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Today the world of Swap Execution Facilities has arrived, and the last material piece of Title VII is now in place amidst the complex mosaic of derivatives reform that began in the United States with the passage of Dodd Frank in 2010. In the words of CFTC Chairman Gary Gensler, "a paradigm shift" has occurred.
But when we step back and view the virtually completed mosaic of our new derivatives laws and regulations what do we have? Do we have a completed puzzle that matches the promised picture on the front of the box, or do we have something different, something that seems more like a Pablo Picasso abstract rendition?
Unfortunately, the first problem is that the arrival of SEFs comes today amidst the rubble of a shut down Federal government and a US Congress in total disarray, with most of the CFTC staff on temporary furlough. As a result, potential important relief requested by Michel Barnier, financial services commissioner for the European Union, to enable multilateral trade execution facilities based in Europe that might otherwise be required to register as SEFs to continue to do business with US persons for at least five months, was not granted, and perhaps could not be granted because of the absence of working CFTC personnel. This request apparently was not addressed before the CFTC closed its doors, despite a flurry of other guidance and no action relief that hastily was issued within the prior few days (often late at night) to accommodate today's SEF roll-out.
However, a bigger issue with Dodd Frank is that it failed effectively to address a significant contributor to the problems of 2008 in any case: the pillared regulation of financial services in the US -- even where relevant products are fungible and market participants are the same -- particularly in connection with futures and securities. Yes, investment banks and ordinary banks failed and required bailouts because of a myriad of reasons that justified most of the laudatory objectives of Dodd Frank, but there was also substantial investment fraud that year too (as there has been since), that seems to have been caught in cracks caused by mostly uncoordinated US regulatory oversight of financial services. Let's not forget that, during 2008, while FINRA reviewed the activities of Bernard Madoff's broker dealer downstairs – which appeared fine – dramatic fraud was occurring upstairs within the walls of the affiliated investment adviser where only the SEC and the states had oversight. Then, shortly after Madoff's house of cards collapsed, Allen Stanford's corrupt practices were also ended in early 2009. And just a few years later, in 2011, MF Global, a combined broker dealer regulated by the SEC and futures commission merchant regulated by the CFTC, collapsed after misusing customer funds.
The response of Congress to all this -- to a complex system of regulation that saw securities regulated by one Federal agency, the SEC (and individual states too); of futures by another, the CFTC; of options and certain hybrid securities and futures products both by the CFTC and/or the SEC; and over the counter derivatives by none -- was to create in the US a third distinct Federal pillar of regulation for swaps, and bifurcate the responsibility for that regulation within the two existing pillars of the SEC and CFTC. (In fairness, Congress did establish the Financial Stability Oversight Council as an overseer of all US financial regulators, but it is not a primary regulator.)
Now, finally, after more than three years following the passage of Dodd Frank, and in the fifth year following the financial crisis of 2008, we finally have in place comprehensive oversight of what once were exclusively OTC derivatives -- at least to the extent they fall within the jurisdiction of the CFTC -- plus or minus a few exemptions and no action letters (by current count, more than 100).
And let's not forget the many agitated non-US regulators who are rightfully dismayed by the efforts of the CFTC not only to regulate within its own borders, but extraterritorially too. The CFTC has justified this, relying on language in Title VII giving it authority where overseas activity has a "direct and significant impact" on activities or commerce in the United States but sometimes forgetting its equally mandatory obligation under Title VII to consult and coordinate with foreign regulatory authorities "…to promote [the] effective and consistent global regulation of swaps" too.
For all this work what precisely do we get: phased-in mandatory central clearing and execution on transparent, regulated platforms for the most liquid swaps, reporting of all swaps transactions; registration of big swaps' traders; daily marking and margin calls; and differential capital requirements for dealers engaging in cleared or uncleared swaps transactions (except to the extent international financial regulators enact capital and liquidity standards that actually may penalize banks for engaging in cleared transactions).
Moreover, we also obtained loose standards of fraud-based manipulation that authorize the CFTC to prosecute manipulation without showing intent or an effect on price, no matter where in the world such problems may occur (even if solely involving non-US persons), or even if the local non-US regulator is already on the case prosecuting the wrong-doers.
But let's be frank (without Dodd): we probably could have gotten all this and more had Congress taken a simpler and more coherent route back in 2010 -- namely (1) build upon the futures regulatory structure already embodied in existing law to regulate futures' close cousin, swaps; and once and for all (2) collapse the CFTC and the SEC into one coherent financial services regulator of all futures, securities and swaps. Indeed, the current debate about futurization suggests that market forces likely will drive swaps and futures regulation to a common plain in any case, but only after much pain and financial expenditure.
However, the same gridlock deriving from the same indifference to holistic solutions that we see played out on the front pages of our newspapers today in connection with far bigger issues, played out in 2010, and instead of enacting something simpler yet more dramatic and comprehensive, our elected representatives adopted legislation drowned in minutiae that has now taken countless hours by both government and private sector employees to implement, let alone even understand -- with even more regulations (and guidance and no action letters) to come. And to think the alternative might have been far less expensive to implement too, saving taxpayer dollars now and in the future.
But today, we have SEFs – which hopefully will be the final material puzzle piece to help accomplish all the goals envisioned by Title VII. But could we have accomplished these goals more coherently and even faster with less dislocation and anguish, obtaining a completed puzzle more like the picture on the box? We will never know for sure, but we can speculate (provided not in a high frequency kind of way).
The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of October 2, 2013, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.
Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office.
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Gary DeWaal
Katten Muchin Rosenman
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1 (212) 940-6558
Today There Are SEFs: The Final Piece in a Pablo Picasso Abstract Rendition of Effective Swaps Regulation?
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