CFTC Seeks to Expand Jurisdiction over U.S. Swap Dealers’ Overseas Affiliates
Chairman Massad recently announced that the CFTC is considering expanding its rules for uncleared swaps to cover affiliates of U.S. swap dealers in an effort to regulate affiliates that may not be covered by existing swaps rules, or the CFTC’s Cross-Border Guidance. As swaps activities continues to shift outside of the U.S. regulator’s reach, the CFTC is looking into exercising jurisdiction over those affiliates whose swaps activities may not be guaranteed by U.S. swap dealers, but rather, are included with U.S. swap dealers in consolidated financial statements.
Chairman Massad noted that following the adoption of the Cross-Border Guidance, the CFTC noted a trend of U.S. swap dealers “de-guaranteeing” the swap transactions of their overseas’ affiliates. Targets of the CFTC’s plan are large U.S. banks with large swaps businesses, and their overseas affiliates. While the plan is still in its early stages, Chairman Massad made clear that certain entities would still be able to rely upon the notion of substituted compliance, meaning that if their own jurisdiction’s laws address margin for uncleared swaps and have been approved by the CFTC, the non-U.S. entity could abide, instead, by the laws of its own jurisdiction.
ISDA Proposes Principles Governing Swaps Execution on Centralized Markets
ISDA has issued a paper proposing uniform principles that governmental agencies should follow when regulating the swaps markets. In its proposal, ISDA notes increasingly fragmented markets, which it asserts results from a lack of uniformity among different jurisdictions’ efforts to centralize execution. Generally, the paper sets forth ISDA’s principles and then recommends changes to existing CFTC regulations. In contrast, the paper notes that in certain instances, its principles are embodied in those regulations proposed by ESMA.
In its proposal, ISDA asserts that regulators should develop a specific objective criteria that will give market participants a clear understanding of when swaps will be required to move from a bilateral market to a centralized market. ISDA also advocates that swaps subject to centralized trading should be made available for trading on a wide variety of centralized markets.
In the U.S., SEFs currently determine when a particular swap will be “made available to trade” (known as a MAT determination) relying upon subjective factors that the SEF deems relevant. Instead, ISDA asserts that the CFTC should make MAT determinations for a particular type of swap and that the CFTC’s MAT determination should be applicable to all SEFs. ISDA proposes that the CFTC should make its MAT determinations based on data available from swap data repositories taking into account daily volumes over a significant time period for a particular swap. Requiring the CFTC to make MAT determinations, ISDA argues, would remove uncertainty from the marketplace and lessen the competitive motivation between different SEFs. In contrast, ESMA’s proposed regulations will require that ESMA make MAT determinations.
ISDA also asserts that centralized markets must offer flexible execution mechanisms that take into account both the trading liquidity and unique characteristics of each type of swap. ISDA notes that current CFTC regulations require rigid execution methods that do not take into account fluctuations in liquidity for particular markets. Rather, ISDA proposes that the CFTC should permit different execution mechanisms such as via auctions, volume matches, and various hybrid systems in order to promote liquidity across a broad range of markets, and by doing so, the CFTC will better implement the Dodd-Frank Act’s goal of promoting trading on SEFs.
CFTC Provides No-Action Relief from Certain Swaps Regulations for Transactions with Legacy Special Purpose Vehicles
The CFTC has granted no-action relief to swap dealers from having to comply with certain external business conduct standards in their dealings with structured finance special purpose vehicles (SPVs) for swaps executed prior to October 10, 2013, referred to in the no-action letter as “Legacy SPV swaps.” Certain CFTC regulations referred to generally as external business conduct standards require that prior to execution, swap dealers obtain certain information from their counterparties, including essential facts and verification that the counterparty meets the definition of an eligible contract participant. Additionally, the external business conduct standards require that prior to execution, swap dealers provide material information to the counterparty.
Under the terms of the Legacy SPV swaps documentation, adverse changes in the swap dealer’s credit rating could cause the swap dealer to be required to take one or more “Remedial Action.” These Remedial Actions include the posting of collateral by the swap dealer, replacing the downgraded swap dealer with an entity that satisfies applicable credit rating requirements, obtaining a guaranty of the swap dealer’s obligations or taking other action agreed upon in the particular Legacy SPV swaps documentation. The swap dealers asserted that the taking of any Remedial Action could require an amendment or modification to the existing Legacy SPV swaps documentation, and arguably could create a new swap for purposes of the external business conduct standards. Due to the nature of the counterparty, SPVs, swap dealers asserted that complying with the external business conduct standards could be impossible. In its letter, the CFTC noted that while SPVs are legal entities, they are not operating entities and are only formed for limited purposes. Additionally, SPVs rely upon the assistance of third party service providers such as administrators or trustees, whose authority and services are limited to those provided in written agreements entered into in certain instances, prior to the enactment of the Dodd-Frank Act or the adoption of swaps regulations. Based on the foregoing, the third party service providers were unable to ascertain whether they even have the authority to provide necessary information or agree to certain terms with swap dealers to ensure compliance with the external business conduct standards.
As a result, the CFTC believed that no-action relief was appropriate and granted no-action relief under limited enumerated circumstances. The no-action relief provides that swap dealers are not required to comply with the relevant external business conduct standards if such regulations apply solely as a result of one or more Remedial Action, and any Remedial Action does not alter the material economic terms of the Legacy SPV swap.
CFTC Commissioner Issues White Paper Calling For Reconsideration of CFTC Swaps Rules
Commissioner Giancarlo recently published an 81 page white paper examining whether certain swaps rules passed under the Dodd-Frank Act should be re-examined and modified in light of their effect on the U.S. swaps industry. In the white paper, Commissioner Giancarlo cautions that the CFTC swaps regulations may dissuade global market participants from doing business in U.S. markets and cause friction with foreign regulators. Additionally, Commissioner Giancarlo notes that the CFTC swaps regulations has created barriers to the formation of SEFs and unnecessarily burdened those existing SEFs with requirements that threaten profitability. The white paper also addresses other issues such as swaps market technology, market fragmentation and increased market liquidity risk.
As an alternative to the current regulatory regime, Commissioner Giancarlo proposes a pro-reform framework relying upon five tenets consisting of comprehensive regulation for the U.S. swaps market, cohesiveness in the regulation of all swaps products, flexibility, professionalism through standards of conduct required for the swaps market personnel and transparency. Following the release of the white paper, market participants expressed support, including ISDA, which noted that Commissioner Giancarlo’s proposals regarding SEFs was consistent with the position taken by the G-20.