Q&A: Sylvie Matherat on extraterritoriality and central clearing

Europe and the US are at loggerheads over the territorial scope of new derivatives rules – as evidenced by a new financial stability review from the Banque de France – but agreement can be reached, says Sylvie Matherat, the central bank’s deputy director-general for the directorate of general operations. By Duncan Wood

Extraterritoriality is a clumsy word that can be summed up in simple terms: applying your laws to people outside your country. That might seem indefensible, but Gary Gensler, chairman of the Commodity Futures Trading Commission (CFTC), makes a good fist of it in the financial stability review published by the Banque de France on April 22.

In one of 23 contributed articles on the topic of over-the-counter derivatives, Gensler argues that exposure racked up by the teeming foreign outposts of US banks ultimately puts the US itself at risk. His conclusion follows naturally.

“I believe it is critical that Dodd-Frank reform applies to transactions entered into by branches of US institutions offshore, between guaranteed affiliates offshore, and for hedge funds that are incorporated offshore but operate in the United States,” he writes.

Europeans see it very differently. “Definition of an extremely broad territorial scope of application providing direct regulatory competence over any transaction likely to impact a country’s jurisdiction is not a solution,” argues Michel Barnier, commissioner for internal market and services at the European Commission (EC), in his own contribution to the review. He points to the CFTC’s proposed guidance on the cross-border application of the US Dodd-Frank Act, published last July, as the principal offender.

Barnier applauds the CFTC for providing a temporary escape from the long arm of Dodd-Frank last December – the agency changed the way it defines a US person, the criterion that tips a swap dealer into US clearing, reporting and execution requirements, regardless of the counterparties’ location. But pages later, the CFTC’s Gensler warns this relief expires in July, and tells non-US firms to start preparing.

It is critical to express what we expect in terms of recovery

Months of talks do not seem to have brought the two sides any closer together, and the stakes were raised on April 18 when a letter from eight finance ministers warned US authorities that the CFTC’s extraterritorial approach was “not sustainable” (see page 6). But not everyone has given up hope. Sylvie Matherat, deputy director-general for the Banque de France directorate of general operations, says she expects an agreement based on mutual recognition of US and European regulations to be reached within the next few months.

She is in a good position to judge. Matherat joined the French central bank in 2007 as its director of financial stability, and is now co-deputy for the broader directorate that encompasses that unit as well as those for market operations, payment systems and market infrastructures. She is also a member of the Committee on Payment and Settlement Systems (CPSS), the Basel Committee on Banking Supervision – where she chairs the liquidity working group – and the payment and settlement systems committee of the European Central Bank (ECB). She is well connected, and it was her invitations that assembled a cast of luminaries for the 247-page financial stability review.

Alongside Barnier and Gensler, the ECB’s Daniela Russo, director-general for payments and market infrastructure, also discusses extraterritoriality, as well as the to-do list for central counterparty (CCP) regulation, which includes the need for a recovery and resolution framework (Risk July 2012, pages 32–34). Paul Tucker, the Bank of England’s (BoE) deputy governor, devotes his own article to the latter topic. Both have some interesting ideas. The ECB’s Russo suggests a single, central resolution authority is needed for CCPs, while the BoE’s Tucker calls for European law to be amended to remove one obstacle to orderly resolution – the possibility of a mass close-out of contracts by clearing house members and clients.

Matherat recognises the importance of CCP resolution, but argues there are more fundamental issues to nail down first – consistent implementation of the principles published last year by the CPSS and the International Organization of Securities Commissions (Iosco), for example, or the need for clearing houses to have access to central bank liquidity in the currency of the contracts they handle (Risk January 2012, pages 14–18). According to the ECB, that second point can only be satisfied by locating a CCP in the appropriate currency zone, and Matherat says this location policy, which rocketed to prominence when it became the subject of a legal challenge filed by the UK Treasury, has not been dropped. She calls it “absolutely necessary” for the safety of the euro area.

Risk: Extraterritoriality is the first meaty issue we get to in the review. Is that a reflection of its importance in your eyes?
Sylvie Matherat: Yes, it’s very important, and there are two ways of looking at it. The first is to think there is basically one major regulation, created by the Group of 20 (G-20) nations, which is then implemented as consistently as possible at a national level – and if you want to facilitate the existence of cross-border banks, then you tackle any differences through reciprocity or equivalence rules.
Then you have the other view, expressed by Gary Gensler, which basically says that because the major actors and major risks are international, you need your own national rules to apply internationally, which leads to extraterritoriality. That’s a major issue for us in Europe, it’s a major issue for the industry.

Risk: Gensler says it is “critical” that US rules apply to certain transactions overseas, while Barnier says the CFTC’s approach is “not a solution”. The differences seem quite entrenched.
SM: At first glance, that seems the case. Michel Barnier’s objective is to give everybody the right to decide on the best regulation to apply – and the objective of Gensler is to tackle risks that are obviously global, and not to stop at the geographical frontier.
There is a way to reach both objectives, which is to have consistent rules in all the major jurisdictions. I think the G-20 regulation is not far from what the Dodd-Frank Act is proposing, and in Europe we’ve been looking at the differences between Dodd-Frank and the European Market Infrastructure Regulation.

Risk: The rules may be very similar on clearing and reporting, but execution rules are a work in progress in both the US and Europe. Is that a grey area?
SM: Those rules are not finalised, that’s true. With all this regulation, it’s quite complex, so being aware of the differences is not easy. You have to do a kind of mapping exercise to identify divergence. Then you have to decide whether each of these instances matters and whether it can be resolved.

Risk: Is the EC talking to the US about this?
SM: Yes. Michel Barnier has already been to the US several times to raise the issue with his US counterparts. It’s very important.

Risk: What do you expect to happen when the CFTC’s temporary US persons relief expires in July?
SM: We don’t know yet. There is strong pressure from both sides, but it’s difficult to know at this stage because discussions are ongoing.

Risk: Barnier and the ECB’s Russo both call for some kind of transatlantic agreement on extraterritoriality before rules in the US and Europe are definitive. Is there room for some new, formal agreement here?
SM: I don’t think it will be something formal, but I am pretty sure an agreement can be reached, based on some form of mutual recognition. Otherwise, implementing the rules will be very difficult. Those discussions have been going on since the end of last year. The best solution is that we converge or that we find acceptable grounds for mutual recognition.

Risk: How quickly could this happen?
SM: We expect something before or during the summer. We would very much prefer mutual recognition and substituted compliance.

Risk: What happens if it doesn’t materialise?
SM: If we don’t manage to reach a situation where we have consistent rules, it might be a problem for international players and there might be a temptation to go back to a more limited type of activity, which would not favour growth. The US is quite stringent in the way its rules are applied, but the authorities there are very pragmatic as well and they know international participants in the OTC market are not small companies, so there are incentives to reach a solution on mutual recognition.

Risk: If non-US banks wanted to avoid duplicative regulation, though, they would have to shrink their business to the extent they were no longer considered a swap dealer in the US, wouldn’t they?
SM: Yes. And that would be a major change. At this stage, I think they’re all hoping for an agreement on the regulation, so they can continue operating.

Risk: Is that a plausible threat?
SM: It’s a negotiating tool for international banks, because they will need to reorganise themselves for some of the regulatory projects in the US. So US regulators face those types of pressure from industry, and at the same time we on the regulatory side are doing our official work, which is to reach an agreement on mutual recognition.

Risk: Two of the articles in the review, from Paul Tucker at the BoE and the ECB’s Russo, touch on the issue of resolution regimes for CCPs. They both think answers are needed quickly. Where are we on this?
SM: Paul Tucker has a special interest in this because he is chairing a group at the Financial Stability Board that specifically deals with resolution – as it applies to CCPs as well. Clearing houses are clearly institutions of systemic importance and therefore, it is critical to express what we expect in terms of recovery and how the key attributes set out by the Financial Stability Board apply to this specific category of financial institution.

Risk: European and US regulators have already finalised technical rules on CCP risk waterfalls. Is there going to be something on top of that?
SM: Well, there are the CPSS-Iosco principles for financial market infrastructures (PFMIs) that were published last year, which are like Basel III for CCPs.
The G-20 intends to make these more binding and, in fact, within the CPSS, we are in the process of running a peer review of the PFMIs, in exactly the same way that the Basel Committee does for Basel III. There will be three levels of application. The first assesses whether each jurisdiction has translated into its own legislation the PFMI principles, and the second looks at whether the jurisdiction complies with the CPSS principles. Then there is level three, which is quite complex and difficult to accept for some jurisdictions – and that means checking the real, practical implementation by CCPs of those principles. So that’s something new, and we’re taking it quite seriously – the revised PFMIs are really intended to be binding rules for CCPs.

Risk: How far have you got with this?
SM: Level one is complete – checking whether jurisdictions have implemented the PFMIs – and we will then check the consistency of implementation in the autumn, before moving on to level three, which is the concrete application of the principles by CCPs. It’s an ongoing process, but we are quite serious about this peer review.

Risk: When will the level one findings be published?
SM: We have to discuss that at the CPSS, but maybe this summer.

Risk: Russo calls for a single CCP resolution authority. Is that a real possibility?
SM: It’s a real idea because, of course, the ECB is quite interested in this kind of issue. But it will be linked to the evolution of the CCP space – if we only have a few CCPs, then fewer resolution authorities are needed.

Risk: Things have gone quiet recently on the ECB’s location policy, requiring CCPs to be located in the same currency zone as the trades they are clearing. Is there now an acceptance that co-operative oversight arrangements are a satisfactory workaround?
SM: I wouldn’t say so, because that is not a substitute. Co-operative oversight arrangements are desirable – even necessary for CCPs and other market infrastructures that have a cross-border dimension – but this kind of arrangement would never be equivalent to direct oversight by the competent authorities of a CCP located in their currency area. In a crisis situation, even if co-operation works well in normal times and is applied in good faith, you could never be sure that the home authority or the resolution authority for the CCP will not take a decision that will be contrary to the interests of the financial system of another cleared currency. That is why the location policy remains absolutely necessary for the euro area.

Risk: We’d heard rumours that the ECB had, to all intents and purposes, dropped the location policy.
SM: No. I don’t know where you heard that. We are strong believers that it is very useful in terms of protecting the financial stability of the euro area.

Risk: Could that be fixed by arranging swap lines between two different central banks?
SM: Central bank emergency liquidity cannot be taken for granted for obvious moral hazard reasons. Therefore, even if a swap line is set up between two different central banks, you cannot expect central banks to commit to activating it. That’s a basic, fundamental policy stance – the central bank must be free to decide whether to activate a swap line or not, based on a case-by-case assessment of the situation. To my knowledge, this has been a consistent position held by the Federal Reserve.

Risk: The BoE’s Tucker says one obstacle to the orderly resolution of CCPs is the potential mass exercise of termination rights by members and clients of a failing clearing house. He proposes removing that obstacle through changes to Europe’s Financial Collateral Arrangements Directive. Is that how you would solve it?
SM: I don’t know if it’s how I would solve it, but this is clearly an issue that crops up in all these resolution discussions. Of course we all agree we should enhance the way systemic entities can be resolved, but at the same time, it’s a very difficult issue because it draws on legal frameworks that are different in every country. The only way to solve that is with new legislation.

Risk: To conclude, what do you think people should take away from the financial stability review?
SM: Just that there are some major issues in the reform of OTC markets – that’s why we decided to cover the subject in the financial stability review – and that we have to be careful. All these regulations are absolutely necessary and helpful but, at the same time, we need to assess the impact of having them piling up. Before implementation, we need a fresh, comprehensive overview so we can be sure the incentives are right and all go in the same direction – allowing us to fulfil the G-20 commitments, which, of course, we all fully share.