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When the Commodity Futures Trading Commission (CFTC) created footnote 88 in the final US rules governing swap execution facilities (SEFs) – requiring all multi-lateral trading facilities to register as SEFs whether they trade regulated swaps or not – the prospect it would be closed on the day of the registration deadline was probably not on the agenda.
As it turns out, the US federal government shutdown, which started on October 1, is compounding an inherently confusing situation around these new rules. Inter-dealer brokers operating trading platforms are now caught in a regulatory vacuum created by whether they should have registered as SEFs by the October 2 deadline.
Market sources suggest the federal shutdown has forced the CFTC to slash its workforce from 600 to 30 at a crucial moment for Dodd-Frank implementation.
Moreover, the apparent implication that non-US trading platforms that trade with US persons will also need to register as SEFs under Dodd-Frank, regardless of whether local regulations will require it, raises the serious cross-border issue that foreign trading platforms will seek to remove US persons from their platforms while the uncertainty persists.
The combination of a tacit regulatory land-grab, historic compliance deadline and a central government shutdown has created a perfect storm for market participants. Indeed, if the potential consequences for cross-border regulatory harmonization and derivatives market liquidity werent so serious, this situation would be hilarious.
Stu Taylor, founder and chief executive of Algomi, a London-based financial technology company, says that although European financial regulators successfully managed a similar crisis in July when the European Commission and the CFTC were able to reach an 11th-hour agreement on European Market Infrastructure Regulation and Dodd-Frank harmonization, the current situation is much more challenging.
The CFTC are basically insisting that firms beyond the US territory now fall into their jurisdiction, and European regulators are saying they dont agree and are asking for last-minute talks, he says.
The Europeans have managed similar situations before, but now we have the US shutdown, which has undermined the capacity for negotiation. [Chairman Gary] Gensler and the CFTC are running on a skeleton staff. European market participants and inter-dealer brokers are scrabbling around trying to find out what they should be doing.
Although law firms have been inundated with advice requests from market participants, SEF providers and multi-lateral trading facility providers, without an official response from the CFTC and an effort to engage with European regulators over the practical implications of footnote 88, the benefits of legal advice are limited.
According to James Schwartz, a derivatives attorney with law firm Morrison & Foerster LLP in New York, what might appear to be a regulatory land-grab by the CFTC is at least partly a consequence of the fact the US regulator is more advanced in its rule writing and implementation than its peers in other main jurisdictions.
There is a very practical issue that underlies a lot of the extra-territorial complications arising from Dodd-Frank, especially in light of the CFTCs stated view that comparable rules from other jurisdictions may apply to certain transactions involving entities with links to the US, says Schwartz.
The CFTC is significantly ahead of its counterparts in other jurisdictions. That is an issue for a very international, cross-border market like the derivatives market. One regulator trying to implement rules ahead of the others has the potential to fragment or disrupt the swaps market significantly, as it appears [European] Commissioner [Michel] Barnier has recognized.
Anecdotally, there are reports that European platforms that provide anonymous trading are becoming sensitive to the risk that they are trading with US persons under Dodd-Frank. Although none has barred US-related participants from trading yet, conversations around the issue are taking place, sources say.
While participants wait for better-resourced US regulatory agencies to clarify their position on foreign market platforms, the risk is that cross-border derivatives trades between US institutions and non-US counterparties will cease to happen and liquidity will shift into European markets.
The only real business hedge against the uncertainty is to restrict derivatives trading to European counterparties and markets, says Algomis Taylor. Over the short-run, if the government shutdown persists for another week, we expect to see liquidity concentrate within Europe and you might have some more strict enforcement, with US counterparties being pushed off platforms.
When liquidity is shocked, it can move very quickly.
Perversely, by being one year ahead of the global regulatory curve, the CFTC has increased short-term risks to US derivatives participants.