Introduction to the Dodd-Frank Act
In the wake of the 2007–2008 financial crisis, legislative and regulatory regimes around the world have introduced laws to reform financial markets—notably the Dodd-Frank Act in the United States and the European Market Infrastructure Regulation (EMIR) in the European Union, as well as other similar laws in many countries and regions. The joint aim has been to provide for a uniform global marketplace without regulatory gaps and disparities between regimes.
A principal objective of these laws is to reduce the systemic risk in financial markets. These laws are focused on certain perceived flaws in over-the-counter (OTC) derivatives markets that many holds responsible for exacerbating the crisis. These reforms restructure the financial regulatory system to restore public confidence and to prevent another crisis from occurring.
These laws have changed the oversight and structure of the OTC derivatives market in the United States and other countries that have sizable derivatives business.
The goal of this blog is to provide a cursory overview of the major reforms of the Dodd-Frank Act and to survey more closely the new global regulatory framework for the derivatives market. This starts with a survey of the Dodd-Frank Act and proceeds to look at how Title VII of Dodd-Frank is reforming the derivatives market structure and constraining its players by reference to each major component of the regulatory framework.
Finally, this blog summarizes how other concurrent reforms—especially the Basel II and Basel III Accords—are affecting the global derivatives market.
Note that this blog is intended to provide only the essentials of the Dodd-Frank Act and derivatives reforms. It is far from comprehensive and is not intended to proffer any legal advice on complying with the Dodd-Frank Act. The objectives of this blog are to
understand the major reforms of Dodd-Frank
understand the derivative reforms prescribed under Title VII
explain the new structure of the OTC derivatives market and the roles of each involved entity
study the key elements of the regulatory framework
The Dodd-Frank Act
In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act or simply Dodd-Frank) became law in the United States. The Dodd-Frank Act is an extensive reform, touching most parts of financial services of the country.
A principal objective of the Dodd-Frank Act is to promote the financial stability of the United States by improving accountability and transparency throughout the financial system, controlling systemic risk, forestalling the need for government bailouts and protecting consumers from abusive market practices. The act has changed entire market practices—how financial products are traded and used by market participants.
The Dodd-Frank Act has 16 titles (major sections), each focusing on specific aspects of regulation. The derivatives market reform is mostly covered under Title VII of the act. This act has reshaped the oversight and structure of the OTC derivatives market including market scope, structure, execution mechanics, pricing, margin, collateral requirements, and supervision.
Furthermore, other major derivative markets of the world have also introduced similar laws in order to level the playing field. The following section provides a summary of the Dodd-Frank Act followed by the derivatives reform.
The Dodd-Frank Act covers broad areas of the financial system with many rules and exceptions. The principal aspects of the act are as follows:
Financial stability reform.
The Dodd-Frank Act creates a core organization named the Financial Stability Oversight Council (FSOC or simply council). The main purpose of this organization is to identify risks to US financial system stability that may arise from ongoing activities of large, interconnected financial companies as well as from outside the financial services marketplace.
It also promotes market discipline through various regulatory agencies. The council is responsible for overseeing various regulatory agencies and aligning the roles of these agencies to avoid any gaps. The act also created the Office of Financial Research (OFR) to assist the FSOC.
Regulatory agencies reform.
In addition to the FSOC, the act creates several new regulatory agencies and enhances the role of several existing agencies in various segments of the financial system. The created agencies include the Bureau of Consumer Financial Protection (Bureau), Office of National Insurance, and Office of Credit Rating Agencies. The agencies with enhanced roles include the Commodity Futures Trading Commission (CFTC), Securities Exchange Commission (SEC), and others.
The act introduces regulations on registration, disclosure, and reporting requirements for asset-backed securities and other structured finance products.
Derivatives business reform.
The act introduces an extensive reform of derivatives business, imposing comprehensive rules on derivatives trading and market participants. The act empowers parallel regulatory agencies, the CFTC, and SEC, and it divides jurisdiction between them while the banking regulators (prudential regulators) will retain jurisdiction over certain aspects of banks’ derivatives activities.
Investor protection reform.
The act addresses certain custody issues and introduces rules relating to investor protection that are aimed at strengthening investor confidence.
Credit rating agency reform. The act introduces several compliance requirements on rating agencies.
Volker rule provisions. The act limits the engagement in proprietary trading by US banks and their affiliates. Furthermore, the rule also limits the owning of, sponsoring of or investing in hedge funds or private equity funds by these entities.
Compensation and corporate governance. The act imposes certain changes to executive compensation policies and corporate governance policies.
The act imposes a more stringent regulatory capital requirement standard on financial institutions. In addition, it also introduces standards on leverage limits, liquidity requirements, and concentration limits. There are many more minor rules that address the objectives of broader reforms of the overall financial system.
The derivatives business reform has been introduced through Title VII in the Dodd-Frank Act. The title is also known as The Wall Street Transparency and Accountability Act of 2010. It imposes comprehensive and far-reaching regulatory rules on derivatives and market participants. The major elements of Title VII are summarized below.
Regulatory framework. Primarily, the CFTC and SEC are given enhanced authority to jointly regulate the derivatives market. These agencies have enhanced governance and compliance structures of the market and participants. The key market players are subject to enhanced compliance, business conduct rules, and processing standards.
However, banking regulators retain jurisdiction over certain aspects of the derivatives activities of banks, such as capital and margin requirements and prudential requirements.
Standardization. The act enforces standardization of certain derivative contracts, central clearing, organized trading platforms, categorization of market participants, and transaction reporting requirements to improve market transparency and mitigate systemic risk.
Electronic Trading. The act requires all standardized contract (eligible for central clearing) trades to execute over an organized trading platform. In addition, the dealers on execution venues are obligated to provide pre-trade price transparency.
Central clearing. The act mandates the central clearing of standardized swap contracts through a central clearing organization. Market participants are required to clear their trades either through a derivatives clearing member or directly through a clearing organization.
Reporting. The act requires all transactions, including standard as well as non-standard swaps, to be reported to trade repositories by the appropriate market entities and parties involved.
Collateral and margin requirements. The act prescribes margin requirement standards for centrally cleared transactions and stringent collateral requirement standards for non-standard (bilateral) transactions to mitigate counterparty credit risk. Furthermore, it also introduces standards for increased capital requirements on major market participants.
Restrictions and limitations. The act also limits the involvement of certain entities in derivatives transactions.
Exceptions. The act includes many exceptions to the involved parties and transactions, and it includes applicable criteria for each exception.
New Market Structure
As stated earlier, the Dodd-Frank Act has changed the landscape of the OTC derivatives market. According to the act, the key market players are the following:
Regulatory agencies. Introduction of new and expanded supervisory agencies to regulate and oversee markets.
Product Classification. All derivative products are classified into two major groups—standard and non-standard swaps.
Market participants. All swap market participants are classified into multiple categories and subject to regulations based on their category.
Trading venues. Introduction of organized trading platforms to trade standard products that are subject to new regulations.
Clearing organizations. Central clearing of standard swaps through CCPs that are subject to additional prudential standards.
Trade repositories. Central databases to collect and report market transactions to regulators and provide a certain level of transparency to the public.
The act appoints the CFTC and SEC to jointly regulate the derivatives market. These organizations operate under the guidance of the FSOC. The broad derivatives jurisdiction has been clearly split between these agencies. The primary objectives of these agencies are to prescribe regulations and oversee markets.
Furthermore, the CFTC and SEC work in conjunction with prudential regulators, such as the Federal Reserve Board (FRB), in respect to prescribing certain rules for banks and other entities that are regulated by these prudential regulators.
Note The key prudential regulators are the Federal Reserve Board, the Office of the Comptroller of Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration, and the Federal Housing Finance Authority.
Product Classification: Swaps
The Dodd-Frank Act amends the Commodity Exchange Act (CEA) by adding definitions of the terms swap, security-based swap, and non-security-based swap.
According to Dodd-Frank, the term swap is broadly defined as agreements, contracts, or transactions linked to an array of underlying such as physical commodities, rates, foreign currencies, broad-based security indices, or US government or other exempt securities (other than municipal securities), unless a predefined exclusion applies.
In general, under the Dodd-Frank Act, all OTC derivative products are simply referred to as swaps—not to be confused with the derivatives class swap. It is important to distinguish between the two terms and to recognize which one is appropriate based on the context.
Throughout this blog, the term swap refers to a derivatives contract under Dodd-Frank unless otherwise specified. Most OTC derivatives are some form of the swap class of derivatives, so swaps became a commonly used term to refer to all OTC derivatives.
The OTC products included in the swaps definition are interest rate swaps, basis swaps, currency swaps, foreign exchange swaps, total return swaps, equity and equity index swaps, debt and debt index swaps, credit default swaps, energy swaps, metal swaps, agricultural swaps, and other commodity swaps. The act mainly covers five major asset classes: interest rate, credit, equity, foreign exchange, and commodity.
Per the act, swaps (derivative products) are divided into two major categories: security-based swaps and non-security-based swaps. The scope of regulation and which rules apply to a given transaction are determined by the type of underlying swap instrument, whether security-based or non-security based.
Security-based swaps are swaps based on financial instruments such as securities or loans. Securities include all financial instruments that are covered under the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act).
Security-based swaps capture most types of commonly traded OTC derivatives. They include contracts based on single, non-exempt securities or a narrow-based security index, single-name CDS, most CDS based on narrow-based indices, and most equity swaps such as total return swaps.
The SEC is responsible for overseeing this category of swaps, markets, and participants.
All swaps that are not security-based swaps fall into this category. The non-security-based swaps are referred to simply as swaps, while security-based swaps are prefixed by the term security-based. The most common non-security-based swaps are the following:
Interest rate swaps. Most plain vanilla interest rates swaps include fixed-to-floating swaps, floating-to-floating swaps (basis swaps), forward rate agreements, and overnight indexed swaps (OIS) in limited currencies (currently USD, EUR, GBP, and JPY are included).
FX derivatives. FX derivatives include foreign exchange options, currency swaps, and nondeliverable forwards. Note that FX swaps and FX forwards, in general, are exempted.
Credit indices. Credit Default Swaps (CDS) are on broad indices, other than security-based CDS.
Total return swaps. These are certain types of total return swaps that do not fall under the definition of security-based swaps.
Options on rates. All options—such as puts, calls, floors, caps, and collars—are based on a rate, such as an interest rate or a currency exchange rate.
Commodity options. All options—such as puts, calls, caps, floors, and collars—for purchase or sale, are based on the value of one or more commodities. However, options that involve the physical delivery of commodities for a business purpose are exempt, with certain conditions.
Other swaps. All other swaps that do not qualify as security-based swaps and not exempt.
The CFTC is responsible for overseeing this category of swaps, markets, and participants with input from the SEC, where appropriate.
Mixed swaps are another category that includes security-based swaps with a commodity component. The CFTC and SEC share the regulatory authority over this type of swaps.
The act excludes the following derivative transactions from being either security-based or non-security-based swaps:
Listed products. Include listed futures, options on listed futures, listed options on securities, and broad and narrow-based security indices, exchange-traded commodity futures, and options on exchange-traded commodity futures.
Securities products. Include unlisted options on securities or on certain indices that are subject to securities laws.
Forwards. Certain physically settled forward contracts and forwards tied to nonfinancial commodities.
FX products. Include FX swaps and FX forwards.
All swaps under the Dodd-Frank Act are divided into the two following major categories based on the central clearing requirement:
Clearable swaps or standard swaps. The act prescribes that swaps be standardized into standard swaps, also known as clearable swaps. All standard swaps are mandated to be traded on an organized trading platform and cleared by a designated clearing organization. Regulators have the authority to enhance the list of clearable swaps, as required.
Non-clearable, non-standard, or bilateral swaps. All swaps other than standard swaps are considered non-standard, non-clearable, or bilateral swaps. These swaps are traded over any traditional channel and not cleared by any central clearing organization. According to the act, however, these transactions are subject to increased collateral requirements and counterparties are subject to increased capital requirements. This category is also known as an off-facility swap.
The act requires all market participants to be registered to trade. Registered participants are known as Eligible Swap Participants (ESP) or Eligible Contract Participants (ECP).
Market participants are classified into three broad categories: Swap Dealers (SDs), Major Swap Participants (MSPs), and End Users (EU). The act prescribes the rules and requirements by these categories. The following sections explain how each participant is classified into one of these categories.
The SD is a financial institution that acts as a dealer or market-maker in a swap transaction. Typically, dealers take the counterparty role in derivative transactions for the benefit of their clients and other market participants, providing liquidity. The act requires all such institutions to be registered as swap dealers.
Based on the instruments they deal, swap dealers may have to register with either or both CFTC and SEC. Furthermore, institutions dealing with non-security-based swaps also have to register with the National Futures Association (NFA), a market association.
Major Swap Participants
A Major Swap Participant (MSP) is a market participant satisfying one or more of the following conditions:
Maintaining a substantial position in swaps
Maintaining swap positions that create substantial counterparty exposure that could have serious adverse effects on the financial stability of the US banking system
Being a highly leveraged financial entity that is not already regulated by any federal banking regulator, The size of the substantial position, exposure, and leverage are prescribed by the appropriate supervisory agency. In summary, SDs and MSPs are larger participants who are critical for market success while they are also sources of major systemic risk.
All ESPs that are not designated as either SDs or MSPs are referred to as end users (EUs). The EU are swap participants with limited assets (with asset thresholds being set by regulatory agencies). However, this category includes certain other institutions that cross the threshold such as the farm-credit association, credit unions, and rural electrical cooperatives.
EUs are further divided into two broad categories: financial and non-financial end users.
An EU is a financial end user if it is a commodity pool, private fund, employee benefit plan, or a person that is predominantly engaged in activities that are in the business of banking or that are financial in nature.
All EUs other than financial end users are referred to as non-financial end users or commercial end users.
Note The term financial entity generally includes SDs, MSPs, commodity pools, private funds, employee benefit plans, and persons predominantly engaged in activities that are in the business of banking or that are financial in nature.
Participant categories are another commonly used classification of derivatives market players. For the phased implementation of the Dodd-Frank Act, all participants are divided into the following three major categories:
Category 1: Entities that include swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, and active funds.
Category 2: Entities that include commodity pools or private funds.
Category 3: All other entities affected.
All standard swaps are subject to mandatory trading on an Organized Trading Platform (OTP) that is electronic and licensed by appropriate regulatory agencies unless the swap is not “available to trade.” The act defines two types of trading platforms: Designated Contract Markets (DCMs) or Swap Execution Facilities (SEFs).
Under the act, a DCM is a large, recognized exchange (board of trade) on which physical commodities and other non-security-based swaps are traded. A SEF is an electronic trading platform on which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants.
Most major conventional exchanges are likely to be classified and registered as both a DCM and a SEF. However, both DCMs and SEFs are required to register with supervisory agencies (CFTC, SEC, or both) and are subject to prescribed trading rules and other requirements.
A SEF or DCM is subject to the determination of whether a swap is made “available to trade” or not and to submit such determinations to regulatory agencies for approval or certification. The rules also propose that, if one SEF makes a swap available to trade, all “economically equivalent” swaps would be deemed “available to trade.”
Note Some of the SEFs are Tradeweb, MarketAxess, Bloomberg, and ICAP, while most major derivative exchanges are either already licensed as DCM or are in the process of obtaining a license.
All standard swaps are subject to mandatory clearing by Designated Clearing Organization (DCO), also known as Central Clearing Counterparty (CCP) or Central Counterparty. DCOs are subject to licensing by the appropriate regulatory agencies and must comply with margin requirement standards and other prescribed rules.
Most DCOs are existing clearinghouses that are licensed to clear standard swap contracts. Similar to a listed market, DCOs are accessible to EUs through Clearing Members (CMs) (also known as FCMs or brokers). Clearing members operate under the rules of DCOs in addition to applicable market regulations.
Note Major clearinghouses that clear standard swaps are CME, ICE Clear, LCH. Clearnet, IDCG, NASDAQ OMX, Eurex Clearing, and others.
One of the key requirements of the act is to collect the data on market transactions into a central repository known as a Trade Repository (TR) or Swap Data Repository (SDR). The act establishes that these repositories are to collect transaction data from responsible market players.
As per the act, an SDR can be defined as a centralized record-keeping facility of swaps that collects and maintains information with respect to swap transactions or positions held by market participants. The act also allows multiple trade repositories to exist and collect data serving different segments of the market.
These repositories serve as central databases, providing reports to regulatory authorities and making applicable data available to the public. According to the act, the requirements of the swap data repository are the following:
Collect swap transaction data from designated reporting entities (the rules designate a specific participant as a responsible reporting entity in each transaction type)
Verify the accuracy of the data submitted and maintain it in a uniform format
Maintain records, data processing, and reporting systems as prescribed by the SEC and CFTC
Report trade data to the SEC and/or CFTC, as prescribed by the act
The previous section defined various key players of the market as prescribed by the Dodd-Frank Act. This section explains new framework, that is, how these players do business and key regulatory requirements imposed on each player and swap transactions. This section is divided into multiple subsections, each explaining different aspects of the new framework.
As we discussed earlier, the Dodd-Frank Act creates a key regulatory entity, the Financial Stability Oversight Council (FSOC). The FSOC is an independent rule-making agency focused on identifying, monitoring, and addressing systemic risk. It is chaired by the treasury secretary and consists of the federal financial regulators as members.
Under the new law, the CFTC and SEC have been given new authority to enforce the required rules and to regulate the OTC derivative markets, products, and market participants. Both of these agencies are members of the FSOC and take significant responsibility toward achieving the goals of the FSOC.
The SEC is given jurisdiction over security-based swaps and all entities dealing with security-based swaps such as ESPN, clearing agencies, trading venues, and trade repositories. The CFTC is given jurisdiction over non-security-based swaps and entities dealing with these swaps. The two regulators share jurisdiction of certainly mixed swaps.
Registration and Licensing
A swap participant must register with the regulators as a swaps dealer, major swaps participant, or end user. This means that a swaps dealer, usually a broker-dealer that makes a market in swaps, must register with either the CFTC or SEC or with both regulators if dealing with both category swaps.
For instance, with large hedge funds and dealers, these are typically subject to registering with both the CFTC and SEC as they mostly deal with both types of swaps.
However, there is an exemption from registration for non-financial companies that are hedging commercial risk. For example, a heating oil company that purchases swaps to hedge its exposure to oil prices could be declared as a commercial end user. Regulations provide many exceptions and required criteria for each exception in detail as part of the rules.
As per the act, all standard swaps (designated as clearable) must be traded on DCMs or SEFs unless there is no registered venue that accepts the swap for trading (not “available to trade”). The act proposes non-security-based swaps that are to be traded on DCMs, non-commodity, and non-security-based swaps, such as interest rate swaps, which are to be traded as SEFs that are on smaller electronic platforms. Security-based swaps, such as single-name CDS, are to be traded on either a SEF or DCM.
These trading platforms are subject to reporting requirements on trading activity. Reporting on trading activity includes information such as the trading swap, presence of buyers and sellers, frequency or size of transactions, trading volume, bid-ask spread, and indicative bids and offers.
A block trade in swaps can be negotiated over the phone and entered into an electronic system after the fact, for reporting purposes. Non-standard swaps can also be traded on these electronic platforms, even if they are not cleared by DCO.
All standard swaps that are designated as clearable must be centrally cleared through a Designated Clearing Organization (DCO). As discussed earlier, central clearing virtually eliminates the counterparty credit risk that existed in earlier OTC transactions. The act also prescribes new margin management standards to all DCOs, which are discussed in later sections.
Both sides of the standard swap contract clear the trade either through a derivatives Clearing Member (CM) or directly (if the party is itself a member of the DCO), rather than establishing a bilateral contract with each other. Typically the relationship between an end user and a Futures Commission Merchant (FCM) is established through the give-up agreement. The CM is also known as the clearing broker, FCM, or simply broker.
Furthermore, the act states that the counterparty to a swap transaction that is not an SD or MSP has the sole right to select the DCO to clear standard contracts. The two counterparties of the contract are not required to but may use the same CM. In practice, swap pricing may be affected by the selected DCO, so the DCO is chosen before the execution. EUs clear their trades through CM, while SDs clear their trades directly through a DCO.
Swap transactions initiated before the Dodd-Frank Act became effective are exempted from the clearing requirement. They may, however, be subject to other requirements such as data reporting and record-keeping.
Per the act, CM accounts at DCO are segregated and portable, which allow EUs to switch to a different CM in case of CM defaults.
Another important note is that the EU may also choose to clear non-standard swap transactions if the transaction is acceptable by any DCO for clearing.
FCM vs. Broker In a futures market, a clearing member is known as FCM, whereas in a securities market, a clearing broker is primarily referred to as a broker-dealer or simply as a broker. After new regulations, the FCM term is being widely used.
The strength and safety of a financial system depend on the strength and risk management practices of its participants. To promote stronger risk management practices among participants, the regulatory agencies prescribe the margin requirement standards for designated clearing organizations (DCOs), and collateral management standards for non-clearable swaps among SDs, MSPs, and EUs.
Margin rules of clearable transactions are prescribed and implemented by regulators in consultation with DCOs. Since DCOs have a major role in providing financial security, stringent margin requirement standards are enforced upon them. It is critical for DCOs to maintain sufficient financial resources that will enable them to withstand any adverse event.
All cleared swaps are subject to margin requirements as established by the DCO. These include daily variation margin (VM) (or mark-to-market variation) and an upfront initial margin (IM) (posting of cash or securities) to cover the DCO’s (and FCM’s) potential future exposure from the default of a contract holder (or FCM).
In case of uncleared swaps (OTC bilateral), regulators prescribe collateral standards such as the subjected swaps, documentation requirements, rules related to Independent Amount (IA) requirements, collateral eligibility and restrictions, the timing of posting collateral, calculation methodology, and collateral custody.
Collateral requirements for these swaps are generally higher than the margin required for cleared swaps. Swaps initiated before the act are not specifically exempt from the margin requirements.
In case of non-dealer transactions (end user to end user), a clearing member must be involved in all clearing activities. The end users that are subject to collateral requirements follow the rules enforced by a clearing member.
In addition to margin and collateral requirements, both SDs and MSPs are subject to new minimum capital requirement standards in order to mitigate the systemic risk to the overall financial system. These new capital requirement standards are comparable to those applicable to banks, such as Basel II or Basel III, providing harmonization across jurisdictions and regulators.
While the CFTC and SEC set capital and margin requirements for DCOs and most other participants, federal banking regulators (prudential regulators) set these standards for the SDs and MSPs that are banks.
Furthermore, the act also prescribes rules for collateral custody. These rules include the separation of client and clearing member collateral and third-party custody, in certain cases.
Note Prudential regulators further divide financial end users into two categories for the purpose of collateral rules enforcement. They are High-Risk Financial End Users (HRFE) and Low-Risk Financial End Users (LRFE).
The act requires reporting of transactions, both clearable and bilateral transactions, to registered Swaps Data Repositories (SDRs). Reporting information details vary by transaction and market. The reporting information typically includes details on new transactions and changes to current positions such as unwind, novation, amendment, revision, and valuation throughout the life of the contract until termination.
The rules designate one or more entities as data reporting entities responsible for reporting, based on the type of the transaction, execution, and clearing method used.
Furthermore, designated data reporting entities are responsible to report data electronically and in real time as soon as technologically practicable. Generally, reporting is expected to occur immediately after execution or confirmation.
Transactions executed on DCM or SEF are supposed to be reported by execution venues. Uncleared swap transactions or transactions that are not executed on SEF or DCM must also be reported to a registered SDR. The designated reporting party would typically be an SD or an MSP, based upon a hierarchy.
The hierarchy includes SD before MSP and MSP before the EU. In cases where neither party is an SD or an MSP (end-user to the end-user transaction), one of the counterparties would be designated as the reporting party to report transaction data to the appropriate SDR.
In addition to reporting, in the case of uncleared (bilateral) swaps, both parties of the swap must maintain detailed records of the swap data, which must be made available to the applicable regulators as required (as part of the record-keeping requirements under the act).
Block transactions or large notional swaps are exempted from some real-time reporting requirements, but they are still required to be disclosed after a certain period of time. By the rules, block trade size thresholds and reporting delays differ depending on the asset class (or sub-asset class swap category) method of execution and the status of the parties.
Under the act, the CFTC and SEC issue annual and semi-annual reports on market data for major swap categories including rate, credit, equity, and commodity swaps. In addition, SDRs makes limited data available to the public in real time. This data includes basic elements, such as swap prices and volumes.
Regulatory agencies require only a limited amount of transaction information to be reported, including terms most common to all standardized products. The CFTC and SEC publish data fields required to be reported and have the authority to enhance the scope.
To collect and track transaction data into a central repository, regulatory agencies have introduced three main unique key fields: Unique Counterparty Identifier (UCI) or Legal Entity Identifier (LEI), Unique Swap Identifier (USI) or Unique Trade Identifier (UTI), and Unique Product Identifier (UPI).
While the UCI is used to uniquely identify each market participant, the USI and UPI are used to identify each market transaction and the underlying product, respectively.
The USI is a two-part, alpha-numeric code that identifies a registered entity and swap transaction that facilitates tracking of positions and/or activity of traders across business units of single as well as multiple firms.
Note To learn more about these identifiers, visit the following online resources: www.ciciutility. org, Advocacy & Resources overview/, http://www2.isda.org/identifiers-and-otc-taxonomies/.
Trading Limits and Controls
Both the CFTC and SEC are given the authority to limit swap positions held by participants in their jurisdictions. These agencies impose aggregate position limits at participant levels, or at a level of a specific class of trades.
Furthermore, these agencies can also prohibit market participants to be involved in a swap transaction in a foreign country that may undermine the stability of the US financial system.
Counterparty details and position limits are regularly reported by DCOs, DCMs, and SEFs.
According to the Dodd-Frank Act, certain EUs are exempted from mandatory clearing and reporting requirements under the following conditions:
That an end user is not a financial end user
An end user is using the swap to hedge or mitigate commercial risk (as defined by the act)
An end user is notifying the appropriate regulatory agencies as to how it meets its financial obligations associated with entering into non-cleared swaps
However, to avoid the abuse of this exemption, the act also mandates that the exempted party is to be identified in reports to the corresponding SDR by the designated transaction reporting entity. In addition, some other rules, such as required annual filings, might be applicable for such exemptions.
In general, exempted end users are known as commercial end users. They include non-financial firms such as pension funds, institutions managing public debt, and commercial and manufacturing companies that use swaps to hedge or mitigate their business risks.
In addition to this exception, the act also grants many other exclusive exceptions and appropriate eligibility criteria to address the specific needs of the market participants.
All persons or entities that are not ESPs per the act are known as non-ESPs. These entities can enter into swaps only via an exchange (using exchange-traded products).
Business Conduct and Compliance
As a result of central clearing, risk is concentrated at the DCOs. In order to avoid this potential risk, regulators have introduced stringent risk management standards governing the operations, the conduct of business, and organizational and prudential requirements, so that DCOs manage their risk properly and avoid any financial system-wide crisis.
In addition to DCOs, all other major participants, such as SDs and MSPs, are also subject to rules governing business conduct, ethics, operations, and risk management practices. The act also introduces rules to mitigate conflicts of interest at DCOs, clearing members, exchanges, and SEFs.
All participants are required to monitor their own trading activity operations and risk management practices in order to ensure compliance.
The rules of the act require SDs and MSPs to maintain daily trading records of swaps. These daily records include recorded communications, such as electronic mail, instant messages, and recordings of telephone calls, daily trading records for each customer or counterparty, and a complete audit trail for conducting comprehensive and accurate trade reconstructions.
All EUs are required to keep full, complete, and systematic records, together with all pertinent data and memoranda, throughout the life of each swap and for five years following the termination or expiration of the swap.
The records can be kept in either paper or electronic form, as long as the records are retrievable upon request by the regulators within the prescribed timeline.
Both the CFTC and SEC are responsible to police the compliance with regulations in their jurisdictions. Both of these agencies have created or enhanced their enforcement groups or squads that are focused on their own respective areas. The primary objective of these groups is to monitor activities and investigate and prosecute any alleged violation.
The Dodd-Frank Act (under Section 716) also introduces the push-out rule or Lincoln rule. According to this rule, banking entities such as banks and other bank holding entities with access to federal government assistance (such as access to the Federal Reserve’s discount window or FDIC deposit insurance) are prohibited from engaging in many derivatives trading activities, with certain exemptions.
The Dodd-Frank Act (under Title VI) introduces the Volcker Rule, which prohibits and limits the ability of banking entities from engaging in certain derivatives activities. The Volcker Rule prohibits these entities from engaging in proprietary trading, and it limits their involvement in sponsoring and investing in private equity funds and hedge funds. However, the act provides certain exceptions to this rule.
Proprietary trading means trading for the firm’s own account. The ban on proprietary trading includes derivatives and other financial instruments that are identified by the CFTC, SEC, and appropriate federal banking agencies.
However, systemically significant non-banking financial entities are not prohibited from engaging in proprietary trading. Nonetheless, these companies are subject to additional capital requirements and quantitative limits enforced by the regulators.
Note The act designates and names certain non-banks as Systemically Important Financial Institutions (SIFI) based on the level of risk they pose to the financial system.
Applicability: US and Non-US Entities
In general, the Dodd-Frank Act is applicable to all US citizens and entities related to US persons who participate in financial markets. In the case of cross-border transactions and non-US entities, the act prescribes detailed criteria on the applicability of the law. In general, the law is applicable to all non-US citizens or entities that deal with a US citizen or that operate in a US swap market with a certain threshold of swap activity.
The act provides detailed definitions of US citizens, non-US citizens, and the thresholds of swap activity and all other details.
Dodd-Frank and Global Reforms
As a consequence of the 2007 financial crises, G20 countries are committed to implementing regulatory reforms that are in line with the Dodd-Frank Act to promote the stability of the global financial system and to ensure no regulatory arbitrage.
The Financial Stability Board (FSB), an international body working to promote financial stability, is taking the lead to coordinate the world’s major markets in order to bring their national level regulatory frameworks into line with each other. The FSB’s OTC Derivatives Working Group is responsible for providing recommendations and monitoring implementations.
The core principles agreed by these G20 countries are to improve transparency in the derivatives markets, mitigate systemic risk, protect against market abuse, standardize certain OTC derivatives, mandate trading on exchanges or electronic trading platforms where appropriate, mandate the central clearing of standard products, and transaction reporting to trade repositories. Furthermore, G20 countries have agreed on enforcing higher capital requirements for non-centrally cleared contracts.
In addition, agreements included that trade repositories should be subject to robust and consistently applied supervision, oversight, and regulatory standards that, at a minimum, meet evolving international standards developed jointly by the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO).
Next to Dodd-Frank, the major market reform regulations are EMIR and MiFID II in the European Union. Although EMIR is already effective, MiFID II is only going to be effective from sometime in 2015.
Global firms trading derivatives in multiple jurisdictions must understand regulatory requirements in both regions they operate out of separately and comply with any regulations that may apply. Although the overall objectives of these reforms are similar, the detailed requirements and implementations are not the same. For instance, the reporting requirements detailed under the EMIR are not the same as under Dodd-Frank. It follows that the firms must comply with each jurisdiction separately.
Note The Group of Twenty (G20) is the premier forum for international cooperation on the most critical issues of the global economic and financial agenda. The G20 brings together finance ministers and central bank governors from 19 countries: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, the Republic of Korea, Mexico, Russia, Saudi Arabia, South Africa, Turkey, the United Kingdom, the United States of America, and the European Union, which is represented by the president of the European Council and by the head of the European Central Bank. For more details visit G20 Argentina.
CPSS: CPSS is a standard-setting body for payment, clearing, and securities settlement systems. To learn more about CPSS, visit the Committee on Payments and Market Infrastructures (CPMI) - an overview.
IOSCO: IOSCO is a recognized global standard-setting body for the securities sector. It is working intensively with the G20 and FSB on the global regulatory reform agenda. To learn more, visit eNaming - Domain brokers.
The European Market Infrastructure Regulation (EMIR) is the European Union (EU) regulation that is similar to its Dodd-Frank US counterpart. The European Union (EU) has introduced OTC derivatives market reforms through the EMIR and MiFID II (explained in the next section).
In addition to EU swap market participants, the EMIR also applies to any entity established in the EU that has entered into (or is a legal counterparty to) a derivatives contract and applies indirectly to non-EU counterparties that are trading with EU parties.
Similar to Dodd-Frank, EMIR’s focus remains on the central clearing of certain OTC derivatives, stringent risk mitigation techniques for non-centrally cleared OTC derivatives, reporting to trade repositories, application of organization, conduct of business and prudential requirements for DCOs, and application of requirements for trade repositories—including the duty to make certain data available to the public and the relevant authorities. However, the implementation details of EMIR are different from Dodd-Frank.
In October 2011, the European Commission (EC) released its proposal to amend and extend the current Markets in Financial Instrument Directive (MiFID); it is referred to as MiFID II. This is expected to be effective beginning some-time in 2015.
In addition to revising the initial MiFID, MiFID II introduces a range of measures that seek to address issues raised by the financial crisis. These measures include improving investor protection as well as the commitments made by the G20 to improve the transparency and regulation of the more opaque markets, such as derivatives.
This reform covers broader financial markets, including derivatives. In respect to derivatives reform, MiFID II introduces derivatives execution requirements, reporting requirements, market structure rules, and other requirements. In summary, MiFID II is expected to fill the gaps between EMIR and Dodd-Frank, eventually leading a well-regulated financial system across the EU and in line with global reforms.
Basel II and Basel III
The Basel II accord was introduced in 2004 by the Basel Committee on Banking Supervision (BCBS). It recommends rules for enhancing credit risk measures, extending the scope of capital requirements to operational risk, providing various enhancements to the earlier accord (Basel I), and detailing the supervision and market discipline. The Basel II is essentially composed of three pillars: minimum capital requirements, supervisory review process, and market discipline.
The Basel III is the latest version, revising Basel II, introduced by the BCBS. After the 2008 financial crisis, the accord was drastically revised in respect to the various risk management aspects of the banking sector. In 2012, Basel III officially replaced Basel II.
Basel III is a comprehensive set of reform measures introduced to strengthen the regulation, supervision, and risk management of the banking sector. The key aspects of Basel III are increased quality, consistency, and transparency of the capital base, a framework to promote more resilient banks with counter-cyclical capital buffers, enhanced risk-based framework with the leverage ratio, and a new global liquidity standard.
Note The initial accord (Basel I) was defined by a group of regulators in Basel at the Bank for International Settlements (BIS), Switzerland, hence the name Basel Accord. To learn more about Basel III, visit Basel III: an international regulatory framework for banks.
The Dodd-Frank Act is the most substantive reform of the US financial system. It introduces many rules touching various parts of the financial system. This blog provided a summary of overall reforms and thoroughly discussed the reform of the derivatives business, which was covered under Title VII. In general, the Dodd-Frank Act imposes more stringent regulatory requirements on the larger financial institutions and critical market players, such as central clearing agencies, to reduce systemic risk.
The major areas related to derivatives impacted by the act are derivative product classification, trade execution via SEFs, central clearing mandate of standard swaps, MSP regulations (capital, liquidity, and leverage standards), and transaction reporting to swap data repositories. Finally, this blog briefly discussed global market reforms such as EMIR, MiFID II, and Basel III.