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As part of our review & assessment of Dodd-Frank, I thought it would be useful to summarise progress to date & try to draw some conclusions about the speed & direction of the implementation.

Some background on Dodd-Frank

Dodd-Frank and other similar legislation, e.g., MiFID II in Europe, came about as a result of the September 2009 G-20 meeting in Pittsburgh. This meeting was just after the global financial crisis (GFC) and proposed a number of changes to the banking system to address the systemic failures that caused the GFC and create a “Framework for Strong, Sustainable and Balanced Growth”.

The Financial Stability Board (FSB) was created to coordinate and monitor progress in strengthening financial regulation. In turn, the FSB formed a working group comprising the Committee on Payment and Settlement Systems (CPSS), the International Organization of Securities Commissions (IOSCO) and the European Commission to make recommendations for the implementation of the G-20 guidelines.

With regard to OTC derivatives, IOSCO investigates and provides evidence to support the changes proposed by the G-20 (and IMHO that process will continues for some time). Dodd-Frank was enacted on 21 July 2010 and contains regulations for banks and consumers although it is the banking regulations that specifically concern us. In particular, the clauses on execution, clearing and reporting framework for OTC derivatives.

The Dodd-Frank act, and the deadlines

The act specified times by which the relevant authorities must implement rules to enforce the required behaviour (CFPB, HUD, CFTC, MSRB, DAG, NCUA, DVA, OCC, FCA, OFR, FED, OTS, FDIC, RHS, FHFA, SEC, FSOC, TREAS, FTC) (email me for the expanded list, or google the acronyms for some interesting interpretations).

In total, this equates to 387 separate rulings. In particular for OTC derivatives, the SEC & CFTC have to propose & implement the 150 rules, although some 21 must be delivered 360 days from enactment, i.e., July 2011. And an additional 98 rulings in Q3 2011.

In general the rulings follow a standard procedure of consultation, preliminary statements, further commentary/consultation, then final pronouncement. For each rule. In previous years the number of rulings per annum didn’t reach double figures.

Just who is the regulator?

It is a peculiarity of the US system that two agencies are tasked with implementing regulations, CTFC for futures & options, and SEC for securities. As CDSs are both index & single-name, this means that both agencies are regulating the same asset class (I know that CDS aren’t strictly speaking a class but bear with me here). So, the CFTC regulates index CDSs (CDX for the US) and the SEC regulates single-name CDSs. Given the massive increase in the number of rulings, both agencies need significantly more funding both to hire people to run the rule-making processes and to specify, buy and implement technology to enforce the new rules.

In summary

The new rules mandate that any derivative subject to clearing (not yet defined) must be traded on a swap execution facility (SEF) and reported to a registered swap repository. The feedback we get is that all the banks with operations in the US are making plans to deal with the legislation as written. Given the tone & content of statements at the time from Mr Gensler, this is prudent behaviour.

As time has marched on the original comments have been modified. I think this was inevitable. The ways in which OTC derivatives trade have been developed over a long period of time and these models are not overly complex once you understand the details of the instruments in question and the reasons for the relative opacity of the market. In many thin markets, a public order book will not aid price discovery or transparency.

In addition, the US mid-term elections were held after Dodd-Frank was passed which resulted in the Republicans gaining control of the lower house. My view is that the Republicans are more Wall St friendly than the Democrats, hence the budget “review” committees that may well cause significant problems for the agencies’ expansion plans.

Where are we now?

This chart provides an interesting view of the current status (click to enlarge).

The complete and very useful presentation is here. It is likely that the CTFC & SEC will continue to miss their mandated deadlines, but I am confident that all the rules will eventually come into force. The rule making process I referred to above has been proven over many years to be the most effective way to ensure that the new rules do not fall foul of “The Law of Unintended Consequences”.

In February of this year the first reported CDS trade that complied with SEF rules was processed. There are a number of FI markets that have registered as SEFs. More recently we have seen FX markets register (FxAll for example). Given that it is relatively straightforward for current markets to conform with the SEF rules, I expect more to follow.

What next?

Last month, the FED recommended that FX spot & forwards be exempted. We wait for the CFTC to define the other specific instruments types that will be regulated as per the act.

Single-dealer platforms (SDPs)

What does this mean for SDPs? A bank can quote rates on all derivatives but must pass its client to a SEF to execute a derivative that can be cleared.

My question is: How will this work?

If there are multiple SEFs listing the same instrument, will there be a trade-through rule to ensure that the client gets the best rate? And when the resulting trade is cleared, how will the clearer ensure that the buyer and seller have clearing relationships with it?

For many banks, extending their services to allow clients to trade, clear and report through them will be an obvious step. But a bank system that has been built to cope with say, a hundred or so prime clients may not scale well enough to cope with all clients that the bank will trade with. And can those services be offered within an existing SDP?

If you take the view that the SEFs must be open, then a bank SDP can route executions to a SEF, in much the same way that equity trades are passed to a lit exchange or dark pool for execution. Therefore the services that differentiate a bank in terms of pre-trade, execution & post-trade plus other support services can still be delivered through an SDP.

MiFID II

My next post in this series will look at the state of play of MiFID II.

Filed under: Dodd Frank, FX, MiFid, Regulation, Single-Dealer Platforms | Tagged: Dodd Frank, MiFIDII, regulation, SDP, single-dealer platform |