Footnote 513 exceeds CFTC's statutory brief: O'Malia

Failure to define a "significant or direct" threat to the US economy has brought regulatory overreach

Scott O'Malia

The recent clarification of footnote 513 of the Commodity Futures Trading Commission's (CFTC) cross-border rules, which significantly widened the geographical scope of US regulatory oversight, has been criticised by CFTC commissioner Scott O'Malia as being outside of the organisation's statutory brief.

Asian dealers believed that footnote 513, issued by the CFTC in July, meant that swaps for foreign clients arranged by US-based traders or brokers and then booked through those firms' overseas arms would be exempt from the Dodd-Frank rules.

However, outgoing CFTC chair Gary Gensler recently confirmed that non-US swap dealers and non-US clients would be brought under US regulatory oversight if their trades are arranged, negotiated or executed by US personnel – a stance which prompted disappointment from Asian dealers. O'Malia, speaking on the sidelines of the FIA Asia conference in Singapore today, says this latest development is indicative of US regulatory overreach.

"Some applications of US regulation are way too broad. The Dodd-Frank Act states that our regulations will not apply to activities outside the US unless these have a significant or direct connection on the US economy. The recent footnote 513 interpretation, however, says any role in the US, whether it's a non-US person or not, somehow makes that a US trade. That's a new interpretation of cross-border rules – but it's not what we voted on and doesn't meet the statutory test."

O'Malia says that the extension of US authorities' oversight of the global markets via footnote 513 represents a complete change in direction from the previous activity-based regulatory approach. "We said it was activity-based – now we are rolling that back and instead saying anything that touches the US is ours. That's location basis, which is very different."

Currently, Asia represents 8% of global derivative markets, half of which is in Japan, meaning the six remaining jurisdictions that are building clearing houses in Asia – Australia, China, Hong Kong, India, Korea and Singapore – account for just 4% of global trading.

Responding to a question on how, for example, India's over-the-counter derivatives market could pose a threat to the US economy given its size, the CFTC commissioner said that a failure to define what direct and significant meant in the context of Dodd-Frank had been one of his "main frustrations".

"Dodd-Frank was supposed to focus on every single trade a US person does and now we have applied it to non-US persons, on platforms that are outside the US."

The introduction of swap execution facilities on October 2 led to a marked split in Asian liquidity as a number of regional players looked to avoid trading with US persons and therefore coming under the purview of the CFTC. O'Malia, however, says that this split in liquidity is a function of the current evolutionary state of the market rather than necessarily being a long-term trend.

"A lot of people are saying that they are waiting for their home country regulations to come in place before they build the capability to meet US requirements – it's better to build one system than two given all the complexities involved.

"In this interim period of market and regulatory evolution, you will see a lot of market fracturing but our goal is to finish this process and create a global regulatory system. If we work together so there aren't any gaps between regulators, and therefore the potential for arbitrage, we should be able to heal these differences."

Saying that the CFTC doesn't have the financial resources to police swap execution facilities and on-screen trading, O'Malia argues it's important to look for ways to co-operate with regulators in other jurisdictions in order to monitor US-relevant activity. He gave the example of the European Union as having the most advanced framework of rules with regard to OTC clearing and says it makes sense to rely on regulators there to police their own systems.