IN THE SYSTEM WE TRUST.
Jannah Patchay, partner at Agora Global Consultants, examines the Dodd-Frank Act.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, to call it by its full and unwieldy title, hasn’t had an easy time of it since being signed into law by US President Barack Obama in July 2010. Beset on all sides by critics, it has faced the hurdles of implementation by no fewer than five different US regulatory agencies, accusations of regulation-by-footnote resulting in high-profile legal challenges, and criticism for its lack of foresight in dealing with the more nuanced aspects of market structure such as the credit intermediation prime brokerage model. Five years on, its threats are now more existential than ever: a slow, creeping repeal by stealth, combined with increasingly vocal criticism from insiders on the implementation track. Unhelpfully, many of its provisions remain as of yet unimplemented, making it even more of a target for opponents.
The global financial crisis of 2007-2008 highlighted the need not only for the creation of international standards and best practices in financial markets regulation, but also for effective mechanisms of supervision and enforcement. The crisis originated in a localised collapse of the US subprime lending market and subsequently spread to other countries, driven by a combination of the global interconnectedness of financial markets and the sophistication of financial instruments whose risks were near-impossible to fully ascertain. Along the way, it highlighted the ineffectiveness of existing regulatory transparency requirements and risk models in detecting systemic risk and preventing market contagion. The costs of the crisis to national economies, and their repercussions, are still being felt today. In the US, the collapse of AIG, Lehmans and Bear Stearns highlighted the on-going challenges of counterparty default risk, and provided increased incentives for a drive towards centralised clearing.
These and other recent national and regional regulatory initiatives were aimed at addressing the aforementioned shortcomings in the regulatory model. The Dodd-Frank Act is no exception, with Title VI (the Volcker Rule) focussing on separating out perceived high-risk proprietary trading activities from consumer deposit- and fund-holding. Title VII focussed on addressing the G20’s 2009 commitments to improving transparency, bringing OTC derivatives trading onto electronic, ‘lit’ venues, and imposing a clearing regime wherever possible, with margin requirements for un-cleared derivatives aimed at dissuading and, arguably in some cases, penalising such activity. Dodd-Frank’s first stumbling block was the regulatory infrastructure in which it must be implemented; even following attempts at structural reform, US regulatory agencies remain fragmented by function and product. The Federal Reserve, Securities Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation are all responsible for implementing overlapping parts of the legislation. This has led to a range of discrepancies and delays. All five agencies have differing definitions of a US Person, the fundamental unit of jurisdiction under Dodd-Frank. A sixth definition was jointly devised for the purposes of the Volcker Rule, which required a combined, collaborative implementation. The SEC lags behind the CFTC in its definition of the detailed Title VII requirements.
The CFTC, light-years ahead of other agencies in terms of both the detail and reach of its implementation, has faced an industry lawsuit for its perceived extraterritorial over-reach in applying transaction-level requirements (such as reporting, transparency and mandatory SEF execution) to branches of foreign banks located in the US. Under the guidance of former chairman Gary Gensler, the agency took its remit to safeguard US taxpayer and consumer interests to a level above and beyond anything anticipated by even the lawmakers. This was highlighted recently in CFTC Commissioner Christopher Giancarlo’s fascinating and bold testimony to a US House Committee, in which his criticism of the CFTC’s implementation of Dodd-Frank was scathing to say the least. Giancarlo noted the global market fragmentation caused by SEFs, and lambasts the concept of Mandated Trading on SEFs, which he maintains is not based on any actual legislative requirements. He also criticises the CFTC’s provisions on Margin Requirements for Uncleared Derivatives as being completely out of sync with those of the EU, and potentially detrimental to US firms and trade given its coverage of intra-group trades.
Giancarlo states in no uncertain terms his opposition to the rules, and his belief that they are fundamentally flawed, based on:
- Adoption of an inappropriately US-centric futures regulatory model that “supplants human discretion with overly complex and highly prescriptive rules.”
- The rules’ incompatibility with the “distinct liquidity, trading and market structure characteristics” of the global OTC derivatives market.
- Driving fragmentation of derivatives trading on both artificial product and market lines.
- Actually exacerbating the potential for market fragility and systemic risk through the adverse impact of the above on liquidity.
- Most importantly, failing to live up to the original intent and letter of the Dodd-Frank Act as passed by the US legislators.
Giancarlo has not been alone in his vocal dissent. SEC Commissioner Daniel Gallagher’s closing remarks at that agency’s 24th Annual International Institute for Market Development were similarly critical not only of the agencies’ approach to implementation, but of the actual legislation itself, characterising it as a poorly thought through and inadequately planned “grab bag of legislative wish-list items, many of which had nothing to do with the crisis.”
Dodd-Frank’s weaknesses in both content and implementation have given its opponents ample ammunition and incentives with which to lobby hard against specific provisions on both practical and ideological grounds. Frequent political impasses between the Democrats and the Republicans have made it easier for the latter to use repealing amendments as conditions attached to their acquiescence on wider budgetary concessions. This is a poor outcome not only for the US, in terms of the failure to deliver a significant and much-needed piece of regulatory reform. Regulatory uncertainty is never healthy, and huge expense and effort on the part of UK and other non-US banks and market participants has so far gone into implementing Dodd-Frank’s onerous measures. Further repeal, for purely political purposes, will destroy much-needed trust in the system. However there is no doubt that a closer examination of the content and implementation of Dodd-Frank, wherever possible adopting a more consultative approach with the input of market participants and foreign regulatory bodies, is both necessary and desirable in order to deliver a truly workable solution to both regulatory and financial stability issues as well as cross-border challenges.