Dodd-Frank: US structured products market still assessing impact

The introduction of new prescriptive guidelines and rules under Dodd-Frank Wall Street Reform and Consumer Protection Act in the US' OTC derivatives framework seemed to have left structured notes and certificates of deposit (CDs) unscathed as the proposed restrictions on Title VII regarding the swaps hedging those notes would not apply to the actual instruments/products. However, other elements of the new legislation such as the ban on proprietary trading have had an impact on the market.

Four years after the introduction of the Dodd-Frank Act in 2010, which was aimed at reshaping the regulatory regime of the financial services sector in the US in the aftermath of the financial crisis triggered in 2008 by the sub-prime scandal, the market is still assessing the future impact of the rules to their business although issuance and sales volumes of structured notes continue to keep their traction on the back of new distribution channels driving the increased issuance.

Sales
"My prediction four years ago that the industry would experience a dramatically increased cost of compliance has come to pass," says Keith Styrcula, president of the US Structured Products Association (SPA). "The upward spike in the cost of doing business is caused not just by the implementation of Dodd-Frank, but also by the Volcker Rule, the HIRE Act, and increased requests for information from both the Securities and Exchange Commission (SEC) and the Financial Regulatory Authority (Finra)."

The cost of compliance, says Styrcula, has compressed margins for the issuing firms while the practice of external counsel specialising in structured investments is now devoted to creating compliance manuals, interpreting new regulations and responding to regulatory inquiries - rather than structuring "innovative" new trades that "benefit investors".

"The one aspect I didn't get right is that these increased costs are not being passed on to investors," he says. "They are coming in the form of reduced headcount at the top twenty structured investments issuers."

According to Christopher Schell, partner at Davis Polk law firm, the impact has not been one of wholesale changes so far in how the industry operates since we are still in this regulatory assessment period, but there have been some areas where market participants' ability to do certain types of deals has been affected.

"For example, certain structures such as warrants require more analysis and consideration," he says. "Warrant transactions on commodities are squarely within Dodd Frank, and are effectively not possible to do on a retail basis. So there have been some areas of immediate and deeper impact."

Proprietary trading
The Volcker rule which came out in December 2013 as part of Dodd Frank prohibits proprietary trading by financial institutions with a number of exceptions.

"This is an area of intense focus by the banks to see how to comply and whether their activities fit within the exemptions," says Schell. "The final regulations just came out in December last year and the conformance period was pushed off a year so that firms will need to comply in 2015."

A senior structured products banker at a non-US investment bank says that although the traditional structured products market was one of the few businesses that was left untouched by the new rules because of its client-driven approach, the Volker rule had an impact in the way the delta one business is organised within the investment banks, and pointed at the SEC embargo on new launches of synthetic (derivatives-based) mutual funds and exchange-traded funds (ETFs).

"Under the new rules these strategies were seen mostly as a trading business operated by the bank which puts it under the proprietary trading spotlight," he says. "The way delta one desks operated was adjusted and traders had to open up their platforms and share their trades with clients (insurance companies, pension funds...). The only way to make this business non-proprietary and comply with the Volker rule's client-driven and market making provisions was to open the trading platform to external clients."

However, he says, the flow business is still being adjusted and this could also have an impact on the number of banks active in this space in the US market, especially smaller outfits.

Hedging
The proposed restrictions on Title VII regarding the instruments used to hedge structured notes is one of the relevant aspects of the new rules. Issuers have been engaged for a while in clarifying some aspects of the rules around the use of swaps and security-based swaps used to hedge products.

"The hedging transactions need to go through a separate analysis," says Schell. "Issuers and structurers are still considering how best to structure their internal affairs in order to comply with Dodd Frank with those types of hedging transactions. And the types of hedging transactions are numerous: it can be done with options but it can also be done with swaps. It might be done in the cash market or with affiliates. There are many issues to analyse."

Swaps are subject to regulation by the Commodity Futures Trading Commission (CFTC), while security-based swaps are subject to regulation by the SEC. The CFTC is ahead of the SEC and has finalised more of its Title VII regulations including provisions around swaps which at least for now are subject to far greater tangible rules than security-based swaps.

Under the current rules, swaps include interest rate swaps, non-vanilla FX products, credit default swaps referencing a broad-based security index, total return swaps referencing a broad-based security index, total return swaps referencing more than one loan, commodity swaps, and other swaps referencing broad-based securities indices. In contrast, security- based swaps include total return swaps referencing a single security or loan, total return swaps referencing a narrow-based index of securities, single-name credit default swaps and credit default swaps on a narrow- based index of securities. Mixed swaps combining elements of both swaps and security-based swaps, are subject to joint regulation by the CFTC and SEC.

Suitability
Despite the issues surrounding structured notes at a product development level, the Dodd Frank Act doesn't address suitability or mis-selling, says Ana Pinedo, partner at Morrison & Foerster law firm in New York.

"These are issues that fall under Finra's rules," she says. "Over the last few years most issuers in the US have moved towards simpler products and this approach reduces the possibility for mis-selling but at the same time limits investor choice."

According to Schell, the framework of Finra's sales practice rules have been in place for a long time, especially its rules governing suitability but there has been a lot more from the regulator in the last year and a half including the conflict of interest report, the communication rule changes under 2210 and related regulatory updates on sales practices/communication with investors.

"Market participants have been very focused on the best practices that Finra has identified in terms of conflicts, and individual firms are benchmarking themselves against these best practices to see if they need improvements to make sure that FINRA will be satisfied in how the firm handles conflicts," says Schell. "In addition, there has also been a tremendous amount of attention paid on third party distribution where an issuer or dealer uses a third party to distribute structured notes."

Structured products providers in the US market are putting a significant effort into due diligence to make sure distribution channels are getting the proper legal documentation around suitability and sales practices, but the principles-based nature of the Finra rules and SEC legal bulletins continue to leave a lot of room for interpretation which creates more uncertainty. Who said the structured products market was left untouched by the Dodd Frank Act?