Following yesterday’s announcement by the Commodity Futures Trading Commission and the European Commission of a joint understanding regarding a coordinated approach to the regulation of cross-border derivatives (for a further discussion of this announcement, please refer to our previous client alert on the topic found here), today the CFTC approved (by a 3-1 vote of the Commissioners) final Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations (the “Final Guidance”) and an accompanying exemptive order phasing in compliance with certain aspects of the Final Guidance (the “Phase-in Exemptive Order”).
As of the time of publication of this Alert, the full text of the Final Cross Border Guidance is not available. However, the CFTC has released fact sheets (the “Fact Sheets”) which can be found on the CFTC’s website here. Accordingly, this Alert only summarizes the descriptions of the Final Cross Border Guidance and Phase-in Exemptive Order set forth in the Fact Sheets and therefore may not reflect the final text.
The issuance of the Final Guidance completes a year-long process for the CFTC which began with the issuance of the Proposed Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act (CEA) (the “Proposed Guidance”) on July 12, 2012. Section 2(i) of the CEA, which was added to the CEA by Section 722(d) of the Dodd-Frank Act, provides that the swap provisions of the CEA apply to certain cross-border activities that have a “direct and significant connection with activities in, or effect on, commerce of the United States” or as necessary to prevent the evasion of the swaps provisions of the CEA. Together with the CFTC’s joint announcement with the EC regarding a path forward on a coordinated approach to regulating cross-border derivatives activities, the Final Guidance is intended to set forth the general policy of the CFTC regarding the application of the swap provisions of the CEA (and the CFTC’s regulations thereunder) to cross-border activities.
Phase-in Exemptive Order
Delay of US Person definition and changes to SD registration calculation for Non-US Persons
The Phase-in Exemptive Order provides temporary relief in order to permit market participants to assess the impact of the Final Guidance. The Phase-in Exemptive Order delays, until 75 days after the Final Guidance is published in the Federal Register, the effectiveness of (i) the US Person definition and (ii) the changes in the swap dealer (SD) and major swap participant (MSP) calculations and the associated aggregation rules, each as contained in the Final Guidance and further described below. Until such time, market participants may continue to apply the definition of US Person and to apply the SD and MSP calculation provisions contained in the Final Exemptive Order Regarding Compliance with Certain Swap Regulations issued on January 13, 2013 (the “Exemptive Order”) and which expires on July 12, 2013.
Acknowledging that the Final Guidance will have an impact on certain non-US Persons’ registration determinations, the CFTC indicates that such non-US Persons required to register as a SD as a result of the Final Guidance will not have to do so until two months after the end of the month in which such persons exceed the de minimis threshold for swap dealer registration. It is unclear based on the Fact Sheets when persons are required to register if those persons’ swap dealing activity from and after October 12, 2012, as determined using the aggregation principles and other new tests to be set forth in the Final Guidance, exceeded the de minimis threshold prior to the effective date of the Final Guidance. It is also unclear whether the CFTC would issue no-action relief to affected persons if the Final Guidance could require persons to register retroactively as a result in changes from the Exemptive Order to the Final Guidance, or whether the CFTC will specify in the Final Guidance or otherwise during the 75 day phase-in period that a two month grace period applies regardless of when the de minimis threshold was deemed exceeded based on the Final Guidance. The answer may become clear on reading the text of the Final Guidance once it is made public.
Delay in application of swap provisions of the CEA subject to substituted compliance determinations
The Phase-in Exemptive Order permits a non-US SD or MSP that is organized in Australia, Canada, the EU, Hong Kong, Japan or Switzerland (the “Presumptively Comparable Jurisdictions”) to delay compliance with the Entity-Level Requirements (other than the swap data repository reporting requirement) and the Transaction-Level Requirements until the earlier of December 21, 2013 or 30 days following the issuance of a substituted compliance determination for the relevant regulatory requirement of the jurisdiction in which the non-US SD or MSP is established. Regulators from each of the Presumptively Comparable Jurisdictions have submitted requests to the CFTC for a substituted compliance determination with respect to their respective local swap regulation regimes. For the swap data repository reporting requirement, only non-US SDs and MSPs that are organized in the Presumptively Comparable Jurisdictions that are not part of an affiliated group in which the ultimate parent entity is a US SD, MSP, bank, bank holding company or financial holding company may delay compliance with such reporting requirement for swaps with non-US counterparties until the earlier of December 21, 2013 or 30 days following the issuance of a relevant substituted compliance determination, subject to certain conditions.
The Phase-in Exemptive Order also provides relief for foreign branches of US SDs or MSPs located in the Presumptively Comparable Jurisdictions. In respect of the Transaction-Level Requirements for which substituted compliance is available under the Final Guidance, such foreign branches may comply with the requirements of their home jurisdictions (and only to the extent required by such jurisdictions) until the earlier of December 21, 2013 or 30 days following the issuance of a substituted compliance determination for the relevant regulatory requirement in their home jurisdictions.
Definition of US Person
The definition of “US Person” is a key component of the CFTC’s cross-border guidance as it directly impacts the registration analysis under the CEA as well as the application of the various swap provisions of the CEA in cross-border transactions. The Fact Sheets do not contain the full definition of US Person. However, they do specify, consistent with the reference in yesterday’s joint announcement with the EC, that the final definition of US Person will include collective investment vehicles (e.g., hedge funds) that (i) are directly or indirectly majority-owned by US Persons or (ii) have their principal place of business in US (determined by reference to the location of the managers, sponsors, promoters and the trading function of any such funds). This treatment is a departure from the version of the definition of US Person in the Exemptive Order which specifically excluded offshore funds and collective investment vehicles from the definition of US Person even if they have their principal place of business in the US, but is more in line with the proposed definition of US Person in the Proposed Guidance. The majority-ownership test for funds is disfavored by some market participants as it could result in funds moving in and out of US Person status as a result of changes in ownership. The Fact Sheets also indicate that a non-US Person that is guaranteed by a US affiliate is a US Person by definition, although based on the CFTC’s commentary in its July 12 open meeting, it appears that swaps between non-US SDs and such guaranteed affiliates may fall within the scope of the Dodd-Frank Act, at least for certain purposes.
Swap dealer and major swap participant registration determinations
The method of calculating swap dealing activity toward the de minimis threshold, and the application of aggregation principles to potential SDs that conduct swap dealing activity through multiple affiliates, appears to have changed significantly under the Final Guidance from the Proposed Guidance and the Exemptive Order.
Swap dealer de minimis threshold
According to the Fact Sheets, in performing its de minimis calculations for SD registration:
- a US Person should count all of its swap dealing activity (whether with US or non-US Persons).
- a non-US Person that is guaranteed by, or a “conduit affiliate” of, a US Person (collectively, a “Guaranteed Affiliate”) should count all of its swap dealing activity.
- a non-US Person that is not a Guaranteed Affiliate should count swap dealing activity with US Persons and non-US Persons, but may exclude certain swap dealing activity from such calculation including (i) swaps with non-US branches of US SDs, (ii) swaps with non-US Persons that are not Guaranteed Affiliates, (ii) certain(unspecified) swaps with Guaranteed Affiliates, and (iii) certain (unspecified) swaps that it enters into anonymously on a designated contract market (DCM), swap execution facility (SEF), or foreign board of trade.
Aggregation for swap dealer determination
In implementing the aggregation requirement in CFTC Regulation 1.3(ggg)(4), which requires a person to include the aggregate notional amount of all swap dealing activity of its affiliates under common control, the Fact Sheets indicate that a person (whether US or non-US) should, as a general matter, include all relevant swap dealing transactions of all of its US and non-US affiliates under common control, except for swaps entered into by an affiliate (whether US or non-US) that is registered as a SD. In other words, the Final Guidance would appear to permit both US and non-US persons in an affiliated group that includes a SD to engage in swap dealing activity on a collective basis up to the de minimis threshold without registering any additional entity as a SD. If, collectively, an affiliated group exceeds the de minimis threshold, additional members of the group would have to register as a SD such that, following the new registration, the collective activity of such group’s remaining unregistered members is below the de minimis threshold.
Major swap participant calculation
In determining whether a non-US Person exceeds any of the MSP thresholds, the Fact Sheets indicate that such person should include (1) swaps with a US Person; (2) swaps with a guaranteed affiliate (except that where its obligations under such swaps are guaranteed by a US Person, such swaps should be attributable to the US Person and not its own MSP calculation); and (3) any swaps between another person and a US Person or guaranteed affiliate where it guarantees the obligations of the other person. Other unspecified exceptions also apply.
Application of swap provisions to transactions involving Non-US Persons
Application of swap provisions for Non-US SDs and MSPs
Consistent with the Proposed Guidance, the Final Guidance divides the swap provisions applicable to SDs and MSPs into two broad categories -- “Entity-Level Requirements” and “Transaction-Level Requirements” -- which are comprised of the same substantive rules as in the Proposed Guidance. The Transaction-Level Requirements are further divided into categories. “Category B” is comprised of the external business conduct standards and “Category A” includes all of the other Transaction-Level Requirements such as clearing and trade execution, margining, swap trading relationship documentation, portfolio reconciliation and compression, real-time public reporting, trade confirmation and daily trading records.
Not surprisingly, US SDs and MSPs booking swaps from the US generally are required to comply with all Entity-Level and Transaction-Level Requirements, regardless of whether they are transacting with US or non-US Persons. However, a foreign branch of a US SD or MSP generally is eligible for substituted compliance with the Category A Transaction-Level Requirements with certain counterparties. Furthermore, where a foreign branch of a US SD or MSP that is located in a jurisdiction other than the Presumptively Comparable Jurisdictions enters into a swap with a non-US Person that is not a guaranteed affiliate, comparable requirements in the jurisdiction where the foreign branch is located may be substituted for the CFTC’s Transaction-Level Requirements.
Non-US SDs and MSPs must also comply with the Entity-Level Requirements, except that substituted compliance (as described below) may be available in certain cases. Where Non-US SDs or MSPs enter into a swap with a US Person or a Guaranteed Affiliate, such non-US SDs or MSPs generally should comply with the Category A Transaction-Level Requirements, but substituted compliance may be available for swaps with certain counterparties. Where a non-US Person executes a swap anonymously with a US Person or a Guaranteed Affiliate on a registered DCM or SEF, the CFTC will consider the non-US Person to have complied with the Category A Transaction-Level Requirements in respect of such transaction. Finally, in respect of the Category B Transaction-Level Requirements (i.e., external business conduct standards), the Final Guidance provides that non-US SDs and MSPs only must comply with the external business conduct standards when trading with US Persons.
Application of swap provisions for two unregistered counterparties
If both parties to a swap are unregistered non-US Persons, the swaps provisions of the Dodd-Frank Act generally will not apply. However, where both parties are unregistered, but one (or both) of the counterparties is a US Person, the applicable swaps provisions generally will apply.
The CFTC’s stated policy is that a non-US SD or MSP should be able to comply with comparable home jurisdiction laws in lieu of the corresponding swap provisions under the Dodd-Frank Act. In the coming months, the CFTC expects to issue comparability determinations which may be made on a requirement-by-requirement basis.
Letter 13-45; relief from certain “risk mitigation techniques” for swaps subject both to the CEA and EMIR
In connection with its broad pronouncement to permit substituted compliance and in recognition that comparability determinations will take time, yesterday the Division of Swap Dealer and Intermediary Oversight (the "Division") issued CFTC Letter 13-45 which grants relief for SDs and MSPs from certain requirements under Subpart I of Part 23 of the CFTC’s regulations (defined in the Letter as the “CFTC Risk Mitigation Rules”) in connection with certain uncleared swaps subject to corresponding requirements known as “risk mitigation techniques” under the European Market Infrastructure Regulation (EMIR) and the related EMIR Regulatory Technical Standards (defined in the Letter as the “EMIR Risk Mitigation Rules”). The CFTC believes such relief is warranted in respect of certain derivative transactions that are subject to both the CFTC Risk Mitigation Rules and the EMIR Risk Mitigation Rules as it considers both sets of requirements to be “essentially identical.” The CFTC Risk Mitigation Rules to which the relief provided in the Letter applies include §§23.501 (swap confirmation), 23.502 (other than 23.502(c)) (portfolio reconciliation other than reporting valuation disputes to the CFTC in excess of a specified threshold), 23.503 (portfolio compression), 23.504(b)(2) (requiring swap trading relationship documentation to include confirmations) and 23.504(b)(4) (requiring swap trading relationship documentation to include an agreed procedure for valuation). The relief described in the Letter does not apply to §§ 23.502(c) (requiring reporting to the CFTC of any valuation dispute in excess of $20,000,000), 23.504 (except for (b)(2) and (b)(4)), 23.505 (end-user exception documentation), and 23.506 (swap processing and clearing).
The relief from the CFTC Risk Mitigation Rules applies to (a) uncleared swaps and (b) physically-settled foreign exchange forwards and swaps that have been exempted from the definition of swap by the US Department of the Treasury and, in each case, which are subject to both the CFTC Risk Mitigation Rules and the EMIR Risk Mitigation Rules (such transactions, the “Covered Swaps”). Accordingly, the CFTC has made the determination that the relief provided in CFTC Letter 13-45 will be available to Covered Swaps where the counterparties meet all of the following conditions: (1) one of the counterparties is organized in the EU or otherwise subject to EMIR; (2) one of the counterparties is a US Person; and (3) one of the counterparties is an SD or MSP. Relief also is available in other circumstances where such Covered Swaps are subject to both the CFTC Risk Mitigation Rules and the EMIR Risk Mitigation Rules. For example, the CFTC stated that relief would also be available to a swap between a SD or MSP that is organized in the EU and a non-US affiliate of a US person that is guaranteed by such US Person.
In addition, the CFTC stated that the relief in the Letter also applies to swaps between two SDs or MSPs that are registered with the CFTC, but are organized under the laws of the EU, if such swaps are (i) uncleared swaps or (ii) physically-settled foreign exchange forwards and swaps that have been exempted from the definition of swap by the US Department of the Treasury.
The relief in CFTC Letter 13-45 does not extend to jurisdictions other than the EU or the US.
Within the foregoing parameters, the Division will not recommend that the CFTC take enforcement action against an SD or MSP for failure to comply with the CFTC Risk Mitigation Rules in connection with Covered Swaps if in the alternative such SD or MSP complies with the EMIR Risk Mitigation Rule when entering into Covered Swaps, subject to the following conditions:
- The SD or MSP fully complies with the EMIR Risk Mitigation Rules applicable to the Covered Swaps, the SD or MSP, and its counterparty and
- The SD or MSP fully complies with all of the other requirements of Subpart I of Part 23 of the CFTC’s regulations that otherwise apply to the SD or MSP.
While the relief granted in CFTC Letter 13-45 is a welcome effort at recognizing equivalence between certain Dodd-Frank and EMIR provisions, it does not relieve SDs or MSPs from compliance with any material requirements under the Dodd-Frank Act.