On February 23, 2017, the European Supervisory Authorities (ESAs) announced that neither the ESAs nor competent authorities (CAs) would provide over-the-counter (OTC) derivatives dealers subject to European Market Infrastructure Regulation (EMIR) with relief from the March 1, 2017 deadline to implement variation margin (VM) requirements. However, due to difficulties faced by small counterparties, and for consistency with the guidance issued by the U.S. banking agencies, the ESAs expect CAs to generally apply a risk-based approach in their day-to-day enforcement of VM requirements after March 1.  CAs will require European dealers to take into account counterparty exposures and risk of default, document their steps taken toward full compliance and put in place alternative arrangements to contain risk, such as using existing Credit Support Annexes to exchange VM.  The ESAs and CAs make clear that their risk-based approach does not entail a general forbearance, but that CAs will make a case-by-case assessment on the degree of a dealer’s compliance and progress.  In any case, the ESAs and CAs expect EU derivatives dealers to finalize all necessary documentation before September 1, 2017 and that OTC transactions entered into on or after March 1, 2017 will remain subject to VM obligations for non-centrally cleared derivatives under the EMIR Regulatory Technical Standards.

The European regulators made their announcement on the same day as the Federal Reserve Board (FRB) and Office of the Comptroller of the Currency (OCC) issued guidance for U.S. swap dealer banks.  On February 23, 2017, the FRB and OCC required U.S. swap dealer banks to be in full compliance with their VM requirements by March 1, 2017 for counterparties with significant exposures.  But for swap counterparties without significant exposures, the FRB and OCC expect swap dealer banks to make good faith efforts to comply with the final rule by September 1, 2017.  The FRB and OCC didn’t provide any definitions for significant exposures.

With guidance from the ESAs, CAs, FRB and OCC, as well as the announcement by the Japanese Financial Services Agency that it will delay VM requirements for Japanese dealers applicable to cross-border trades with counterparties in jurisdictions where VM requirements have not yet been implemented, only the Canadian regulators have yet to announce transitional measures or no-action relief.  The U.S. Commodities Futures Trading Commission, plus regulators in Australia, Hong Kong and Singapore elected to provide no-action relief from VM requirements until September 1, 2017 for dealers under their jurisdiction.  Let’s hope global regulators can use the next six months to agree on a consistent framework for VM requirements.  Without such harmonization, global markets could further fragment and liquidity in key OTC derivative products, such as foreign exchange swaps and forwards, could be reduced.  Risk-based approaches are good, but harmonized regulation is better.

U.S. swap dealer banks received much needed breathing room, but not complete relief from the March 1, 2017 variation margin (VM) deadline for swaps and security-based swaps. On February 23, 2017, the Federal Reserve Board (FRB) and Office of the Comptroller of the Currency (OCC) recognized that, considering the scope and scale of documentation and operational changes necessary for swap dealer banks to achieve effective compliance for each of its non-cleared swap transactions, FRB and OCC examiners will focus on the bank’s good faith efforts to comply with the VM requirements, as soon as possible, but in no case later than September 1, 2017.

Significant Exposures

However, for swap counterparties that present significant exposures, the FRB and OCC expect swap dealer banks to be full compliance with the VM requirements by March 1, 2017. The FRB and OCC didn’t define what may constitute significant exposures.  For swap counterparties without significant exposures, the FRB and OCC expect swap dealer banks to make good faith efforts to comply with the final rule by September 1, 2017.  Swap dealer banks should prioritize compliance efforts based on the size of and risk inherent in the credit and market risk exposures presented by each counterparty.  Furthermore, banks must establish governance processes that assess and manage their current and potential future credit exposure to non-cleared swap counterparties, as well as any other market risk arising from such transactions.   The FRB and OCC indicated that their examiners will consider the bank’s implementation plan, including actions taken to update documentation, policies, procedures and processes, as well as its training program for staff on how to handle technical problems or other implementation challenges.

Impact on the Buy Side

The FRB and OCC announcement is important because the largest swap dealers are affiliated with U.S. banking institutions and most counterparties should not present significant exposures to banks affected by the guidance. While the FRB and OCC elected not to provide complete relief, the bank regulatory announcement is critical because the six-month VM rule grace period from the Commodity Futures Trading Commission only covered smaller non-bank and energy swap dealers.  Hopefully, European and Canadian regulators will follow their colleagues in the United States, Australia, Singapore and Hong Kong in postponing their VM deadlines to September 1, 2017.  Without global coordination of VM rules and deadlines, market participants could suffer from decreased liquidity and market fragmentation.  To prevent such trading disruptions, financial end users and other buy-side counterparties must continue to work diligently to establish VM compliant documentation with their dealers as soon as possible.

On February 13, 2017, the U.S. Commodity Futures Trading Commission (CFTC) issued time-limited no-action relief providing a six-month grace period for certain swap dealers to come into compliance with the variation margin rules that are set to come into force March 1, 2017.  As CFTC Acting Chairman Giancarlo noted, as much as 90 percent of financial end-users in-scope under the rules are not ready to meet the new requirements.

Global systemic risk is not reduced by the abrupt cessation of risk hedging activity by American life insurance companies and retirement funds at a time of enormous changes in financial rates and global asset values. This action by the CFTC does not change the scheduled time of arrival for the agreed margin implementation. It just foams the runway to ensure a safe landing.”  – CFTC Acting Chairman Giancarlo

The CFTC’s relief will primarily benefit smaller swap dealers and energy companies registered as swap dealers.  While the relief contains certain conditions, these are not generally onerous. The relief is similar to that provided by regulators in Australia, Singapore and Hong Kong.

However, U.S. prudential regulators and European regulators have yet to issue similar relief.  Given that many of the largest swap dealers are subject to rules issued by the U.S. banking agencies, the Federal Reserve Board, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency, the relief issued by the CFTC will do little to prevent last-minute trading disruptions or market fragmentation if the U.S. banking regulators do not follow suit.  Further, European dealers are subject to variation margin rules promulgated by European regulators under EMIR.  European regulators have yet to issue any final relief, although they have made noises indicating that such relief is being considered.  In short, the CFTC’s relief will have limited benefit to impacted market participants if these other regulators do not follow suit before March 1.

Derivatives traders and lawyers are focused on March 1. Not for any basketball tournaments, but for the variation margin (VM) big bang.  From March 1, 2017, swap dealers and financial end-users will be required to exchange VM on uncleared swaps.  To comply with the applicable VM rules, swaps dealers and financial end users will need to amend their derivatives documentation, including credit support annexes (CSAs).  ISDA created the 2016 VM Protocol (the VM Protocol) to provide a documentation solution that complies with the U.S. banking prudential regulator and Commodity Futures Trading Commission (CFTC) VM rules, as well as similar rules in Canada, Japan and under European Market Infrastructure Regulation (EMIR).  In addition to selecting the relevant jurisdictions required for compliance, counterparties can elect to:

  1. Amend existing master agreements to add new CSAs for VM on terms determined by the VM Protocol.
  2. Amend existing master agreements and CSAs to cover new transactions (but not trades entered into before March 1, 2017) by creating a replica of their existing CSA and then amending it to comply with the jurisdictions selected.
  3. Amend existing CSAs in order to comply with the jurisdictions selected (which would cover all transactions under the master agreements).
  4. Create new ISDA 2002 Master Agreements (using agreed-upon boilerplate terms) with new compliant CSAs.

While the VM Protocol is quite flexible and can satisfy applicable VM requirements in the US, Canada, Europe and Japan, many market participants have elected to not use the VM Protocol. Rather, many participants have decided to negotiate new or amended CSAs on a bilateral basis. Considering that it often takes months to negotiate a single CSA, and that thousands of counterparties will be required to exchange VM on March 1, derivatives lawyers for swap dealers and investment managers are working diligently to finish the new documentation in time.

But, What If…?

If a substantial number of counterparties have not executed bilateral compliant CSAs or adhered to the VM Protocol by March 1, they will not be able to trade uncleared swaps. This could disrupt global swap markets by reducing liquidity and increasing risk by preventing market participants from hedging existing positions.  The easiest solution would be for the CFTC and other global regulators to postpone the March 1 deadline.  Hong Kong and Singapore have already announced a six month phase-in period for counterparties to continue to negotiate compliant documentation.  Australia has also postponed the deadline to September 1, so long as all transactions executed from March 1 are subject to VM requirements by September 1.  Unfortunately, the European Commission may be unwilling or unable to push back the March 1 effective date for the EMIR VM standards.  This could put acting CFTC Chairman Christopher Giancarlo in a difficult position. Chairman Giancarlo has emphasized the importance of harmonizing global derivatives regulation, particularly to prevent market fragmentation.

I am especially concerned that smaller firms, including American pension and retirement funds, may not be able to get their documentation done in time. If they do not, they will be abruptly forced to stop hedging their portfolios at a time of enormous changes in financial rates and global asset values.” – Acting CFTC Chairman Christopher Giancarlo


The CFTC could decide not to provide relief in order to maintain consistency with the EMIR VM standards.  The CFTC elect to provide short-term transitional period of relief, much as it did on September 1, 2016 for large swap dealers to complete the custodial arrangements needed to comply with the initial margin requirements applicable to dealers (the 2016 Relief).  However, the 2016 Relief was implemented at the last minute and offered only a 30-day period for a small number of dealers to complete less complex documentation.  Given that the VM rules have a global impact and the upcoming March 1 deadline will affect a much larger set of counterparty relationships, the most practical way forward would be for the CFTC to work with European and Asian regulators to push-back the March 1 deadline to September 1, 2017, or implement a six-month phase-in period.  Hopefully, with the post-election changes at the CFTC, U.S. regulators will have more flexibility to harmonize derivatives regulation than they did under the prior administration.  Let’s hope that U.S. and global regulators can agree on a consistent approach.  Otherwise, the March 1, 2017 VM big bang will cause March madness.

In his speech on November 3, 2016 at Chatham House in London, Financial Stability Board (FSB), Secretary General, Svein Andresen noted the “hype” that surrounds financial technology, or fintech, and urged global regulators to actively monitor and act on risks as they emerge.

Much hype surrounds the development of fintech and for regulators it is essential to understand what developments are going to change the way financial markets operate and those that won’t.”                            –FSB Secretary General Andresen

Secretary General Andresen highlighted the FSB’s progress in considering the implications of distributed ledger technology by working jointly with the FSB’s Committee on Payments and Markets Infrastructure, as well as the impact of peer-to-peer lending and machine learning applications.  At the national level, the FSB has examined innovation facilitators – sandboxes, hubs and accelerators to better understand the risks of new financial technology.

Based on the FSB’s investigation into blockchain and other financial technologies, the FSB has identified three elemental promises common to a broad range of fintech innovations: (i) greater access to and convenience of financial services, (ii) greater efficiency of financial services and (iii) a to push toward a more decentralized financial system, in which fintech firms may be disintermediating traditional financial institutions.  The FSB believes that these elements could have financial stability implications.  However, Secretary General Andersen is not presently concerned that new financial technologies increase systemic risk.  For now, the FSB recommends that global regulators continue to monitor potential risks and assess developments in fintech.

FSB Secretary General Andresen’s complete speech at Chatham House in London is available here.

On November 3, 2016, Comptroller of the Currency Thomas J. Curry spoke at Chatham House in London about responsible innovation and Office of the Comptroller of the Currency (OCC) efforts to address financial technology. Comptroller Curry began his speech by noting the rapid growth of the “fintech” sector and how banks, like taxis, could face an “Uber moment” if banks fail to embrace changes in technology and demographics.

If Uber turned your smartphone into a taxi dispatch, fintech is turning your phone into a financial advisor, a loan officer, a money transmitter, and an automated teller.” -Comptroller Curry

But, as noted by Comptroller Curry, banks are different than taxis. Banks provide critical financial infrastructural and are systematically important in ways that taxis are not.  Banks are responding to the technological revolution by creating innovation laboratories of their own, investing in promising applications (like distributed ledger technology) and collaborating with fintech startups.  In response to the growing intersection of banks and technology, in March 2016, the OCC published its views on Supporting Responsible Innovation in the Federal Banking System and recently developed its Responsible Innovation Framework.  Comptroller Curry’s speech in London provided two key updates on the OCC’s efforts to encourage responsible innovation.

Comptroller Curry made it clear that he doesn’t support regulatory “safe spaces” that would allow companies to try out new financial products and services without risk of penalty.  Instead, companies should seek guidance from regulators when developing a pilot to test new products.  Comptroller Curry mentioned that the OCC’s new Office of Innovation may assist companies in creating responsible pilots by acting as the central point of contact and clearing house for requests.

Unfortunately, Comptroller Curry did not provide much new information about the OCC’s proposed new limited-purpose charter intended to facilitate financial technology.  He did state that, if the OCC decides to grant a “fintech” charter, any institutions under such charter will be held to the same high standards of safety, soundness, and fairness as other federally chartered institutions.  While this would appear to discourage the innovation that the OCC hopes to facilitate, it does put the “taxis” trying to disrupt financial services on the same regulatory field as banks responding to the technological revolution.

The complete text of Comptroller Curry’s speech at Chatham House in London is available here.

On October 26, 2016, the Office of the Comptroller of the Currency (OCC) announced it would establish a framework for “responsible innovation.”  The agency plans to establish an Office of Innovation to implement this framework, with the goal of improving its ability to identify, understand, and respond to financial innovation affecting the federal banking system.  The full recommendations are available here.

The move follows similar initiatives by international regulators, such as those in the UK, Singapore, Hong Kong and Australia to provide a framework, or even a safe-harbor “regulatory sandbox” for financial technology firms and banks implementing new technologies to test innovative products and services, such as distributed ledger technology (blockchain), digital currencies, streamlined payment transfers or marketplace lending.

The OCC supports responsible innovation that enhances the safety and soundness of the federal banking system, treats customers fairly, and promotes financial inclusion.

– Comptroller of the Currency Thomas J. Curry

The Office of Innovation would have staff located in Washington D.C., New York and San Francisco. Although the framework does not provide a full-blown “safe space” or “regulatory sandbox” that would provide a safe harbor from consumer protection requirements, it does contemplate a voluntary pilot program that would facilitate adoption of new solutions and the enhancement of risk management by permitting testing and discovery with agency involvement before a full-scale commitment and rollout of technologies.  In addition, the framework’s objectives include:

  • establishing an outreach and technical assistance program for banks and nonbanks,
  • conducting awareness and training activities for OCC staff,
  • encouraging coordination and facilitation,
  • establishing an innovation research function, and
  • promoting interagency collaboration.

The OCC expects the new office to begin operations in first quarter 2017. The OCC refrained from making a decision on whether to provide special purpose national bank charters for non-bank financial technology companies, a prospect which it continues to evaluate. The agency plans to publish a paper later in 2016 seeking comment on possible limited-purpose charters targeted toward non-bank fintech firms.


On October 13, 2016 the Commodity Futures Trading Commission (CFTC) approved an order (the Order) to delay the deadline for certain market participants to apply for provisional registration as a swap dealer.  The CFTC had previously established December 31, 2017 as the initial registration de minimis threshold phase-in termination date for market participants with dealing notional amounts above the threshold.  Instead of dropping to a $3 billion dealing threshold on December 31, 2017, the swap dealer de minimis threshold will remain at $8 billion until December 31, 2018.  In his statement announcing the Order, Chairman Massad summarized the key issues:

“The de minimis threshold determines when an entity’s swap dealing activity requires registration with the CFTC. Registration triggers capital and margin requirements as well as other responsibilities, such as disclosure, recordkeeping, and documentation requirements. In 2012, the CFTC set the threshold initially at $8 billion in notional amount of swap dealing activity over the course of a year, and provided that it would fall to $3 billion at the end of 2017.”

With the CFTC’s decision to postpone the threshold phase-in termination deadline, middle market banks, utilities and energy producers will have additional time to consider how the compliance requirements will impact their swap trading activities. Some market participants have already taken steps to comply with the capital, margin, disclosure, recordkeeping, and documentation requirements noted by Chairman Massad.  However, other participants may be forced to limit dealing activity or even close trading desks to avoid registration.  In the CFTC’s preliminary and final swap dealer de minimis exception reports, the CFTC noted potential for:

  • increased concentration in the swap dealing market,
  • reduced availability of potential swap counterparties,
  • reduced liquidity,
  • increased volatility, and
  • higher fees or reduced competitive pricing.

Based on the potential for further reduction in market liquidity and the challenges associated with the implementation of capital and margin requirements, the CFTC decided to push back its swap dealer registration de minimis threshold deadline until the end of 2018. The CFTC’s decision is a relief for market participants, particularly banks that rely on the insured depository institution exemption to remain below the de minimis threshold, as well as for utilities and energy producers with large non-financial commodity marketing operations, which will need to develop operationally-efficient methods for determining and reporting swap notional amounts.  The Order will enable the CFTC to perform a thorough analysis of market liquidity and more fully assess how capital and margin rules are working.

On October 11, 2016, Commodity Futures Trading Commission (CFTC) Commissioner Christopher Giancarlo made an important request to other financial regulators after the October 7, 2016 flash crash in the British Pound.  Commission Giancarlo’s request follows his prescient warnings in 2015 that uncoordinated regulations were draining liquidity from U.S. financial markets, as well as his recent podcast reminding regulators and market participants that “21st century markets need 21st century regulation.” Speaking about the October 7th flash crash in Sterling, CFTC Commissioner Giancarlo stated:

“It has been almost two years since I sounded the alarm about heightened market liquidity risk in the global financial system.  The increased risk is in part due to untested bank capital constraints imposed by U.S. and overseas bank regulators under the Dodd-Frank Act and similar laws.

Last Friday, the British pound suddenly crashed six percent against the U.S. dollar in volatile trading. The abrupt “flash crash” of the world’s fourth-most-traded currency was exacerbated by a lack of tradeable market liquidity.

There have been at least twelve major flash crashes since the passage of the Dodd-Frank Act.  The growing incidence of these events shakes confidence in world financial markets.

We can no longer continue to avoid the question of whether the amount of capital that bank regulators have caused financial institutions to take out of trading markets is at all calibrated to the amount of capital needed to be kept in global markets to support the health and durability of the global financial system.

Today, I repeat my call for a thorough and unbiased analysis by U.S. financial regulators and their overseas counterparts of the systemic risk of unprecedented capital constraining regulations on global financial and risk-transfer markets.”

Flash Crashes and Phantom Liquidity

Reduced liquidity in cash and derivative fixed income markets is due in part to macroeconomic forces beyond increased regulatory scrutiny. But Commissioner Giancarlo is correct.  Disparate regulations including Basel III capital requirements, Title VII of the Dodd-Frank Act rules and the Volcker Rule have combined to sap liquidity from even the deepest and most stable markets.  The October 15, 2014 U.S. Treasury market flash crash was perhaps the first big warning for market participants.  Unfortunately, the October 7th late night Sterling sell-off will not likely be the last fixed income flash crash.  With banks stepping back from their traditional role as market makers, non-bank liquidity providers shouldn’t be burdened with regulations that limit their ability to hold inventory or make bids (particularly during times of market stress).  U.S. financial regulators can encourage new market participants to step in and act as liquidity providers by eliminating certain elements of proposed Regulation Automated Trading, continuing to refine Swap Execution Facility requirements and better coordinating the cross-border margin rules with non-U.S. regulators.  To paraphrase CFTC Commissioner Giancarlo, “21st century liquidity providers need 21st century regulation.”

On October 7, 2016, Federal Reserve Board (Fed) Governor Lael Brainard spoke at the Institute of International Finance Annual Meeting Panel in Washington, DC about the potential for distributed ledger technology, or blockchain, to transform important back office systems. Governor Brainard’s October 7, 2016 speech follows up on her April 14, 2016 speech on “The Use of Distributed Ledger Technologies in Payment, Clearing, and Settlement” where the Fed first spoke about blockchain’s benefits and the need for regulatory safeguards.  Governor Brainard’s recent speech again noted blockchain’s well publicized potential to improve payment, clearing and settlement systems for trade finance, securities markets and commodities and derivatives trading.  Additionally, Governor Brainard also discussed the emergence of distributed ledger protocols couples with self-executing contractual clauses, to create so-called “smart contracts.”  When speaking about smart contracts, Governor Brainard said:

“Although the idea of automating certain aspects of contracts is not new, and banks do some of this today, the potential introduction of smart contracts does raise several issues for consideration. For example, what is the legal status of a smart contract, which is written in code? Would consumers and businesses rely on smart contracts to perform certain services traditionally done by their banks or other intermediaries? Could the widespread automated interaction of multiple counterparties lead to any unwanted dynamics for financial markets? These and other considerations will be important factors in determining the extent of the application of smart contracts.”

Fed Governor Brainard reiterated the possible benefits and regulatory challenges presented by blockchain, smart contracts and other financial technologies. Governor Brainard announced that the Fed will study the need for 21st century financial services oversight and that the Fed expects to publish a research paper later this year to summarize its findings.  As part of the Fed’s study, the Fed will “continue to deepen their engagement with a range of financial institutions, technologists, multi-stakeholder consortia, and academic experts to refine our understanding of financial technologies.”

Considering Blockchain and FinTech Regulation

The Fed’s support for the adoption of distributed ledger technology is encouraging and their continued focus on better payment, clearing and settlement systems is critical. The Fed should continue to work closely with Office of the Comptroller of the Currency (OCC) to maintain consistency with the OCC’s financial technology initiatives to consider any regulation that may impact the development of blockchain, smart contracts or other financial technologies.  When studying financial technology, the Fed and OCC may enjoy listening to Commodity Futures Trading Commission (CFTC) Commissioner Christopher Giancarlo’s podcast and reading Commission Giancarlo’s May 10, 2016, speech on “Blockchain: A Regulatory Use Case” as well as his March 29, 2016 speech, “Regulators and the Blockchain: First, Do No Harm.”  Because, when considering the safeguards for blockchain, smart contracts and other financial technologies, Commissioner Giancarlo is correct, “21st century markets need 21st century regulation.”