Regulation of the OTC derivatives markets was a hallmark of the Dodd-Frank Act. While the swaps regulations will take time to implement, and may not necessarily impact Introducing Brokers in a direct manner, IBs should nonetheless pay attention to the swaps regulation drama for a couple of reasons. First, the CFTC’s focus on swaps means that their attention is not on other proposals, like Proposed Regulation 1.71. Secondly, as the swaps regulations begin to take form, there will be time and opportunity for IBs to modify their business models to capitalize on the new systems.
Proposed Regulation 1.71
Proposed Regulation 1.71 has quickly taken a backseat to the swaps regulations. In broad terms the proposal would require FCMs and IBs to implement certain “Chinese Wall”-like procedures to ensure there are no conflicts of interest with respect to research and execution. While such a concept may work in the context of the securities industry, it does not necessarily translate well to the managed futures industry. Comments on the proposal (including comments by the NIBA) make it clear that that managed futures industry feels that the regulators do not completely understand the IB business model and how the regulation might affect many of these small businesses.
To a certain extent the CFTC has listened to comments from the industry. The timeline for submitting comments to the CFTC for this and other regulations was extended and has allowed more people to provide insight into how the regulations might affect their businesses. Extending the comment period has also provided the CFTC with some breathing space and the opportunity to further fine-tune the language and application of the proposed regulations. In the event the CFTC decides to move forward with Proposed Regulation 1.71, it seems likely that IBs will be excluded from the scope of regulation, or there will be some sort of carve out based on the IB’s activities. Extending the comment period means that final implementation of Regulation 1.71 will be extended, allowing the CFTC to once more focus on the swaps regulations.
Swaps
During the Dodd-Frank implementation process, the 900-pound gorilla for both the CFTC and the SEC has been the regulation of the swaps markets. Dodd-Frank requires these two agencies to work together to create a comprehensive regulatory scheme for certain OTC derivatives. The CFTC and the SEC have yet to complete this task and have recently released interim orders which essentially put a hold on implementation of many of the effects the laws would have on market participants. That is, no registration requirements are in effect and no clearing is required until the CFTC and the SEC complete their draft of regulations overhauling the industry. During the stay, the CFTC and SEC will be continuing to work on rewriting the regulations and seeking input from the industry.
For IBs, the delay is an opportunity to figure out how their businesses can be modified to take advantage of the new swaps regulation. While the OTC derivatives market is usually reserved for the largest well-funded players, parts of the regulation will provide that previously unregulated products will become exchange traded and many products will need to be cleared. These two areas represent opportunities for IBs to find out how they can modify their practices to develop new business.
Business as usual…
As many within the industry understand, the CFTC and the SEC are both underfunded agencies tasked with an incredible undertaking. To develop a regulatory framework and begin regulating OTC derivatives is a costly endeavor. Even in the best of times, flush with money and resources, this would be a formidable task. Accordingly, less urgent proposals like regulation 1.71 are likely to remain on the backburner. So we are essentially left with the question – how is the industry to prepare for potential implementation of Proposed Regulation 1.71 and what should firms be doing right now? Given that the comment period for Proposed Regulation 1.71 was extended and that the CFTC recently put a hold on implementation of the swaps regulations pending more planning, it is likely that we will not see anything for sometime – either for Proposed Regulation 1.71 or for swaps. Until we do, it will be business as usual for IBs.
Bart Mallon is a partner of the law firm Cole-Frieman & Mallon LLP (www.cole-frieman.com). Mr. Mallon’s practice is focused on the securities and managed futures industry. If you have questions or comments regarding any of the items in this article, please contact Mr. Mallon directly at 415-868-5345.
