OTC Derivatives Reform: A ’Sea of Change’?

OTC derivatives legislation and clearing reforms understandably have European and US market participants scratching their heads about what this "sea of change" has in store for them and the future of OTC markets. David Felsenthal, a partner at Clifford Chance LLP, has given the matter some serious thought, and provides some guidance in his January 14, 2012 post at Harvard Law School's Forum on Corporate Governance and Financial Regulation.

According to Felsenthal, the reforms being considered focus primarily on transparency about on positions and exposures of individual firms in OTC derivatives, a transparency sorely missing during the financial crisis.

In an attempt to combat this problem, the regulatory measures share a certain amount of common ground. Put simply, they aim to improve transparency by requiring participants to disclose more information about the positions they hold. They also aim to reduce risk through changes to clearing and collateral requirements. Specific measures in the proposed regulation include reporting and clearing obligations for eligible OTC derivatives, measures to reduce counterparty credit risk and operational risk for bilaterally cleared OTC derivatives, common rules for central counterparties (CCPs) and for trade repositories, and rules on the establishment of interoperability between CCPs.

The focus on transparency is not in itself surprising, though as usual the devil is in the details. According to Felsenthal, the most likely areas of concern are

lack of clarity,
cost and competitiveness issues,
variability of the implementation timetable between juridictions,
unintended consequences.

The implementation timetables are particularly troubling. The US timetable has shifted widely, and the EU efforts have hit some roadblocks.

Sitting alongside these uncertainties is the variability of the implementation timetable. The US is not that much further on than six months ago, with little in the way of solid implementation dates. We believe that the regulations on mandatory clearing will be the first to be implemented, but this looks to have shifted back to mid-2012 and that can still only be a guess. This would bring them into the same proposed implementation timescale as new rules under Volcker requirements (discussed later) which are scheduled for July 2012.

It’s a similar story in Europe as the extended ‘trialogue’ between European Council, Commission and Parliament means that the European Securities and Markets Authority’s (ESMA) ‘fleshing out’ of the EMIR framework is being held back. The prospect of implementation by the end of 2012 looks challenging. In addition, CRD4 and MiFID II have their own timetables, with the former expected to apply from January 2013 and the latter currently likely to apply from the end of 2014 following a two-year transposition period.

Given the issues legislators and regulators are wrestling with, the shifting implementation dates are entirely understandable. Crafting regulation of OTC derivatives that effectively handles extraterritoriality (i.e., how to treat domestic versus foreign counterparties and institutions) has turned out to be particularly challenging, as has managing the overlap and consistency of regulations between jurisdictions. These two issues are key to preventing regulatory arbitrage, and effective combatting risk contagion.

As far as operational regulation, Documentation and collateral segregation issues abound with many market participants disagreeing about the best way forward.

In terms of clearing agreements for end users, there is a trend in the US towards the use of existing futures brokerage documentation, but with an OTC addendum. However, some are questioning whether this method, though relatively straightforward, is appropriate. Many in the dealer community are used to the bilateral agreement so it seems the obvious route, but isn’t the whole point of the cleared world that you don’t take risk on your counterparty? In which case, do you need this sort of agreement with them?

Perhaps the most contentious issue is the segregation of collateral. In the US, client collateral is traditionally held on an omnibus basis by the futures brokerages, with some scope for them to reinvest. The collapse of MF Global has further heightened calls for client collateral to be kept separate and transparent for each customer – although it could lead to increased cost for end users.

Felsenthal also sees issues presented by the Volker Rules and their implementation in the US, and discord amongst the EU players on a whole raft of issues, including platform trading obligations, and new short selling regulations, which will require disclosure of net short positions in shares and sovereign debt.

While the potential effects of OTC derivatives reform on day-to-day activities may be easy to identify the broader effect remains to be seen as governments and regulators hash out the details. This is clearly an area OTC market participants should watch closely both for opportunities to comment and influence its direction, but also for areas of potential business opportunities.

The full text of Felsenthal's post is available at: http://blogs.law.harvard.edu/corpgov/2012/01/14/whats-over-the-horizon-for-otc-derivatives/

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MILESTONES FOR LENDER DIRECTED VOTING

May 8, 2014: Council of Institutional Investors; - CII Elects New Board, Names Jay Chaudhuri Board Chair. http://www.bloomberg.com/news/2014-01-31/north-carolina-treasurer-may-cede-pension-control-5-questions.html )

February 2014: Swiss Minder Initiative implies the value of LDV. http://www.ipe.com/switzerlands-minder-initiative-will-cripple-securities-lending-experts-warn/10000947.article.

January 2014 – FL SBA begins their SecLending Auction Program with eSecLending.

November 27, 2013 – CSFME staff call with Glass Lewis Chief Operating Officer. He gave his commitment for cooperation and support for LDV, and most importantly, he suggested that perhaps we should discuss with a Broadridge/State Street/Citi the scenario that permits Citi to forward an “Omnibus Ballot” of proxies to State Street, which State Street would then take and assign the proxies to their pension lenders/LDV participants, which would then be incorporated into a single ballot and sent to Broadridge. This eliminates the secondary ballot issue. While this description is oversimplified, Glass Lewis was fairly certain the parties involved could operationally create such a combined ballot. Responding to the question on cost, the Glass Lewis executive stated that the cost depends on the number of voting policies a fund has. Most funds have one policy; therefore, depending on the client, the cost would be $.75 – $2.00 per ballot.

October 21, 2013 – CSFME staff call with ISS Chief Operations Officer. He committed his cooperation and support to advance LDV’s implementation into the markets. He responded to the question about cost: “It depends on the client and the services they use. $6-7 per ballot on average.”

June 25-28, 2013 – CSFME staff attended ICGN Annual Conference in NY, NY. Spoke with executives of CalSTRS; ICGN Chair and Blackrock about LDV. We received favorable comments and encouragement from each.

June 6, 2013: CSFME meets with Chief Investment Officer for NYC Pension Funds. While very much in favor of the LDV concept, the comments that the NYC Pension Fund Boards are for the most part followers in new initiatives and would prefer a roll-out by other funds first.

April 5, 2013: ‘SEC gives CSFME limited approval for LDV going forward’ providing brokers assign proxies only from their proprietary shares.

March 26, 2013 – CSFME and its legal team presented the case for LDV to SEC Commissioner Dan Gallagher. Present by phone and speaking on behalf of LDV were representatives of FL SBA who spoke about the difficulty of timely recall of shares on loan following release of record date and issues on agenda; and a representative from CalSTRS who spoke about their recall policy affecting income.

March 13, 2013 – CSFME meet staff of Senator Rob Portman and Congressman Steve Stivers of Ohio. These meetings were for the purpose of lining up political support, should the SEC resist the LDV concept. We also met and spoke with CII Deputy Director Amy Borrus for one hour and 15 minutes for a scheduled 30 minute meeting. She expressed great interest in the value of LDV to long-term beneficial owners.

January 17, 2013 – CSFME conference call with CoPERA Director of Investments. Among CoPERA’s concerns were: (1) How are agents/brokers notified re: LDV? (2) Who moves or approaches first lender to agent or agent to lender? CSFME responds that a side letter is needed between lender, agent and broker.

November 8, 2012 – CSFME conference call with Council of Institutional Investors (CII) detailing LDV. Some in attendance were opposed to securities lending because of their desire to vote 100% of recall. This position would be irrelevant giving CalSTRS’ change to policy on proxy recall.

October 24, 2012, 2PM – CSFME presents LDV to Broadridge Institutional Investor Group. At this meeting, a representative of CalSTRS states: “We would view brokers willing to provide proxies more favorably than those who would not.” We were also informed by CalSTRS that they were looking to change their 100% recall policy. A representative of SWIB led a discussion on International Voting Issues, and apparently was chairing 3 meetings to determine the following: 1. who is voting internationally? 2. What are the issues in the international markets? 3. How do we increase and improve international processes?

October 24, 2012, 11AM – EWB/KT conference call with ICGN. Executives stated that the argument for LDV may not be as strong in a non-record date market, and asked what would be the cost for LDV. They further stated that they would like to see the U.S. go with LDV first and would need more information and operational detail.

October 13, 2012 email note from Elizabeth Danese Mozely to Broadridge’s Institutional Investor Working Group: “TerriJo Saarela, State of Wisconsin Investment Board, will provide commentary on their fund’s interest in international voting and an update on her participation in the Council of Institutional Investors’ working group on international voting. Our discussion will include the differences in process for voting abroad, share blocking, attendance at the meeting via proxy or Power of Attorney (POA), best practices available through the various laws and regulations, etc.”

September 18, 2012: CSFME contacts Blackrock/ICGN Chair for a brief on LDV.

August 13, 2012 – CSFME conference call with OTPP. Discussion of LDV was not timely in that their SecLending Program stopped lending securities through agents in mid-2006. State Street is their custodian and they were using a tri-party repo through Chase to Lehman, until the Lehman collapse. All the assets sat at Chase. It was not clear who had voting rights. At the time of this discussion in August 2012, OTPP was thinking formulating an SLA because they do not have the capacity to lend securities on their own. We have had no discussion with them since.

August 2, 2012 – CSFME contacts Ontario Teachers’ Pension Plan (OTPP) regarding LDV.

March 19, 2012 – CSFME conference call with executive in charge of securities lending for Franklin Templeton

February 22, 2012 – ICGN sends LDV letter of support to the SEC, signed by Chairman of the ICGN Board of Governors.

September 30, 2011 – CalSTRS sends LDV letter of support to the SEC, signed by Director of Corporate Governance Anne Sheehan.

July 18, 2011 – Florida SBA sends LDV letter of support to the SEC, signed by Executive Director and Chief Investment Officer.

November 2011 – CSFME introduces Council of Institutional Investors editor to LDV.

July 5, 2011 – CSFME sends a Comment Letter to the Securities and Exchange Commission regarding LDV.

October 2010 – CSFME releases report: Borrowed Proxy Abuse: Real or Not? This report and the SEC’s Securities Lending and Short Selling Roundtable prompted the question from beneficial owners and regulators regarding the need to recall shares on loan to vote proxies, why can’t lenders receive proxies for shares on loan when we get the dividends? From this question, the idea for Lender Directed Voting was born.

January 2010 – SEC issues rules that brokers no longer have the discretion to vote their customers’ shares held in companies without receiving voting instructions from those customers about how to vote them in an election of directors. http://www.sec.gov/investor/alerts/votingrules2010.htm. The rule, periodically, contributed to the difficulty of corporate meetings attaining a quorum.

Fall 2009/2010 – Four public pension funds join CSFME in Empty Voting studies/LDV initiative; FL SBA, CalSTRS, SWIB and CoPERA.

September 29-30, 2009 - SEC Announces Panelists for Securities Lending and Short Sale Roundtable; http://www.sec.gov/news/press/2009/2009-207.htm.

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Corporate Governance Blog

OTC Derivatives Reform: A ’Sea of Change’?

Corporate Outreach Milestones