Hedge Fund Intelligence Navigating Derivative Regulations

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Hedge Fund Regulation
Navigatin g the C omplex Web of Derivative Regul ations
By Joshua Satten, Global Head of OTC Structured Products

The surge in derivatives regulations is among the most complex challenges facing the financial
services industry today. The United States, the European Union, and half a dozen other nations
are in various phases of implementing rules that govern the execution, clearing, reporting, and
reconciliation of derivative instruments. Regulatory regimes are similar in character but divergent
in the particulars, creating a complex web of obligations that have investors, managers, and
administrators working to understand their obligations and how to address them.
REGULATIONS ARE COMPLEX, AND VARY BY REGION

Derivatives regulations can be incredibly complex and vary greatly. This complexity is predicated
on several factors including fund domicile, products traded, the domicile and regulatory status of
the counterparty to a given trade, entity type, trading volume, and other factors.
We can group types of derivative regulations into four broad buckets:
1. A move towards centralized clearing;
2. Electronic execution requirements for trading over-the-counter (OTC) products;
3. Risk mitigation requirements, such as portfolio reconciliation and dispute resolution; and
4. Requirements to report and disclose activity to a trade repository.
One point of note is that the United States and Europe have taken very different approaches in
terms of how they are bringing standardization and transparency to the marketplace. The United
States focused primarily on centralized clearing and then on implementing risk mitigation and
trade reporting processes, whereas Europe’s initial focus has been more on the risk mitigation
and trade reporting requirements, and currently plans to mandate centralized clearing closer to
2016. This adds to the challenge for managers, particularly those with funds in multiple markets,
or whose trading counterparties are subject to additional or differing regulatory obligations.
A second key difference is that the United States’ trade reporting requirements center on swap
dealers and major swap participants – the large brokers and banks deemed to be systemically
important. Where trading with an “end user” – a buy side fund manager, for example – the
dealers are responsible for reporting in a one-sided model; their counterparties are not required
to report. Conversely, under the European Market Infrastructure Regulation (EMIR) we see a
mandate for two-sided reporting where both parties to the trade are required to report to a trade
repository regardless of entity type (with certain narrowly defined exceptions).
The third key difference is that most of these regulations focus on OTC derivatives products
(swaps and options) across asset classes, with some including foreign exchange. However, EMIR’s
rules include exchange-traded derivatives such as listed options and listed futures, which makes
the European regime more holistic – and more complex.
The end result is that while the types of rules are similar, the implementation of the rules – in
terms of timing, format, etc. – is quite diverse. This makes compliance more complicated, and
creates a need for managers to have consistent and robust legal and operational support to stay
compliant – especially if they are contemplating geographic expansion or investment diversification.

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