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From Securities Regulation Daily, July 12, 2013

CFTC finalizes guidance on cross-border derivatives regulation, embodying substituted compliance

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

Against the backdrop of a recently agreed upon Path Forward with the European Commission on cross-border derivatives regulation, the CFTC voted 3-1 to adopt final guidance to provide greater legal certainty and clarity to U.S. and non-U.S. market participants regarding obligations under the Commodity Exchange Act (CEA) with respect to cross-border swaps activities. The guidance embodies the concept of substituted compliance, under which the CFTC would defer to comparable and comprehensive foreign derivatives regulatory regimes. The CFTC also approved by a 3-1 vote an exemptive order giving market participants time to phase in to this new market reality by providing temporary conditional relief from certain swap provisions of the Dodd-Frank Act to non-U.S. swap dealers, as well as foreign branches of U.S. swap dealers.

The Dodd-Frank Act amended the CEA to establish comprehensive regulation of swaps by the CFTC. Dodd-Frank Act Section 722(d) amended the CEA by adding Section 2(i), which provides that swaps provisions of the CEA apply to cross-border activities having a direct and significant connection with activities in, or effect on, commerce of the United States, or when they contravene Commission rules or regulations necessary or appropriate to prevent evasion of the swaps provisions of the CEA enacted under Title VII of the Dodd-Frank Act. The guidance sets forth the general policy of the Commission in interpreting how Section 2(i) of the CEA provides for the application of the swaps provisions of the CEA and Commission regulations to cross-border activities.

Under the doctrine of substituted compliance, which is at the heart of the guidance, and consistent with CEA Section 2(i) and comity principles, the Commission’s policy is that a non-U.S. swap dealer or major swap participant may comply with a foreign jurisdiction’s law and regulations in lieu of compliance with the attendant CEA and Commission regulations. In issuing comparability determinations, which will be based on whether a foreign regime’s requirements are comparable to and as comprehensive as the corollary areas of regulatory obligations encompassed by the Entity and Transaction-Level Requirements (see below), the Commission will rely upon an outcomes-based approach to determine whether foreign requirements achieve the same regulatory objectives as the Dodd-Frank Act. The foreign regulations must be comparable and comprehensive but not necessarily identical.

In their presentation, CFTC staff explained that the substituted compliance regime set forth in the guidance means that, if the Commission issues a comparability determination for a given entity or transaction level requirement, the Commission generally would permit an applicant to substitute compliance with the requirements of the relevant home jurisdiction’s law and regulations, or in the case of foreign branches of U.S. swap dealers the foreign location of the branch, in lieu of compliance with the corresponding requirement under the CEA and CFTC regulations. The guidance broadly describes the process and the factors that it would consider in making this comparability assessment.

The staff emphasized two points in connection with substituted compliance. First, “comparable and comprehensive” does not mean that the CFTC would look for identical regulations abroad. Rather, the Commission would take into account all relevant factors including the scope and objectives of the relevant regulatory requirements, and the comprehensiveness of the foreign regulators compliance program when making the assessment. Second, this assessment does not entail a rule by rule analysis, rather the Commission would make this assessment on a category by category basis.

Commissioner Scott O’Malia noted that the substituted compliance regime is an outcomes-based regime. He is concerned that there be a process in place to make substituted compliance determinations that involve the CFTC Commissioners, CFTC staff and the non-U.S. jurisdiction seeking a substituted compliance determination. He urged the staff to come up with a process to continuously update the Commissioners on what they are working on and where they are in terms of the submissions from foreign regulatory regimes. There will probably be some very disappointed regulators who believe they are equivalent but who receive a different outcome than they expect, noted the Commissioner. So, he wants a transparent process on substituted compliance that lets foreign jurisdictions have an idea on substituted compliance at the 5th hour rather than the 11th hour.

Chairman Gary Gensler agreed on the need for regular updates, Commission briefings or Commissioner briefings. Noting that the Commission already has six submissions on substituted compliance from non-U.S. jurisdictions, the CFTC Chair asked the staff to develop a process within the next two weeks that’s a real process to keep the Commission updated on the six jurisdictions.

Commissioner O’Malia also urged the staff, and the staff agreed, to invite foreign regulators to participate in some sort of dialogue if they want to defend their submissions on substituted compliance or to talk about their submissions. This dialogue would be very helpful in order to gain an understanding of what non-U.S. regulators are thinking, how they execute their own regulations and where they believe they are comparable.

The CFTC explained that the various Dodd-Frank Act swaps provisions applicable to swap dealers and MSPs can be conceptually separated into Entity-Level Requirements, which apply to a swap dealer or MSP firm as a whole, and Transaction-Level Requirements, which apply on a transaction-by-transaction basis.

The Entity-Level Requirements under Title VII of the Dodd-Frank Act and the Commission’s regulations promulgated thereunder relate to: (i) capital adequacy; (ii) chief compliance officer; (iii) risk management; (iv) swap data recordkeeping; (v) swap data repository reporting (“SDR Reporting”); and (vi) physical commodity large swaps trader reporting (“Large Trader Reporting”).

The guidance divides these requirements into two categories. The first category of Entity-Level Requirements includes capital adequacy, chief compliance officer, risk management, and swap data recordkeeping under Commission regulations 23.201 and 23.203 (except certain aspects of swap data recordkeeping relating to complaints and sales materials) (“First Category”). The second category of Entity-Level Requirements includes SDR Reporting, certain aspects of swap data recordkeeping relating to complaints and marketing and sales materials under Commission regulations 23.201(b)(3) and 23.201(b)(4) and Large Trader Reporting (“Second Category”).

The Transaction-Level Requirements include: (i) required clearing and swap processing; (ii) margining (and segregation) for uncleared swaps; (iii) mandatory trade execution; (iv) swap trading relationship documentation; (v) portfolio reconciliation and compression; (vi) real-time public reporting; (vii) trade confirmation; (viii) daily trading records; and (ix) external business conduct standards.

The guidance classifies all Transaction-Level Requirements except external business conduct standards as “Category A” Transaction-Level Requirements, and classifies external business conduct standards as “Category B” Transaction-Level Requirements.

Global Markets Advisory Committee. Concomitantly, the CFTC voted 4-0 to name Commissioner Bart Chilton as sponsor of the Global Markets Advisory Committee. At Chairman Gensler’s urging, Commissioner Chilton agreed to open a transparent process inviting foreign regulators and home country regulators to participate in defending their regulatory regimes before the Commission makes a decision on substituted compliance. Commissioner Chilton added that substituted compliance is not something that the CFTC will look at one time, take a snapshot and call it quits. Rather, substituted compliance is an evolving and a morphing doctrine; and the Commissioner believes that the GMAC can play a really important role in that regard. In general these markets are changing so fast that the CFTC needs to think anew about them, said Commissioner Chilton, involving the CFTC and the GMAC in what the Commissioner called an epic global endeavor.

Market Risk Committee. Chairman Gensler also said that the CFTC is considering establishing a new Advisory Committee to be headed by Commissioner Wetjen to be named the Market Risk Advisory Committee. The CFTC is working with the General Services Administration to approve this new committee. The new committee will pull together a group of outside individuals of diverse backgrounds to give the CFTC advice on broad issues of market risk. Chairman Gensler originally thought of creating an End-Users Advisory Committee, but believes that the effort of what the CFTC is looking at with an End-Users Advisory Committee can be consumed by the Market Risk Advisory Committee because it’s all about risk. He will work with the committee on the end-user component.

Definition of U.S. Person. The definition of U.S. person, a foundational element of the guidance, is largely territorial-based. The definition would include collective investment vehicles (including hedge funds and commodity pools) that are directly or indirectly majority-owned by U.S. persons or that have their principal place of business in the U.S.(focusing principally on location of the investment managers, fund sponsors and promoters, and the sales and trading desk used by the fund). A non-U.S. person that is guaranteed by and an affiliate of a U.S. person is not included in the definition of U.S. person.

CFTC staff said that the term U.S. person is a useful concept when considering the extent to which U.S. transactional level requirements should apply to swap transaction. The definition would include natural persons that are U.S. residents as well as corporations, business entities and funds that are organized in the United States or have their principle place of business here.

De Minimis Calculations. With respect to the swap dealer de minimis calculations, the Commission’s policy under the guidance is that a U.S. person should generally count in its swap dealer de minimis calculations all of its dealing swaps, whether with U.S. or non-U.S. counterparties. A non-U.S. person that is a guaranteed or conduit affiliate should also generally include in its swap dealer calculation all of its dealing swaps, whether with U.S. or non-U.S. counterparties.

Exemptive Order. Under the Exemptive Order, market participants may continue to apply the swap dealer and MSP calculation provisions contained in the January Order, from July 13, 2013 until 75 days after the Guidance is published in the Federal Register. Accordingly, during this time period, a non-U.S. person may exclude (from its swap dealer de minimis and its MSP threshold calculations) any swap where the counterparty is not a U.S. person, or any swap where the counterparty is a foreign branch of a U.S. person that is registered as a swap dealer.

Also during this time period, with respect to aggregation of affiliate positions under Commission Regulation 1.3(ggg)(4) for purposes of the swap dealer de minimis calculations, a non-U.S. person that was engaged in swap dealing activities with U.S. persons as of December 21, 2012 may exclude the aggregate gross notional amount of swaps connected with the swap dealing activity of its U.S. affiliates under common control. Similarly, a non-U.S. person engaged in swap dealing activities with U.S. persons as of December 21, 2012, and who is an affiliate under common control with a person that is registered as a swap dealer, may also exclude the aggregate gross notional amount of swaps connected with the swap dealing activity of any non-U.S. affiliate under common control that is either (i) engaged in swap dealing activities with U.S. persons as of December 21, 2012 or (ii) registered as a swap dealer.

A non-U.S. person may exclude the aggregate gross notional amount of swaps connected with the swap dealing activity of its non-U.S. affiliates under common control with other non-U.S. persons as counterparties.

A non-U.S. person previously exempt from registration as a swap dealer, but who must now register as a swap dealer because of changes to the scope of the term “U.S. person” or because of changes to the swap dealer de minimis calculation, is not required to register as a swap dealer until two months after the end of the month in which such person exceeds the de minimis threshold for swap dealer registration.

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