Try to keep up. The foreign office of a US bank is subject to Commodity Futures Trading Commission (CFTC) rules on swaps clearing, execution and reporting, unless it is an affiliate that is not guaranteed by the US parent. These non-guaranteed affiliates (NGAs) and, crucially, their non-US clients are in the clear.
If, however, the NGA is not overseen by one of the US prudential supervisors, its financial results are consolidated with those of its US parent and it is executing a trade with a swap dealer, major swap participant or financial end-user that will not be sent to a clearing house, then it will be subject to the CFTC's rules on bilateral margining.
The first of these paragraphs is the result of the CFTC's 2013 guidance on the application of its swaps rules to cross-border trades; the seemingly narrow exception that follows is contained in the agency's draft rules on margin for non-cleared trades, published in June. It reverses everything an NGA had previously believed to be true, but only in a very specific context. So it is no big deal. Probably.
"In terms of direct application, this new rule should be a non-event: it nominally only applies to margin for uncleared swaps and only to covered swap entities that are not supervised by a prudential regulator, so it would only apply in a narrow context for most large US banks. For us, it would catch only two of our registered swap dealers and they are the two entities with the smallest derivatives exposure. So this would be a blip on the screen, except for one potentially worrisome factor in the broader cross-border context," says an in-house counsel at a US bank.
The situation around the definition of US persons is a little strange... and I think the CFTC will encounter more practical challenges going forward
Josh Sterling, Morgan Lewis
"The interpretative guidance would have applied CFTC measures extraterritorially only to US persons or guaranteed affiliates of a US person. This concept has now been expanded to capture a new foreign consolidated subsidiary concept. This effectively means that so long as an overseas affiliate's results are consolidated with the financial results of a US person, or parent, the CFTC rules apply to their
non-cleared swaps, regardless of whether that affiliate is guaranteed or not," he adds.
US banks are worried by the change of direction. After the CFTC finalised its cross-border guidance, overseas affiliates of US persons began to formally renounce any guarantee or financial commitment from their US parent companies. The logic was simple: with all statutory guarantees dropped, the CFTC guidance would not apply to the foreign subsidiary or its clients.
This caused consternation among US regulators and politicians, some of whom argued that even in the absence of an explicit guarantee, US parents would still bail out a failing foreign affiliate to protect the reputation of the firm as a whole. These implicit, non-contractual guarantees mean exposure racked up overseas still puts the US parent at risk and should therefore fall within the ambit of US regulation, critics insisted.
The foreign consolidated subsidiary concept addresses these concerns.
"In the commission's view, the fact that an entity is included in the consolidated financial statements of another is an indication of potential risk to the other entity that offers a clear and objective standard for the application of margin requirements," the proposals state. In such cases, the swap activities of a foreign affiliate, even if de-guaranteed, "have a direct impact on the financial position, risk profile, and market value of a US parent entity... and a potential spill-over effect on the US financial system".
The words ‘direct impact' are crucial, because the Dodd-Frank Act limits the territorial scope of the resulting rules to cases where overseas activities have a "direct and significant connection with activities in, or [which have an] effect on, the commerce of the US".
The question now is whether the inclusion of the new concept in the CFTC's margin rules means anything for its broader, cross-border guidance.
"US banks may argue that in the cross-border guidance the CFTC said that if they did not guarantee their offshore affiliates they would not be subject to the margin rules, but now, in this proposed rule, the commission is saying that if those affiliates are consolidated on the financial statements they are still subject to the rules, even if there is not a guarantee. The CFTC is changing the rules of the game in this one particular area around non-cleared margin, but not apparently in the context of the broader cross-border guidance," says Julian Hammar, an attorney at law firm Morrison Foerster in Washington DC and formerly associate general counsel at the CFTC.
The interpretative guidance would have applied CFTC measures extra-territorially only to US persons or guaranteed affiliates of a US person. This concept has been expanded to... a new foreign consolidated subsidiary
In-house counsel, US bank
This creates an odd two-tier cross-border regime for swap dealers. For the purposes of collecting margin on non-cleared trades, the London office of a US bank would have to apply a test focusing on the consolidation of financial results, while in all other regards the test would relate to the existence of a guarantee. Effectively, market participants would be asked to apply two concurrent definitions at the same time.
The approach was questioned by CFTC commissioner Christopher Giancarlo when the draft rules were published.
"I have many concerns and questions regarding the proposal, including the shift from the transaction-level approach set forth in the July 2013 cross-border interpretative guidance to a hybrid approach and what this means for the status of the guidance moving forward [and] the revised definitions of ‘US person' (defined for the first time in an actual commission rule) and ‘guarantee', and how these new terms will be interpreted and applied by market participants across their entire global operations," wrote Giancarlo in his statement on the rules.
US person questions
The altered definition of ‘US person' raises similar questions, but affects the entire sweep of derivatives market participants – not just banks.
According to the CFTC's cross-border guidance, a trade in which one party is classified as a US person is always subject to US transaction-level swap regulations. This would apply to any fund that was more than half owned by other US persons – a criterion that hedge funds and other asset managers complained would be impossible to monitor continually, and might see them yo-yoing in and out of US oversight. The CFTC also left its options open to expand the definition by including a catch-all phrase that the term was "including, but not limited to" the description in the document.
The new CFTC non-cleared margin rule introduces a narrower definition of US person, which eliminates the "including, but not limited to" language, as well as the 50% fund ownership prong. Derivatives lawyers welcome those changes, but caution the relief on offer appears limited.
For instance, eliminating the ownership element would only amount to practical relief if the counterparty is a majority US-owned fund located outside of the US in a non-cleared trade – and only then for the purposes of posting margin. Under the broader guidance language, the fund would still have to abide by all other US person transaction-level requirements. This is illusory relief, some lawyers argue.
"The situation around the definition of US persons is a little strange in that you would have to check whether a trade is cleared or non-cleared, and whether in one circumstance you meet one definition of US person while in another circumstance you could meet a different definition. I do think that is a little odd and I think the CFTC will encounter more practical challenges going forward," says Josh Sterling, a partner at law firm Morgan Lewis in Washington, DC.
Anthony Fawcett, an attorney specialising in derivatives at law firm Purrington Moody Weil in New York, says the changes to the definition resemble "a concession that has been offered up for cosmetic purposes, with little substance".
The obvious question is whether the CFTC intends to take the definitions and concepts included in the proposed non-cleared margin rules and apply them more broadly.
Eight attorneys with whom Risk spoke – including several recent CFTC employees now working in the private sector – say they are unaware of any plans to replace the cross-border guidance with a formal rule.
Comments from CFTC chairman Timothy Massad on the release of the draft margin rule also appeared to signal the commission might try to translate other parts of the cross-border guidance into rules, but that the passage of a single comprehensive rule on extraterritorial issues is unlikely (see also here).
"As stated in the guidance, ‘the commission will continue to follow developments as foreign regulatory regimes and the global swaps market continue to evolve. In this regard, the commission will periodically review this guidance in light of future developments'. That is essentially what we are doing here. With each area of our rules, the implications of cross-border transactions for our policy objectives may vary, but the approach we are proposing today for margin may not be appropriate with respect to other areas of regulation," Massad said.
This also worries some lawyers, who say banks may wonder how safe they are in conforming to the non-binding guidance when the CFTC has taken a different line in its enforceable rules. The lack of bite in the guidance was tested in a lawsuit brought by four industry associations in late 2013, with a US district court judge ultimately ruling the guidance was not – as the plaintiffs claimed – regulation in disguise.
"I think this rule, if adopted, would set a precedent. This US person definition would only apply to non-cleared margin issues, but having said that, this would be an enforceable rule and the CFTC would be laying out its rationale for adopting a different definition from what is in the cross-border guidance. I think people are looking at the definition in this proposal and are trying to figure out what this might mean for the definition in the guidance, which the commission and the US district court has made clear is not enforceable," says Dan Berkovitz, a partner at law firm WilmerHale in Washington, DC and former CFTC general counsel.
"If this definition is adopted this would still have an effect beyond the scope of this particular rule, because the guidance is only guidance and people are going to point to this as a rule. A collective investment vehicle facing an enforcement action that may be a US person under the guidance but not under the rule would argue it is not a US person under this definition, that the guidance is unenforceable, and that there is no rational reason why the standard under the rule should not also apply under these circumstances. I think this would weaken the CFTC's ability to rely on that prong of the definition in other contexts, even though this reading is technically confined to the margin rule," Berkovitz adds.
Footnote 513 lives on in ‘through or by' language
Less than two weeks after the Commodity Futures Trading Commission (CFTC) published its staff advisory 13-69 in November 2013, furious industry protests saw the agency issue no-action relief – meaning the industry would not be punished for failing to follow the new guidance.
The relief has since been extended five times; the latest extension being granted on August 13.
The advisory was an attempt to clarify footnote 513 of the CFTC's final cross-border guidance, and stated that non-US swap dealers regularly using persons located in the US to "arrange, negotiate or execute" swaps with fellow non-US person counterparties would have to comply with the CFTC guidance as if those entities were US persons. In other words, if the London office of a US bank was trading with an Asian fund client, and either a trader, salesperson, risk manager or back-office employee in New York was involved in the transaction, it would have to comply with CFTC swaps rules.
Lawyers see echoes of this in the CFTC's draft cross-border margin rules. Their concerns centre on a phrase appearing twice in the preamble to the rule, rather than in the rule itself: "The proposed rule treats uncleared swaps executed through or by a US branch of a non-US covered swap entity (CSE) the same as those swaps of a non-US CSE, except that the exclusion from the margin rules would not be available to a US branch of a non-US CSE."
The thinking is simple, even if the implications might not be: if a non-US CSE is trading with another non-US counterparty through its US branch, it would have an unfair advantage over its US CSE competitors if it did not have to adhere to the same CFTC non-cleared margin standards as other banks based in the US. As such, lawyers warn, the ‘through or by' test may be indistinguishable from the ‘arrange, negotiate or execute' test contained in letter 13-69.
"Whether a back-office person in the US consulting on an otherwise totally non-US trade would be enough to pull you into the CFTC nexus in this rule is still something of an open question. The new rule says a trade between non-US CSEs is exempt unless one of them is acting through or by a US branch. It seems pretty clear that when the CFTC says ‘through or by' a US branch, they are talking about the same footnote 513 concept of having personnel based in the US. They have not really fleshed that out very well and I think a lot of people will find that element controversial," says Jeffrey Robins, a partner specialising in derivatives issues at law firm Cadwalader, Wickersham & Taft in New York.
If the industry seeks clarification of the phrase, the CFTC could quickly find itself in the same bind that currently exists for advisory 13-69, lawyers warn – fielding questions it cannot answer about a rule it is reluctant to either abandon or enforce.
"The commission didn't go into detail on what ‘through or by' a US branch actually means, but this definition may have broader implications in similar circumstances. When a regulator sets forth a general principle in a specific rule, it can be very hard for that regulator to depart from that principle in another specific application. In this case, if executed ‘through or by' is the standard it adopts here, why would it not apply elsewhere and what would the rationale be for applying something different?" asks Dan Berkovitz, a partner at law firm WilmerHale in Washington DC and former CFTC general counsel.
"Advisory 13-69 initially took an extremely broad view of the type of activity in the US that would trigger the application of Dodd-Frank requirements for non-US swap dealers – namely, whether the non-US dealer regularly uses persons in the US to arrange, negotiate or execute swaps with non-US persons. But then the commission backed off [from] its application, asked for public comment on it, but never came back to clarify its meaning. That huge question is still out there and has not been answered, even though the release was put out for comment in January 2014," he adds.
Isda CEO criticises clashing rules on bilateral margin
US regulators have put dealers in “a very difficult position”, according to Scott O’Malia, chief executive officer of the International Swaps and Derivatives Association, by diverging from one another on bilateral margin rules and splitting from their foreign counterparts.
“It’s extraordinarily difficult,” O’Malia told reporters at Isda’s annual European conference in London on September 22. “You can’t necessarily comply with two different regulations at once, so we’ve asked for a substituted compliance regime that can sort some of this out. But they’re putting us in a very difficult situation if they have rules that create these differences.”
In a September 11 comment letter to the Commodity Futures Trading Commission (CFTC), which shares responsibility for the US rules with other regulators, Isda called for the margin framework to be harmonised in the US and internationally. Failing that, the letter says international standards should be used as the benchmark when national regulators assess whether foreign regimes are comparable.
O’Malia said he “remains hopeful” that regulators will listen.
Europe and Japan published their draft rules in mid-2014, with US prudential regulators following shortly after. In July this year, the CFTC issued its own proposals, which apply to cross-border trades involving US swap entities that are not caught separately by the prudential framework.
In each case there are differences between the various regimes. For example, the CFTC proposals suggest US entities should apply their domestic rules when collecting margin and accede to foreign rules when posting – an approach that would, among other things, see each side of the trade applying a different exposure threshold when calling for margin.
O’Malia highlighted other differences between the various regimes, including the US requirement that trades between affiliates be margined in the same way as trades between two unrelated counterparties.
“Regulators ought to be commended in many respects for getting as much co-ordinated as possible, but there are many key differences. There are differences around haircutting, concentration limits and inter-affiliate trades,” he said. “We think inter-affiliate is probably one of the biggest issues in the US. It requires inter-affiliate trades to be initial and variation-margin posted. That will make it expensive and is a considerable difference to European rules.”
The comment period for the CFTC proposals ended on September 14, drawing 20 comment letters.
Like Isda, the Japanese Bankers Association (JBA) calls for harmonised international rules and sketches out a contingency plan. If the various rules cannot be integrated, national authorities will need to analyse and approve the various foreign regimes. The association warns any delays in this process could further fragment global liquidity by preventing firms from trading with counterparties in unapproved jurisdictions.
“From this point of view, the CFTC is requested to ensure comparability with other national regulations before, instead of after, the finalisation of the proposed rule, and then to make substituted compliance available for all national regulations without requiring a comparability assessment, thereby giving an option of substituted compliance to [the] parties to each transaction,” says the JBA letter.
Asset manager Vanguard described the commission’s approach to cross-border trades – which, apart from the bilateral margin framework, exists as a set of guidelines rather than hard-and-fast rules – as “perhaps the most problematic initiative in the entire swap regulatory reform exercise”. Among other things, the firm objects to the fact that the CFTC is now applying two different definitions of a US person: one in the margin rules and another in the cross-border guidelines.
Speaking at Isda’s US conference in mid-September, CFTC commissioner Sharon Bowen said the agency was working “really hard” on the margin rules and was hoping to publish something “really soon”.
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