On June 29, 2015, the Commodity Futures Trading Commission (CFTC) proposed rules that will determine the cross-border application of its margin requirements for uncleared swaps (Margin Proposal)1. With the Margin Proposal, the CFTC is revisiting, in a significant way, its 2013 cross-border interpretive guidance (Cross-Border Guidance),2 which set out the CFTC’s general approach to cross-border application of its swap rules. It is unclear whether the approach taken in this limited, albeit important, context is a harbinger of things to come. Nonetheless, the Margin Proposal is noteworthy for several reasons beyond its potential impact on 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. For example, it proposes to narrow the definitions of U.S. person and of guarantee (for purposes of applying its margin requirements for uncleared 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 is proceeding now with formal rule-making rather than publishing further guidance and interpretive views.
- The CFTC has signaled a greater interest in collaborating and, in important respects, trying to find common ground with regulators in other countries. For example, the Cross-Border Guidance did not admit the possibility of substituted compliance for the margining of uncleared swaps where a non-U.S. swap dealer transacts with a U.S. person (other than the limited circumstance of its transacting with the foreign branch of a U.S. swap dealer); the Margin Proposal contemplates a broader possibility in this regard.
- On the domestic front, some elements of the Margin Proposal may be viewed as reflecting the CFTC’s taking a supervisory perspective not dissimilar from that of U.S. bank regulators. For example, the Margin Proposal would apply the margining requirements based on group accounting consolidation (whether or not an inter-affiliate guarantee is present). This approach echoes the approach traditionally taken by banking regulators toward consolidated supervision.
The Margin Proposal was anticipated in an Advance Notice of Proposed Rule Making (ANPR) published by the CFTC in November 2014, when the CFTC also proposed rules that will generally implement the Dodd-Frank Act’s statutory margining requirement for uncleared swaps (CFTC 2014 Proposal).3 The Dodd-Frank Act requires U.S. federal regulators—the CFTC, the Securities and Exchange Commission (SEC) and five U.S. prudential regulators (Prudential Regulators)—to adopt implementing rules covering both initial and variation margin. The Prudential Regulators proposed their implementing rules in September 2014 (Prudential Regulator Proposal and, together with the CFTC 2014 Proposal, 2014 Proposals).4 The 2014 Proposals mirror to a significant degree the final international standards on margin requirements for non-centrally cleared derivatives issued in September 2013 by the Basel Committee on Banking Supervision (BCBS) and the Board of the International Organization of Securities Commissions (IOSCO).5
The 2014 Proposals establish initial and variation margin requirements that CFTC-registered swap dealers and major swap participants must post to and collect from their counterparties. Under the 2014 Proposals, each registered swap dealer and major swap participant that is supervised by one of the Prudential Regulators will be required to meet the minimum initial and variation margin requirements set by the Prudential Regulators;6 other registered swap dealers and major swap participants (collectively referred to as covered swap entities or CSEs) will be subject to requirements set by the CFTC.7
Important elements of the Margin Proposal are highlighted below, including differences between the Margin Proposal and cross-border aspects of the Prudential Regulator Proposal. Annex A summarizes the application of the Margin Proposal in tabular form. Note that the CFTC’s uncleared swap margin requirements will ultimately apply to swaps only where one party to the transaction is a CSE.
The Margin Proposal is open for public comment through September 14, 2015.
Perhaps the most striking aspect of the Margin Proposal is its definition of U.S. person (which is set out in its entirety in Annex B). With this definition, the CFTC expressly eschews the open-ended approach taken by the Cross-Border Guidance, which gave the phrase an open-ended meaning that relied on detailed examples to demonstrate the CFTC’s interpretation. It achieved this in the Cross-Border Guidance by prefacing its "definition" of U.S. person (which is also set out in Annex B) with the phrase "including but not limited to." However, the CFTC states in the Margin Proposal:
The proposed "U.S. person" definition does not include the prefatory phrase "includes, but is not limited to" that was included in the Guidance. 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.8
Thus the CFTC’s proposed definition perhaps signals a shift in regulatory approach generally—from interpretation to rule-making. The definition also clearly indicates an interest in closer alignment with other regulators—the SEC in this case. The CFTC states:
[T]he Commission notes that 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.
To demonstrate the point, the CFTC then sets out the entire text of the SEC cross-border definition (which is also set out in Annex B).9
As to the substance of the definition, of greatest interest is the absence of a 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)." The CFTC proposes to drop this prong from the "U.S. person" definition in the Margin Proposal solely as it relates to the CFTC’s margin requirements for uncleared swaps, doing so in part because of "implementation issues raised by commenters."10 As a result, for purposes of the cross-border application of the CFTC’s margin requirements, an offshore investment fund would presumably be permitted to rely solely on the CFTC’s principal place of business test to determine whether it was a U.S. person.
A Prudential Point of View
The ANPR contemplated three alternative general approaches to the cross-border application of the CFTC’s margin requirements for uncleared swaps. It defined them as the "Guidance Approach" (which would be consistent with the Cross-Border Guidance), the "Prudential Regulators’ Approach" (which would follow the cross-border approach reflected in the Prudential Regulator Proposal) and the "Entity-Level Approach"(which was newly set out in the ANPR). In formulating the Margin Proposal, the CFTC is now taking (in its own words) a "hybrid" approach. It explains:
The Proposed Rule is a combination of the entity- and transaction-level approaches and is closely aligned with the Prudential Regulators’ Approach. In general, under the Proposed Rule, margin requirements are designed to address the risks to a CSE, as an entity, associated with its uncleared swaps (entity-level) . . . .11
Thus the CFTC’s principal focus in the Margin Proposal is limiting the risk of CSE failure, not the risk faced by non-dealer market participants (such as end-users) when they trade with CSEs. Given this perspective, it is not surprising that the CFTC also cites the internal risk management function of swap margin and likens it to capital:
Margin, by design, is complementary to capital. That is, margin and capital requirements serve different but equally important risk mitigation functions that are best implemented at the entity-level. . . . Standing alone, either capital or margin may not be enough to prevent a CSE from failing, but together, they are designed to reduce the probability of default by the CSE and limit the amount of leverage that can be undertaken by CSEs (and other market participants), which ultimately mitigates the possibility of a systemic event.12
Note the reference to systemic risk. Here, the CFTC sounds much more like a prudential bank regulator than a traditional market regulator. Presumably this reflects CFTC’s "close consultation with the Prudential Regulators"13 in the context of preparing the Margin Proposal.
Foreign Consolidated Subsidiaries
Evidence of prudential regulation can also be seen in the CFTC’s approach to Foreign Consolidated Subsidiaries. In a way that the Cross-Border Guidance does not, the Margin Proposal targets non-U.S. CSEs if they are consolidated for accounting purposes with an ultimate parent that is a U.S. person. Under the Cross-Border Guidance, transaction-level requirements (such as swap margining) do not apply to a non-U.S. CSE (even if part of a U.S. banking group) unless its obligations are guaranteed by a U.S. person. In proposing to expand the application of its margin rules, the CFTC is following the lead of the Prudential Regulators, which historically supervise consolidated groups without reference to the presence or absence of inter-affiliate guarantees.
Moreover, the Margin Proposal addresses the perception that certain U.S. banking organizations took advantage of a loophole in the Cross-Border Guidance when they "de-guaranteed" certain non-U.S. dealing subsidiaries.14 In this regard, the CFTC notes (speaking again like a prudential bank regulator) that even in the absence of a parent guarantee, swaps of a consolidated subsidiary of a U.S. parent "raise substantial supervisory concern in the United States."15
Although the Margin Proposal would subject a Foreign Consolidated Subsidiary to the CFTC’s margin requirements, it would permit the Foreign Consolidated Subsidiary to avail itself of substituted compliance (if otherwise available for the non-U.S. jurisdiction in question, as discussed below), but only if the Foreign Consolidated Subsidiary did not transact with the benefit of a guarantee from its U.S. parent (or any other U.S. person). The availability of substituted compliance in this context (and in others) is discussed further below.
The Margin Proposal’s treatment of guarantees is interesting for two principal reasons. First, the term "guarantee" is defined narrowly and with specificity. This 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. Under the Margin Proposal, guarantees are circumscribed to those arrangements where:
a party to a swap transaction has rights of recourse against a U.S. person. . . [e.g.,] the party has a conditional or unconditional legally enforceable right to receive or otherwise collect, in whole or in part, payments from the U.S. person in connection with the non-U.S. person counterparty’s obligations under the swap.
The Margin Proposal acknowledges a narrowing of the definition (by comparison to that found in the Cross-Border Guidance);16 however, it does not address the fact that the Cross-Border Guidance treated guarantees inconsistently or that the Margin Proposal’s definition of guarantee is nearly the same as the narrower of the two principal approaches to guarantees taken in the Cross-Border Guidance.17
Second, guarantees (as defined) are referenced principally where a non-U.S. CSE’s obligations are guaranteed—not, by contrast, where any non-U.S. counterparty of the CSE is guaranteed by a U.S. person. This again signals a shift in approach from the CFTC Cross-Border Guidance—e.g., from the approach of a regulator focused on protecting non-dealer market participants (including U.S. persons who guarantee their obligations), to that of a regulator concerned with the prudential supervision of dealers themselves.
Thus, when the question is which uncleared swap transactions of a non-U.S. person are subject to the CFTC’s margining requirements, the presence of a guarantee from a U.S. person is relevant only if the guaranteed non-U.S. person is registered with the CFTC as a CSE (with one narrow exception).18 Where a non-U.S. CSE is guaranteed by a U.S. person, then it is subject to margining requirements in the same manner as a U.S. CSE. But in the absence of the non-U.S. CSE itself having a relevant U.S. connection (including being a Foreign Consolidated Subsidiary of a U.S. group or operating through a U.S. branch), the CSE would be permitted to comply with its home jurisdiction’s margin requirements (assuming the CFTC has made a substituted compliance finding) even when it trades with a U.S. person.
As noted above, the CFTC has indicated a greater willingness to permit substituted compliance on the part of non-U.S. CSEs. Under the Cross-Border Guidance, substituted compliance would not have been permitted with respect to any transaction-level requirement (including swap margining) when a non-U.S. CSE traded with a U.S. person, with one limited exception. The exception was where the U.S. person is a U.S. bank operating through a foreign branch. Thus, the CFTC demonstrated distrust of the ability of non-U.S. regulatory regimes to protect non-dealer U.S. market participants (even where the CFTC has made a comparability finding supporting the application of substituted compliance in other circumstances).
Under the Margin Proposal, the CFTC’s perspective has changed. If the CFTC finds that non-U.S. swap margin regulation is "comparable to the [CFTC’s] corresponding margin requirements," it will permit non-U.S. CSEs to comply with the non-U.S. regulation (in lieu of the CFTC’s own) even when dealing with most U.S. persons. It draws the line, and requires its own rules to apply, if the U.S. person is itself a CSE, but even here it 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 to post or collect variation margin).
The broader point is that the Margin Proposal effectively turns the Cross-Border Guidance on its head 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 U.S. person would have been ensured CFTC protection (i.e., no substituted compliance was possible) except where the U.S. person is itself a CSE (and operating through a foreign branch).
- Under the Margin Proposal, a U.S. person is ensured CFTC protection only where the U.S. person is itself a CSE; and, thus, non-dealer 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 (provided, of course, the CFTC has found the non-U.S. system comparable to its own).
All of this is consistent with the theme enunciated above (and acknowledged in the Margin Proposal): In developing the Margin Proposal, the CFTC has focused primarily on the prudential regulation of regulated swap dealers to mitigate the risk of failure, rather than on market regulation for the benefit of non-dealer market participants.
Whether substituted compliance will open the door to significant variations in how market participants are treated in different jurisdictions remains to be seen. The CFTC stresses in the Margin Proposal its intention to consult closely with non-U.S. regulatory counterparts. Moreover, the general thrust of regulatory developments in this area has been, since the publication of international standards noted above, one of cross-border cooperation in pursuit of cross-border consistency.
Treatment of U.S. Branches of Non-U.S. CSEs
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, extended this position beyond U.S. branches; the letter 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." This position (under both footnote 513 and the advisory) cover the margin requirements for uncleared swaps because they were categorized as transaction-level requirements under the Cross-Border Guidance.
The Margin Proposal does not mention either footnote 513 or the staff’s advisory. However, at least as to margin requirements for uncleared swaps, it revisits both. The Margin Proposal provides that uncleared swaps between non-U.S. CSEs and non-U.S. persons are excluded from 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 Margin Proposal does not propose particular standards for determining when a non-U.S. CSE has executed a swap in a manner that would meet this condition. Instead, it asks specific questions in this regard (including whether a Volcker Rule standard should apply here as well):
How should the Commission determine whether a swap is executed through or by a U.S. branch of a non-U.S. CSE for purposes of applying the Commission’s margin rules on a cross-border basis? Should the Commission base the determination of whether the swap activity is conducted at a U.S. branch of a non-U.S. CSE for purposes of applying the Commission’s margin rules on a cross-border basis on the same analysis as is used in the Volcker rule?19
Comparison With the Prudential Regulator Proposal
The Margin Proposal is substantially similar, but not identical, to the Prudential Regulator Proposal for cross-border application of margin requirements for uncleared swaps. The similarities (and minor differences) relate to aspects of the two proposals that exclude some uncleared swaps entirely from CFTC regulation and that permit substituted compliance with respect to others.
Excluded Swap Transactions
Under both the Margin Proposal and the Prudential Regulator Proposal, certain uncleared swaps of certain non-U.S. CSEs20 would be excluded entirely from the application of U.S. margin requirements. One difference between the Margin Proposal and the Prudential Regulator Proposal is how U.S. nexus is defined. In the case of both proposals, the criteria for U.S. nexus are two-fold: (i) the nexus of the non-U.S. CSE to the United States, and (ii) the nexus of its swap counterparty to the United States.
With respect to the first criterion, the exclusion under the Margin Proposal is available (as noted above) only to non-U.S. CSEs that are neither guaranteed by a U.S. person nor have an ultimate parent entity that is a U.S. person and consolidates the CSE for accounting purposes (as the result of a controlling financial interest under U.S. GAAP); moreover, even if these two conditions are met, the exclusion is not available if the non-U.S. CSE is a U.S. branch.
Exclusion under the Prudential Regulator Proposal is restricted to "foreign covered swap entities," a category which excludes not only U.S. entities, but also non-U.S. entities that are controlled, directly or indirectly, by a U.S. entity or that are U.S. branches of non-U.S. banks. "Control" for these purposes is defined as:
- ownership, control or power to vote 25 percent or more of a class of voting securities of the company, directly or indirectly, or acting through one or more other persons;
- ownership or control of 25 percent or more of the total equity of the company, directly or indirectly, or acting through one or more other persons; or
- control in any manner of the election of a majority of the directors or trustees of the company.21
Thus, a question arises whether the GAAP-based test under the Margin Proposal would produce a different result from the "control" test under the Prudential Regulator Proposal.
With respect to the second criterion for exclusion, there is also broad similarity with some variation. In the case of both proposals, an eligible non-U.S. CSE is not able to claim exclusion in respect of a swap with (i) a U.S. person, (ii) a non-U.S. person that is guaranteed by a U.S. person, or (iii) a non-U.S. CSE that (A) is a Foreign Consolidated Subsidiary (in the case of the Margin Proposal) or (B) is not a foreign covered swap entity (in the case of the Prudential Regulator Proposal).
Both the Margin Proposal and the Prudential Regulator Proposal permit substituted compliance in certain circumstances (where exclusion is not permitted). Under both proposals, full (as opposed to partial) substituted compliance is available only to non-U.S. CSEs and only if their obligations are not guaranteed by U.S. persons. However, the Margin Proposal imposes a further restriction not found in the Prudential Regulator Proposal: if the (non-guaranteed) non-U.S. CSE’s counterparty is either a U.S. CSE or a non-U.S. CSE that is guaranteed by a U.S. person, then substituted compliance is available only in respect of the obligation to collect initial margin from the counterparty. A similar limitation does not apply under the Prudential Regulator Proposal (which permits full substituted compliance in analogous circumstances).
Both proposals permit U.S. CSEs and non-U.S. CSEs that are guaranteed by U.S. persons to take advantage of only limited substituted compliance. Such CSEs may avail themselves of substituted compliance but only in respect of their obligation to post initial margin. However, the Margin Proposal contains an additional condition in this context that is not found in the Prudential Regulator Proposal: the limited relief is permitted only if the counterparty of the U.S. CSE or (guaranteed) non-U.S. CSE is a non-U.S. person and is not guaranteed by a U.S. person. The Prudential Regulator Proposal permits the limited relief without regard to the identity of the counterparty (provided the counterparty is required to collect initial margin under the relevant non-U.S. regulatory framework).
Click here to view Annex A.
Click here to view Annex B.