Wednesday, January 6, 2010

Cracks in transatlantic derivatives rules

Original posted in the Financial Times by Jeremy Grant, Tom Braithwaite and Aline van Duyn:

As US lawmakers and European bureaucrats return to work after the holidays, one of their top priorities will be to finalise new rules to deal with the derivatives instruments that proved so destabilising during the financial crisis.

Yet seven months after the US kick-started sweeping reforms of the privately negotiated – or over-the-counter – derivatives markets, there are signs that the US and Europe are diverging in their approach.

That matters because ever since policymakers on both sides of the Atlantic started to address the issue they have insisted that a streamlined, global approach is crucial to avoid market participants picking and choosing where to conduct their business in a process known as “regulatory arbitrage”.

The OTC markets make up a huge part of the financial system, dwarfing exchange-traded futures and options markets. That gives them importance to the wider financial system, a point dramatically highlighted when Lehman Brothers collapsed in 2008, leaving many OTC trades incomplete and causing panic.

There is broad agreement between Washington and Brussels that OTC derivatives must be shifted from – in the words of a European Commission policy document produced in October – “predominantly OTC bilateral to more centralised clearing and trading”.

The aim is to introduce safeguards should participants default, spreading “counterparty risk” throughout the financial system. A clearing house guarantees that trades are completed even if one party defaults.

A bill finalised last month by the House of Representatives mandates the clearing of OTC derivatives that a clearing house will accept for clearing and which regulators believe should be cleared.

The US is far from finalising a new regime for OTC derivatives since the Senate has yet to agree its own version of the House bill. But already the US is seen as taking a more “prescriptive” approach, where Europe is more “consultative”, according to Edmund Parker, head of the derivatives practice at law firm Mayer Brown in London.

The Brussels proposals are more broad-brush and less specific, conceding that any new policy should “duly take into account the specificities of the asset class involved”.

Mr Parker says: “They are looking at this as ‘this is the regulation we want to have in place’ rather than the EU approach which is ‘here are the sort of things we want to cover and we’ll look to implement only following wider consultation’.”

One possibility for regulatory arbitrage centres on the issue of capital charges on OTC derivatives that end up not being cleared.

David Clark, chairman of the Wholesale Market Brokers Association, representing inter-dealer brokers in the OTC markets, says: “Should there be a disparity between levels of capital charges, market participants will simply move to the business centre with lower capital charges.”

Such issues will be highlighted on Wednesday when more than 160 European companies write to Brussels asking to be exempted from a requirement that OTC derivatives be cleared.

Richard Raeburn, chairman of the European Association of Corporate Treasurers, which is leading the call, says companies are taking advantage of a more consultative approach by Brussels to secure concessions, fearful that the US could take a tough line.

In the US, the Senate draft version is “largely based” on the Treasury and House versions, notes Davis Polk, a law firm, and “creates a strong presumption of clearing of all swaps”.

Although the Senate banking committee is due to overhaul its first attempt at financial reform, led by Chris Dodd, banking committee chairman, there is little chance that the broad outlines will be altered dramatically.

That has already led large end-users of derivatives and the banks that service them to look abroad for less prescriptive examples. Some derivatives industry lobbyists in Washington say they are hopeful that the Europeans will take a more deliberate thoughtful approach.

The British approach to OTC derivatives reform, spelled out in a report by the Financial Services Authority and Treasury last month, is being seen as the first attempt to analyse the consequences of forcing OTC derivatives into clearing houses. It cautions against too much clearing given the systemic importance of clearing houses.

One reason why the US is perceived as more prescriptive is that the US legislative process – involving more sophisticated lobbying by special interests than in Europe – means there is more scope for provisions to be inserted into legislation, often at the last minute.

For example, a provision in the House bill limiting bank ownership of clearing houses to 20 per cent is not even under discussion in Brussels.

If the US and Europe do end up diverging on key issues, another danger emerges. Other countries such as Japan, India and South Korea are embarking on their own OTC derivatives reforms. Yet regulation there is a wild card, especially if the US and Europe cannot agree a benchmark to follow.

“An open question remains about what happens to regulation in newer markets in Asia,” says Joel Telpner, partner at Jones Day. “We are hopeful that new regulations will be consistent with efforts in the US and Europe, but we do not know that yet for sure.”

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