On May 24, 2016, the Commodity Futures Trading Commission (the CFTC) adopted a final rule (theCFTC Cross-Border Rule)1 for the cross-border application of the CFTC's margin requirements for
non-cleared swaps pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act
(Dodd-Frank). The CFTC Cross-Border Rule overlaps to a large extent with the analogous cross-border rule adopted last year by five U.S. prudential regulators (the PR Cross-Border Rule; together with the CFTC Cross-Border Rule, the Cross-Border Rules).2 However, the CFTC Cross-Border Rule differs in a few key substantive respects from the PR Cross-Border Rule; in many ways, it differs in form and terminology.
In adopting the CFTC Cross-Border Rule, the CFTC made only minor changes from its related rule proposal last year (the CFTC Cross-Border Proposal).3 However, the CFTC departed, in certain important respects, from the cross border interpretive guidance it published in 2013 (the Cross-Border Guidance),4 which set out the CFTC's general approach to cross-border application of the rules it is required to promulgate pursuant to Dodd-Frank.
This Sidley Update provides brief background information related to the Cross-Border Rules and then describes important elements of the CFTC Cross-Border Rule, highlighting key differences between it and the PR Cross-Border Rule.5 Appendix A provides two tabular summaries of the CFTC Cross-Border Rule.
The Cross-Border Rules are part of the CFTC's and Prudential Regulators' rules implementing
Dodd-Frank's margining requirements for bilateral swaps and security-based swaps (collectively,
Non-Cleared Swaps)6 that are not cleared by a registered derivatives clearing organization or clearing agency.7 Dodd-Frank required U.S. federal regulators to adopt implementing rules for collecting and posting initial and variation margin by the following registered swap entities (Swap Entities): swap dealers and major swap participants registered with the CFTC, and security-based swap dealers and major security-based swap participants registered with the Securities and Exchange Commission (theSEC). The CFTC finalized its margin rules (the CFTC Margin Rules),8 other than with respect to their extraterritorial effect, in December 2015. In contrast, the Prudential Regulators finalized their margin rules, including the PR Cross-Border Rule (the PR Margin Rules; together with the CFTC Margin Rules, the Margin Rules) in October 2015. A previous Sidley Update describes the Margin Rules in detail.9
The PR Margin Rules cover Swap Entities that are supervised by one of the Prudential Regulators (Bank CSEs). The CFTC Margin Rules cover Swap Entities that are not so supervised (Non-Bank CSEs; together with Bank CSEs, CSEs) if they are registered with the CFTC. The SEC is expected to adopt implementing rules to cover Non-Bank CSEs that are registered with the SEC.
The CFTC Cross-Border Rule is noteworthy for several reasons beyond its impact on the CFTC's swap margin requirements:
- In revisiting elements of the Cross-Border Guidance, the CFTC has indicated a willingness to rein in the substance of its earlier approach to extraterritoriality. For example, it has narrowed the definitions of U.S. person and guarantee (though only for purposes of applying its margin requirements for non-cleared swaps).
- Moreover, the CFTC has indicated a willingness to alter the means by which it takes cross-border regulatory action related to swaps, as it has now engaged in formal rule-making rather than publishing less formal guidance and interpretive views.
- The CFTC has signaled a greater interest in collaborating with, and, in important respects, finding common substantive ground with, derivatives regulators in other countries. For example, the
Cross-Border Guidance did not admit the possibility of substituted compliance for the margining of non-cleared swaps where a non-U.S. swap dealer transacts with a U.S. person (other than when transacting with the foreign branch of a U.S. swap dealer); the CFTC Cross-Border Rule contemplates a much broader possibility in that regard.
- From a domestic perspective, some elements of the CFTC Cross-Border Rule may be viewed as reflecting the CFTC's position as a prudential supervisor in relation to Non-Bank CSEs that is not dissimilar to that of the Prudential Regulators in relation to Bank CSEs. For example, the CFTC Cross-Border Rule applies margining requirements based on group accounting consolidation (whether or not an inter-affiliate guarantee is present). That approach echoes the approach traditionally taken by banking regulators in the context of consolidated supervision of banking organizations. More generally, the CFTC’s principal focus in the CFTC Cross-Border Rule is limiting the risk of CSE and systemic failure, not the risk faced by non-dealer market participants (such as end-users) when they trade with Non-Bank CSEs. The CFTC explained that "margin serves as a first line of defense not only in protecting the CSE but in containing the amount of risk in the financial system as a whole, reducing the potential for contagion arising from uncleared swaps."10
Overview of the Rule
In some circumstances, the CFTC Cross-Border Rule entirely excludes swap transactions from application of the CFTC Margin Rules. In other circumstances, substituted compliance may be
available—either for all purposes or only for a Non-Bank CSEs' obligation to post or to collect initial margin. In circumstances where the CFTC Cross-Border Rule provides for neither exclusion nor substituted compliance, the rule may nonetheless permit limited relief with respect to non-U.S. legal systems under which margin segregation requirements are problematic or the enforceability of netting agreements is subject to doubt.
The CFTC Cross-Border Rule establishes a number of threshold-level criteria when determining the treatment of a cross-border non-cleared swap transaction. With respect to the relevant Non-Bank CSE, the rule effectively asks:
- Is it a "U.S. person"?
- If it is not a U.S. person, then is it nevertheless:
- guaranteed by a U.S. person?
- a "foreign consolidated subsidiary" (i.e., a subsidiary that is consolidated under U.S. GAAP with an ultimate parent entity that is a U.S. person)?
- transacting by or through a U.S. branch?
The CFTC Cross-Border Rule also considers, for each non-cleared swap transaction, the Non-Bank CSE's counterparty. It effectively asks with respect to the relevant counterparty:
- Is it a U.S. person, and, if so, is it:
- a CSE (whether a Bank CSE or a Non-Bank CSE)?
- a non-CSE?
- If it is not a U.S. person, is it nevertheless:
- guaranteed by a U.S. person, and, if so, is the guarantor:
- a CSE (whether a Bank CSE or a Non-Bank CSE)?
- a non-CSE?
- a CSE, and, if so, is it:
- a foreign consolidated subsidiary?
- transacting by or through a U.S. branch?
- guaranteed by a U.S. person, and, if so, is the guarantor:
Applying these criteria, the CFTC Cross-Border Rule excludes a non-cleared swap transaction entirely from the application of the CFTC Margin Rules (subject to a limited exception11) if:
- the Non-Bank CSE is not a U.S. person, is not guaranteed by a U.S. person, is not a foreign consolidated subsidiary, and is not trading through a U.S. branch; and
- the counterparty is not a U.S. person, is not guaranteed by a U.S. person, and either is not itself a CSE or, if it is a CSE, is neither a foreign consolidated subsidiary nor trading through a U.S. branch.
At the other end of the relief spectrum, the CFTC Cross-Border Rule provides neither for an exclusion nor for the availability of substituted compliance with respect to a non-cleared swap transaction where both the Non-Bank CSE and its counterparty are, or are guaranteed by, U.S. persons. In the middle are certain other permutations of Non-Bank CSEs and counterparties, for which different kinds of substituted compliance may be available. The various permutations are described below; in addition, they are graphically represented, and the related treatment for each permutation under the CFTC Cross-Border Rule is summarized, in Table 2 of Appendix A.
The Prudential Regulators apply conceptually similar criteria. However, the PR Cross-Border Rule does not make distinctions based on whether a Bank CSE's counterparty is itself a CSE (as does the CFTC Cross-Border Rule), and the PR Cross-Border Rule generally uses different terminology (e.g., it does not define or use the term "U.S. person").
The definition of "U.S. person" in the CFTC Cross-Border Rule (which is reproduced in its entirety in
Appendix B) is narrower than the definition of the same term found in the Cross-Border Guidance. With its new definition, the CFTC has departed, solely with respect to the application of margin requirements, from the expansive approach taken in the Cross-Border Guidance, which gave the term an open-ended meaning that relied on detailed examples to demonstrate and rationalize the CFTC's interpretation. The more expansive approach in the Cross-Border Guidance had been achieved primarily by prefacing the "definition"of U.S. person (which is also set out in Appendix B) with the phrase "including but not limited to." However, as the CFTC states in the CFTC Cross-Border Rule:
The Final Rule's "U.S. person" definition also does not include the prefatory phrase "includes, but is not limited to" that was included in the Guidance. As stated in the proposed rule, the Commission believes that this prefatory phrase should not be included in order to provide legal certainty regarding the application of U.S. margin requirements to cross-border swaps.12
Thus, the U.S. person definition in the CFTC Cross-Border Rule perhaps signals a shift in regulatory
philosophy from broad interpretation by way of general principles, to technical restraint via specific
rule-making. The CFTC Cross-Border Release also indicates an interest on the CFTC's part in closer alignment with other domestic financial regulators—the SEC in this case. The CFTC states:
The Commission notes that, as discussed in the proposed rule, the proposed definition of "U.S. person" is similar to the definition of "U.S. person" used by the SEC in the context of
cross-border security-based swaps.13
As to the substance of the definition, of greatest interest is the absence of a U.S. majority-ownership prong for collective investment vehicles. The Cross-Border Guidance's concept of U.S. person includes "any commodity pool, pooled account, or collective investment vehicle (whether or not it is organized or incorporated in the United States) of which a majority ownership is held, directly or indirectly, by a U.S. person(s)." In line with the CFTC Cross-Border Proposal, the CFTC has dropped that prong from the "U.S. person" definition in the CFTC Cross-Border Rule (solely as it relates to the CFTC's margin requirements for non-cleared swaps).14 As a result, for purposes of the cross-border application of the CFTC's margin requirements, an offshore investment fund will be permitted to rely solely on the CFTC's principal place of business test to determine whether it is a U.S. person.
The PR Cross-Border Rule, unlike the CFTC Cross-Border Rule, does not use the defined term "U.S. person." The Prudential Regulators expressly declined a commenter's request to define “U.S. person”; however, they stated that in concept they were seeking a "bright-line" test in framing their
cross-border rule. In substance, the analogous test under the PR Cross-Border Rule is whether a person is an entity organized under the laws of the United States or any state (including any non-U.S. branch or office thereof, and any such entity that is a subsidiary of a foreign bank) or a natural person who is a resident of the United States. Thus, the Prudential Regulators' standard, unlike the CFTC’s final definition of "U.S. person," obviates inquiry into a person's "principal place of business." The difference will be relevant to collective investment vehicles that are domiciled outside the United States but are managed from the United States in a manner that results in their being U.S. persons under the "principal place of business" prong of the definition (but not covered by the Prudential Regulators' analogous test).
Foreign Consolidated Subsidiaries
Evidence of the influence of the Prudential Regulators' point of view upon the CFTC can arguably be seen in the CFTC's approach to any Non-Bank CSE that is a "foreign consolidated subsidiary" (an FCS), which is a non-U.S. Non-Bank CSE that is consolidated pursuant to U.S. GAAP with an ultimate U.S. parent.15 Under the Cross-Border Guidance, transaction-level requirements (including swap margining) do not apply to a non-U.S. Non-Bank CSE (even if it is part of a U.S.-based corporate group) in transactions with a non-U.S. person unless the Non Bank CSE's obligations are guaranteed by a U.S. person. In effectively expanding the application of its margin rules under the CFTC Cross-Border Rule (to non-guaranteed FCSs), the CFTC is following the lead of the Prudential Regulators, which supervise consolidated U.S. banking groups without reference to the presence or absence of inter-affiliate guarantees or similar binding credit enhancements.
Despite an approach to FCSs that is not tied to the presence of a guarantee or other credit enhancement from a U.S. person, guarantees remain relevant in other respects under the CFTC
Cross-Border Rule. For example, although the CFTC Cross-Border Rule subjects FCSs to the CFTC's margin requirements without reference to guarantees, it permits them to rely on substituted compliance only if they do not transact with the benefit of a guarantee of their trading obligations from a U.S. person (assuming substituted compliance is otherwise available for the non-U.S. jurisdiction in question, as discussed below).
Although the PR Cross-Border Rule does not include a defined term such as "foreign consolidated subsidiary," its own (broader) definition of "foreign covered swap entity" includes "[a]n entity that is a subsidiary of an entity that is organized under the laws of the United States or any State." The definition of “subsidiary” states (in part): "A company is a subsidiary of another company if . . . the company is consolidated by the other company on financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles, the International Financial Reporting Standards, or other similar standards." Thus, the PR Cross-Border Rule includes a criterion that is effectively the same as the criterion represented by the CFTC Cross-Border Rule definition of foreign consolidated subsidiary.
The CFTC Cross-Border Rule defines "guarantee" narrowly and with specificity. That approach contrasts with the approach to guarantees under the Cross-Border Guidance, where the term was used inconsistently and, at least in one context, was given a very broad meaning. Thus, the CFTC
Cross-Border Rule circumscribes guarantees to those arrangements where a party to an uncleared swap has "rights of recourse against a guarantor," which will be the case if:
the party has a conditional or unconditional legally enforceable right to receive or otherwise collect, in whole or in part, payments from the guarantor with respect to its counterparty’s obligations under the uncleared swap.16
The CFTC Cross-Border Rule acknowledges the narrowing of the definition (by comparison to the definition found in the Cross-Border Guidance);17 however, the CFTC does not explicitly address the fact that the Cross Border Guidance treated guarantees inconsistently for different purposes, or that the CFTC Cross-Border Rule’s final definition of guarantee is nearly the same as the narrower of the two distinct approaches to guarantees taken in the Cross-Border Guidance.18
The PR Cross-Border Rule’s definition of "guarantee" is similar to the CFTC's definition, as it too is tied to "rights of recourse" by a guarantee beneficiary against a guarantor.
The CFTC Cross-Border Rule contemplates full substituted compliance (i.e., in relation to requirements both to collect and to post margin) if one set of conditions is met, and contemplates two limited types of substituted compliance (i.e., one only for initial margin posting requirements, and the other only for initial margin collection requirements) if other, more lenient, sets of conditions are met.
For any type of substituted compliance to be available under the CFTC Cross-Border Rule, the CFTC must make a comparability finding in respect of the relevant non-U.S. jurisdiction’s margin requirements for Non-Cleared Swaps.19
Once such a comparability finding is made, full substituted compliance will be available to non-U.S. person Non-Bank CSEs that are not guaranteed by a U.S. person (including such Non-Bank CSEs that are FCSs or that transact by or through a U.S. branch). However, if the Non-Bank CSE's counterparty is itself a Non-Bank CSE and is a U.S person or is guaranteed by a U.S. person, then substituted compliance is available only in respect of the Non-Bank CSE's obligation to collect initial margin (i.e., the Non-Bank CSE's obligation under the CFTC Margin Rules to post initial margin to its U.S.-related counterparty is not capable of being met by substituted compliance).
The second limited form of substituted compliance is available to Non-Bank CSEs that are themselves U.S. persons or guaranteed by U.S. persons. If the counterparty to such a Non-Bank CSE is itself neither a U.S. person nor guaranteed by a U.S. person, substituted compliance is available to the Non-Bank CSE with respect to its obligation to post initial margin (i.e., the U.S. or U.S.-guaranteed Non-Bank CSE's obligation under the CFTC Margin Rules to collect initial margin from its non-U.S. counterparty is not capable of being met by substituted compliance).
The PR Cross-Border Rule provides for only a single limited version of substituted compliance (in addition to full substituted compliance in more limited circumstances). It applies to certain Bank CSE obligations to post margin, in circumstances broadly similar to those under which the second form of limited substituted compliance described above would apply (involving a U.S. or U.S.-guaranteed CSE when it transacts with counterparties that are not, and are not guaranteed by, U.S. persons). The PR Cross-Border Rule does not include an equivalent to the first limited form of substituted compliance described above (involving certain margin collection requirements). Thus, in circumstances where the CFTC Cross-Border Rule would permit substituted compliance only with respect to obligations to collect margin—i.e., where non U.S. Non-Bank CSEs trade with counterparties that are U.S. Non-Bank CSEs as described above—the PR Cross Border Rule would permit substituted compliance with respect to obligations both to post and to collect initial margin. However, the difference will likely prove to be technical, rather than substantive, in practice. Even though substituted compliance may be available to a non-U.S. Bank CSE with respect to its obligation to post initial margin to a counterparty that is a U.S. Non-Bank CSE, such a counterparty will be required nevertheless to collect initial margin in accordance with the CFTC’s Margin Rules (because the counterparty, as a U.S. Non-Bank CSE, will not itself be permitted to take advantage of substituted compliance in respect of its own collection obligation). Thus, the counterparty’s collection obligation effectively undercuts the availability of substituted compliance to the non-U.S. Bank CSE in respect of its posting obligation.
As noted above, the CFTC Cross-Border Rule indicates a greater willingness on the part of the CFTC to permit substituted compliance by non-U.S. CSEs than is apparent in the Cross-Border Guidance. Under the Cross Border Guidance, substituted compliance is not permitted with respect to any
transaction-level requirement (including non-cleared swap margining) applicable to transactions between a non-U.S. CSE and a U.S. person, with one limited exception. The exception is a non-U.S. CSE's transactions with a U.S. person that is a bank operating through a foreign branch. Thus, in its Cross-Border Guidance, the CFTC demonstrated distrust of the ability of non-U.S. regulatory regimes to protect non-CSE U.S. market participants (even if the CFTC were to have made a comparability finding supporting the application of substituted compliance in other circumstances).
If the CFTC finds that the relevant non-U.S. swap margin requirements are "comparable to the [CFTC's] corresponding margin requirements," then non-U.S. CSEs will be deemed compliant with the CFTC Margin Rules if they comply with the non-U.S. regulation (in lieu of the CFTC’s own) even when dealing with most U.S. persons. The CFTC draws the line, and requires its own rules to apply, if the U.S. person is itself a CSE, but even here the CFTC would permit substituted compliance with respect to those rules requiring the non-U.S. CSE to collect initial margin from the U.S. CSE (though not those rules requiring the non-U.S. CSE to post initial margin to the U.S. CSE, or requiring it to post or collect variation margin).
The broader point is that the CFTC Cross-Border Rule effectively turns the Cross-Border Guidance on its head insofar as the margining of non-cleared swaps is concerned, with respect to the ability of
non-U.S. CSEs to rely on substituted compliance when dealing with U.S. persons:
- Under the Cross-Border Guidance, a counterparty that is a U.S. person would have been ensured CFTC protection (i.e., no substituted compliance by the non-U.S. CSE was permitted) unless the U.S. person counterparty is itself a CSE (and is operating through a foreign branch).
- Under the CFTC Cross-Border Rule, a counterparty that is a U.S. person is ensured CFTC protectiononly if the U.S. person counterparty is itself a CSE; and, thus, non-CSE U.S. market participants may find themselves relying on protections under a non-U.S. regulatory system when dealing with a
non-U.S. CSE (if, of course, the CFTC has found the non-U.S. system comparable to the U.S. system).
All of this is consistent with the theme enunciated above: When formulating the CFTC Cross-Border Rule, the CFTC focused primarily on the prudential regulation of regulated swap dealers and major swap participants to mitigate the risk of their failure, rather than on market regulation for the direct benefit of non-dealer market participants.
Whether substituted compliance will open the door to significant variations across different jurisdictions in how market participants are treated remains to be seen. In the CFTC Cross-Border Rule, the CFTC stresses in the preamble its intention to consult closely with non-U.S. regulatory counterparts. Moreover, the general thrust of developments in this area has been, since the publication of international standards upon which the Margin Rules are based, one of intensifying cross-border cooperation in pursuit of cross-border consistency.
Treatment of U.S. Branches, U.S. Personnel and U.S. Agents
In the Cross-Border Guidance's well-discussed footnote 513, the CFTC took the position that "a U.S. branch of a non-U.S. swap dealer or MSP would be subject to transaction-level requirements, without substituted compliance available." The CFTC staff, in its November 2013 Advisory 13-69 (the Advisory), extended that position beyond U.S. branches; the Advisory indicated that the requirements would apply to non-U.S. swap dealers "regularly using personnel or agents located in the U.S. to arrange, negotiate, or execute a swap with a non-U.S. person." Both footnote 513 and the Advisory covered margin requirements for non-cleared swaps because those requirements were categorized as transaction-level requirements under the Cross-Border Guidance.
The CFTC Cross-Border Release does not mention either footnote 513 or the Advisory. However, at least as to margin requirements for non-cleared swaps, the CFTC Cross-Border Rule revisits both. The rule provides that non-cleared swaps between non-U.S. CSEs and non-U.S. persons are entirely excluded from the application of the CFTC’s margin requirements, subject to a number of qualifications and conditions. One of those conditions is that the "non-U.S. CSE is not a U.S. branch of a non-U.S. CSE." However, the CFTC Cross-Border Rule does not set forth a standard for determining whether a non-U.S. CSE has executed a swap in a manner that would meet this condition, and the CFTC
Cross-Border Release does not provide any detailed guidance for ascertaining whether the condition is satisfied, as it simply speaks of a non-U.S. CSE "conducting swap activities from within the United States by or through a U.S. branch"20 (without further elaboration).21 Thus, the CFTC declines to answer the related question that it specifically posed in the CFTC Cross-Border Proposal: "How should the Commission determine whether a swap is executed through or by a U.S. branch of a non-U.S.
CSE . . .?"22 Perhaps the CFTC will address the question when (as is still expected) it more generally addresses footnote 513 and the Advisory.
The Prudential Regulators, when addressing comments regarding their original proposal of the PR
Cross-Border Rule, considered how to treat "a swap transaction with a foreign counterparty [that] is booked by a foreign swap entity but arranged, negotiated, or executed by persons operating from a U.S. branch of such swap entity." The Prudential Regulators stated that they "would generally consider the entity to which the swap is booked as the counterparty for purposes of this section." Although the PR Cross-Border Rule includes no further elaboration of that point, the Prudential Regulators' statement, combined with the express terms of the PR Cross-Border Rule, indicates that a non-cleared swap transaction undertaken by personnel or agents of a non-U.S. Bank CSE who are located in the United States will be eligible for exclusion from the incidents of the PR Margin Rules if the transaction is not booked in a U.S. branch or agency of the non-U.S. Bank CSE (and if other conditions for exclusion are met). It remains to be seen whether the CFTC will follow suit.
Margin Treatment of Non-Cleared Swaps in Certain Jurisdictions: Custodial Segregation and Netting
In addition to offering its two principal forms of relief—the exclusion of certain non-cleared swap transactions from application of the CFTC Margin Rules altogether, and the availability of substituted compliance for others—the CFTC Cross-Border Rule offers two additional, though limited, forms of relief. Each is intended to reduce the economic burden that would otherwise be imposed on parties to non-cleared swaps by the CFTC Margin Rules in a specific cross-border context. In one case, the subject is custodian segregation requirements if they are inconsistent with applicable non-U.S. law in specified circumstances. In the second case, the subject is requirements for the calculation of margin amounts if the governing law for the master agreement in question does not provide sufficient certainty regarding the enforceability of netting under the agreement.
Relief from custodial segregation requirements (or from certain adverse consequences arising out of the commingling of custodial assets) is available to non-U.S. branches of Non-Bank CSEs that are U.S. persons and to FCSs. However, the relief granted pursuant to the CFTC Cross-Border Rule is subject to strict conditions that may limit its applicability.23
Non-Netting Jurisdiction Requirements
When a Non-Bank CSE determines the amount of margin that it is required to collect from, or to post to, a particular counterparty under the CFTC Margin Rules, it is permitted to net offsetting exposures arising from different swap transactions if the transactions are governed by an "eligible master netting agreement" as defined under the rules. One of the elements of that definition requires the Non-Bank CSE to conclude, after sufficient legal review and with a well-founded basis, that netting would be respected under the applicable law governing the agreement.24 The CFTC Cross-Border Rule provides limited relief to a Non-Bank CSE if it is unable to reach such a conclusion with respect to a given agreement (as a result of the application of laws in a relevant jurisdiction that do not unambiguously support the enforceability of close-out netting). In those circumstances the Non-Bank CSE, despite not reaching the requisite conclusion, may treat the swaps covered by the agreement on a net basis for the purposes of calculating and complying with specified requirements under the CFTC Margin Rules to post margin; however, it must still treat the swaps on a gross basis when applying specified requirements under such rules to collect margin.25