On May 24, 2016, the Commodity Futures Trading Commission (CFTC) adopted final rules (cross-border margin rules)1 that specify how its recently issued uncleared margin rules apply to cross-border transactions. Chairman Timothy Massad and Commissioner Sharon Bowen voted in favor of the rules. Commissioner J. Christopher Giancarlo voted against the rules, protesting what he views to be an overly complicated approach: "In effect, the Commission's approach is somewhat principles-based, except when it is rulesbased and somewhat objective, except when it is subjective."2 The rules go into effect 60 days from the date of publication in the Federal Register.
The Dodd-Frank Act required U.S. banking regulators (Prudential Regulators), the CFTC, and the Securities and Exchange Commission (SEC) each to adopt rules requiring swap dealers (SDs) and major swap participants (MSPs) to post margin to and collect margin from certain financial counterparties when entering into swaps that are not centrally cleared.3 At the end of 2015, the Prudential Regulators finalized rules, which included provisions regarding the application of the rules' margin requirements to cross-border transactions.4 The CFTC adopted its uncleared margin rules at the beginning of 2016. The CFTC's rules apply to non-prudentially regulated SDs and MSPs (covered swap entities or CSEs) and largely resemble the Prudential Regulators' margin rules in substance.5 However, the CFTC's rules left a placeholder for the application of its margin requirements in a cross-border context, which the cross-border margin rules now address.6
The cross-border margin rules' definitions are central to determining whether and how the CFTC's uncleared margin rules will apply to cross-border transactions. Application depends largely on whether each counterparty to an uncleared swap is a "U.S. person," is controlled by a U.S. person such that the counterparty is consolidated on the U.S. person's financial statements, or is guaranteed by a U.S. person with respect to obligations arising under the uncleared swap.7 In general, the U.S. person definition takes a territorial approach by covering persons domiciled or organized in the U.S.8 Furthermore, because U.S. person status is determined at the entity level, any foreign operations of a U.S. person legal entity would be included in the U.S. person status. While certain aspects of the U.S. person definition track the definition adopted by the CFTC for purposes of its other swap regulations,9 noteworthy distinctions exist. For example, the cross-border margin rules' U.S. person definition does not include funds that are majority-owned by other U.S. persons.10
The cross-border margin rules identify a subcategory of non-U.S. persons that are CSEs (non-U.S. CSEs) whose uncleared swaps are guaranteed by a U.S. person. These entities -- referred to as "U.S Guaranteed CSEs"11 -- are treated as CSEs that are U.S. persons (U.S. CSEs) for purposes of the cross-border margin rules due to added systemic risk the CFTC views to exist based on a U.S. person being ultimately liable for any default under the swap. A guarantee is generally defined to mean an arrangement pursuant to which one party to an uncleared swap has rights of recourse against a guarantor with respect to its counterparty's obligations under the uncleared swap, regardless of whether such guarantor is affiliated with the swap counterparty. To address evasion concerns, the CFTC has broadened the guarantee definition to encompass scenarios where the guarantor itself has a conditional or unconditional legally enforceable right to receive or otherwise collect, in whole or in part, payments from any other guarantor with respect to the counterparty's obligations under the uncleared swap.12
The cross-border margin rules identify a second subcategory of non-U.S. CSE whose ultimate parent entity is a U.S. person that is required to consolidate the non-U.S. CSE in its financial statements in accordance with U.S. GAAP. These "Foreign Consolidated Subsidiaries" (FCSs) are generally treated as non-U.S. CSEs, although they are not eligible for the outright exclusion under the cross-border margin rules described below. The CFTC views these entities to require greater scrutiny under margin rules than other non-U.S. CSEs (except for U.S. Guaranteed CSEs) because their financial position, operating results and statement of cash flows are included in the financial statements of a U.S. person and therefore affect the financial position, risk profile and market value of that U.S. person.13
Depending on the combined status of counterparties to an uncleared swap, the cross-border margin rules provide that the CFTC's margin requirements will apply in full or in part, substituted compliance may be available for some or all requirements,14 or a complete exclusion from the requirements may be available. The CFTC characterizes its final cross-border margin rules as largely harmonious with the cross-border approach taken by the Prudential Regulators in their margin rules.15
Generally, the stronger the nexus of a counterparty's status to the U.S. financial system, the less likely substituted compliance or exclusion will be available.16 For U.S. persons and U.S. Guaranteed CSEs, substituted compliance is only available with respect to posting margin to a non-U.S. person counterparty that is not guaranteed by a U.S. person. Conversely, non-U.S. CSEs (including FCSs) whose obligations under the relevant uncleared swap are not guaranteed by a U.S. person are eligible for substituted compliance for all margin requirements when facing any counterparty other than a U.S. CSE or U.S. Guaranteed CSE.
Complete exclusion from the CFTC's margin rules is available only for uncleared swaps between a non-U.S. CSE and a non-U.S. counterparty (including another non-U.S. CSE), provided that neither counterparty's obligations under the swap are guaranteed by a U.S. person and neither counterparty is an FCS or U.S. branch of a non-U.S. CSE. However, the exclusion is not available if risk from the uncleared swap at issue is transferred through an inter-affiliate trade to a U.S. CSE or a U.S. Guaranteed CSE, and the non U.S. CSE's market-facing uncleared swap with the non-U.S. counterparty is not subject to comparable initial margin requirements in the non U.S. CSE's home jurisdiction.
Please refer to the chart at the end of this alert for an overview of how the CFTC's margin rules will apply to uncleared swaps in a cross-border context.
The cross-border margin rules provide relief from certain of the CFTC's margin requirements where compliance with such requirements would not be possible due to legal or operational limitations in a non-U.S. jurisdiction. More specifically, when entering into uncleared swaps with non-U.S. persons whose local jurisdiction lacks the legal or operational infrastructure necessary to comply with the CFTC's custodial requirements for margin, an FCS or foreign branch of a U.S. CSE is not required to post initial margin or hold with a third-party custodian any initial margin that is required to be collected, subject to certain conditions.17 Additionally, where a CSE cannot conclude with a well-founded basis that a netting agreement with a counterparty in a foreign jurisdiction meets the "eligible master netting agreement" definition in the CFTC's margin rules, the CSE can nonetheless net uncleared swaps in determining the amount of initial margin that it must post, subject to certain conditions.18
In order for substituted compliance to be available, the CFTC must issue a comparability determination with respect to a specific margin requirement of a foreign jurisdiction. In addition to outlining the process by which a comparability determination should be requested, the cross-border margin rules also outline the approach the CFTC will take in reaching a decision. Notably, the CFTC states that it will take an outcome-based approach to assessing comparability, focusing on whether foreign margin rules are comparable to the CFTC's rules in purpose and effect instead of whether they are identical in approach.19 The CFTC may determine that some or all of a jurisdiction's margin rules are comparable, which should at least require they be consistent with international standards of the Basel Committee on Banking Supervision and the International Organization of Securities Commissions, although such consistency alone may not be sufficient to finding comparability.20
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