On October 1, 2018, Chairman J. Christopher Giancarlo of the Commodity Futures Trading Commission ("CFTC") published a white paper entitled "Cross-Border Swaps Regulation Version 2.0: A Risk-Based Approach with Deference to Comparable Non-US Regulation" (the "White Paper").9 The White Paper is intended to contribute to the process of cross-border swaps reform to produce a regulatory framework consistent with congressional intent, while balancing the need to both (i) mitigate systemic risk and support swap market activity to promote economic growth and (ii) show deference to non-US regulation when it achieves comparable outcomes to CFTC regulation.
The White Paper offers high-level principles and recommendations for reform. It does not propose detailed modifications to specific CFTC regulations, and refrains from setting any timetables for implementation. Chairman Giancarlo considered the CFTC's experience over the last few years in regulating the US derivatives market, the need for comity with non-US regulators and the implementation of swaps reforms in non-US jurisdictions to determine where the original regulatory efforts would benefit from reconsideration. From this, Chairman Giancarlo developed the principles and recommendations set out in the White Paper.
The White Paper complements the white paper previously published by CFTC Chairman J. Christopher Giancarlo and CFTC Chief Economist Bruce Tuckman on April 26, 2018. For further information on that white paper, please refer to our client alert available at the link here.10 This article will discuss the CFTC’s existing rules and guidance as well as the White Paper's proposals for further reform of the CFTC's cross-border framework.
Section 2(i) of the US Commodity Exchange Act provides in pertinent part that the CFTC's jurisdiction over swaps shall not apply to activities outside the US unless they have a "direct and significant connection with activities in, or effect on, commerce in the United States…".11 The scope of the CFTC's extraterritorial jurisdiction has been the subject of several CFTC rules, rule proposals, guidance, staff advisories and no-action relief. In the White Paper, Chairman Giancarlo argues that the CFTC's existing cross-border framework, in certain respects, extends the CFTC's jurisdiction beyond what Congress intended when it passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act").
CFTC Cross-Border Guidance
On July 26, 2013, the CFTC issued interpretive guidance (the "CFTC Cross-Border Guidance")12 setting forth its views on the cross-border application of certain provisions of the Dodd-Frank Act. The CFTC Cross-Border Guidance addressed several important topics:
- the final definition of the term "US person," including the treatment of foreign branches of US swap dealers and major swap participants, guaranteed affiliates, and conduit affiliates;
- the determinations of whether a non-US person is engaged in more than a de minimis level of swap dealing or holds swap positions above any of the major swap participant thresholds; and
- compliance obligations, including substituted compliance by non-US persons, foreign branches of US swap dealers and major swap participants with entity-level requirements and transaction-level requirements.
The CFTC noted in the CFTC Cross-Border Guidance that it has a strong supervisory interest in swap dealing activities that occur within the US, regardless of the status of the counterparties.
For further information on the CFTC Cross-Border Guidance, please refer to our client alert available here.
CFTC Staff Advisory 13-69
In response to requests from market participants for clarification regarding the applicability of US transaction-level requirements for swaps between a non-US swap dealer and a non-US counterparty, the CFTC issued Staff Advisory 13-69 (the "Staff Advisory") on November 14, 2013.13 In the Staff Advisory, the CFTC concluded that personnel or agents of a non-US swap dealer, regardless of whether the non-US swap dealer is an affiliate of a US person, are generally required to comply with transaction-level requirements if such personnel or agents (i) are located in the US and (ii) regularly arrange, negotiate or execute swaps with a non-US person. In reaching this conclusion, the CFTC reasoned that agents of a non-US swap dealer that regularly arrange, negotiate or execute swaps are performing core, front-office activities, and to the extent these activities are conducted in the US, they would be within the scope of regulation by the Dodd-Frank Act.
Following the release of the Staff Advisory, the CFTC received multiple requests from non-US swap dealers for no-action relief to extend the timeline for compliance with such transaction-level requirements in order to allow regulated entities to make the necessary internal policy adjustments to comply with the requirements. In response, on November 26, 2013, the CFTC granted time-limited relief, which was subsequently extended by a series of no-action letters, the most recent of which extended the deadline to the effective date of any corresponding CFTC action specifically addressing whether a particular transaction-level requirement is applicable to such situation.14
Cross-Border Application of the CFTC's Initial and Variation Margin Rules
On May 24, 2016, the CFTC issued final rules and accompanying interpretative guidance setting forth the application of the CFTC's initial and variation margin rules to cross-border swap transactions (the "CFTC Cross-Border Margin Rules").15 The application of the CFTC's final initial and variation margin rules to cross-border swap transactions was not set out in the CFTC Cross-Border Guidance, but was rather explicitly addressed in this separate rulemaking.
Among the various concepts used in the CFTC Cross-Border Margin Rules, the CFTC introduced a new entity classification of "foreign consolidated subsidiary" ("Foreign Consolidated Subsidiary"). This was defined to capture any swap dealer or major swap participant subject to the CFTC's jurisdiction that is not a US person in which an ultimate parent entity that is a US person has a controlling interest, in accordance with US GAAP, such that the ultimate parent entity includes the non-US swap dealer or major swap participant's operating results, financial position and statement of cash flows in its consolidated financial statement, in accordance with US GAAP.
Notwithstanding that the Foreign Consolidated Subsidiary entity classification was also included in the 2016 Proposed Cross-Border Rule (as defined and discussed below), Chairman Giancarlo stated in the White Paper that he did not consider this entity classification, on its own, to be an appropriate method of determining the cross-border applicability of Dodd-Frank Act requirements. We note that the White Paper did not discuss the CFTC Cross-Border Margin Rules.
For further information on the CFTC Cross-Border Margin Rules, please refer to our client alert, available here.
2016 CFTC Cross-Border Proposed Rules
On October 11, 2016, the CFTC released proposed rules and accompanying interpretative guidance (the "2016 CFTC Cross-Border Proposed Rules")16 which set forth the application of certain requirements under the Dodd-Frank Act to cross-border swap transactions. The purpose of the 2016 CFTC Cross-Border Proposed Rules was to codify a definitional foundation for the CFTC's cross-border framework and the rules regarding the cross-border application of both swap dealer and major swap participant de minimis threshold calculations and certain of the CFTC's external business conduct standards applicable to swap dealers and major swap participants.
It was intended that the 2016 CFTC Cross-Border Proposed Rules, along with other future rulemakings, would supersede the CFTC Cross-Border Guidance with respect to the matters covered by such rules. However, following the release of the White Paper, it would seem that these proposed rules are unlikely to be finalized in their proposed form and will instead be replaced with new proposals that are consistent with the concepts and principles outlined in the White Paper.
White Paper's Proposed Cross-Border Approach of the CFTC
In the White Paper, Chairman Giancarlo first maintains that it is inappropriate for the CFTC to continue to rely on interpretative policy statements or guidance (such as the CFTC Cross-Border Guidance) in lieu of formal rules and advocates that it should instead adopt rules through a process that complies with notice-and-comment and cost-benefit consideration requirements.
The White Paper notes that the CFTC Chairman intends to direct CFTC staff to develop new rule proposals based on the principles set forth in the White Paper to address cross-border swaps transactions. The resulting final rules would replace the existing mixture of CFTC rules and guidance as well as certain CFTC staff advisories and no-action letters.
The White Paper recommends that any such new rule proposals should be guided by the following six (6) principles:
Below we address each of the areas of swaps reform considered in the White Paper: Registration of Non-US CCPs, Registration of Non-US Trading Venues, Registration of Non-US Swap Dealers, Clearing and Trade Execution Requirements, and ANE Transactions.
White Paper's Cross-Border Recommendations
Consistent with the above principles, the White Paper recommends that the CFTC address cross-border regulation of swaps based on whether the applicable entity or activity is within (i) the US, (ii) a Comparable Jurisdiction or (iii) a Non-Comparable Jurisdiction.
Registration of Non-US CCPs
Given that many regulated central counterparties ("CCPs") operate in non-US jurisdictions and under different regulatory regimes, Chairman Giancarlo argues in the White Paper that overlapping regulation and supervision should be avoided as this creates inefficiencies and increases the costs of US persons accessing non-US CCPs.
Registration of Non-US Trading Venues
The CFTC currently requires that a multilateral trading platform located outside the US that provides US persons located in the US, including personnel and agents of non-US persons located in the US, with the ability to trade or execute swaps on the platform to register with the CFTC as either a swap execution facility ("SEF") or derivatives contract market ("DCM").18
The White Paper argues that this registration requirement has resulted in the bifurcation of the global swaps markets by forcing non-US trading venues to deny participation to persons located in the US.
Registration of Non-US Swap Dealers
In the White Paper, Chairman Giancarlo argues that the CFTC's approach to its swap dealer registration rules has resulted in an inappropriate extraterritorial application of those rules that does not appropriately consider whether the dealing activity truly poses a "direct and significant" risk to the US financial system.
The White Paper sets out the following with respect to the cross-border application of swap dealer registration and the counting of swaps notional amounts to the swap dealer de minimis registration threshold.
Clearing and Trade Execution Requirements
Broadly, the Dodd-Frank Act requires that a swap be cleared if the CFTC has issued a clearing determination that the swap is required to be cleared, unless an exception or exemption applies.22 Additionally, if a swap is required to be cleared, the Dodd-Frank Act requires that the swap be executed on a DCM or SEF, unless no DCM or SEF makes the swap available to trade.23 The White Paper reasons that, while the clearing requirement addresses systemic risk to the US financial system, the accompanying trade execution requirement does not and instead furthers the goals of market efficiency and enhanced transparency. The White Paper recommends a cross-border approach that takes into account the differing purposes of these requirements.
2016 CFTC Cross-Border Proposed Rules
The 2016 CFTC Cross-Border Proposed Rules addressed the regulation of swap activity by non-US entities that would fall within the scope of transactions that are arranged, negotiated or executed using personnel located in the US ("ANE Transactions"). These terms do not include internal back-office activities such as clerical tasks that are performed by personnel who are not involved in the sale or trading of the swap.
The recommendations of the White Paper in connection with the regulation of ANE Transactions are predicated on two preliminary points:
- If a swap is executed in the US (irrespective of whether or not it is also arranged or negotiated), then the counterparties should be required to follow US swap execution rules. That is, it would be subject to the CFTC's clearing and trade execution requirements, which would require such swap to be traded on a SEF and centrally cleared, unless an exception or exemption applied.
- ANE Transactions are, by definition, between non-US persons and do not pose systemic risk to the US financial system merely by virtue of being arranged, negotiated or executed within the US and, for this reason, ANE Transactions should not count toward a potential non-US swap dealers' de minimis threshold if the non-US dealer is in a Comparable Jurisdiction.
Taking into account the above preliminary points, the White Paper sets out two scenarios where swaps are arranged or negotiated in the US but executed in a Comparable Jurisdiction (i.e., the first preliminary point above does not apply as the swap is not executed in the US).
Analysis and Final Thoughts
We highlight below some analysis and final thoughts on certain of the concepts and principles set forth in the White Paper.
Foreign Consolidated Subsidiaries
Unlike the 2016 CFTC Proposed Cross-Border Rules and the CFTC Cross-Border Margin Rules, Chairman Giancarlo did not include a separate "Foreign Consolidated Subsidiary" category in the White Paper. Chairman Giancarlo argues that it is overreach to require a Foreign Consolidated Subsidiary that engages in swap dealing activity wholly outside the United States to register with the CFTC, based solely on the theory that they pose a hypothetical risk to the US financial system due to an accounting connection. Instead, a better approach would be to not require a Foreign Consolidated Subsidiary to register as a swap dealer if their dealing activities occur wholly outside the US and are addressed, from a risk perspective, by their home country regulator through comparable regulation. Accordingly, in Comparable Jurisdictions, the White Paper recommends that Foreign Consolidated Subsidiaries whose swap dealing activity occurs outside the United States and does not involve direct activity in the US with US persons not be required to register as a swap dealer if they are subject to comparable regulation by a non-US regulator, including being subject to capital and margin requirements for uncleared swaps. For Non-Comparable Jurisdictions, the White Paper notes that this is more complex and that the CFTC should consider the issue in light of the requirements of the Dodd-Frank Act and the concepts and principles set out in the White Paper.
Non-US Banks and Brokers: Counting of Dealing Swaps
Non-US banks and brokers engaged in swap dealing activity in non-US markets regularly look to the deeper liquidity found in the New York and London markets to hedge their local client facing swaps. Assuming that the regularity and nature of their swaps business constitutes swap dealing activity, swaps entered into in order to hedge risk and exposure from this local market activity would also be included in the swap dealing activity of the non-US bank or broker. Both the original local market client-facing swap and the related hedging swap with a dealer in a larger market are likely within the scope of what the CFTC would consider to be "swap dealing activity".
Under the CFTC Cross-Border Guidance, a non-US person (that is not a guaranteed affiliate or a conduit affiliate25) is only required to count towards its swap dealer de minimis threshold those dealing swaps that are entered into with US persons (other than foreign branches of a US swap dealer) and guaranteed affiliates (except where the guaranteed affiliate is a registered swap dealer, is engaged in a de minimis level of swap dealing activity and is affiliated with a swap dealer, or is guaranteed by a non-financial entity).
The result was different, however, under the 2016 CFTC Proposed Cross-Border Rules, which would have required the non-US person to count each swap entered into with any US person, Guaranteed Entity or Foreign Consolidated Subsidiary toward its swap dealer de minimis threshold. In addition, Foreign Consolidated Subsidiaries themselves were also required to count all their dealing swaps. By treating Foreign Consolidated Subsidiaries the same as Guaranteed Entities, the CFTC significantly expanded its jurisdiction over non-US banks and brokers that were not otherwise captured under the CFTC Cross-Border Rules by requiring them to count additional swaps, which had the practical effect of increasing the likelihood that they would exceed the de minimis threshold and be required to register as swap dealers.
Under the White Paper, the entity classifications found in the 2016 Proposed Cross-Border Rules were retained (e.g., no "affiliate conduit" classification) and the exemptions found in the CFTC Cross-Border Guidance were generally restored with respect to non-US banks and brokers in Comparable Jurisdictions and Non-Comparable Jurisdictions. However, for Foreign Consolidated Subsidiaries themselves, the position remains somewhat uncertain as the White Paper does not provide a firm recommendation on how they should be treated – while the White Paper presents some examples of situations where Foreign Consolidated Subsidiaries should be treated similarly to Other Non-US Persons, the White Paper concludes that further consideration was warranted by CFTC staff in order to determine how to properly treat Foreign Consolidated Subsidiaries.
The White Paper marks a continuation of Chairman Giancarlo's focus on reassessing the efficacy of existing CFTC swap regulations. In particular, the White Paper indicates a strong preference to consolidate the current approach on cross-border application of CFTC swap regulations into a single set of coherent rules, which would replace the existing mixture of CFTC rules and guidance as well as certain CFTC staff advisories and no-action letters. While market participants may welcome many of the principals and recommendations set forth in the White Paper, it remains to be seen to what extent these will influence future CFTC rulemakings.