US Regulation

Clamping down on the global derivatives market

Originally published in the September/October 2012 issue

Prior to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act the US financial market place was lightly regulated in respect to investment managers. Whilst there had been attempts in the past to change the regulatory landscape, this was of limited effect due to legal challenges. Dodd-Frank changed all this and resulted in an enormous amount of additional regulation for the global financial market.

Dodd-Frank was a reaction to the financial crisis of 2008, which highlighted the damage that unregulated financial products and a lack of transparency can do to the financial system. Regulators have been pushing for tighter controls on financial markets across the board and one focus for improved transparency has been the derivatives markets, cited by many as being the central cause of the 2008 crisis. As a result, the Commodity Futures Trading Commission (CFTC), which has historically regulated futures and options trading as well as commodities, has increased its scope by including swap trading and hedging within its remit, which will have significant ramifications for firms operating inside and outside the US across the entire sector. The CFTC is assuming certain regulatory powers under Dodd-Frank and is working more closely with the Securities and Exchange Commission (SEC) to address what are believed to have been gaps in the regulatory responsibility of each agency.

Certain amendments pursuant to Dodd-Frank will have a significant impact on UK-based investment managers. First, the CFTC and SEC jointly enacted a long-awaited final rule defining a “swap,” a “security-based swap” and a “mixed swap”, such that many operations will fall under its remits, including much of London’s derivative operations. Second, the CFTC expanded the definitions of commodity pool operator (CPO) and commodity trading advisor (CTA) to include those managers that advise US clients regarding swaps, including interest rate swaps, currency swaps, and credit default swaps. A manager of a private fund that trades over-the-counter derivatives and operates or sells into the US must either register as a CPO or a CTA or be exempt from registration. Thus, a UK-based CTA can come under the requirement by advising US clients and a UK-based CPO can come under the requirement by admitting US investors.

It is also important for managers to understand that the CFTC has also removed an exemption widely used by investment advisers to avoid falling within its regulatory scope, regardless of the amount of commodity interests traded. Firms operating in this space that have not previously registered with the CFTC will have to do so and become subject to its compliance regime by 31 December, 2012. However, there are a number of exemptions that will still be available for firms to benefit from. Key for investment advisers is to understand the implications for their entire group and determine whether any of the entities can take advantage of one of the exemptions available.

Many investment managers are only just waking up to this new regulatory requirement and how much preparation is required for compliance. There is a real danger that firms will be caught out as they will have to analyse many products they offer to assess whether they fall within the extended remit of the CFTC. Investment managers need to know when they should register and understand the obligations that come with membership of CFTC and the National Futures Association (NFA), the futures industry’s self-regulatory organisation.

Once a manager determines that it needs to register, it must identify the “principals” and “associated persons” that should be included in the application and obtain fingerprints for those individuals. In addition, associated persons must take the National Commodities Futures Examination (Series 3) or the Limited Futures Examination (Series 32), as appropriate. Managers must then move to get the systems in place for regular financial and risk reporting as this aspect of the regulation is likely to be the most draining on a company’s resources.

Once registered, investment managers will be subjected to a number of CFTC and NFA disclosure, reporting and record-keeping requirements. They will be expected to submit details on assets under management, leverage, counterparty exposures and trading positions. Aggregating all of the data will not be straightforward and managers should not underestimate the amount of work involved. Managers will have to collate this data from multiple feeds, often from their fund administrator(s) and break the data down by performance and geographical sectors, among other criteria.

With the 31 December deadline only a few months away and the potential requirement for many individuals to sit for examinations, there is a very short timeline for those who need to register. This timeline can be managed by moving quickly and getting ahead of the rush. Understanding how swaps are defined and which products qualify should take priority, as this is likely to be the determining factor as to whether firms can take advantage of key exemptions.

Whilst increased transparency is to be welcomed, we expect that because regulation will always be behind the curve of the markets and the products that they offer, there will be a number of unintended consequences. It is likely that managers will react by seeing this as an opportunity to change the financial products that they offer so that they do not fall within the scope of the CFTC. Whilst the CFTC has proclaimed that products designed to purposefully evade the CFTC’s definition of a swap will be deemed a swap for regulatory purposes, we expect that there will be a flurry of new products entering the market place. Firms must therefore ensure that any new products are not designed to circumvent Dodd-Frank and are for legitimate business purposes.Furthermore there is the risk that this increased regulation will result in making the market less competitive because overly broad regulations from the CFTC might duplicate or conflict with rules of foreign regulators, which will put some firms at a competitive disadvantage. However, the CFTC’s move towards tighter regulation is entirely in step with the current thinking at the Financial Services Authority (FSA), which is concerned with the loophole that exists when foreign banks with London “branches” cannot be regulated as closely by the FSA resulting in a number of trading disasters.

The pendulum has swung away from the perceived “light touch” regulation that fuelled the 2008 US financial crisis and towards the argument that the financial sector must operate on a global level and should be regulated as such. Investment managers need to ensure they are on top of all new requirements so they do not get caught out.

Gregory Worsfold is an Associate at Kinetic Partners LLP. He spent several years in the financial services industry before joining Kinetic in 2012. He specialises in FSA, SEC and CFTC regulation advising multi-billion dollarasset managers.