Dodd-Frank Act Two-Year Anniversary
Five takeaways on Dodd-Frank’s impact on derivatives
As we approach the two-year anniversary of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), it’s worth pausing for a moment to take stock of how it has already influenced the financial services and banking industries, and what may lie ahead. Today, its full impact remains to be seen – financial services institutions are still grappling with the enormity and complexity of the 2,300-page law. And regulators from numerous federal agencies are still writing many of the rules that are anticipated to affect different corners of the industry, which may contribute to uncertainty.
At the same time, after two years its impact has become clearer. For example, Title VII of the Dodd-Frank Act is designed to provide a comprehensive framework for the regulation of the over-the-counter (OTC) derivatives market. The intent is to provide greater transparency and centralization to reduce risk between counterparties. These rules will subject swap dealers and major swap participants to capital and margin requirements. The rules will also require many derivatives to be traded electronically on swap execution facilities or exchanges, reported to swap data repositories, and cleared through clearinghouses. But as regulation ramps up, the infrastructure, workflows, and even the language used within the industry are changing significantly. As a result, many participants are uncertain about the future of the industry and the impact these rules are likely to have on their business and compliance processes and profitability.
For financial services executives working to understand where they should be focusing when it comes to derivatives issues in the age of Dodd-Frank, here are five important observations.
Uncertainty looms over the extraterritorial scope and reach of the regulations
Many financial institutions appear to be struggling with the extraterritorial scope of the provisions – specifically how these rules will be applied across borders and to what extent they will cover the U.S. operations of foreign firms (and vice versa). Under the statute, firms cannot avoid regulations by simply moving offshore and are likely to be subject to foreign compliance requirements if they do. U.S. swap rules may even apply to non-U.S. entities, such as swap dealers, that do business with U.S. persons or entities. As other countries roll out their version of derivatives reform, those entities may become subject to conflicting sets of regulations governing the same transactions.
Compliance deadlines are unsettled
As many financial institutions deal both in interest rate and credit default swaps, they will have to register with both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The SEC has authority over security-based swaps, while the CFTC has jurisdiction over all other swaps. Both agencies have been missing statutory deadlines and both have published compliance time line extensions. The two agencies have also been proposing and adopting rules at a different pace, creating much uncertainty around when affected institutions will in fact have to comply.
While both agencies have accepted a provisional registration scheme, the SEC has been taking a more deliberate approach in introducing and finalizing swap dealer rules. It has also proposed to postpone compliance with all of the rules before requiring compliance with any of them. Meanwhile, the CFTC appears to be more aggressive – not only in its pace to adopt final rules, but also in its approach for compliance.
Establish processes and infrastructure that serve long-term needs
Financial institutions may have a short time frame in which to become compliant with regulations once they are finalized and deadlines are established. As a result, they may create ad hoc infrastructures and processes that aren’t sustainable over the long term, after initial compliance requirements are met. For example, firms that are developing reporting engines in response to new regulations may not have had the time to build in the necessary processes. Subsequently, they may find themselves continually cleaning up and resubmitting data – a heavily manual approach that could prove burdensome as the volume of information increases. Firms should look to build infrastructure and processes that allow them to remain compliant with less effort in the long run.
Identify market differentiators and competitive advantages
Dealers may be able to offer different pricing alternatives for products depending on where they will be cleared. Pricing differences may result from differing initial margin and variation margin rules for each counterparty clearing house (CCP). Because clearing interconnectivity is unlikely to occur soon (and may be difficult to achieve without intervention from regulators), dealers could potentially exploit pricing differences for a fee or spread. Without interconnectivity, it is likely that each central clearer will develop liquidity in certain products. Attracting additional flow by exploiting these differences will help offset some of the additional costs related to becoming members of multiple CCPs, including clearing deposits and fees.
Mitigate credit risk while reducing costs and improving efficiency with collateral management
With increased pressure on liquidity and firm profitability, swap dealers will be looking to expand collateral services to attract additional trading, clearing, and financing activity. To achieve this goal, institutions should have an enterprise-wide view of their collateral pools, which may allow them to offer their clients the ability to transform collateral that is not eligible to meet margin requirements and replace it with collateral that is using inventory available internally. An enterprise view of collateral can also support efficiency and profitability targets by optimizing the allocation of assets against collateral requirements and minimizing funding costs through re-use of available collateral.
Institutions are responding to these trends by creating integrated technology solutions, consolidating collateral management functions, developing collateral optimization algorithms and collateral hierarchies, and identifying cross-product margining and netting opportunities across legal entities.
Because there’s a lot more to know about the Dodd-Frank Act, these takeaways are presented as part of a series of issue-focused insights into the impact of this legislation. In the coming days, Deloitte will release a more in-depth look at the law’s potential implications in other areas such as the Volcker Rule and living wills. Deloitte has released takeaways on compensation, stress testing, and consumer protection. For more information, please visit us at Financial Regulatory.
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