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From Securities Regulation Daily, June 29, 2015

CFTC proposes margin requirement for cross-border uncleared swaps

By Lene Powell, J.D.

In one of the most important Dodd-Frank rules for the regulation of the over-the-counter swaps market, the CFTC issued a proposed rule that specifies how margin requirements for uncleared swaps would apply in a cross-border context. With a limited exclusion, covered swap entities would have to comply with margin rules for all uncleared swaps in cross-border transactions. The proposed rule would allow for certain substituted compliance, permitting swap entities to comply with comparable margin requirements in a foreign jurisdiction as an alternative means of compliance.

Significantly, to address the recent practice of some banks “de-guaranteeing” or removing guarantees for the swap transactions of their offshore affiliates, the proposed rule looks at whether the financial results and positions of the non-U.S. swap dealer are consolidated in the financial statements of the U.S. parent, regardless of whether or not there is an explicit guarantee.

In his previous role as TARP administrator at Treasury, CFTC Chairman Timothy Massad is attuned to the fallout from the 2008 financial crisis. In particular, he observed that the federal government committed over $180 million to bail out AIG, in order to prevent its failure due to excessive swap risk from its overseas operations.

“We got all that money back, but that is a painful example of why the cross-border application of the margin rule is important,” said Massad.

According to Massad, the proposed rule is “very similar” to the approach proposed in the fall of 2014 by the prudential regulators, including the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation. Although the CFTC commissioners voted unanimously to propose the rule, Commissioner J. Christopher Giancarlo said he voted for the proposal only so the public can comment, not because he agrees with it. He is concerned about how the CFTC will determine whether rules of other jurisdictions are similar enough to allow substituted compliance, as well as the practical implications of not allowing an exclusion for foreign consolidated subsidiaries.

Margin for uncleared swaps. Many swaps are mandated by the Dodd-Frank Act to be centrally cleared, but there will always be a large part of the swaps market that is not required to be cleared, said Massad. Margin is an important tool to address counterparty credit risk from these uncleared swaps.

Last October, the CFTC proposed margin rules for uncleared swaps and sought comment on three approaches to applying the rules in a cross-border context. The prudential regulators also proposed their own rules last fall. As Massad explained, there is significant overlap between swap dealers regulated by the CFTC and those regulated by the prudential regulators. There are approximately 100 registered swap dealers, of which about 40 are subject to supervision by the prudential regulators and about 60 are subject to CFTC rules. Of the latter, about two-thirds are affiliates also subject to supervision by prudential regulators. If CFTC margin rules are very different from the margin rules of the prudential regulators, firms have an incentive to move activity from one entity to another to take advantage of differences in the rules, Massad said.

U.S. covered swap entities. The proposed rule is generally designed to address risks to a CFTC-registered swap dealer or major swap participant that does not have a prudential regulator (“covered swap entity” or CSE).

U.S. swap dealers would be required to comply with the rule in all their transactions, but would be eligible for substituted compliance for margin that they post (but not that they collect) for swaps with certain non-U.S. counterparties. This approach differs from the one set forth in last year’s cross-border guidance, which did not allow for substituted compliance for U.S. CSEs in any circumstance. Massad said the distinction in the treatment of posted versus collected margin is because the U.S. has a strong interest in collected margin, since it addresses the risk that flows back to the U.S.

Non-U.S. CSEs. How the rules apply to non-U.S. CSEs depends on whether the non-U.S. CSE’s swap obligations are guaranteed by a U.S. person or its financial statements are consolidated with those of a U.S. ultimate parent entity.

  • Uncleared swaps of non-U.S. covered swap entities whose obligations under the swap are guaranteed by a U.S. person would be treated the same as uncleared swaps of U.S. covered swap entities.
  • Uncleared swaps of non-U.S. covered swap entities whose obligations under the swap are not guaranteed by a U.S. person would be eligible for substituted compliance, unless the counterparty is a U.S. covered swap entity or a non-U.S. covered swap entity whose obligations under the swap are guaranteed by a U.S. person.
  • Uncleared swaps entered into by a non-U.S. CSE with a non-U.S. person counterparty (including a non-U.S. CSE) would be excluded from the Commission’s margin rules, provided that neither counterparty’s obligations under the relevant swap are guaranteed by a U.S. person and neither counterparty is a Foreign Consolidated Subsidiary nor a U.S. branch of a non-U.S. CSE.

Substituted compliance and definitions. The proposed rule includes a comparability standard that focuses on whether the rules of a foreign jurisdiction achieve comparable outcomes. The proposal sets forth the standard of review that will apply to determinations, as well as procedures for requests for comparability determinations, including eligibility and submission requirements.

Generally, the proposed rule would define the term “U.S. person” to include individuals or entities whose activities have a significant nexus to the U.S. market, either by being domiciled or organized in the U.S. or by having a sufficiently deep connection to the U.S. market. The proposal gets rid of the U.S. majority ownership test from last year’s guidance, which looked at whether there was 50 percent U.S. person ownership of a fund or other collective investment vehicle. The proposed rule also includes a definition of “guarantee” that focuses on the right to receive payments from the U.S. person in connection with the non-U.S. person’s obligations under the swap.

MainStory: TopStory CommodityFutures Swaps Derivatives

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