Today at the SEC and in government agencies around the world, regulators are shaping the rules that will govern the way over-the-counter derivatives are transacted. It’s a crucial task given the magnitude and importance of this market to the international financial system.
In the process, all of us are grappling with the fact that these transactions rarely respect national boundaries. They are complex transactions that routinely cross borders, and are potentially subject to multiple sets of rules.
To ensure our regimes work effectively, we need to have a common sense, flexible approach to the cross-border regulation of derivatives.
The Cross-Border Reality of OTC Derivatives
As most of you know, following the financial crisis there was a new focus placed on the regulation of OTC derivatives – and for good reason. The experiences of companies like AIG highlighted how the default – or even the potential default – of a single party involved in a series of derivatives transactions could create widespread instability.
We all saw that it didn’t matter whether the counterparty or trading desk was here or overseas, or whether the contract was executed in Miami or Milan. What mattered was that the potential spillover ultimately limited the willingness of market participants worldwide to extend credit.
In the United States, Congress passed the Dodd-Frank Act mandating the creation of a new regulatory regime to govern this multi-trillion dollar market – a market that U.S. regulators previously had been largely barred from regulating.
The CFTC was given responsibility for “swaps,” and the SEC responsibility for a portion of the OTC derivatives market known as “security-based swaps” – those which include, for example, swaps based on a security, such as a stock or a bond, or a credit default swap.
But the increased focus on OTC derivatives regulation was not exclusively a U.S. phenomenon. Other regulators and governments also sought to address the tremendous risks associated with derivatives transactions. And, they came to the conclusion that a comprehensive scheme of regulation would be necessary.
Consistent with this effort, the leaders of the G20 nations committed to a global effort to regulate OTC derivatives with the stated goals of mitigating systemic risk, improving market transparency, and protecting against market abuse.
For our part, the SEC has pursued those goals by proposing substantially all of the core rules required by Title VII of the Dodd-Frank Act – the portion governing OTC derivatives. We also have published an overall roadmap – or “policy statement” as it is formally known – to let market participants know how and in what order we intend to implement the new regime.
A key element of the policy statement concerns how we intend to apply our rules to cross-border activities. We have committed to issuing this cross-border proposal before fully implementing our regulatory framework. To help ensure we get this right, both the SEC staff and I have spent countless hours meeting with other regulators in the U.S. and around the globe who are also dealing with these same issues.
Of course, trying to get all the various regulatory pieces to fit together in a sensible way is crucial for a derivatives market that is international in scope. That’s because a party to any transaction needs to know which laws it must abide by when its transaction touches more than one country.
The Uniqueness of OTC Derivatives Compared to Other Securities and Financial Products
This cross-border challenge hasn’t manifested itself in the same way for other securities and financial products as it has for the OTC derivatives markets – in part because of the way in which those markets developed.
Consider securities regulation, which pre-dated the technology that made cross-border transactions feasible on a large scale. So, for many years securities regulation was largely crafted with only domestic markets and domestic market participants in mind.
Over time, as cross-border activities became more common in various parts of the securities arena, regulators began to address questions that arose on an issue-by-issue basis. A holistic approach to considering cross-border securities transactions generally wasn’t considered because, frankly, it wasn’t needed. Now, with derivatives, it is.
In sharp contrast to the traditional securities markets, the multi-trillion dollar OTC derivatives market became a significant market well after the advent of global trading – exploding in size over the last 20 years, operating relatively seamlessly across jurisdictions, and evolving largely without regulatory restraints. Today, cross-border derivatives transactions are the norm not the exception.
Therefore, once regulations are implemented across the major derivatives jurisdictions, the majority of derivatives transactions could be subjected to multiple regulatory regimes. The potential for conflicts among those regimes is obvious.
Against this backdrop of conflicting or contradictory rules, market participants have the ability to move – or restructure – their OTC derivatives activity with relative ease, avoiding more regulated markets, in search of less regulated ones. After all, derivatives are contracts between counterparties – they need not be anchored to any particular geographic location or market.
Some refer to the threat of migration to less regulated jurisdictions as regulatory arbitrage; others a “race to the bottom.” But whatever you call it, this very real possibility threatens the objectives of all of us who seek to reduce systemic risk, improve transparency, protect against market abuse and ensure the global system functions properly.
Investors and the markets deserve better.
Dealing With the Cross-Border Impact of Regulation
That means that getting these cross-border issues right for OTC derivatives is crucial. I know that. And my domestic and international counterparts know that. Yet, as we build this new framework from the ground up and with a common set of goals, we must accept that each jurisdiction necessarily is approaching derivatives reform from a slightly different direction.
Countries come at the process from different historical, legal and regulatory perspectives, and move forward at different speeds. No amount of effort is going to completely reconcile these differences.
After many years of regulatory experience, I have learned that it may not be fruitful to try to convert one another to our own particular regulatory philosophies. Instead, we should continue to expend our energy on a search for compatible, rather than identical, approaches to cross-border issues.
This means ensuring that our different regulatory regimes do not produce the gaps, overlaps or conflicts that could disrupt the global derivatives market and lead to regulatory arbitrage. Focusing on “compatible” rather than “identical” regulation brings us close to a system that achieves our collective goals of mitigating systemic risk, improving transparency, and protecting against market abuse, while also recognizing the legitimate and important differences between our regulatory regimes and markets.
Two Ends of the Spectrum
The importance of a compromise approach becomes evident when we look at the spectrum of approaches available.
The All-In Approach
At one end of the spectrum is the view that any transaction that touches a jurisdiction – or a person in that jurisdiction – in any way, needs to be subjected to the entire range of regulatory requirements specific to that jurisdiction. Let me call this the “all-in” approach.
Although this approach gives full weight to the unique requirements of local law, I am concerned that subjecting any derivatives transaction – that has any connection to a country – to all of the rules and regulations of that country risks unnecessary duplication and conflict. Indeed, to the extent two sets of rules conflict, this approach would place market participants engaging in a cross-border transaction in the untenable position of choosing which country’s requirements to violate. Market participants may have to withdraw from one of those markets or incur the costs associated with restructuring their business.
The Recognition and Reciprocity Approach
At the other end of the spectrum is the view that broad deference should be given to a foreign jurisdiction’s full regulatory regime – in lieu of one’s own regulatory regime – so long as it is comparable in its objectives. Market participants, intermediaries, and infrastructures would be subject to one set of rules for their cross-border activity. The entire regime is recognized as comparable or not comparable – it’s all or nothing. This approach is often referred to as “equivalence” or “recognition.”
Along these lines, some proponents of this approach also demand reciprocal treatment. In other words, “I will recognize the comparability of your rules only to the extent you recognize the comparability of mine.”
At first glance, a recognition approach may appear reasonable and consistent with a desire to reduce conflicts, inconsistencies, and duplicative requirements among regulatory regimes. But as I have discussed the details with my foreign counterparts, I have developed increasingly serious concerns about the potential consequences of an “all or nothing” approach.
Recognition may be an important tool in crafting cross-border regulation in some contexts, but wholesale recognition cannot be the exclusive tool if it means critical regulatory requirements in one regime are jettisoned as a result.
Further, I become particularly concerned when such wholesale recognition is combined with reciprocity. In other words, “I refuse to recognize your regime unless you recognize mine as equivalent in all respects.” In my opinion, tying recognition and reciprocity does not move us toward our united goals.
This is a because a regulator might feel compelled to recognize a foreign country’s regulations as “equivalent” solely to avoid the quid pro quo consequences of not having its own regulations deemed “equivalent” in return. The regulator might feel pressure to gloss over major differences and make a sweeping equivalency determination – that is, even when a regime imposes a critical policy requirement and the foreign regime does not.
This type of recognition, driven by the threat of reciprocity could actually create regulatory gaps between these so-called “equivalent” regimes, allowing certain market participants to exploit the differences and escape important requirements by simply choosing to comply with the more permissive regime.
Additionally, a regulator may feel forced to submit to the threat of not being eligible for recognition treatment because its own regulated entities could suffer if the foreign country does not determine there is equivalence. This could happen when Country A chooses not to allow market participants from Country B to do business in Country A unless Country B deems the other country’s regulatory regime to be equivalent.
I am particularly concerned that this forced recognition approach could substantially disrupt an established market and spark a regulatory race to the bottom, as regulators facing such “equivalency” determinations realize the seeming futility of maintaining comparatively higher standards in key policy areas. Alternatively, it could spark a kind of trade war in financial services, and lead to fragmentation of the global marketplace.
There must be a better way.
A Middle Ground
In short, subjecting every OTC derivatives transaction that touches the United States in some way to all aspects of U.S. law – that is, the “all-in” approach – ignores the realities of the global marketplace. And yet, treating clearly different regimes as equivalent across all key policy areas risks will create regulatory gaps, regulatory arbitrage, and a potential regulatory race to the bottom.
I believe that there is, in fact, a middle ground.
The Commission has not yet, as a body, proposed the specifics of its approach. But I personally support an approach that would permit a foreign market participant to comply with requirements imposed by its home country that are comparable with U.S. regulation, so long as it abides by U.S. requirements in areas where the home country’s regulations are not comparable.
I call this approach “substituted compliance.”
It’s an approach that accepts the inevitable differences between regulatory regimes when those differences nevertheless accomplish similar results. There’s no “my way or the highway.” Instead, parties may substitute compliance with one regulatory regime for another. But we would reserve the right to insist upon compliance with our own regulations when necessary. It’s an approach that focuses on what we see as real threats to the Dodd-Frank goals of stability, transparency, and investor protection.
For example, the SEC could make a determination that would allow market participants based in a foreign jurisdiction to follow their own jurisdiction’s capital requirements. But at the same time, the SEC could require these market participants to follow SEC rules concerning, for instance, public reporting requirements, if the foreign jurisdiction itself did not have a comparable set of public reporting requirements. This approach provides flexibility to market participants and regulators alike, allowing us to eliminate duplicative regulation when it is truly duplicative, while recognizing that regulatory regimes will necessarily differ in some respects.
While this approach does envision looking at different pieces of a jurisdiction’s set of rules, I do not believe that the ultimate determination of substituted compliance will be based on a line-by-line comparison of those rules. Instead, in making a substituted compliance determination, one would look at key categories of regulation. In addition, one would keep the focus on regulatory outcomes, not the means of achieving those outcomes.
Of course, in making these determinations, one would look not just at the way in which a country’s laws and regulations are written, but also, and crucially, at how that country supervises and enforces compliance with its rules.
I can’t stress how important this aspect of the substituted compliance approach is to me. Because effective regulation does not end with writing rules, it begins there. Effective supervision and enforcement of those rules is key not only to achieving the G20 goals, but also to advancing the SEC’s core mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.
For all of these reasons, I believe that the substituted compliance approach provides a workable approach and a necessary balance in the global market and regulatory environment in which we operate.
A Comparison of Substituted Compliance to Recognition and Reciprocity
As the SEC staff and I have discussed this approach, I have learned that the distinction between substituted compliance and what I call recognition and reciprocity is sometimes elusive. So let me illustrate.
Consider the public reporting requirements I mentioned earlier. As most of you know, the Dodd-Frank Act requires that transaction, volume, and pricing data of all security-based swaps be publicly disseminated in real time, except in the case of block trades. These requirements are designed to promote transparency and efficiency in the security-based swap market, by providing more accurate information about the pricing of security-based swap transactions, and thus about trading activity. Promoting transparency and efficiency in the security-based swap market is one of the primary goals of the new regulatory framework established by the Dodd-Frank Act, not an afterthought.
Given the key role that public transparency requirements play in the U.S. efforts to bring sunshine to the largely opaque OTC derivatives markets, I fully expect that public reporting would be one of a number of key categories of requirements that would be the focus of a substituted compliance determination for foreign regulatory regimes.
But the fact that a foreign regulatory regime might not be comparable to ours with respect to public transparency should not be fatal to an SEC substituted compliance determination in other areas. In fact, the SEC could still recognize other areas of a foreign regulatory regime – such as mandatory clearing or capital requirements. Foreign market participants would, however, continue to be subject to the SEC rules regarding public reporting.
This outcome under a substituted compliance approach contrasts markedly with the “rock and a hard place” approach that an equivalence determination for an entire foreign regulatory regime would present. If the SEC were to adopt such a “recognition and reciprocity” approach, we would be faced with the difficult choice: either not make an equivalence determination with respect to the foreign regime or determine that a foreign regulatory regime is “equivalent” – even if a key aspect of our regulatory regime were absent.
I recognize, of course, that the differences between substituted compliance in specific regulatory areas and an equivalence determination for an entire foreign regulatory regime raise difficult issues and there are many competing interests. And regulators, me included, can have very strong views about the right approach. I nonetheless am committed to resolving these and other difficult issues. And I am gratified that our regulatory partners are equally determined to fashion arrangements that support investor protections and capital formation, while bringing needed stability to our global financial system.
Trade Repositories and Access to Data
So clearly it will be crucial to align the different regulatory regimes for cross-border transactions in a way that minimizes the risk of gaps, conflicts, and inconsistencies. But, this is not the only consideration in working through effective regulation in the cross-border arena. It also will be crucial for regulators to make sure that their different regimes work together, for example, to provide comprehensive data on cross-border transactions.
This is important because the relevant authorities must have an accurate view of the global derivatives market through access to data they need to carry out their mandates. Comprehensive information helps regulators identify and address systemic risk and promote stability across markets, as well as monitor for, and protect against, market abuse.
However, compiling comprehensive transactional data is challenging enough in a complex domestic market. And, it gets far more complicated in the cross-border world of derivatives, where, for example, the vast majority of credit default swaps cross national borders.
Fortunately we’re not starting from scratch. It is estimated that some information on well over 90 percent of outstanding gross notional amounts in credit derivatives were reported to a trade repository at the end of 2012. However, submission of this information was largely voluntary, and the result of substantial supervisory encouragement. Additionally, it didn’t include all the information regulators need to effectively oversee this market.
One goal of regulation in this area is to increase the quality and quantity of information reported to trade repositories, so that regulators have the data they need to do their jobs.
There are, however, challenges to getting the data that regulatory authorities need. Certain countries have privacy laws, blocking statutes, and other laws that restrict or limit the disclosure of certain information about trade counterparties. Such measures may interfere with global regulatory reporting by prohibiting or limiting entities from reporting the identity of their counterparty into trade repositories – thereby undermining the usefulness of these repositories. Regulators internationally, as well as individual jurisdictions, are actively working to develop potential cures.
As an interim solution, some market participants have received temporary relief to submit reports to certain trade repositories with “masked” data – that is, data that includes some, but not all, of the required relevant information. This is of course a temporary, pragmatic fix to an immediate challenge arising from the new regulatory regime for reporting. But, it is not a long-term solution.
Regrettably, potential impediments are not solely the province of foreign law. Another challenge to getting data comes from the Dodd-Frank Act itself. That Act requires regulators to agree to bear certain potential costs arising from data sharing. In particular, before an SEC-registered trade repository can share information with a domestic or foreign regulator other than the SEC, the regulator must agree, among other things, to indemnify the trade repository for certain litigation expenses that may be incurred by the repository. The CFTC has a similar provision.
We understand that foreign authorities may be prohibited under their laws from satisfying the indemnification requirement. In fact, even certain U.S. authorities, are not permitted to provide an open-ended indemnification agreement. Given the limitations of the indemnification requirements, foreign regulators have expressed concerns about their ability to directly access data held in an SEC- or CFTC-registered trade repository.
That is why the SEC has publicly advocated for a legislative fix and is considering ways to address this issue in our forthcoming proposal on cross-border issues.
More generally, I can tell you that I personally am committed to doing what I can to make sure that comprehensive data on the global OTC derivatives market are made available to all regulators with a mission-based need for that information. As one of the regulators charged with reforming the OTC derivatives market, I believe the SEC and fellow regulators must strive for no less.
In short, I believe that the regulators of OTC derivatives across the globe working together in good faith and common purpose can bring about a more stable, more transparent, and fairer OTC derivatives market, while preserving its global, dynamic character. But I believe we will succeed only if we find the middle ground.
There is far too much at stake, in my view, for regulators to do any less.