Hedge funds could struggle to find clearing member due to regulatory uncertainty

Date: Tuesday, June 14, 2011
Author: Charles Gubert, COO Connect

Some hedge funds could find themselves in a last minute mass scramble to find a clearing member to deal with their over-the-counter (OTC) derivatives transactions due to the regulatory uncertainty concerning clearing in both the US and European Union (EU).

These delays could prove costly for asset managers. Industry experts have warned that some fund managers might be unable to find a clearing member if they leave the decision too late. Stuart Anderson, vice president of BlackRock Multi Asset Client Solutions, said this could pose problems for smaller asset managers with limited resources.

“The largest asset managers have been incredibly proactive in finding and securing a clearing member. However, if some of the smaller asset managers leave it too late, they might be pushed down the prime brokers’ lists of priorities. This will make it difficult for them to get the required legal documentation in place to meet the deadlines,” he said.

Several prime brokers have also warned that hedge funds should not procrastinate despite the lacking clarity over the regulations.

Both the US Dodd Frank Act and the European Markets Infrastructure Regulation (EMIR) state that financial institutions trading in OTC derivatives must clear their trades through a central counterparty (CCP) clearing house via their prime broker or agent bank.

However, the regulation especially in the US has been subject to delays. The Commodities Futures Trading Commission (CFTC) is holding a public meeting on Tuesday, June 14 to discuss implementation dates for Dodd Frank. It is expected the CFTC will acknowledge it cannot meet the July 2011 deadlines. Meanwhile, the European Commission (EC) is unlikely to vote on the issue until mid 2012.

In the US, Congressional Republicans have drafted legislation to delay the implementation of OTC derivatives rules until the end of 2012. Jill Sommers, the Republican-appointed commissioner at the CFTC recently warned there was regulatory arbitrage between the US and EU. However, she did add that regulators on both sides of the Atlantic were working together to iron out any differences that may exist.

One area that may cause consternation between US and EU regulators is the EU’s decision to give pension funds a three year reprieve on clearing their OTC derivatives. The decision to force pension funds to clear OTC derivatives had raised criticisms due to the costs they would have to bear for putting up cash collateral. This was all the more galling considering these conservative institutions mainly use OTC derivatives for hedging risk.

There are also concerns that there is regulatory arbitrage within the US between the CFTC and the Securities and Exchange Commission (SEC). A report in April 2011 by advisory firm Aite Group said there was a lack of clarity over the definitions and terms while jurisdictional confusion was likely to arise due to the regulatory oversight being divided between the SEC and CFTC.