October 10, 2012

In the Post Dodd-Frank Derivatives World, October 12th Matters

Hester Peirce

Former Senior Research Fellow
Summary

October 12 is a big day in the over-the-counter (OTC) derivatives world, as key provisions of Dodd-Frank's derivatives framework are set to go into effect. Regulators are adding to the anticipation by leaving the markets in suspense about how the rules work. The uncertainty surrounding what will happen on the 12th is emblematic of the government's unstructured approach to the Dodd-Frank implementation process.

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October 12 is a big day in the over-the-counter (OTC) derivatives world, as key provisions of Dodd-Frank's derivatives framework are set to go into effect. Regulators are adding to the anticipation by leaving the markets in suspense about how the rules work. The uncertainty surrounding what will happen on the 12th is emblematic of the government's unstructured approach to the Dodd-Frank implementation process.

Dodd-Frank charged regulators with building a new regulatory structure for OTC derivatives, a widely used class of financial contracts that had not previously been subject to comprehensive regulation. In an awkward allocation of power, Congress assigned similar and overlapping rule-writing responsibilities to the Securities and Exchange Commission and the Commodity Futures Trading Commission. Bank regulators and the Treasury Department also have roles to play in getting the regulatory infrastructure up and running. Rushed and uncoordinated rulemakings threaten to roil a market that is central to the functioning of the modern economy.

The CFTC, which is responsible for the October 12 deadline, has outstripped its fellow domestic and international regulators in adopting OTC derivatives rules. It has largely ignored suggestions to slow down and apply some careful thought to the order in which rules should be adopted and implemented. As a consequence, Friday - the day on which the CFTC's derivatives requirements begin in earnest-is fast approaching and the hundreds of questions submitted to the CFTC in an effort to understand how those new rules will work remain unanswered.

CFTC Commissioner Chilton provided assurances last week that "it would not be appropriate, reasonable, or responsible for the Commission to proceed against entities for non-compliance with a Dodd-Frank rule unless and until they have received a response from the Agency to an existing request" for clarification and that he "cannot envision the Commission moving forward with such an action." He expressed concern that, "without some palliative measures at this point, there could be potential harm to markets and ultimately to consumers." Markets cannot rely on one Commissioner's inability to envision enforcement actions based on non-compliance with as-yet unclear requirements.

Derivatives dealers, fearing that a slight misstep could land them in a heap of trouble, might stop participating in the OTC derivatives markets until these ambiguities are cleared up. If dealers step back, companies that need to protect themselves from risks associated with their business will not be able to do so, and their unprotected risk will be reflected in higher prices for consumers.

Fears of ending up on the wrong end of a CFTC enforcement action were only heightened by the CFTC announcement last Friday that fiscal year 2012 was a record-breaking year for enforcement actions and that its enforcement director plans to enforce new Dodd-Frank rules as they become effective. The CFTC has delayed the implementation of some rules already, but it ought to take a more comprehensive approach to adjusting implementation deadlines.

Conveniently, one important set of implementation questions and attendant concerns about harmful effects was mooted late last month by a federal court that threw out the CFTC's position limits rule. The court concluded that Dodd-Frank's directive to the CFTC was ambiguous and rejected the rule because the CFTC had failed to acknowledge the statutory ambiguities, let alone to resolve them. As a consequence of this ruling, the position limits rule--which former CFTC Commissioner Dunn worried "may actually lead to higher prices for the commodities we consume on a daily basis"--will not take effect on October 12 as scheduled.

Nevertheless, many other open questions remain. The CFTC is not the only regulator taking its sweet time to resolve interpretative questions. Treasury, which is charged with deciding the scope of a foreign exchange products exemption, has proposed an exemption, but has not finalized a rule. A failure to do so before the CFTC's October 12 deadline means that entities engaged in these markets will become subject to the new regulatory regime for OTC derivatives pending Treasury's finalization of the exemption.

Even those who long to shrink the OTC derivatives markets understand the need for market participants to have sufficiently advance notice of the rules that will govern their transactions. Regulating markets implies a degree of regularity; we have yet to see any regularity in the approach taken by the newly anointed OTC derivatives regulators. If they don't quickly resolve the situation, Dodd-Frank could do more to upset the markets than to regulate them.