Holes in the patchwork, however, notably counterparty credit risk, opacity of trading and counterparty exposure to regulators, and lack of intermediary oversight, were set for reform following the global financial crisis. The world’s response to the CFTC’s flawed swaps regime has been a swift “No thank you”. Global trading markets have divided into separate swaps liquidity pools between those in which US persons are able to participate and those in which US persons are effectively shunned.
According to a survey conducted by the International Swaps and Derivatives Association, the circa $400tn market for US and euro interest rate swaps, two of the most widely used products for business risk hedging, has effectively split into two over the past 12 months. Traditionally, users of swaps products chose to do business with global financial institutions based on factors such as quality of service, product expertise, resources and professional relationship. Now, those criteria are secondary to the question of the institution’s regulatory profile.
Non-US persons are avoiding financial institutions bearing the scarlet letters of “US person” in certain swaps products to steer clear of the CFTC’s problematic regulations. Fragmentation of global swaps markets between US persons and non-US persons means smaller, disconnected liquidity pools and less efficient and more volatile pricing. Divided markets are more brittle with shallower liquidity, posing a significant risk of failure in times of economic stress or crisis. In short, market fragmentation caused by the CFTC’s ill-designed trading rules – and the application of those rules abroad – is increasing the systemic risk that Dodd Frank regulatory reform was predicated on reducing.
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