In 2010, more than 8,000 domestic equity securities traded in the U.S. OTC market. Yet, research studying this market is limited. Stocks in this market tend to be small. The OTC market generally offers less investor protection than the traditional exchanges, and fraudulent and abusive practices in this market cause significant economic harm to investors. Thus, this market illustrates the trade-off that securities regulators face between their charter to ensure investor protection and their desire to create a viable market for small growth firms. This trade-off has come into focus with the passage of the JOBS Act in 2012, which intends to lower the regulatory burden on firms when they access public capital markets. One of its key provisions is to loosen the ownership limits for SEC registration, which will likely increase the number of unregistered securities in the OTC market. This change raises significant concerns with respect to investor protection. In light of these initiatives, it is important to understand the efficacy of existing regulatory regimes in the OTC market. In our paper, The Twilight Zone: OTC Regulatory Regimes and Market Quality, which was recently made publicly available on SSRN, my co-authors (Ulf Bruggemann, Aditya Kaul, and Ingrid Werner) and I analyze the association between these regulatory regimes and market quality.
Posts Tagged ‘OTC derivatives’
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) enacted a new regime of substantive regulation of over-the-counter (“OTC”) derivatives under U.S. securities and commodities laws. Over the course of 2013, many key provisions of Dodd-Frank are being implemented by the Commodity Futures Trading Commission (the “CFTC”) with respect to “swaps.” While many of the regime’s requirements focus on “swap dealers” (“SDs”) and “major swap participants” (“MSPs”), commercial entities that enter into OTC derivatives transactions to hedge or mitigate risk, referred to as “end users,” will also become subject to a wide range of substantive requirements.
In particular, end users will need to:
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.
As a result of the Dodd-Frank Act, the over-the-counter derivatives markets have become subject to significant new regulatory oversight. As the markets respond to these new regulations, the menu of derivatives instruments available to asset managers, and the costs associated with those instruments, will change significantly. As the first new swap rules have come into effect in the past several months, market participants have started to identify risks and costs, as well as new opportunities, arising from this new regulatory landscape.
This memorandum and the accompanying timeline is designed to provide asset managers, and those interested in the activities of asset managers, with background information on key aspects of the swap regulatory regime that may impact their derivatives trading activities. The memorandum highlights practical considerations and potential opportunities for asset managers, as they assess the impact these regulations will have on their trading activities.
In the short term, asset managers should be sure to:
In the wake of the financial crisis, both the U.S. and the EU have enacted legislation to regulate the “over-the-counter” (“OTC”) swaps market and are in the process of adopting implementing rules that will make such legislation fully effective. In the U.S., Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), enacted on July 21, 2010, provides for the regulation of the swaps market and grants to the Commodity Futures Trading Commission (the “CFTC”) and the Securities and Exchange Commission (the “SEC,” and with the CFTC, each a “Commission” and together, the “Commissions”) broad authority to regulate the swaps market and its principal participants. In the EU, the European Market Infrastructure Regulation (“EMIR”) is expected to become effective during 2013 and will create a regulatory framework for the swaps markets in all EU member states.
Both the EU and the US have now adopted the primary legislation which aims to fulfill the G20 commitments that all standardised over-the-counter (OTC) derivatives should be cleared through central counterparties (CCPs) by end 2012 and that OTC derivatives contracts should be reported to trade repositories (and the related commitments to a common approach to margin rules for uncleared derivatives transactions). The US Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in July 2010 and the text of the EU Regulation on OTC Derivatives, CCPs and Trade Repositories (EMIR) was finally published in the Official Journal on 27 July 2012.
There is a significant commonality of approaches between EMIR and the Dodd-Frank Act in relation to the regulation of OTC derivatives markets, but there are also some significant differences. This paper summarises the way in which the two regimes treat different categories of counterparty and highlights certain other major differences between EMIR and the Dodd-Frank Act in relation to OTC derivatives regulation.
On June 19, 2012, the Financial Stability Board (FSB) issued a progress report to the G20 Leaders on the steps FSB member nations have taken to implement financial reforms designed to improve the stability of the global financial system. The FSB reviewed, among other things, its members’ Basel implementation, adoption of resolution-planning regimes, oversight of the so-called “shadow banking system,” reform of the OTC derivatives market, and the effectiveness of the FSB itself. The FSB concluded that its member nations have made significant progress in implementing globally agreed financial reforms, but large strides are still necessary – particularly regarding recovery and resolution planning – to protect the global economy against future financial crises.
What is the FSB?
The FSB is an informal body of financial regulatory authorities from the G20 nations and the former members of the Financial Stability Forum. It was established in 2009 – in the wake of the 2008 financial crisis – with the intent of improving global financial stability by coordinating the way in which the world’s major economies implement their own financial reforms. At present, the FSB is not an independent legal entity but acts under the auspices of the Bank for International Settlements (BIS), an international organization that assists central banks in promoting financial stability and serves as an international central bank itself. The FSB has no enforcement authority; it derives its legitimacy from the cooperative participation of its member nations. As described below, however, the FSB’s institutional power may be growing: the G20 Leaders recently granted the FSB authority to organize itself as an independent legal entity.
After the publication of fifteen revised drafts of the long-awaited Regulation of the European Parliament and Council on OTC Derivatives, Central Counterparties and Trade Repositories (commonly known as “EMIR”), you would be forgiven for thinking that the Europeans were never likely to see a conclusion to legislative attempts to regulate their over-the-counter (“OTC”) derivatives market. However, on 9 February 2012, a trialogue meeting of the European Parliament, the Council and the European Commission at long last reached agreement on the final text of EMIR , and since we last provided an update on OTC derivatives reform in the EU , the wheels of the legislative process have turned extensively, even if slowly.
Although the publication of the legislation finally puts in place the broad regulatory framework to govern the OTC derivatives market and establishes common rules for central counterparties and trade repositories, much of the real detail has yet to be drafted. The European Securities and Markets Authority (“ESMA”) now has responsibility for putting the flesh on the bones, in the form of drafting scores of technical standards to implement the EMIR provisions.
Users of commodity derivatives markets are now facing major changes under proposed European and US legislation. Stronger supervision of the commodity derivatives market is one of the key areas of the G20 regulatory reform agenda. In Europe, the European Commission is proposing to regulate the activities of a wider range of commodity derivatives traders through amendments to MiFID. End-users will become subject to mandatory clearing requirements for OTC derivative transactions above certain thresholds once the recently agreed EMIR proposal comes into force. For the first time, the wholesale energy market and the commodity spot market will become subject to the market abuse regime. In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act brings in a comprehensive reform of the OTC derivatives market. This publication gives an overview of the impact of the various recent European and US regulatory changes from the perspective of non-financial businesses involved in commodity derivatives trading.
Various proposals have been introduced since the onset of the financial crisis to strengthen financial regulation across the full spectrum of financial services at international, EU and domestic levels. Previous client publications address many of these proposals. This publication draws together various threads of regulation in the context of their impact on commodity derivatives trading.
European and US market participants are having to prepare for the introduction of OTC derivatives legislation and clearing reforms, despite continuing uncertainty about the exact nature of significant elements of the new rules. Given the ‘sea of change’ engulfing the sector it’s important to focus on the practical effects of new regulation from a clearing member or market participant perspective.
Mapping the ‘sea of change’
Before going into any detail on individual areas of concern, it is worth very briefly sketching out the regulatory framework. In the US, the mechanism for implementing OTC derivatives regulations and clearing reforms is contained in the Dodd-Frank Act, while in Europe, the main legislation is the European Market Infrastructure Regulation (EMIR – as below), supported by further reforms in the Markets in Financial Instruments Directive (MiFID) and the Capital Requirements Directive 4 (CRD4). These changes are in response to the financial crisis, which highlighted a lack of information on positions and exposures of individual firms in OTC derivatives. This issue was seen to have prevented regulators from getting a clear view of the inherent risks building up in the system. It was also judged to have impeded accurate assessment of the consequences of a default and, as described by a recent European Commission impact assessment, “helped fuel suspicion and uncertainty among market participants during a crisis”.