CFTC Defines Cross-border Reach of Dodd-Frank Swaps Rules

Practical Law Legal Update 7-520-1962 (Approx. 6 pages)

CFTC Defines Cross-border Reach of Dodd-Frank Swaps Rules

by PLC Finance

Definition of "US Person"

The term "US person" would include, but not be limited to, any:

Natural person who is a resident of the US.
Corporation, partnership, LLC, business or other trust, association, joint-stock company, fund or any similar form of enterprise that is organized or incorporated under US law, having its principal place of business in the US or in which one or more of the owners responsible for the entity's liabilities is a US person.
Individual account where the beneficial owner is a US person.
Commodity pool, pooled account or collective investment vehicle in which a majority ownership interest is held by a US person.
Commodity pool, pooled account or collective investment vehicle of which the operator would be required to register as a commodity pool operator (CPO) under the Commodity Exchange Act (CEA).
Pension plan for employees, officers or principals of a legal entity with its principal place of business inside the US.
Estate or trust the income of which is subject to US income tax.

SD and MSP Definitions Apply Globally

The CFTC notes that its definitions of "swap dealer" and "major swap participant" do not distinguish between US and non-US persons. Non-US persons who meet or exceed the notional thresholds of qualifying swap activity specified in the final CFTC definitions of "swap dealer" and "major swap participant" (see Practice Note, Is Your Client a Swap Dealer or Major Swap Participant? Breakdown of Final Dodd-Frank Definitional Rulemaking) in US-facing swap transactions would be required to register with the CFTC as SDs or MSPs, as applicable, and would become subject to comprehensive requirements under Title VII of the Dodd-Frank Act.

Entity-level Requirements and Transaction-level Requirements

The CFTC has distinguished between entity-level requirements, which apply to an SD or MSP as a whole, and transaction-level requirements, which apply on a swap-by-swap basis.

SDs and MSPs are subject to entity-level requirements relating to, among other things:

Capital adequacy.
Appointment of a chief Title VII compliance officer.
Risk management.
Swap data recordkeeping.
Swap data reporting.
Physical commodity swaps reporting.

For more detailed information on Dodd-Frank regulatory requirements for SDs and MSPs, see Practice Note, Summary of the Dodd-Frank Act: Swaps and Derivatives: Requirements for Swap Dealers and Major Swap Participants (MSPs).

The proposed interpretive guidance states that the following are transaction-level requirements that apply on a swap-by-swap basis:

Clearing and exchange trading.
Margining and margin collateral segregation for uncleared swaps.
Swap trading relationship documentation.
Execution of a written trade confirmation.
Real-time public swap data reporting.
Retention and maintenance of daily trading records.
External business conduct standards.
Portfolio reconciliation and compression.

Proposed Cross-border Aggregation Rules for SDs

The CFTC proposes that:

Any non-US person who engages in more than a de minimis level of US-facing "swap dealing" would be required to register as an SD under Title VII.
Any US person must include in its determination as to whether it is an SD the aggregate notional value of all swap dealing transactions:
- between it and any of its non-US affiliates that are under common control.
- of any of its non-US affiliates that are under common control, where the obligations of the non-US affiliate are guaranteed by a US person.

The CFTC also proposes that, for purposes of the de minimis SD determination, a non-US person would not be required to include the notional value of swap dealing transactions in which its US affiliates engage.

The de minimis threshold of swap dealing for SDs is generally $3 billion of non-hedging swap activity over the previous 12 months (or less), subject to a phase-in level of $8 billion. However there are certain important exceptions. For specific information on what constitutes the "de minimis" level of swap activity that causes an entity to be required to register with the CFTC as an SD, see Practice Note, Is Your Client a Swap Dealer or Major Swap Participant? Breakdown of Final Dodd-Frank Definitional Rulemaking.

Proposed Cross-border Aggregation Rules for MSPs

In making the determination as to whether or not they are required to register as an MSP under Title VII, all non-US persons would be required to aggregate the notional value of all of their non-exempt US-facing swap positions and determine if the aggregate notional value of those positions exceeds the levels specified in the final MSP definition. Non-US persons would not be required to count any swap positions in which its counterparty is a non-US person.

The level of swap activity for MSPs is generally $1 billion or more (but less than $8 billion) of daily average uncollateralized exposure over the previous calendar quarter ($3 billion for rate swaps). However, there are certain important exceptions and other formulations for determining compliance with this threshold, including some that involve potential future exposure. For specific information on what constitutes a level of non-exempt swap activity that causes an entity to be required to register with the CFTC as an MSP, see Practice Note, Is Your Client a Swap Dealer or Major Swap Participant? Breakdown of Final Dodd-Frank Definitional Rulemaking.

"Substituted Compliance" with Foreign Regulations Sufficient in Certain Circumstances

The CFTC proposes to permit non-US SDs and MSPs, under certain circumstances, to comply with entity-level requirements (see Entity-level Requirements and Transaction-level Requirements) under their home jurisdiction's laws and regulations in place of compliance with the entity-level requirements of the CEA and the CFTC's regulations (as modified by Title VII of Dodd-Frank) if the CFTC finds that those requirements are comparable to the requirements under the CEA and CFTC regulations. This is known as "substitute compliance." Under substitute compliance, the CFTC would:

Make comparability determinations for substituted compliance on an "individual requirement" (firm-by-firm) basis, rather than on the basis of a foreign regulatory regime as a whole.
Permit substituted compliance for entity-level requirements where the non-US SD or MSP counterparty is subject to comparable regulations in its home jurisdiction.

For transaction-level requirements (see Entity-level Requirements and Transaction-level Requirements), the CFTC would permit substituted compliance for swaps entered into between:

A non-US SD or MSP and a non-US person whose swap obligations are guaranteed by a US person.
A non-US SD or MSP and a non-US affiliate conduit.
A foreign branch of a US person and a counterparty that is a non-US person.

For swap data reporting, which is considered a transaction-level requirement in the proposed interpretive guidance but which is entity-level for SDs and MSPs, the CFTC would permit substituted compliance for swaps entered into by non-US SDs and non-US MSPs with non-US counterparties provided that the CFTC has direct access to the swap data for the non-US SDs and MSPs that is stored at a foreign trade repository.

Allowing substituted compliance would address the CFTC's supervisory concerns while minimizing the potential for conflicts with the requirements under foreign jurisdictions. It is also an attempt by the CFTC to address concerns raised by industry groups, market participants and foreign officials regarding issues of comity and so-called "mutual recognition" of foreign swaps and derivatives regulatory regimes.

Applications for Substituted Compliance

A non-US person may submit an application for substituted compliance with the requirements of its home jurisdiction in place of Dodd-Frank requirements (as reflected in the CEA and CFTC regulations). Alternatively, a group of non-US persons from the same jurisdiction or a foreign regulator may submit an application for substituted compliance on behalf of a non-US person subject to a foreign supervisory regime.

At a minimum, the applicant would be required to specify the factual basis for requesting that the CFTC recognize comparability of a foreign regulatory regime's coverage of a particular Dodd-Frank requirement and include all applicable legislation, rules and policies. An applicant would be expected to represent that it is licensed and in good standing with its supervisor in its home country.

The CFTC may then enter into an appropriate memorandum of understanding or similar arrangement with the relevant foreign supervisor. Non-US SDs and MSPs that have been granted substituted compliance would then be required to notify the CFTC of any material changes to information submitted in support of a comparability finding to ensure that the comparability determination remains valid.

In determining whether it will recognize substituted compliance, the CFTC would evaluate all relevant factors for each case including:

The scope and objectives of the relevant foreign regulatory requirements.
The comprehensiveness of the relevant foreign regulatory requirements.
The comprehensiveness of the foreign regulator's supervisory compliance program.
The authority of the relevant foreign regulators to support and enforce its oversight of the non-US SD or MSP applicant's branch or agency with regard to such activities to which substituted compliance applies.

Substituted Compliance Not Permitted under Certain Circumstances

Certain provisions of Title VII of the Dodd-Frank Act, such as those relating to swap clearing, exchange trading, real-time public data reporting, large-trader reporting and other swap data reporting and recordkeeping rules, also apply to persons or counterparties other than SDs and MSPs. The CFTC has proposed interpretive guidance on the application of these provisions to cross-border transactions in which neither counterparty is an SD or MSP. The proposed guidance includes that:

If neither of the counterparties to the swap are an SD or MSP, substituted compliance with a foreign regulatory regime will not be permitted for Dodd-Frank requirements relating to swap clearing, exchange trading, real-time public data reporting for swaps in which at least one of the counterparties is a US person.
Non-US clearing members with reportable positions in specified physical commodity swaps or swaptions would be required to report all reportable positions under large-trader reporting rules that require routine reports. Substituted compliance for these entities would not be permitted for these rules.
Substituted compliance would be permitted for swap data reporting and recordkeeping relating to transactions where at least one party is a US person, provided that the CFTC has direct access to the swap data for these transactions that is stored at the foreign trade repository.

Criticisms of Proposed Interpretive Guidance

Banking industry group SIFMA responded to the proposed cross-border interpretive guidance, criticizing the CFTC for:

Issuing "guidance" rather than a rule because a rule would provide market participants with greater certainty regarding the likelihood of, and process for, changes that could have significant repercussions on worldwide swap activity and swap entity structuring.
Issuing proposed guidance in an attempt to circumvent the requirement for a cost-benefit analysis of proposed rules.
Failing to coordinate on this important matter with the SEC.
Introducing unnecessary uncertainty into international finance markets by not delaying the implementation of related compliance requirements until final cross-border swaps rules are adopted.

For more on swaps regulation under the Dodd-Frank Act, see Practice Note: Summary of the Dodd-Frank Act: Swaps and Derivatives.

CFTC Defines Cross-border Reach of Dodd-Frank Swaps Rules | Practical Law