading and settlements of swaps is what the CFTC is addressing with some intense work in building the foundation and structure for making rules in this gigantic sector of the market that has been hitherto before unregulated. The CFTC has identified 31 areas, will release concept papers, invite public debate and comments to move forward with its mandate of forming the rules that can go into effect under the aegis of Dodd Frank Act.

The major areas and topics the CFTC has identified are:

1.       Foundation and House-keeping:

a.       The biggest challenge in this area will obviously be definitions. There are so many terms (starting from the word swap itself) that are used in the market in a very general and loose sense. For a rule to hold, very precise definitions will be needed. Terms like swap dealer, swap participant, non-financial participant, settlement, un-cleared swaps and the like will take a lot of work to hammer into a industry-wide (world-wide, really) acceptable meaning. This is going to be easier said than done.

b.      Registration – who to register the various players in derivatives game, their legal classes, roles, authority, responsibilities and penal actions for each type of participant

c.       Code of conduct within as well as without (i.e. counterparties)

d.      Capital and margin requirement for non-bank participants

e.      Bankruptcy & Liquidation treatments of derivatives (one of the major causes of disruption in 2008)

2.       Clearing:

a.       A key goal of the legislation is to define the core principles for clearing

b.      End-user exceptions permissible

c.       Mandatory clearing process

d.      ‘Systemically important’ treatment of DCO (derivatives clearing organization)

3.       Trading:

a.       Core principles, rules and workflow

b.      Documentation maintenance across lifecycle and transaction legs

c.       Identifying, defining & registering parties to trading

d.      Interface with global (external to US) trading systems and processes

4.       Data;

a.       Core principles regarding data elements to be provided, captured, processed

b.      Data storage and processing entities and responsibilities

c.       Real-time reporting requirements, if any

d.      Data ownership, stewardship and security

5.       Particular Products:

a.       Derivative trades can be created literally on the fly and it is difficult to enforce the product discipline of an equities or bond market. If a regulator does not know what product is being traded, he has no control over the systemic risks being created. On the other hand, excessive regulation may hurt US’s ability to compete in this extremely competitive and location-agnostic business

b.      Portfolio level margining, reporting and systemic risk oversight

c.       Joint decisions with SEC on product categories and actual oversight classification

6.       Anti-manipulation:

a.       Restrictive or otherwise manipulative trading practices

b.      Disruptive practices and processes

c.       Treatment of whistle-blowers

7.       Position Limits:

a.       Large Traders, bona-fide hedging,  aggregate limits

b.      Systemic risk aspect of position limits

8.       Other linkages:

a.       Volcker Rule

b.      Credit Rating agency and process

c.       Investment Adviser reporting

d.      Fair credit reporting

I may have missed a few but I think the point is clear.

House Agriculture Committee Chairman Frank Lucas has already proposed an 18-month delay to implementing these rules and as expected, the industry lobbies are supporting the delay whole-heartedly.

My problem?  This is humongous and both the CFTS’s desire to release the rules asap and the industry’s desire to delay appear moot to me. Even if CFTC could get all the rules out quickly and the industry is eagerly looking forward to implementing them, creating and permeating all these rules thru the entire  ecosystem, getting people to understand the definitions, create the documentation, workflow and clarity in contracts, the actual trading and settlement platforms, the arbitration and legal framework to resolve issues, the front, mid and back offices, the cross-border legs involving possibly every other country in the world is unrealistic. Imagine the technology platforms and the new legal entities that need to come into existence to develop, test, operate and maintain them at the scale required and at the assurance level required to process trillions of dollars of trades. Especially at a time when not all participants are going to open their purse-strings easily for upgrading their skills, technology and people.

My solution? Big bang implementation of this rule (or group of rules) is not going to work, whether today or 18 months from today. The idea behind the rule is sound and a good, old incremental approach is what I can see taking us. Maybe it will take five years but two benefits, one, we can prioritize and channel limited resources in a properly directed manner and second, it will get us there!