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From Securities Regulation Daily, July 11, 2013

CFTC and European Commission agree on path forward on cross-border derivatives regulation

By Jim Hamilton, J.D., LL.M.

European Commissioner for the Internal Market Michel Barnier and CFTC Chair Gary Gensler have reached an agreement for a path forward regarding their joint understandings on a package of measures for how to approach cross-border derivatives regulation. As part of the agreement, the CFTC and the European Commission have pledged not to seek to apply their respective regulations unreasonably in the other jurisdiction, but to rely on the application and enforcement of the rules by the other jurisdiction. A possible requirement for certain market participants or infrastructures to register with an authority is acceptable to ensure recourse in the event of a failure to provide satisfactory application or enforcement of rules.

The path forward responds to the G20 commitment to lower risk and promote transparency in the over-the-counter (OTC) derivatives markets, which were are at the heart of the financial crisis. The CFTC and the European Commission share a common objective of a steadfast and rigorous implementation of these commitments. Together with the European Securities Market Authority (ESMA), the European Commission and the United States have made significant progress in their regulatory reforms. Close legislative and regulatory coordination and cooperation between the European Commission and the CFTC have ensured that the rules in place pursue the same objectives and generate the same outcomes. As a result of the joint collaborative effort, in many places, final rules are essentially identical, even though the regulatory calendars are not always synchronized.

The agreement essentially represents an acceptance by the respective jurisdictions of the CFTC’s doctrine of substituted compliance and the European Union’s equivalence doctrine. Under substituted compliance, the CFTC would defer to comparable and comprehensive foreign regulations. The E.U. uses a system of equivalence based on a broad outcomes-based assessment of the regulatory framework of the U.S. or other non-E.U. third country. Once equivalence has been determined, infrastructures and firms from that country can access and provide their services across the 28 Member States of the E.U. under their home jurisdiction rules.

The EC and the CFTC believe it is important that jurisdictions and regulators be able to defer to each other where this is justified by the respective quality and enforcement of regulations. Both sides aim to conclude these discussions as soon as possible, at which stage the substance of relevant relief will be reflected by the CFTC in its guidance relating to substituted compliance, while the E.U. equivalence decisions will have been in place and, where necessary, amended to reflect this partnership.

Path Forward. Under the Path Forward pact, for bilateral uncleared swaps, and because E.U. and U.S. rules for risk mitigation are essentially identical, the CFTC plans to issue no-action relief for certain transaction-based requirements. In this regard, the E.U.’s system of equivalence can be applied to allow market participants to determine their own choice of rules. For the trading-execution requirement, the CFTC plans to permit foreign boards of trade that have received direct access no-action relief to also list swap contracts for trading by direct access to avoid market and liquidity disruption.

The EC, ESMA, and the CFTC will continue to work together on similar approaches to straight-through-processing and harmonized international rules on margins for uncleared swaps and have essentially identical processes with regard to adopting mandatory clearing obligations and regulating intra-group derivatives trades. They also share common goals of ensuring that the overseas guaranteed subsidiaries and branches of U.S. and E.U. persons are not allowed to operate outside of important G20 reforms.

Their approaches for reporting to trade repositories are also very similar and the EC, ESMA, and the CFTC will continue to work with each other to resolve remaining issues, such as consistent data fields, access to data, and other issues related to privacy, blocking, and secrecy laws. They will seek to resolve any material issues that may arise in line with the conclusions that may be drawn from discussions in international forums on this subject.

With respect to central counterparties (CCPs), CFTC rules and the European Market Infrastructure Regulation (EMIR), the main vehicle for E.U. derivatives regulation, are both based on international minimum standards. CCP initial margin coverage is the only key material difference, and the parties will work together to reduce any regulatory arbitrage opportunities. They will also endeavor to ensure that central counterparties that have not yet been recognized or registered in the U.S. or the E.U. will be permitted to continue their business operations.

Both sides plan to conclude these discussions as soon as possible, at which stage the substance of relevant relief awarded by the CFTC will be reflected in its guidance relating to substituted compliance, while the E.U. equivalence decisions will have been in place and, where necessary, amended to reflect this partnership. For the future, the authorities have agreed to continue to work collaboratively and to consider any unforeseen implementation effects that might arise in the application of their respective rules.

Pursuant to respective legislative frameworks and mandates, certain E.U. rules are stricter in some areas and certain U.S. rules are stricter in others. The calendar of compliance dates is not always synchronized due to differences in legislative and rulemaking processes, but that does not change the common goal or common approach.

There is strong recognition by the CFTC and the EC that the derivatives market is international, with the majority of the global swaps and derivatives business conducted within or between the E.U. and the U.S. A significant amount of transactions take place between cross-border counterparties. Recognizing the high degree of similarity that already exists between their respective requirements, the CFTC and the European Union seek to address conflicts of law, inconsistencies, and legal uncertainty that may arise from the simultaneous application of E.U. and U.S. requirements. Thus, the CFTC, the EC, and ESMA have worked closely and collaboratively to fully understand each other's concerns and regulatory approaches. Importantly, the authorities have agreed to implement the derivatives regulations in a manner that will address conflicts, inconsistencies, and uncertainty to the greatest extent possible and consistent with international legal principles.

As derivatives participants come into compliance with new regulatory regimes around the globe, a close working relationship between the U.S. and E.U. with regard to cross-border swaps regulation is viewed as mutually beneficial. The CFTC and the European Commission are hopeful that, by coordinating their efforts, they are providing a model for other regulators and jurisdictions, for example Asia Pacific regulators, working to implement their G-20 commitments.

Where a definition has to be given of market participants or infrastructure subject to U.S. or E.U. jurisdiction, as a matter of principle, it will be construed on a territorial basis, to the extent appropriate. When foreign entities not affiliated with or guaranteed by U.S. persons are required to register, transaction-level requirements will apply to transactions with U.S. persons and guaranteed affiliates. For example, E.U.-registered dealers who are neither affiliated with, nor guaranteed by, U.S. persons would generally be subject only to U.S. transactional rules for their transactions with U.S. persons or U.S. guaranteed affiliates. Additionally, for market participants that are subject to the requirements of Title VII of the Dodd-Frank Act or EMIR, the CFTC’s Division of Swap Dealer and Intermediary Oversight plans to issue a no-action letter specifying that where a swap or other OTC derivative is subject to joint jurisdiction under U.S. and E.U. risk mitigation rules, compliance under EMIR will achieve compliance with the relevant CFTC rules.

The EC and the CFTC believe that it is important that they be able to defer to each other when it is justified by the quality of their respective regulation and enforcement regimes. The CFTC seeks to issue final guidance on the cross-border application of its requirements setting out how its rules apply to cross-border swaps activities. For requirements that are applicable at the entity level, the CFTC has proposed that substituted compliance will be permitted for the requirements applicable in the E.U. that are comparable to, and as comprehensive as, those applicable in the U.S.

The CFTC plans to clarify that where a swap is executed on an anonymous and cleared basis on a registered designated contract market (DCM), swap execution facility (SEF), or foreign board of trade (FBOT) the counterparties will be deemed to have met their transaction-level requirements, including the CFTC’s trade-execution requirement.

To date, an FBOT operating pursuant to a direct access no-action relief letter may permit identified members or other participants located in the U.S. to enter trades directly into the trade matching system of the FBOT only with respect to futures and option contracts. However, an FBOT registered pursuant to Part 48 of the CFTC’s regulations also can list swap contracts for trading by direct access, subject to certain conditions. In view of the apparent interest on the part of certain FBOTs operating pursuant to the no-action relief in listing swaps for trading by direct access, the CFTC’s Division of Market Oversight plans to amend the no-action letters to permit those FBOTs to list swap contracts, subject to certain conditions. In the future, registered FBOTs will be permitted to list swap contracts for trading by direct access, subject to the same conditions.

As the markets and regulatory regimes continue to evolve, and in order to ensure a level playing field, promote participation in transparent markets, and promote market efficiency, the CFTC will extend appropriate time-limited transitional relief to certain E.U.-regulated multilateral trading facilities (MTFs), in the event that the CFTC’s trade execution requirement is triggered before March 15, 2014. Such relief would be available for MTFs that have multilateral trading schemes, a sufficient level of pre- and post-trade price transparency, non-discriminatory access by market participants, and an appropriate level of oversight. The CFTC staff will issue no-action letters to this effect. In addition, the CFTC will consult with the EC in considering extending regulatory relief to trading platforms subject to requirements that achieve regulatory outcomes comparable to those achieved by the requirements for SEFs. Both parties will assess progress in January 2014.

While important E.U. rules on mandatory trade execution and trading platforms under the Markets in Financial Instruments Directive and Regulation are almost complete, the CFTC and European Commission are working collaboratively to share ideas and ensure harmonization to the maximum extent possible. They are also working together on similar approaches to straight-through-processing so that market participants and infrastructure in both jurisdictions can benefit from the operational improvements that lower risk to the system.

The CFTC and the E.U. have essentially identical rules in important areas of risk mitigation for the largest counterparty swap market participants. Under the European Market Infrastructure Regulation (EMIR), the E.U. has adopted risk mitigation rules that are essentially identical to some of the CFTC’s business conduct standards for swap dealers and major swap participants. In areas such as confirmation, portfolio reconciliation, portfolio compression, valuation, and dispute resolution, the respective regimes are essentially identical.

To achieve that outcome for requirements applicable to transactions, the CFTC’s Division of Swap Dealer and Intermediary Oversight plans to issue a no-action letter specifying that for market participants that are subject to the requirements of Title VII of the Dodd-Frank Act or EMIR, the staff will not recommend any enforcement action against certain covered market participants in cases where those participants comply with the relevant requirements under EMIR, which are deemed to be essentially identical to the requirements imposed by the CFTC. Where a swap is subject to joint jurisdiction under U.S. and E.U. risk mitigation rules, compliance under EMIR will achieve compliance with the relevant CFTC rules.

The EC is conducting, with ESMA, an equivalence assessment of the requirements applicable in the U.S. under the jurisdiction of the CFTC. Where the EC finds the requirements to be equivalent, it can allow market participants the choice to comply either with EMIR rules or with the equivalent CFTC rules.

The CFTC and Commission are working together with other regulators from around the world to harmonize rules on margin for uncleared swaps. In the expectation that those internationally agreed rules will be applied and enforced in a substantially identical manner, this can be reflected in an equivalence decision in the E.U., and be the subject of substituted compliance by the CFTC.

The CFTC and European Commission have a shared goal of ensuring that the overseas guaranteed affiliates and branches of U.S. and E.U. persons are not allowed to operate outside of important G20 reforms. From a CFTC perspective, Dodd-Frank cross-border transaction requirements generally cover swaps between non-U.S. swap dealers and U.S. persons or guaranteed affiliates of U.S. persons, as well as swaps between two guaranteed affiliates that are not swap dealers. Compliance with transaction requirements for these trades could be satisfied through substituted compliance.

Similarly, foreign branches of U.S. swap dealers may be able to comply with CFTC rules through substituted compliance, as long as the foreign branch is bona fide and the swap is actually entered into by that branch. Lastly, the definition of U.S. person should include offshore hedge funds and collective investment vehicles that are majority-owned by U.S. persons or that have their principal place of business in the United States.

From an E.U. perspective, it is equally essential that any unmitigated risks posed in the E.U. by non-E.U. entities not escape regulation. EMIR will cover transactions undertaken between non-E.U. entities where those transactions pose unmitigated risk that would have a direct, substantial, and foreseeable effect in the E.U. It will also cover transactions undertaken by non-E.U. entities where this is necessary to prevent regulatory evasion. ESMA will consult on the types of entities and contracts that should be determined as meeting these criteria. In particular, ESMA will consider whether such unmitigated risks may exist in respect of transactions undertaken by non-E.U. entities that are guaranteed by E.U. entities or by E.U. branches of non-E.U. entities. The EC will then adopt draft Regulatory Technical Standards determining which contracts should be covered by EMIR.

Mandatory clearing. The CFTC and European Commission have essentially identical processes with regard to adopting mandatory clearing obligations. When the E.U. adopts its first mandatory clearing determination beginning next year, it is likely to cover the same classes of interest rate swaps and credit default swap indices as the CFTC’s determination. In terms of which market participants are covered by mandatory clearing, the regulators have broadly similar approaches and have agreed to a stricter-rule-applies approach to cross-border transactions where exemptions from mandatory clearing would exist in one jurisdiction but not in the other. This approach is designed to prevent loopholes and any potential for regulatory arbitrage. With regard to intra-group swaps, the CFTC and EC have broadly similar approaches with regard to mandatory clearing.

Derivatives clearing organizations. With regard to derivatives clearing organizations and central counterparties that are registered in both the U.S. and the E.U., CFTC rules and EMIR are both based on international minimum standards. One material difference with regard to the two regulatory regimes is initial margin coverage. The CFTC and EC vowed to work together to reduce any prudential concerns or regulatory arbitrage opportunities and to reflect this in their respective decisions on registration and equivalence.

In order to avoid significant market fragmentation and uncertainty around clearing obligations, the EC and the CFTC will endeavor to ensure that those infrastructures can clear derivatives for their clearing members until registration/recognition has been determined. The E.U. can achieve this through the EC’s equivalence decisions and ESMA’s recognition of foreign central counterparties, while the CFTC can do this through targeted no-action relief.

Trade repositories. For reporting trades to trade repositories, the CFTC and EC determined that their approaches are very similar and they will continue to work to resolve remaining issues, such as consistent data fields, access to data, and other issues related to privacy, blocking, and secrecy laws. They will resolve any material issues that may arise in line with the conclusions that may be drawn from discussions in international forums on this subject.

Future efforts. For the future, the cross-border authorities have agreed to continue to work collaboratively and to consider any unforeseen implementation effects that might arise in the application of their respective rules. They will continue discussions with other international partners with a view to establishing a more generalized system that would allow, on the basis of these countries' implementation of the G20 commitments, an extension of the treatment the E.U. and the CFTC will grant to each other.

MainStory: TopStory InternationalNews Derivatives

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