On July 20, 2015, the International Swaps and Derivatives Association (ISDA) published a briefing note discussing significant achievements and outstanding challenges in the process of implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) derivatives market reforms.

ISDA identifies the following areas of progress:

  1. Clearing:
    1. Dodd-Frank Act Requirement: The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) have the authority to mandate clearing for a derivatives class, so long as it is accepted for clearing by a clearing entity. Under the Dodd-Frank Act framework, the SEC is given regulatory authority over “security-based swaps,” the CFTC has regulatory authority over “swaps,” and the CFTC and the SEC share authority over “mixed swaps.”
    2. Progress: In 2013, the CFTC’s first clearing mandates for certain interest rate and credit derivatives classes came into force. Since then, significant progresses have been made and central clearing is now well established.
    3. ISDA SwapsInfo Data (DTCC/Bloomberg SDRs): During the first half of 2015,
      • 75% of average daily interest rate derivatives notional volume was cleared, compared to 76.5% over the course of 2014, and 57.9% in the first quarter of 2013 before the US clearing mandates came into force (see Chart 1 at p.3); and
      • 78% of average daily credit default swap (CDS) index notional volume was cleared, compared to 74.7% over the course of 2014 (see Chart 2 at p.4).
  2. Trade Execution:
    1. Dodd-Frank Act Requirement: Derivatives instruments subject to clearing mandate must be traded on a regulated exchange or a swap execution facility (SEF), so long as those instruments are made available to trade (MAT) by an exchange or a SEF.
    2. Progress: The CFTC’s SEF rules were introduced in 2013, and the first interest rate and credit derivatives products that classified as MAT were required to be traded on these venues in 2014. Since then, the proportion of derivatives transactions executed on these platforms has increased rapidly both in the interest rate and the credit derivatives sectors.
    3. ISDA SwapsInfo Data (DTCC/Bloomberg SDRs): During the first six months of the 2015,
      • 55% of average daily interest rate derivatives notional volume was traded on a SEF, compared to 52.4% in 2014 (see Chart 3 at p.5); and
      • 69% of average daily CDS index notional volume was traded on a SEF, compared to 62.5% over the whole of 2014 (see Chart 4 at p.6).
  3. Reporting:
    1. Dodd-Frank Act Requirement: Information relating to swap transactions must be reported to an authorized swap data repository (SDR) for regulatory reporting. Certain transaction and pricing data also has to be reported to a SDR and made publicly available.
    2. Progress: The first US reporting obligations for swaps came into force at the end of 2012. By the end of 2013, all traded swaps instruments were required to be reported under CFTC rules. As a result, regulators can now scrutinize individual trades and counterparties, and aggregate data to analyze broader trends and/or market concentrations that may pose systemic risk.
  4. Regulation of Swap Dealers (SDs) and Major Swap Participants (MSPs):
    1. Dodd-Frank Act Requirement: Swap market participants that qualify as SD or MSP must register with the CFTC. SDs and MSPs are subject to a variety of requirements relating to external and internal business conduct, capital, margin, reporting and record keeping.
    2. Progress: US margin rules for non-cleared derivatives are close to finalization. The Basel III capital rules are phased in gradually from 2013 to 2019.
    3. CFTC Data: CFTC provisional registrations as of June 25, 2015 (see Table 1 at p.8): SD = 104; MSP = 1; SEF = 21; and SDR = 4.

ISDA outlines new challenges that have emerged and certain areas that need to be reassessed, as follows:

  1. Cross-Border Harmonization:
    1. Outstanding Issue:
      • Divergences have emerged in the timing and substance of national derivatives regulations.
      • These divergences have exposed derivatives users to multiple and potentially inconsistent requirements, thus derivatives users are now increasingly choosing to trade with counterparties in their own jurisdictions.
      • These divergences have also led to fragmentation of liquidity pools along geographic lines, which ultimately reduces choice, increases costs, and could make it more challenging for end users to enter into or unwind large transactions, particularly in stressed market conditions.
    2. ISDA Data (LCH.Clearnet): A change in interest rate swap trading behavior has emerged, which has coincided with the introduction of US SEF rules. Non-US entities tend to avoid trading mandated products with US counterparties, so as not to be required to trade on a CFTC-registered SEF that offers restrictive methods of execution for these instruments. The most liquid pool for euro interest rate swaps has developed away from SEFs and remains centered in Europe, thereby denying access to those US derivatives participants restricted to trading on SEFs. ISDA research indicates that (see Chart 5 at p. 9):
      • 4% of regional European interdealer volume in euro interest rate swaps was traded between European dealers in the third quarter of 2013; and
      • 7% of regional European interdealer volume in euro interest rate swaps was traded between European dealers in the fourth quarter of 2014.
    3. ISDA Proposals: To help minimize the problems caused by cross-border discrepancies, ISDA suggests:
      • Harmonization of rule sets, particularly with respect to clearing, trading and reporting;
      • Allowing US counterparties to apply overseas rules when trading in non-domestic jurisdictions, so long as the overseas regulatory regime is deemed to be equivalent to US regulations; and
      • Implementation of a transparent substituted compliance mechanism based on broad outcomes.
  2. Clearing:
    1. Outstanding Issue: Central counterparties (CCPs) have become a systemically important part of the derivatives market infrastructure.
    2. ISDA Proposals: ISDA indicates that more work is needed to strengthen CCP resiliency, with focus on:
      • Greater transparency on margin methodologies and minimum standards for stress tests; and
      • Acceptable CCP recovery mechanism and resolution processes not involving the use of public money.
  3. Commercial End Users:
    1. Outstanding Issue: Although the CFTC has issued no-action relief, there is uncertainty as whether commercial end users that utilize centralized treasury units (CTUs) to net and consolidate their hedging activities would be eligible for clearing exemption.
    2. ISDA Proposals: ISDA encourages legislation action to clarify that end users that hedge their risk through CTUs are not denied clearing exemption.
  4. Trade Execution
    1. Outstanding Issue: Limited trading on US SEFs and emergence of cross-border incongruities.
    2. ISDA Proposals: To encourage more trading on US SEFs and help facilitate cross-border harmonization, ISDA suggests that regulators should adopt:
      • Targeted amendments to US SEF rules, including allowing greater flexibility in execution mechanisms under certain circumstances; and
      • Changes to the MAT determinations process and block trade rules.
  5. Reporting
    1. Outstanding Issue: It is difficult for regulators to gain an accurate and comprehensive picture of global risk exposures and possible concentrations due to significant differences in reporting requirements within and across jurisdictions.
    2. ISDA Proposals: ISDA calls for:
      • Regulators across the globe to identify and agree on the trade data they need to fulfill their supervisory responsibilities, and then issue consistent reporting requirements across jurisdictions;
      • A repeal of SDR indemnification requirements under the Dodd-Frank Act to facilitate cross-border sharing of information and data; and
      • The industry and regulators to collaborate to develop and adopt standardized product and transaction identifiers, as well as reporting formats.
  6. Regulation of SDs and MSPs
    1. Outstanding Issue: All SD, MSP, SEF and SDR registrations are still provisional.
    2. ISDA Proposals: ISDA suggests that the CFTC should provide final registration to SDs, MSPs, SEFs and SDRs to end regulatory uncertainty.
  7. Margin
    1. Outstanding Issue: Uncertainty in the rules and cross-border incongruities.
    2. ISDA Proposals: ISDA believes is time to focus on:
      • Finalizing the non-cleared derivatives margin rules as soon as possible to maximize the time for preparation and to progress the implementation efforts by the industry; and
      • Achieving global consistency in the rule sets.
  8. Capital
    1. Outstanding Issue: Uncertainty in the rules and cross-border incongruities.
    2. ISDA Proposals: ISDA suggests that:
      • Capital rules should be globally consistent to prevent financial institutions and non-financial corporates in one jurisdiction being put at a competitive disadvantage;
      • Regulation should be coherent and appropriate to the risk of a given activity; and
      • How each regulatory component interacts with other regulatory components should be comprehensively assessed to ensure the cumulative impact is fully understood to avoid excessively high financing costs for borrowers and increased hedging costs for end users.

ISDA’s Briefing Note “The Dodd-Frank Act: Five Years On” is available at ISDA’s public website – ISDA Focus: Dodd-Frank section (http://www2.isda.org/dodd-frank/).