Regulations
Financial regulation can be defined in 4 broad categories : 1) Private Equity or Hedge Funds, 2) Broker-Dealers and Private Investors, 3) Banks and other similar financial institutions 4) Central Clearing for exchanges. The following describes the U.S. System.
Private Equity
Private Equity funds typically obtain funding from Public pension funds, Endowments, Funds of funds, Corporate pension funds, Banks and other financial institutions, Insurance companies, family offices, High net-worth individuals, Sovereign wealth funds.
Generally, any issuer that invests or trades in securities is considered an investment company and must register under the US Investment Company Act 1940, with certain exemptions.
In a private equity fund the general partner or managing member controls the fund and investors are not involved in the operations. Investors can have the ability to terminate the fund without cause, with around 75% to 80% of the vote. The institutional Limited Partner Association (ILPA) which is a members organisation have developed best practices, one of which is a net asset value coverage test (generally at least 125% of the traded price) to ensure a sufficient margin of error on valuations
Broker Dealer
Although broker-dealers are guided by the U.S. Securities and Exchange Commission, major rules governing broker-dealers were enacted by the Federal Reserve through Regulation T in 1998, and the Net Capital Rule CFR 240.15c3-1 and also by the industry organization, FINRA through Rule 4210. A source for Code of Federal Regulations (CFR) is Law.cornell.edu
Title 12 – Banks and Banking, Part 220 – (Credit by Brokers and Dealers), Regulation T, governs extension of credit by brokers to their clients. The initial margin for accounts on margin is 50%, the amount of funds needed to enter into a trade. FINRA’s Rule 4210 further requires a minimum maintenance margin as the value of the trade fluctuates.
FINRA’s rule permits member firms to offer portfolio margining to customers, provided that the firm has a real-time intra-day monitoring system. The member firm is expected to have risk monitoring capabilities. Stress testing levels are not prescribed by FINRA but at a minimum it is expected that firms will conduct stress up and down 25%. Although unlisted derivatives are eligible products, since the only permitted option valuation model is OCC’s TIMS and since OCC only provides TIMS for listed products, it would not be possible to combine unlisted derivatives in a portfolio. FINRA has rules to accommodate convertible bonds by referring to the TIMS value for the underlying equity.
Banks
The prudential bank regulators in the U.S. are the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA) and the Federal Reserve Board (FRB) or the Fed.
The Fed is the primary regulator of all financial firms (bank or nonbank) that are designated as systematically significant by the Financial Stability Oversight Council (FSOC); Holding companies (Bank, financial, savings and loans); State banks members of the Federal Reserve System (FRS) which is the central bank of the United States; US branches of foreign banks, foreign branches of US banks, systemically significant payment, clearing, settlement systems. The FDIC regulates state banks and thrifts not members of the FRS.
The Dodd-Frank Act (DFA) grants authority over the largest financial firms to the FDIC and the Fed.
The Dodd-Frank Act significantly impacted existing regulations by:
• Mandatory Clearing: many derivatives must use central clearing.
• Volcker Rule: US banking organizations are prohibited from engaging in proprietary trading or owning hedge funds or private equity funds.
The Group of Twenty Finance Ministers and Central Bank Governors, known as “G-20” have formally endorsed Basel III. Although endorsed, the standards need to be implemented by regulatory authorities of member countries by statute or regulation. See also Basel III
An issue for banks is the Basel Committee on Bank Supervision's bcbs352 – Minimum Capital Requirements for Market Risk (Jan 2016). The bcbs document allows for an Internal Models Approach for Market Risk which is preferable to a Standardized Approach, so much so that the International Swaps Dealers Association (ISDA) have built an industry ISDA SIMM 2.0 model, 4th iteration, live Dec 4th 2017. The ISDA model combines sensitivities (delta, gamma, vega) with tables of scaling factors. Settlement is bilateral and the counterparties must agree on the sensitivity calculations.
A further problem arising from bcbs352 is the non-modellable calculation. A non-modellable risk factor has onerous limitations on liquidity horizons and further, no correlation or diversification effect is allowed between non-modellable risk factors. It is the definition of non-modellable that is concerning, since the test is based on quality and availability of price. For example the price must be one for which an actual transaction between other arms-length parties have done an actual transaction; the price must be from a committed quote. A risk factor must have at least 24 observable real prices per year. This could be a problem for options where volatilities for longer expiries and tenors might be unavailable. Through time, an option that is at-the-money might become a low delta option and a traded price might case to exist.
Central Clearing
The U.S. Commodity Futures Trading Commission (CFTC) is an independent agency of the US government that regulates futures and options markets, under Title 17 of Code of Federal Regulations, Commodity Exchange Act (CEA). Part 39 applies to derivatives clearing organizations (DCOs).
Margin requirements under Risk Management require that models generate initial margin requirements sufficient to cover potential future exposure to clearing members within a liquidation period with a minimum of 1 day for futures and options, 1 days for swaps on agricultural, energy and metals products, 5 days for all other swaps, under a confidence level of at least 99% for:
(A) Each product for which the DCO uses a product-based margin methodology
(B) Each spread within or between products for which there is a defined spread margin rate
(C) Each account held by a clearing member at a DCO, by house origin and by each customer origin, and
(D) Each swap portfolio, including any portfolio containing futures and/or options held in a commingled account.
DCO responsibilities with reference to margining:
• The system for initial margin must be reviewed and validated by a qualified and independent party on a regular basis.
• Reductions are allowed for related positions that are significantly and reliably correlated.
• Back tests must cover a period not less than 30 days.
Haircuts should be applied to assets accepted as initial margin taking into account stressed market conditions.
Risk limits are required for each clearing member.
Stress tests are required on a daily basis for each large trader, and on a weekly basis for each clearing member account.