Risk: To broaden the discussion, there has been a lot written about the extraterritorial reach of some of the rules – in particular, the Dodd-Frank Act. There have been attempts by regulators to co-operate, but is enough being done to eliminate some of the extraterritorial impact?
Eric Litvack: As yet, clearly not, because it hasn’t been resolved. It is a thorny issue and there is a lot to be done in a very short period of time. One of the things that is not explicitly on the menu but is implicit in most subjects is the issue of extraterritorial reach. Most of the regulators are busy drawing up final rules and technical standards, and they are primarily looking at their domestic markets, which is natural enough. Those that are more used to the issue of dealing with multilateral memorandums of understanding are perhaps incorporating that more into their language, but none of them have yet satisfactorily resolved the issue.
Every time we go in to discuss this issue with regulators, the answer we get is ‘oh yes, no problem, we are speaking to our peers’. They are speaking to their peers, and they have been speaking to their peers for the better part of two years now – but we’re still not there, and there is a lot that needs to be done before we cross the finish line. Just to implement Dodd-Frank for an individual dealer, you need to register your firm as a dealing house, which is not necessarily a concept that exists in the equivalent form in Europe. If you are a European bank and you register as a swap dealer in the US, you are taking on a number of disclosure requirements that may be illegal in your home country.
One clearing house per asset class is the most efficient and systemic risk-reducing model – that should be the aim
There needs to be more recognition of home country supervision and a more defined framework for co-operation between regulators – particularly on a transatlantic basis. Until that is sorted out, we won’t be able to have a functioning cross-border G-20-compliant framework, because Dodd-Frank won’t work for non-Americans and Emir might not work for certain non-Europeans.
The Volcker rule is an example of where the devil is in the extraterritorial detail. One of the poster-child issues has been the exemption granted from the Volcker interdiction on proprietary trading for government and municipal debt. One might ask what sort of activity has been touched by grace, so it is okay to speculate with depositor money. The answer that US regulators have come up with is US debt because ‘we need to protect our home territory’. I’d say that is a somewhat cynical answer and, clearly, it could pose problems for other jurisdictions – it prevents US banks from acting as dealers in similar assets of foreign governments, and it potentially creates restrictions on foreign dealers that want to register in the US, as they would then take on a significant burden of US compliance when they are dealing with their home country or non-US assets. So it is a real crossed web that needs to be simplified for it to work properly.
Risk: As you say, the Volcker rule is one example of extraterritoriality, but another might be the margin requirements on uncleared swaps, which were proposed by US prudential regulators in April last year. Regulators are looking at this issue on a global basis but, as it stands, it is a US rule that may have extraterritorial reach. What issues does this raise?
Michele Faissola: This is a critical issue that needs to be resolved. It will potentially have a huge impact on liquidity, particularly if you think about the impact on second-tier firms, which might have a modest business in the US and really need to decide if it is worthwhile to continue to have that business. That touches on other aspects, such as capital charges for non-collateralised transactions. We have clearly been asked to put an excessive amount of capital against that. If I look at the crisis, the bilateral credit support annex has worked pretty well, and we have not seen any significant problem. But we are moving towards a model where the cost of transacting is reaching a level where the clients might simply decide not to hedge, and that is not desirable.
The biggest impact is on liquidity, and it comes from all different angles. The Volcker rule, capital requirements, compliance, reporting obligations and transparency are all going in one direction, and that is to make the cost of transacting much higher than before. I’m not convinced the end-user will ultimately pay for it. You will probably end up with some form of consolidation across the industry, because you are essentially raising the bar. The membership cost is becoming much higher, and only the firms with very large businesses can justify that kind of entry-point fee. Second, you will see lots of clients using other instruments. We are already seeing that to some extent – some clients are moving out of derivatives and into cash instruments.