Dodd-Frank Act: Compliance with External Business Conduct Standards in the Derivatives Market
On April 17, 2012, the final Commodity Futures Trading Commission (CFTC) rules1 relating to external business conduct standards for swap dealers and major swap participants became effective. This action, required under Title VII of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), is meant to enhance transparency, reduce risk, and promote accountability in the over-the-counter (OTC) derivatives industry. The original compliance date, October 15, 2012, has since been extended to January 1, 2013, at which point market participants must meet a series of requirements, including extensive changes to documentation and other policies and procedures.
Under the CFTC rules, swap dealers (SDs) and major swap participants (MSPs) must obtain certain information in their dealings with counterparties before they can execute new swaps or amend existing ones. The rules require SDs and MSPs to verify the eligibility of counterparties and to provide additional disclosures. However, several concerns have emerged from the marketplace: Is it feasible to meet the deadline for collecting the information? Are counterparties aware of the rule and the options available to them? How will SDs and MSPs provide comprehensive and consistent pre-trade and post-trade disclosures?
For SDs and MSPs who wish to understand what they should consider focusing on when it comes to these external business conduct rules, here are five important observations.
Time is of the essence in collecting information from counterparties
SDs and MSPs have a short time in which to collect the necessary information from their counterparties on the buy side. If SDs and MSPs don’t obtain that data and perform due diligence by January 1, 2013, they will no longer be allowed to trade with those particular counterparties, which could affect the ability of end-users to hedge risk and, ultimately, the general market liquidity for OTC Derivatives. Some dealers are concerned that counterparties may not be fully aware of this requirement or understand what it compels them to do. Meanwhile, some counterparties may be reluctant to provide sensitive information to SDs and MSPs. Because the amount of information that SDs and MSPs must collect is significant, some think the task may be too difficult to accomplish by January 1.
Counterparties may not know about industry-developed mechanisms to help with compliance
The International Swaps and Derivatives Association (ISDA) recently finalized a new protocol2 designed to help market participants comply with external business conduct standards. Among other functions, the protocol can help counterparties provide the disclosure documentation that SDs and MSPs need to satisfy the “know your counterparty” requirement. Additionally, ISDA has developed an online tool that can help market participants make simultaneous changes to multiple master agreements and other contracts governing swaps. This online tool for addressing the new protocol may help participants comply with business conduct rules more quickly by streamlining processes and reducing duplicative efforts. However, some counterparties on the buy side may be largely unaware of the protocol and online tool. For that reason, education is a priority.
Data capacity may be affected as counterparty information is collected
SDs and MSPs will need to make sure they have the ability, including the infrastructure and personnel, to facilitate the acquisition, storage, and access of information they receive from counterparties under the new rules. This is a new requirement that SDs and MSPs did not have to account for when they designed their current systems. The amount of data they collect will likely depend on the number of agreements they have with counterparties, which could affect their capacity.
A consistent, general disclosure will be needed for daily marks
For any recorded position, SDs and MSPs must report an end-of-day mark – akin to a closing price –for that derivative. But some SDs and MSPs could have a hard time figuring out that daily mark since prices could vary based on counterparty agreements, position size, or other variables, for example. SDs and MSPs will need to disclose the underlying methodologies and material assumptions used to calculate the daily marks and scenarios. However, many are having difficulty in determining what information can be provided in a blanket or generic disclosure and what must be tailored for the counterparty on a case-by-case basis. Further complicating the matter, the end-of-day mark is an additional disclosure on top of the normal mark-to-market valuations that clients are used to seeing for daily collateral requirements.
Disclosures for intraday trades will take greater industry coordination
For uncleared swaps, SDs and MSPs are required to provide counterparties with the mid-market mark and to disclose the methodology and assumptions used to prepare it. While mid-market marks are essentially the midpoint between the bid and ask prices, SDs and MSPs must be able to distinguish the various components that make up these prices (e.g., hedging or funding costs) in order to disclose a value based solely on the derivative itself. Some dealers are having a hard time addressing that in a consistent manner across multiple asset classes. They are also working on an industry-wide approach to provide a consistent, effective way to deliver that information to counterparties, requiring extensive coordination with trade-execution vendors and other stakeholders.
Deloitte’s observations and high-level takeaways offer some valuable context and insight that swap dealers, major swap participants, and their counterparties can use to help them better understand and implement the complex rules and reforms – whether they’re about derivatives, capital and liquidity standards, or tax obligations. As rulemaking and other financial reform activities evolve and develop, Deloitte will continue to provide in-depth observations to help institutions better respond to this new regulatory environment. For more information, please visit us at Financial Regulatory
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1Federal Register, Volume 77 Issue 33 (Friday, February 17, 2012)
2 ISDA August 2012 DF Protocol overview is open from August 13, 2012, via the following link: http://www2.isda.org/functional-areas/protocol-management/protocol/8
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