In voting against the motion by the CFTC on Thursday, commissioner Sharon Bowen claimed that approval would introduce greater systemic risk to the derivatives market due to what she believes are key differences between the US and Japanese rules.
Bowen was right to demand a public hearing on the matter, even though doing so meant a delay and added complexity to the roll out of uncleared margin rules in Canada, Japan and the US on September 1. Bowen was also right to voice her concerns over the unintended consequences such a decision could foster if it sets the standard for future negotiations of this kind.
But the worst case scenario she painted will only come to pass if the CFTC and Japan’s Financial Services Agency down tools completely now. If there's no further convergence between the countries, Bowen's fears might be realised, and firms in both countries will start working out how to play the regulatory arbitrage.
Left untended, even innocuous-seeming differences between two regulatory regimes could fester, and leave weaker markets in their wake. Only a major market downturn will expose problems — and by then it will be too late to fix them.
But a clear and immediate signal from both the CFTC and JFSA that they intend to start working to narrow their remaining differences would go a long way to ensuring that regulatory arbitrage never gets a foothold in the first place. The determination of substituted compliance, or equivalence, is a useful starting point for those discussions and a gesture of goodwill that can only help strengthen the relationship.
Recognising equivalence tells the market that the US and Japan have the same intentions about the purpose and effect of the rules, even if their regimes are not identical in every detail. An international market will never be perfectly aligned, though, and regulators need also to show they are able to be flexible.
This is important to acknowledge, because the complaints of commissioner J. Christopher Giancarlo about the way the rules were implemented on September 1 were also valid. Dealers and their clients largely got away with a muddled roll out of the rules, but it was as much through luck as judgement in many cases.
If markets had been more volatile then the teething problems of compliance – particularly relating to not having all custodial agreements in place in time – could have been much more problematic. Coordination between the CFTC and US prudential regulators, never mind international coordination between the US and Japan or the US and Europe, could have been much better.
Giancarlo’s assertion that “agent swaps markets almost ground to halt amid chaos and confusion over the application of the new margin rules” may have been overstating the reality. But his view that “this disruption was totally avoidable had the CFTC and its fellow US regulators been less concerned with sticking to an arbitrary deadline and more concerned with the impact of a self-induced market shock on the welfare of American business” was not.
It is lamentable that US, Japanese and Canadian regulators felt compelled to push ahead with the rules before they were completely ready, or indeed while 21 of the 24 overseas regulators — notably Europe, Australia and Singapore — had fallen behind. But having done so and managed to avoid too much pain in doing so for now, it is imperative that every regime steps up the pace on work to bring themselves back into alignment.
The US-Japanese determination should be taken as a public rallying call to that effect, not as a complacent end state. As Giancarlo concluded, “the determination does appropriately recognise that certain differences between US and Japanese margin regimes achieve comparable outcomes. Wrong approach. Right result.”