James Schwartz and Chrys Carey, of counsels at Morrison & Foerster, explore the impact of a recent Commodity Futures Trading Commission white paper – including how its author’s suggestions would affect cross-jurisdictional application of its regulations – and consider potential obstacles to the implementation of these proposals
After years of aggressively pushing the extraterritorial reach of its rules, the Commodity Futures Trading Commission (CFTC) – the primary US derivatives regulator – now appears ready to take a more pragmatic approach. The most recent evidence of the CFTC’s push toward pragmatism is its chairman J Christopher Giancarlo’s white paper, Cross-border swaps regulation version 2.0. This paper, however, neither sets out nor proposes any rules, and is intended to represent only Giancarlo’s views. Moreover – although arguably a step in the right direction – the white paper seems unlikely in any immediate way to resolve the significant issues that the CFTC faces in relation to the cross-jurisdictional application of its regulations. These include issues relating to both the CFTC’s agreements with the European Union and the slow pace of harmonisation with the other US derivatives regulator, the Securities and Exchange Commission (SEC).
If adopted, the ideas contained in the white paper would add nuance to the CFTC’s approach to cross-border matters – in particular its use of the doctrine of substituted compliance. Under substituted compliance, a party may comply with non‑US derivatives rules rather than the CFTC’s rules if the CTFC determines the requirements of the relevant foreign jurisdiction are comparable with and as comprehensive as the CFTC’s own rules. Probably the white paper’s most important innovation is the distinction drawn between swaps regulations intended to protect against systemic risk and those that address particular market and trading practices. The former category includes rules related to centralised clearing, margin, dealer capital and regulatory reporting. Those rules, Giancarlo argues, should be understood to mitigate risk that may have a direct and significant connection with the US and, to the extent that non‑US rules addressing such matters may apply within the US or to US persons, those non‑US rules should be evaluated stringently for purposes of substituted compliance. In contrast, he argues, the US should be more flexible with respect to the potential application of non‑US rules on particular market and trading practices, such as rules relating to trading platform practices, and trade execution methodologies and mechanics.
The extent to which Giancarlo’s ideas can help facilitate cross-border transactions remains to be seen. To make any substantial progress, the CFTC will likely need to overcome a degree of ill feeling harboured by regulators overseas that did not appreciate the CFTC’s aggressive push to extend the reach of its own rules in the years immediately following the passage of the Dodd-Frank Act in 2010. For example, in its 2013 cross-border guidance, the CFTC took the view that its transaction-level requirements would generally apply to any swap to which a US person was a party, even though it was never made clear why in any given swap involving two parties located in two different jurisdictions, its transactional requirements should apply instead of those of the other jurisdiction.
While the white paper’s ideas could make it easier for the CFTC to find comparability for certain types of rules for purposes of substituted compliance, it seems likely that, in many cases, the doctrine could continue to be difficult to apply. It is often difficult to discern whether two different rule sets are “comparable” and equally “comprehensive”. The white paper notes that the CFTC’s current substituted compliance regime “encourages a somewhat arbitrary, rule‑by‑rule comparison of CFTC and non‑US rules under which a transaction or entity may be subject to a patchwork of CFTC and non‑US regulation”. Underscoring the difficulty of substituted compliance itself, the CFTC has published only two comparability determinations since the end of 2013: for Japanese margin requirements in September 2016, and for EU margin requirements in October 2017.
The white paper can also be expected to leave unresolved political tensions that have sprung up around the US‑EU agreement regarding central counterparties (CCPs), which appear to come to a head recently with a top EU civil servant complaining that Giancarlo is “blackmailing” EU legislators by threatening retaliation if EU rules for CCPs become law.
The tensions arise from changes that the EU is seeking to make to its rules regarding the supervision of CCPs and a 2016 agreement between the EU and the CFTC that provided for mutual recognition of CCPs. The European Commission (EC) recently proposed amendments to its CCP oversight rules, which would replace the current EU regime of deference to third-country CCP oversight regimes that the EU has determined to be equivalent to applicable EU regulations with a two‑tier scheme. Under the new scheme, third-country CCPs would be scrutinised and sorted into two tiers, depending on their perceived systemic importance to EU markets. Non‑systemically important CCPs would be Tier 1 and would continue to operate under an equivalence determination and recognition scheme substantially similar to what exists today. Systemically important CCPs would be Tier 2 and would be subjected to additional EU regulatory and supervisory requirements, regardless of the robustness of their existing home jurisdiction supervision.
The CFTC is concerned that the EU’s proposed regulation would effectively make EU authorities primary supervisors of US CCPs that the EU determines pose systemic risk to it, and would apply EU law to all aspects of their business – including US business. As a result, US Tier 2 CCPs would be subject to regulation and supervision by both the CFTC and EU authorities without deference to existing CFTC regulation and supervision. Further, as recently noted by CFTC commissioner Rostin Behnam, the CFTC and EU requirements for segregation of collateral are in certain respects inconsistent, which would make it challenging if not impossible for US CCPs subject to EU regulation to comply with both US law and EU law.
Although currently less controversial, the US‑EU agreement regarding trading venues has also proved problematic. Similar to the agreement regarding CCPs, the EU and CFTC last year reached an agreement that, subject to certain conditions, the EC would adopt an equivalence decision to recognise CFTC‑authorised swap‑execution facilities (SEFs) as eligible venues for the execution of derivatives transactions that are subject to EU trading obligations and that the CFTC would exempt EU‑authorised swap trading venues from the requirement to register with the CFTC as SEFs. Even though its implementation by both the CFTC and the EU undoubtedly represents progress on this front, mutual recognition of trading venues brings into focus other questions and causes complexity because of the lag in transatlantic equivalence and substituted compliance determinations in connection with other related substantive requirements, such as clearing and reporting.
Cross-jurisdictional difficulties exist on the domestic front, too, with continuing delays in the harmonisation of the CFTC’s rules for swaps with the SEC’s rules for security-based swaps, notwithstanding a report released last year by the US Department of the Treasury that recommended the CFTC and the SEC give high priority to a joint effort to harmonise their rules to the fullest extent possible. That report noted the significant differences between the SEC’s rules for security-based swaps and the CFTC’s rules for swaps, including, among others, differences in rules relating to trade reporting requirements, trading, clearing and capital and margin requirements.
In June, the two agencies finalised a memorandum of understanding in which they recognised the need for enhanced co‑ordination, co‑operation and information sharing with regard to issues of common regulatory interest, and established a regulatory liaison to facilitate the discussion and co‑ordination of regulatory action, information exchange and data sharing. In addition, the SEC’s current regulatory agenda indicates a proposed rule identified as Harmonization of certain title VII rules. Regarding this possibility, a link from the regulatory agenda states that an SEC division is considering proposing rules to harmonise certain Dodd‑Frank Act rules with those of the CFTC.
How harmonisation of the CFTC and SEC rules could happen, however, remains a matter of conjecture. The CFTC’s rules for swaps are largely final. In contrast, while many of the SEC rules have been finalised, certain key rules have not yet been issued in final form. Harmonising the rules themselves would likely require revisions of existing final rules and re‑proposal of certain proposed SEC rules. It is not especially heartening that the SEC, in its recent reopening of the comment period for its proposed rules on margin and security-based swap dealer capital requirements, did not make clear that it intended its rules to conform to those of the CFTC, or even to the international framework on which the CFTC’s margin rules are based.
A more expedient approach could be, as suggested by former CFTC commissioner Mark Wetjen, to take a substituted compliance-like approach in which market participants might have the choice to comply with a CFTC rule or the parallel SEC rule. However, it is not clear that either agency is considering such an approach.