With the recent release of the SEC's first set of final rules for cross-border security-based swaps (SBS), final rules are now in place detailing the extraterritorial application of Dodd-Frank Title VII swaps rules to both SBS and non-security-based swaps (swaps). These rules generally extend to any swap transaction involving a US person regardless of where the parties enter into the swap.

While this can be easy to spot in some cases, in others, identifying these swaps can be tricky, especially when non-US persons enter into transactions with non-US affiliates of US persons. However, US regulators have agreed that the jurisdictional lines should be drawn based on where the exposure under the transaction ultimately resides. In many cases, this may be with a US guarantor. Therefore, under both the final CFTC and SEC Dodd-Frank cross-border swaps rules, a swap entered into with a non-US person is still subject to Title VII swaps rules if the swap is guaranteed by a US person. This can occur in one of two ways:

The final SBS cross-border rules define "conduit affiliate" as an entity that:

The CFTC does not provide a specific definition for the term "conduit affiliate" in its final cross-border swaps guidance (final guidance). However, the final guidance does list the following non-exclusive factors to be considered in determining whether a non-US person is a conduit affiliate of a US person:

Other factors and circumstances may also be relevant to a CFTC conduit affiliate (also referred to as affiliate conduit) determination.

The rationale of these rules, of course, is to minimize the risk that unregulated swap exposures will harm the US financial system. Because of the interconnectedness of the global swaps markets, any major swap counterparty default, no matter where it occurs, poses some danger to the US economy, which is why US regulators would like to extend their reach as far as possible. However, principles of comity and deference to the regulatory efforts in other jurisdictions present limitations, especially given the ongoing US-EU financial markets regulatory dialogue (see Legal Update, Joint statement on US-EU financial markets regulatory dialogue: July 2014).

Non-US market participants generally prefer to enter into swaps that are not subject to Title VII rules due to the added expense that requirements such as mandatory clearing and exchange trading, as well as extensive requirements for uncleared swaps, typically add to the cost of a transaction. Market participants may also be subject, or soon to be subject, to overlapping but imperfectly duplicative sets of derivatives rules, and may have a legitimate interest in selecting one jurisdiction for regulatory compliance purposes. Separate compliance costs in two different jurisdictions render some transactions economically prohibitive.

As the US is further along on its swaps rules under the G-20 commitments than other jurisdictions including the EU and Asia, non-US market participants can play regulatory arbitrage, at least for the time being, until global derivatives regulatory harmonization or equivalence is achieved, and avoid Title VII rules by entering into swaps with non-US persons. Removing the US exposure under the transaction by removing a US entity's guaranty of what is otherwise a swap between two non-US entities (or "de-guarantying" the swap, as it has become known) offers something of a market-based compromise to derivatives regulatory jurisdictional issues.

Some, such as California Representative Maxine Waters, have called for regulators to investigate the practice of de-guarantying. Others have been critical of the SEC rules, which appear tacitly permissive on the de-guaranty issue. However, the practice at least serves to de-link the swap from directly impacting the US financial system, especially where the non-US affiliate is a separately capitalized entity that is subject to another jurisdiction's prudential banking regulation.

The SEC cross-border release seems to all but concede on the de-guaranty issue, acknowledging that the final cross-border rules for SBS "may not capture all of the risks of the vast cross-border derivatives market that may flow back to the United States. As public reports have recently highlighted, for example, some U.S. financial firms are 'de-guaranteeing' their foreign affiliates. To the extent that the new financial arrangements do not create a legally enforceable right of recourse against a US person, our rules may not bring these affiliates within our regulatory oversight due to the limits of our statutory authority."

The SEC states further that it will work with US and foreign regulators to "actively monitor these and other developments and the potential exposure of the United States and work to develop and use our collective powers to address them as necessary." The takeaway: The SEC appears to have declined to issue an express prohibition of cross-border SBS de-guarantying.

For its part, the CFTC declined to comment when asked recently whether the practice of de-guarantying to avoid the application of Dodd-Frank swaps rules is prohibited or discouraged. The CFTC has yet to directly address the issue or to take a public position, so there remains some uncertainty with respect to cross-border de-guarantying in the broader (non-security-based) swap markets, which are subject to CFTC oversight. However, CFTC guidance or a clarification on the issue may be forthcoming, though any such guidance is likely to apply prospectively. Regardless, for the time being, cross-border de-guarantying appears a safer bet in the case of SBS than CFTC-regulated swaps.

The practice of cross-border de-guarantying contributes to the global fragmentation of derivatives liquidity pools that is already underway as a result of disparate and uncoordinated global regulatory efforts. US regulators may ultimately determine that facilitating this fragmentation is their best bet in the current environment for mitigating the dangers posed to the US financial system by unregulated or under-regulated swap exposures.

Many, like Representative Waters, point out that a US parent would be unlikely let a non-US swap dealer affiliate fail regardless of whatever guarantees may or may not be in place, which ultimately brings the risk back to the US. Because of this, the practice of de-guarantying could appear in some situations to be borne more out of evasion than compliance, a factor market participants should be aware of when contemplating a de-guaranty.