Finance ministers warn US on extraterritoriality

Letter to US Treasury secretary says OTC rules should be applied within national borders only. Signatories include French, German, UK finance ministers

The US approach to the cross-border application of over-the-counter derivatives rules is "not sustainable" according to a letter sent to US Treasury secretary Jack Lew yesterday by eight finance ministers and the European Commission. Implementation of reforms agreed by the Group of 20 (G-20) nations has moved faster in the US than in other jurisdictions and in July last year the Commodity Futures Trading Commission (CFTC) proposed that its transaction-level rules on clearing, execution and reporting should apply to all trades involving a US person, regardless of the location of the counterparties.

Without identifying the CFTC rules, or the US directly, the finance ministers' letter rejects that stance: "An approach in which jurisdictions require that their own domestic regulatory rules be applied to their firms' derivatives transactions taking place in broadly equivalent regulatory regimes abroad is not sustainable. Market places where firms from all our respective jurisdictions can come together and do business will not be able to function under such burdensome regulatory conditions."

The letter is signed by Wolfgang Schäuble, Pierre Moscovici and George Osborne - the finance ministers for Germany, France and the UK, respectively - as well as their counterparts in Brazil, Japan, Russia, South Africa and Switzerland, and Michel Barnier, commissioner for internal market and services at the European Commission.

The signatories call for domestic regulators to allow their firms' overseas offshoots to comply with foreign rules - through substituted compliance or equivalence arrangements - in cases where the foreign rules are deemed to be similar in outcome to the regulator's own.

"Differences in national legal regimes and market customs make it unfeasible to achieve identical regulatory frameworks. As such, when assessing equivalence, it will be vital to assess whether the outcome delivered by the rules is equivalent in terms of the protections provided, and not to seek a precise rule-by-rule match up," it says.

Market places where firms from all our respective jurisdictions can come together and do business will not be able to function

The CFTC had proposed allowing substituted compliance, but via a complex system. For example, regardless of the counterparties' location, the foreign affiliate of a US person that has its swaps guaranteed by a US person would have to apply CFTC rules when trading with another US person. But it would be allowed to adopt substituted compliance when trading with another non-US entity that is also guaranteed by a US person, and would not have to apply the rules if trading with a non-US person that is not guaranteed by a US person.

In addition, the CFTC's version of substituted compliance would be applied on a rule-by-rule basis - so, firms would be allowed to follow foreign regulation in specific instances where it is equivalent to that in the US, but would have to revert back to US rules in areas where equivalence has not been established.

The finance ministers call for a broader approach: "Access to substituted compliance should be determined on the basis of an objective assessment of equivalence at the jurisdictional level. Where the rules in a foreign jurisdiction have been assessed as equivalent by the home authority, substituted compliance must be available in all circumstances for transactions with, and entities established in, that foreign jurisdiction," it says.

The letter adds that decisions of equivalence with a foreign jurisdiction must be assessed by the home authority and there should be no requirement for individual firms to apply for substituted compliance relief.

The letter also criticises registration requirements for foreign firms. The US requires certain foreign entities to register as swap dealers under CFTC rules.

"We regard the imposition of registration requirements on foreign firms as an unnecessary additional burden. We accept that this approach has already been adopted in some jurisdictions, and do not believe that it will prevent the regulatory outcome envisaged by the G-20 in 2009, provided it is accompanied by a full substituted compliance regime applied to those firms," says the letter.

The US Treasury reacted to the letter in an emailed statement, saying it is working hard with other jurisdictions to find practical compromises. The US is currently in the processing of finalising its own derivatives rules but has already introduced mandatory clearing of OTC derivatives for certain firms - a milestone that may not be reached in Europe until 2014.

"The US and Japan are furthest along in the reforms while other countries' efforts have been delayed. We look forward to working closely with the countries who signed the letter and our other partners in the G-20 and the Financial Stability Board to put a strong framework in place."