Much of the legislation passed in 2010 has come into force, although some remaining elements still need to be worked out. The Dodd-Frank regulation has embraced some regulations in Europe such as the Basel capital requirements. It is clear that the Dodd-Frank Act will have an impact on the regulations in Europe as well as other major financial centres around the world.
2014 saw the regulations come into full force and it will be a crucial year for Wall Street and the regulators, who will be scrutinising Wall Street firms and insurance companies to ensure enforcement. Futures commission merchants (FCMs) in particular will be under the microscope, along with, to a lesser extent, swap dealers (SDs) and major swap participants (MSPs).
Before getting into the main elements that make up the Dodd-Frank Act, it’s important to first understand the main objectives of the regulation. It was created to ensure an end to the ‘too big to fail bailouts’ notion of banks that existed within the US and to ensure that we have a better warning system, one that detects systemic risks before they threaten the overall economy.
The principal elements of the regulation include:
The creation of a consumer protection agency that helps to protect consumers with financial products such as mortgages, credit cards and others.
Improved transparency and accountability of complex financial instruments, which were key drivers of the Act. Examples such as collateralized debt obligation (CDO) eliminate unregulated areas such as over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders.
A focus on executive compensation and governance to prevent abuses of executive payouts by providing shareholders with a say on pay and corporate affairs, along with a non-binding vote on executive compensation and golden parachutes.
Tough new rules for transparency and accountability for credit rating agencies to protect investors and businesses – some of the financial meltdown has been attributed to the credit rating agencies and how they are funded.
The Volcker rule, added to the act in 2010. This banned the speculative investments of the banks’ own funds (known as proprietary trading) by commercial banks that had key roles in the financial crisis between 2007 and 2010.
Financial Stability Oversight Council
The council is chaired by the Secretary of the Treasury and voting members consist of heads of the Treasury, Federal Reserve, Office of the Comptroller of the Currency (OCC), Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), Federal Deposit Insurance Corporation (FDIC), Federal Housing Finance Agency (FHFA), National Credit Union Administration (NCUA) and the Bureau of Consumer Financial Protection (CFPB), as well as an independent member with insurance expertise who is appointed by the president and confirmed by the Senate.
Non-voting members include the director of the Office of Financial Research, the director of the Federal Insurance Office, a state insurance commissioner, a state banking supervisor, and a state securities commissioner.
The purpose of the council is to identify threats to US financial stability that may arise from ongoing activities of large, interconnected financial companies as well as from outside the financial services marketplace.
Regulatory Agencies and Agency Oversight Reform
The regulation of the financial industry by various government agencies with their varying rules and standards led to certain entities not being regulated at all, with others subject to less oversight than their peer financial firms, which were organized under different charters. The Dodd-Frank Act overhauls the existing agency oversight system. Some existing agencies had major changes in oversight and new agencies were created. See the diagram below for a summary view.
Volcker Rule - Title VI
The Volcker Rule was added to the act with the aim of reducing the amount of speculative investments on large firms’ balance sheets. It limits banking entities to owning no more than 3 per cent of the total ownership interest in a hedge fund or private equity fund. It caused many firms to restructure or eliminate proprietary trading operations.
The rule prohibits banks from proprietary trading and restricts investment in hedge funds and private equity by commercial banks and their affiliates. The act also directed the Federal Reserve to impose enhanced prudential requirements on systemically identified non-bank institutions engaged in such activities.
Derivatives Regulations - Title VII
Title VII provides a framework for the regulation of swap markets. It grants the CFTC regulatory authority over swaps such as energy and agriculture. It excludes security-based swaps (SBSs). It requires that certain swaps be cleared and executed by a clearing house or executed by an electronic execution facility. The execution facility acts as a middleman between two parties engaging in a swap transaction by promising to compensate the non-defaulting party for the transaction in the event the other party defaults – effectively providing greater stability in the swap markets. It also applies to related cash or forward transactions.
Title VII provides a framework for the regulation of swap markets, which were largely responsible for the 2008 financial crisis. Business conduct standards increase transparency and promote market integrity with regard to swaps and SBS transactions, consequently lowering the levels of risk inherent in such transactions. Clearing requirements ensure that any risk of loss caused by a defaulting counterparty is absorbed by large, independent institutions. Regulators will be able to make well-informed decisions because they will have increased access to data on swap and SBS markets provided by swap and SBS data repositories. Increased reporting requirements and the availability of pricing information will also lead to greater price efficiencies in swap markets.
If the CFTC or the SEC determines that a swap or an SBS is of a type that should be cleared, swaps and SBSs must be cleared by clearing houses. A clearing house is an institution that acts a middleman between two parties engaging in a swap transaction by promising to compensate the non-defaulting party for the transaction in the event that the other party defaults. Any swap or SBS requiring clearing must also be executed on an electronic execution facility, or a designated contract market in the case of a swap or a national securities exchange or in the case of an SBS, unless no such facility makes such a swap or SBS available to trade.
What Records Need to be Retained?
Registered participants must keep records of all trade activities and provide reports to the regulators. SDs and MSPs must provide the following:
- Transactional records associated with trades
- Pre-trade execution communication, including oral communication on cell phone
- Trade execution information entered on trade order system
- Post-trade execution information including confirmation, termination, amendment etc.
Registered participants are any firms that have swaps deal volumes greater than $3 billion annually.
How Long do Records Need to be Kept?
Transactional records are required to be retained for the life of the swap plus five years – the exception is oral communications where the retention is the life of the swap plus one year.
To capture oral communications for the trading floor and desktop devices there are many premise-based voice recording vendors. To meet the requirements of capturing the mobile communications, in-network solutions from vendors such as TeleWare are the simplest to implement with no impact on user behaviour.
What is Trade Reconstruction?
CFTC can request a trade reconstruction from every SD and MSP. The regulations do not specify the type of requests, but the data entities above along with UTC time need to be searchable.
Oral Records must be readily accessible during the one year retention period. Readily accessible means before the start of the next business day – as few as 14 hours.
Transactional records must be readily accessible during the life of a swap and during first two years after swap termination.
Transactional Records in the last three years of the retention period must be provided within 72 hours – three business days.
Non-transactional records must be readily accessible during the first two years of the retention period.
CFTC has defined trade reconstruction as ‘comprehensive and accurate trade reconstruction’. It is therefore necessary for the entire sequence of events leading up to the trade to be included along with reliable timing information. This includes all oral (fixed or cellular phone and voicemail) and written (email, chat, SMS and Fax) communication that led to trade execution.
Securitization Reform – Title IX
The purpose of this section of Dodd-Frank is to increase investor protection and greater accountability in executive compensation and corporate governance.
Particular focus was placed on asset-backed securities. These are fixed income or other security collateralized by financial assets such as loan, mortgage, lease and CDOs. The financial firms (the securitizers) are required to have skin in the game by retaining 5 per cent of the risk, rather than selling 100 per cent of these securities onward at no risk to themselves.
In addition, asset and data-level disclosures of the loan brokers and originators and their compensations, amount of risk retention, repurchase requests and underwriting deficiencies.
Compensation and Corporate Governance
The requirement is that at least once every three years, a public corporation is required to submit the approval of executive compensation to a shareholder vote. Once every six years there should be a shareholder vote regarding whether the required approval of executive compensation should be more often than once every three years. Shareholders may disapprove any golden parachute compensation to executives via a non-binding vote.
Investor Protection Reform
This revises the structure and powers of the SEC, credit rating organizations and the relationship between customers and broker-dealers to protect investors from secondary markets. The regulation led to the creation of the Office of the Investor Advocate – which was created before the act but is specifically authorized by the act.
Title IX authorizes the SEC to require point-of-sale disclosures when retail investors purchase investment products or services. It allows the SEC to create a whistle-blower programme. It also includes further regulation of credit agencies, discussed in the next section.
Credit Agency Rating Reform – Title XI
Credit agencies play a critical gatekeeper role in the debt market, capital formation, investor confidence and efficient performance of the economy. During the financial crisis, conflicts of interest and inaccuracies contributed to the crisis. The act gives the SEC oversight over the credit agencies through the Office of Credit Ratings to enhance the regulations.
The Federal Reserve Board and the OCC have permitted certain financial institutions to begin using the agencies’ Advanced Approaches capital framework to determine their risk-based capital requirements. Under the framework, which implements standards developed by the Basel Committee on Banking Supervision, firms must meet specific risk measurement and management criteria. The agencies’ framework applies to large, internationally active financial institutions and includes the financial institutions’ subsidiaries.
Financial institutions intending to use the Advanced Approaches framework must conduct a satisfactory trial run (‘parallel run’) to show that the firm can comply with the framework for at least four consecutive quarters using risk-measurement and risk-management systems that adhere to the Advanced Approaches framework. Eight bank holding companies, plus their eligible subsidiaries, have successfully completed their trial runs, the agencies said, and may now begin using Advanced Approaches.
In, addition the Federal Reserve published a final rule clarifying that these institutions using the Advanced Approaches framework will also incorporate the changes into the capital planning and stress testing cycles that begin October 1, 2015. This was introduced a year later than previously decided in order to give financial institutions more time to comply.
Eight bank holding companies, eight national banks and four state member banks have completed their parallel run: The Bank of New York Mellon Corporation, the Bank of New York Mellon and BNY Mellon National Association; Citigroup Inc. and Citibank, NA; The Goldman Sachs Group, Inc. and Goldman Sachs Bank USA; JPMorgan Chase & Co., JPMorgan Chase Bank, NA, Chase Bank USA National Association and JPMorgan Bank and Trust Company, National Association; Morgan Stanley, Morgan Stanley Bank, NA and Morgan Stanley Private Bank, NA; Northern Trust Corporation and The Northern Trust Company; State Street Corporation and State Street Bank and Trust Company; and US Bancorp and US Bank National Association. These firms will use the Advanced Approaches framework to calculate and publicly disclose their risk-based capital ratios beginning with the second quarter of 2014.
By Mark Miller - General Manager, T-Ware Connect (US arm of TeleWare).