New Financial Markets Regulation

Chapter 7
New Financial Markets Regulation

Introduction

The reform proposals discussed in Chapter 6 led to the development of new regulatory initiatives in the United States, the United Kingdom and other jurisdictions. The financial markets regulatory reforms in the US and the UK represented a comprehensive response to the financial crisis. The introduction of the Dodd-Frank Wall Street Reform and Consumer Protection Act 20101 in the US heralded a new era for the comprehensive regulation of financial markets, financial products and financial intermediaries. The Dodd-Frank Act 2010 also introduced groundbreaking reforms for consumers of financial services and residential mortgages.

The Dodd-Frank Act 2010 implemented many of the reforms that were proposed by a number of regulators, including the US Federal Reserve, the US Securities Exchange Commission, the Commodities and Futures Trading Commission, the US Department of the Treasury and the Office of the Comptroller of the Currency. The reforms were designed to provide enhanced regulation and supervision of financial markets and financial intermediaries in the US. Most notably, the Act provides for comprehensive regulation of credit default swaps and centralized clearing of OTC derivatives contracts.

The Dodd-Frank Act 2010 established the Financial Stability Oversight Council (FSOC) to provide supervision and regulation of non-bank financial institutions. The Financial Stability Council will also be responsible for providing up-to-date research and information concerning the activities and financial condition of banks, including non-bank financial entities that have total consolidated assets of $US50 million. In addition to these new initiatives the Act also introduced new measures designed to regulate the activities of advisers to hedge funds, including private equity fund managers and investment banks.

Significantly, the Dodd-Frank Act 2010 also introduced comprehensive measures to provide greater investor protection. One of these reforms included establishing a new Office of the Investor Advocate, which has the responsibility of representing and promoting the interests of aggrieved retail investors. The Act introduced comprehensive reforms designed to improve financial protection to consumers of financial products, financial services and financial markets. To achieve the stated aim of improving consumer protection, the Act established the Bureau of Consumer Financial Protection, providing the Bureau with a legal mandate to investigate allegations of consumer abuse.

New legislation similar to the Dodd-Frank Act 2010 has also been introduced in the UK in the form of the Financial Services Act 2010 (UK).2 The FSA 2010 introduces new measures aimed at protecting consumers, including providing them with compensation and redress if they have suffered loss or damage. Importantly, the FSA 2010 also introduces the new objective of promoting the financial stability of the UK financial system.

Both Acts are consistent with the overall objective of improving the way financial markets, financial products and financial intermediaries are regulated and supervised in the US and the UK. At the centre of both legislative initiatives are the twin objectives of promoting financial stability and providing adequate protection to consumers and investors in financial markets.

The Dodd-Frank Wall Street Reform and Consumer Protection Act 2010

President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010. The Act was a joint effort of Congressmen Barney Frank and Senator Chris Dodd. The legislation represented the responses of the House and Senate to the global financial crisis. The Act introduced sweeping reforms to the US financial architecture, including new regulation for OTC derivatives.

Regulation of OTC Swaps Markets

As is discussed in Chapter 2, OTC derivatives, including credit default swaps, synthetic derivatives and structured financial products, played a significant role in the current crisis. Credit default swaps had previously been largely unregulated and not subject to supervisory oversight by the Security Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC). The use of financial instruments such as credit default swaps also introduced potential conflicts of interest for hedge fund advisers and investment bankers.

The conflicts of interest were the subject of much enquiry and investigation by the US Senate Subcommittee into Wall Street and the Financial Crisis.3 It was alleged by the US Senate enquiry that conflicts of interest existed because investment banks would often take opposite positions to the clients they had been advising. The use of structured financial products, including credit default swaps, was often used to alter the risk profile of residential mortgage-backed securities so that the security would attract a higher investment rating.

The Dodd-Frank Act 2010 considered that the time had come to regulate all OTC swaps markets and all financial intermediaries dealing in OTC derivatives. The definition of “swap,”4 and “swap dealer” under the Dodd-Frank Act 2010 had the same definition as under the Commodity Exchange Act 1936.5 Congress and the US Senate were also clearly of the view that before any rule-making would take place, the SEC and the CFTC would consult with each other and with any other regulator so as to achieve regulatory consistency and comparability.6

The issue of regulatory consistency was important given the previous history of disagreements and turf wars between the two regulators. Regulatory consistency was to be achieved as far as possible in relation to any new rule or order that was issued by the SEC or CFTC in relation to “swaps, swap dealers, derivative clearing organizations with regard to swap, eligible contract participants,”7 including “security-based swap dealers, security-based swap participants, major security-based swap participants, eligible contract participants with regard to security-based swaps, or security-based swap execution facilities,”8 and “mixed” swaps.9

The Dodd-Frank Act 2010 also confirmed existing limitations on the jurisdiction and authority of the CFTC to makes rules or orders for: security-based swaps,10 activities or functions concerning security-based swaps,11 security-based swap dealers,12 major security-based swap participants,13 security-based swap data repositories,14 associated persons of a security-based swap dealer or major security-based swap participant,15 eligible contract participants with respect to security-based swaps16 and swap execution facilities with respect to security-based swaps.17

The Act also confirmed existing limitations on the jurisdiction of the SEC to regulate and make rules or impose orders with respect to: swaps,18 rules and orders in relation to activities or functions concerning swap dealers,19 major swap participants,20 swap data repositories,21 persons associated with a swap dealer or major swap participant,22 eligible contract participants with respect to swaps23 and swap execution facilities with respect to swaps.24

The limitations imposed on the SEC and CFTC jurisdictions were to ensure that there would be no confusion over the roles and responsibilities of each regulator. In effect, exclusive jurisdiction would be conferred on the CFTC over the regulation of OTC swaps markets except in the case of securities-based swaps, which would remain under the scope and ambit of the SEC. In relation to “mixed swaps,”25 the SEC and the CFTC would be required to consult with each other and the Board of Governors to ensure that any rules or orders were jointly issued.26

The Dodd-Frank Act 2010 also made provision for the possibility that agreement could not be reached by the CFTC and the SEC to jointly prescribe rules and regulations in a timely manner in relation to their joint rule-making authority. The Act provided that the FSOC would have authority to resolve any dispute involving joint rule-making within a reasonable time of a request being made.27

Importantly, the Dodd-Frank Act 2010 arms the CFTC and the SEC with legal authority to deal with any “abusive swaps.” The term “abusive swaps” is defined in Section 714 to include any types of swaps or security-based swaps that the Commodity Futures Trading Commission or the Security Exchange Commission considers “detrimental to – (A) the stability of a financial market; or (B) participants in a financial market.” Section 714 provides legal authority to either the CFTC or the SEC to collect all relevant information as may be necessary and to issue a report with respect to the abusive swaps.

The Act goes further to give authority to the CFTC and the SEC to undertake a joint study in relation to OTC swap regulation in the United States, Asia and Europe. The joint report aims to provide detailed information on clearing house and clearing agency regulation in the United States, Asia and Europe. The report must also contain information which identifies areas of regulation around the world that are similar in the United States, Asia and Europe, including other areas of regulation that can be harmonized.28

The purpose of the joint report is to evaluate the costs and benefits of harmonizing US regulation of OTC swaps with swaps regulation from other jurisdictions. By harmonizing regulation, not only is the objective of regulatory consistency achieved but the problem of regulatory arbitrage is also overcome. In essence, if all of the world’s OTC swaps markets are harmonized from a regulatory perspective there is little or no incentive for financial intermediaries to engage in “regulatory window shopping.” This is because regulation would be the same in all jurisdictions, thereby curtailing the incentive for financial intermediaries to transact in lower-cost jurisdictions.

Systemic Risk Swaps

The Dodd-Frank Act 2010 also introduced heightened regulation for institutions that pose systemic risk. All swap entities that pose systemic risk to the US financial sector will be subject to heightened prudential supervision.29 Not only will entities which pose a systemic risk to the United States be subject to heightened prudential supervision and regulation but also any firm that is placed into receivership or declared insolvent as a result of swap or security-based swap activity will not receive taxpayer funds.30

The prohibition of the use of taxpayer funds for any potential bailout is an obvious change in US government policy, which had previously allowed the use of taxpayer funds to prevent a liquidation or for government-sponsored bailouts. Section 716 of the Act makes the prohibition clear and goes further, prohibiting any “federal assistance”31 for government-sponsored bailouts of any swap entity or security-based swap entity or activity.32 The prohibition of any bailout of swap entities follows the widespread public outcry over the bailouts of Wall Street investment banks and hedge funds at the height of the crisis.

In addition to the prohibition on government-sponsored bailouts of swap entities and security-based swap entities, a ban on proprietary trading in derivatives has also been imposed by Section 716(m) of the Dodd-Frank Act 2010.33 The ban on proprietary trading in derivatives puts into place the so-called Volcker Rule.34 Section 619 of the Dodd-Frank Act 2010 implements the Volcker Rule to prohibit “banking entities from engaging in proprietary trading or from investing in, sponsoring, or having certain relationships with a hedge fund or private equity fund.”35

Standardized Algorithmic Models

Another important initiative of the Dodd-Frank Act 2010 was the proposal to commission a joint study by the SEC and the CFTC to investigate the use of standardized computer-readable algorithmic descriptions.36 The objective of the proposed study is to assess whether standardized computer-readable algorithms can be used to describe both complex and standardized financial derivatives.37 The study will also examine the extent to which the algorithmic descriptions, along with standardized legal definitions, may be used as binding legal definitions for derivatives contracts.38

The use of standardized and computer-readable algorithms for complex and standardized financial derivatives is an attempt to improve the understandability and transparency of valuations and payment obligations. During the height of the financial crisis, questions were asked as to whether certain financial derivatives had become overly complex, causing confusion and uncertainty among end-users.

The former Federal Reserve Chairman, Alan Greenspan, noted the complexities and non-transparent nature of complex financial derivatives. According to his testimony, the mathematical and algorithmic models used to value and construct payment obligations for financial derivatives may not have been sufficiently accurate to properly quantify risk:

It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts, supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.39

A detailed examination of whether algorithms failed to properly take into account the risks involved with the use of complex financial derivatives during the global financial crisis may provide important new directions. Hence, a study that investigates their use as provided by the Dodd-Frank Act 2010 should provide greater clarity for valuation models used to price financial derivatives.

If it is the case that mathematical models have incorrectly priced risk with complex financial derivatives, then the error or omission may represent an important factor in explaining why synthetic derivatives, collateralized debt obligations and credit default swaps had such an adverse impact during the global financial crisis.40 The underpricing of risk would certainly be of concern, particularly if Greenspan’s view is correct. If the mathematical formulas used to price risk and value financial derivatives led to underpricing, then serious ramifications could follow for ill-informed end-users. Not only would end-users and purchasers of these instruments potentially overpay for the financial derivative, there may in fact be insufficient capital provided to absorb any shortfall in the case of loss or default.

Insufficient capital requirement for losses that flow from mispriced financial instruments would present an important system-wide weakness. If Greenspan is correct, then capital requirements would need to be much higher to take into account heightened levels of financial risk. Capital adequacy and liquidity ratios would need to be modified for banks and investment firms that hold financial derivatives as part of their net assets.41

Greenspan raises an interesting point worthy of further investigation. Hopefully, the study proposed by the Dodd-Frank Act 2010 will properly investigate the issue, since it potentially has widespread ramifications not only for the pricing of risk but also for the adequacy of capital and liquidity requirements.

Derivatives Clearing Organizations

The Dodd-Frank Act 2010 also introduced amendments to the way derivatives would be now cleared and settled. The amendments included establishing derivatives clearing organizations to provide for centralized clearing and settlement of OTC financial derivatives.42 Centralized clearing and settlement of forwards, options, swaps and commodity options can now take place through a registered derivatives clearing organization.43 The Dodd-Frank Act 2010 amended the Commodity Exchange Act 1936 to make it mandatory for commodity swaps to be cleared through a centralized exchange unless an exemption applies.44 The Dodd-Frank Act 2010 also amended the Securities Act 1933 to provide for the clearance of security-based swaps through a centralized derivatives exchange and their regulation by the SEC. The Dodd-Frank Act 2010 also provides for voluntary registration for centralized clearing. An entity which is not required to clear agreements, contracts or transactions under the Commodity Exchange Act 1936 can voluntarily register as a derivatives-clearing organization with the CFTC.45

The Dodd-Frank Act 2010 also amended the Commodity Exchange Act 1936 to provide for a set of comprehensive core principles for derivatives clearing organizations which ordinarily should include:

Transparency is improved if OTC derivatives are centrally cleared through a derivatives exchange. OTC derivatives that are bilaterally negotiated and settled tend to have little, if any, disclosure. OTC derivatives exposures are also not publicly known and are usually the subject of confidentiality agreements. Hence, market regulators including the SEC and the CFTC have inadequate information to provide effective and proper supervisory oversight.

Although there is some evidence to suggest that OTC derivatives did in fact contribute to the global financial crisis by increasing exposure to leverage and volatility, it remains unclear whether providing centralized clearing will lead to much improvement. This is because almost all markets (exchange-traded and OTC) became highly volatile at the height of the global crisis. At the time Lehman Brothers collapsed, credit markets effectively froze, which led to worldwide restrictions on the availability and supply of credit. The problems encountered in credit markets soon spilled over to other financial markets, including exchange-traded equity markets, futures markets and OTC derivatives markets.

As is discussed in Chapter 6, a number of enquiries have recommended that improvements be made to the current regulatory framework in the United States and in Europe. The Dodd-Frank Act 2010 recognizes that regulatory failure was as much to blame for the global financial crisis as was market failure. Regulatory gaps, poor oversight and supervision, insufficient and ineffective regulatory action, all existed side by side with market failure. The policy responses by regulators and central banks were largely reactionary, responding to the crisis rather than pre-empting the meltdown.

Public Reporting of Swap Transaction Data

In a bid to improve market transparency in swaps markets, the Dodd-Frank Act 2010 introduced a new provision requiring the “real-time public reporting” of swap transactions.80 Under Section 727, the Dodd-Frank Act 2010 provides that swaps which are subject to mandatory clearing81 must provide real-time public reporting of such transactions.82 In relation to swaps that are not subject to mandatory clearing but are nevertheless cleared at a registered derivatives organization, the Commission will also have authority to require real-time public reporting.83

Swaps that are not subject to mandatory clearing and are not voluntarily cleared at a centralized derivatives organization can opt for real-time reporting of such transactions.84 The requirement for real-time reporting ensures that such transactions will be disclosed in a manner that does not disclose the business transaction and market positions of any person.85 The requirement for public reporting of swap transactions data will also apply to swaps which are required to be cleared under a centralized derivatives organization but are not in fact centrally cleared.86

The main purpose for the disclosure requirement under section 2(a) of the Commodity Exchange Act 1936 as amended by Section 727 of the Dodd-Frank Act 2010 is to “make swap transactions and pricing data available to the public in such form and at such times as the Commission determines appropriate to enhance price discovery.”87 In terms of improving market transparency, enhancing price discovery of swaps is considered to be an important objective, since it provides market participants with important information to make informed decisions.

Importantly, the amendments introduced by the Dodd-Frank Act 2010 that provide for the public disclosure of swap transactions data are comprehensive. As is discussed above, the amendments cover not only all swaps that are subject to the mandatory clearing requirement but also swaps that are voluntarily cleared through centralized derivatives organizations. Swaps transactions data will also have to be reported for swaps that are not cleared centrally. The comprehensive nature of the disclosure requirement is aimed at removing incentives to circumvent reporting requirements. Whether a swap is centrally cleared or not is irrelevant, all market participants engaged in swap transactions will be required to disclose and report transactions data.

Legal Certainty for Swaps

The Dodd-Frank Act 2010 also makes provision for minimizing the legal risk for swaps that are transacted in the United States.88 Section 739 of the Dodd-Frank Act 2010 amends section 22(a) of the Commodity Exchange Act to provide that:

no agreement, contract or transaction between eligible contract participants […] shall be void, voidable, or unenforceable, and no party to such agreement, contract, or transaction shall be entitled to rescind, or recover any payment made with respect to, the agreement, contract, or transaction under this section or any other provision of Federal or State law, based solely on the failure of the agreement, contract or transaction.89

Many OTC derivatives participants had been adversely affected by legal risk and legal uncertainty.90 In the past, OTC derivatives have been challenged on the basis that they amounted to unlawful gambling and bucket shops.91 Some contracts have been held to be void and unenforceable by the courts;92 and in some disputes, losing counterparties have been allowed to walk away from loss-making derivatives agreements.93

To overcome the legal risk posed by gaming statutes and state bucket shop laws, the US and UK legislatures have introduced comprehensive reforms. In the US, the Commodity Exchange Act 193694 was amended with the passing of the Commodity Futures Modernization Act 2000 and the Bank Products Legal Certainty Act 2000. The amendments removed the legal risk posed by state gaming and bucket shop laws to OTC financial derivatives transacted in the US. In the UK, the Financial Services Act 1986 introduced amendments to provide for greater legal certainty for financial investments, including OTC derivatives.95

The amendments introduced by the Dodd-Frank Act 2010 build on these earlier reforms and are designed to further minimize legal risk for swaps. The recent amendments to the Commodity Exchange Act 1936 introduced by the Dodd-Frank Act 2010 provide for greater legal certainty for all swaps transactions carried out in the US. The Dodd-Frank Act 2010 amendments provide for greater legal certainty for hybrid instruments96 and long-dated swaps transacted before the enactment of the Wall Street Transparency and Accountability Act 2010.97

Swaps Enforcement Procedures

The Dodd-Frank Act 2010 introduced amendments to deal with enforcement procedures under the Commodity Exchange Act 1936. The amendments provide that the CFTC shall have exclusive authority to enforce the provisions of the Wall Street Transparency and Accountability Act of 2010.98

Prudential regulators will also have exclusive authority to enforce provisions against swap dealers or major swap participants. Prudential regulators can refer any suspected breaches of non-prudential requirements by swap dealers or major swap participants under the Commodity Exchange Act 1936 to the CFTC.99 The CFTC has the authority to report to the prudential regulator any suspected breaches of prudential requirements by a swap dealer, including a major swap participant.100

The enforcement procedures and referral process introduced by the Dodd-Frank Act 2010 are designed to improve regulatory and prudential oversight of swap-related activity. Any suspected breach of prudential or non-prudential requirements by swap participants will be the subject of referral. Once referred to the prudential regulator, the alleged breach will be investigated and if found to have occurred will result in enforcement procedures against swap dealers and major swap participants.

The Dodd-Frank Act 2010 introduced amendments to the Commodity Exchange Act 1936 to prohibit insider trading in relation to swap transactions, contracts of sale of a commodity for future delivery, and options executed or traded on a securities exchange.101 Insider trading has been a perennial problem with exchange-traded transactions because of the difficulty of identifying and enforcing the dissemination of non-public information.

To aid with the enforcement of insider trading rules, the Dodd-Frank Act 2010 introduced a new offence involving the imparting of non-public information with the intention to assist another person directly or indirectly in the use of that information. The use of the information must lead to the person entering into or offering to enter into a contract of sale of a commodity for future delivery.102 Included in the new offence of insider trading for swaps is the offence of theft of non-public information.103

The insider trading provisions introduced by the Dodd-Frank Act 2010 implicitly recognize that regulation of swap markets may in fact be prone to market manipulation. There has certainly been evidence that market manipulation, including insider trading, churning, runs and ramping, have been present in exchange-traded markets. However, with OTC derivatives markets, which are not exchange-traded but instead bilaterally negotiated between two or more sophisticated entities, there has been little evidence to suggest that insider trading is a problem.

This is likely to change once OTC derivatives markets become centrally cleared through a centralized derivatives organization, because swaps markets may then become prone to market manipulation. This is because price discovery is one of the by-products of centralized clearing.104 With price discovery comes the potential problem of price or market manipulation as speculators move in to cash in on insider trading. Although public disclosure and centralized clearing can aid in overcoming the problems of opaqueness, centralized derivatives exchanges may also lead to problems of insider trading, as is currently found with other exchange-traded markets.

The new insider trading provisions introduced by the Dodd-Frank Act 2010 represent a good starting point, but the provisions need to be broadened and enhanced to incorporate other types of market manipulation. If it is mandatory that swap dealers and large swap participants in the US clear their swap contracts through a centralized derivatives organization, there will need to be implementation of additional market manipulation provisions. Centralized exchanges such as securities and futures markets have detailed market manipulation provisions dealing with all types of market abuses including insider trading, churning and the spreading of false rumours.

Regulation of Hedge Fund Advisers

In response to the call for greater transparency and regulation of Wall Street investment advisers, the Dodd-Frank Act 2010 introduced amendments requiring hedge fund advisers to be registered with the Commission.105 The registration and regulation of hedge fund advisers also extends to cover investment advisers of a private fund, as well as foreign private advisers undertaking transactions and providing advice to clients located in the United States.106

Investment advisers and hedge fund advisers will not only be required to register with the Commission but they may also need to maintain proper records and reports for members of the public. The reports should ordinarily include information which is relevant for the “protection of investors, or for the assessment of systemic risk by the Financial Stability Oversight Council.”107

The maintenance of records for the purposes of providing relevant information regarding the financial stability of investment markets is consistent with the overall aim of the Dodd-Frank Act 2010 to improve transparency of hedge fund activity. The records that are required to be maintained by hedge fund advisers are comprehensive and intended to provide a detailed picture of counterparty risk exposures and trading positions of clients.108

The records once developed and properly maintained will provide the Commission and other regulators with greater transparency regarding the trading activities and risk exposures of hedge fund counterparties. This is an important initiative since it provides additional information for regulators, including the CFTC and the SEC to make proper risk assessments of hedge funds and investment banks.

One of the major problems highlighted by the financial crisis was the lack of transparency with hedge fund and investment bank trading activity. The lack of adequate transparency with hedge fund reporting led to an inadequate understanding by regulators of the build-up of risk in the shadow banking sector. By requiring proper reporting and disclosure of counterparty credit risk exposure, off-balance sheet financing and trading and investment activity, market regulators will be in a better position to evaluate and assess any build-up of risk.

Importantly, the Commission can also make available to the FSOC,109 “all reports, documents, records, and information filed with or provided to the Commission by an investment adviser […] as the Council may consider necessary for the purpose of assessing the systemic risk posed by a private fund.”110 The ability of the Commission to collect and make available records from hedge fund and investment advisers to the FSOC for the purposes of assessing and evaluating systemic risk represents an important development in improving transparency with hedge funds and investment bank advisers.

The Financial Stability Oversight Council