The Commodity Futures Trading Commission and the Securities and Exchange Commission both addressed cross-border swap activity last week. The CFTC issued proposed rules while the SEC issued final rules related to such cross-border conduct.
The CFTC also issued final rules amending certain requirements of derivatives clearing organizations related to governance, risk management, reporting and other matters, and proposed rules prohibiting post-trade name give-up practices for swaps that are meant to be cleared and are anonymously executed in the first instance on swap execution facilities.
Three divisions of the CFTC additionally issued relief to swap dealers and other market participants to assist in an industry migration from swaps that rely on the London Interbank Offered Rate and other interbank offered rates to swaps that reference alternative benchmarks.
The CFTC’s proposed cross-border rules principally clarify when a person’s cross-border swaps or swap positions implicate swap dealer registration requirements. The proposed rules also introduce a substituted compliance regime from certain CFTC regulations for non-US swap dealers that “emphasizes a holistic, outcomes-based approach that is grounded in principles of international comity.” The CFTC said its proposal leverages the adoption of comprehensive swaps regulation in many jurisdictions since July 2010 outside the United States, and reflects concerns about market fragmentation that arise when there are conflicting and duplicative requirements between US and non-US regulators.
Among other things, the CFTC proposed that the definition of US person should be based solely on the US physical presence or legal organization of a person. For collective investment vehicles, however, the territorial analysis should apply to the geographic location of the office from which the manager primarily directs, controls and coordinates the fund; the fact that a CIV is majority owned by one or more US persons should not trigger it being designated a US person on its own.
As proposed, a US person would have to include all dealing swaps in its de minimis threshold calculation (i.e., US $8 billion of gross notional value dealing swaps on a rolling one-year basis) to determine whether it must register as a swap dealer. Only non-US persons that are formally guaranteed by US persons (“guaranteed entities”) and significant risk subsidiaries would have to count all their dealing swaps against the de minimis threshold and potentially register as swaps dealers. (An SRS would be a newly defined entity and constitute non-US persons that are part of a holding company organization with an ultimate parent entity with US $50 billion or more of global consolidated assets and not subject to consolidated supervision and regulation by the Board of Governors of the Federal Reserve System or capital standards and oversight by the non-US person's home country regulator that are consistent with international standards for banks.)
Other non-US persons would have to count dealing swaps with US persons and guaranteed entities against the de minimis threshold, except for swaps with a foreign branch of a registered swap dealer or a guaranteed entity that is registered as a swap dealer. Swaps against an SRS would not have to be counted.
The CFTC also proposed that non-US swap dealers that arranged, negotiated or executed swaps from the US (“ANE Transactions”) would not have to comply with CFTC swap dealer transaction-level requirements in connection with their swaps with non-US persons. Generally, said the CFTC, such swap transactions would already be subject to regulation and oversight “similar to the Commission’s transaction-level requirements” in the non-US persons’ home countries. Moreover, non-US swap dealers engaging in ANE transactions would have their ANE activities subject to CFTC anti-fraud and anti-manipulative conduct prohibitions, argued the Commission. (Click here to access 7 U.S.C. § 9(1) and here for CFTC Rule 180.1.)
The CFTC based its proposal rules on its reading of relevant law (click here to access 7 U.S.C. § 2(i)) that applies swaps provisions to non-US activities that either have a “direct and significant effect on U.S. commerce” or “a direct and significant connection with activities in U.S. commerce, and through such connection present the type of risks to the U.S. financial system and markets that [Dodd-Frank] directed the Commission to address.” As a result, the CFTC determined to interpret the term “direct” to require “a reasonably proximate causal nexus” and not “foreseeability, substantiality, or immediacy.” Also, in light of the evolution of global swaps regulation, the CFTC determined to apply principles of international comity to minimize conflicts with other countries’ laws.
In supporting the Commission’s reliance on other countries’ regulatory regimes in connection with the oversight of cross-border swaps activity, CFTC Chairman Heath Tarbert invoked Immanuel Kant’s concept of the “categorical imperative.” He said it “would be absurdity” if the CFTC imposed its requirements on non-US persons whenever the swaps transactions had a “remote nexus to the United States.” This, he said, would lead to every regulator trying to oversee everyone else. As a result, he argued, “[w]e should not impose our regulations on the non-U.S. activities of non-U.S. companies in those jurisdictions that have comparable capital and margin requirements as our own.”
Commissioner Dan Berkovitz expressed a different perspective, decrying what he claimed was the creation of “multiple loopholes for U.S. banks to evade the Commission’s oversight of their cross-border activity [that would] pose risk to the U.S. financial system.” Among other things, he said that the proposed application of US swap dealer requirements to the newly created SRS entities would apply to few, if any firms. As a result, he claimed “[t]his is a Seinfeldian regulation – a regulation about nothing.” He also objected that the CFTC’s proposed approach regarding ANE transactions would authorize US persons “to undertake substantial dealing activity in the United States and then evade regulation by booking the trades in foreign entities.”
The CFTC will accept comments on its proposed cross-border swap dealing rules for 60 days following their publication in the Federal Register.
The SEC’s final rules on cross-border activity dealt with cross-border activity involving security-based swaps, including single name credit default swaps. They will be effective the later of March 1, 2020 or 60 days after their publication in the Federal Register.
Derivatives Clearing Organizations
The CFTC’s final DCO rules amendments deal with governance, as well as certain risk management and reporting obligations and other matters. Among other things they address include DCOs’ obligation to obtain written acknowledgments from certain depositories; governance and conflicts of interest; procedures for registration and implementing rules and clearing new products; compliance with core principles; financial resources; participant and product eligibility; risk management; default rules and procedures; reporting; and fully collateralized positions.
DCOs must comply with all new CFTC requirements by one year after the date of publication of the final rules in the Federal Register. The CFTC proposed amendments to its DCO rules in May 2019 (click here to access the relevant Federal Register release).
Post-Trade Name Give-Up and LIBOR Transition
The CFTC also proposed to ban post-trade name give-up practices for intended-to-be cleared swaps executed anonymously on swap execution facilities. The revised rule would prohibit a SEF from directly or indirectly disclosing the identity of relevant counterparties – including through a third-party service provider. Moreover, the revised rule would require SEFs to enact and enforce rules to preclude persons from causing such a disclosure.
Comments on this proposal will be accepted by the CFTC for 60 days following its publication in the Federal Register.
Separately, the Divisions of Swap Dealer and Intermediary Oversight, Market Oversight and Clearing and Risk published no-action letters to help swap dealers and other industry participants migrate from uncleared swaps that reference LIBOR or other interbank benchmarks to swaps that reference alternative benchmarks such as the secured overnight financing rate.
Memory Lane: In September 2014, a US federal court mostly tossed out all legal challenges brought by three industry groups to the CFTC’s first attempt post-adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act to address swap dealer registration and other related issues emanating from cross-border activities in its 2013 Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations. (Click here for background on the CFTC’s Interpretive Guidance in the article “CFTC Enacts Interpretive Guidance and Passes Exemptive Order regarding Cross Border Swaps Transactions” in the July 16, 2013 edition of Between Bridges.)
In ruling generally against the plaintiffs, the court adopted the CFTC’s principal argument, that Dodd-Frank’s swaps requirements applied extraterritorially when swaps activity outside the United States had a “direct and significant connection” with US commerce without the need for any implementing regulations. As a result, the court said, “[t]he CFTC was not required to issue any guidance (let alone binding rule) regarding its intended enforcement policies. … Indeed, the CFTC’s decision to provide such a non-binding policy statement benefits market participants and cannot now, all other things being equal, be turned against it.”
Notwithstanding, the court ordered the CFTC to conduct a cost-benefit analysis regarding the extraterritorial application of many of the CFTC’s rules addressed in the cross-border guidance. (Click here for further details regarding the court’s ruling in the article “Federal Court Tosses Out Challenges to CFTC Cross-Border Guidance and Policy Statement” in the September 16, 2014 edition of Between Bridges.)
In response, the CFTC sought comment on its cross-border guidance in March 2015. (Click here for details in the article “CFTC Formally Responds to Court Judgment on International Guidance; Calls for Public Comments” in the March 15, 2015 edition of Bridging the Week.)
The CFTC incorporated responses to its 2015 solicitation in a 2016 cross-border rules proposal that is now withdrawn and replaced by the CFTC’s current proposal. (Click here for details regarding the CFTC’s earlier proposal in the article “CFTC Requires All Non-US Consolidated Subsidiaries of US Parents to Count All Swaps in De Minimis Threshold in Proposed Cross-Border Rules” in the October 16, 2016 edition of Bridging the Week.)
Totally Irrelevant (But is It?): Footnote 8 to Chairman Tarbert’s written comments to the CFTC’s proposed cross-border rules contains some of the best derivatives-industry observations of 2020:
"Yet, even at first glance, derivatives regulation and Kant’s philosophy share some strikingly common attributes Title 17 of the Code of Federal Regulation [containing all CFTC rules] and The Critique of Pure Reason… (1781) are impenetrable to all but a handful of subject matter experts. And scholars spend decades writing and thinking about them, often coming up with more questions than answers."
Sadly, I still remember back in 1982 when I began my practice of derivatives law, the infamous “white book” that contained the Commodity Exchange Act and all CFTC regulations was less than an inch or so thick. Now the white book is no longer white and it is approximately six inches thick. Simpler times seem “a long time ago in a galaxy far, far away."