Swaps Rules in Limbo as CFTC Deadline About to Hit

Financial firms are facing a looming deadline for new rules on the global trading of derivatives, without any clear sense of what final decision the Commodity Futures Trading Commission might make. Then again, for what it's worth—the CFTC doesn't seem certain about how to proceed either.

The issue in question is the cross-border treatment of derivatives trading, which CFTC Commissioner Mark Wetjen has described as “the most consequential and complicated policy judgments that the agency must make under the Dodd-Frank Act.” The agency issued proposed rules one year ago, with a goal of implementing final rules by July 12, 2013.

That deadline is now just about here. The CFTC, however, has been hamstrung over differences its proposal has with the Securities and Exchange Commission—which also has some rulemaking responsibility for derivatives—and with international regulators, who want the CFTC to delay the final rules yet again while they lobby against what they see as regulation that creeps into their own jurisdictions. Moreover, investor advocates and like-minded lawmakers such as Sen. Elizabeth Warren (D-Mass.) are prodding the agency to act now.

Do as We Say

On May 1, completing a two-year effort, the SEC proposed rules governing cross-border activities in security-based swaps, the trades it has responsibility over as per the Dodd-Frank Act. Its approach differs in many ways from what the CFTC has proposed and is considered to be less onerous for multinational interests. As an additional concession, the SEC reopened the comment period on many of its previously issued swap regulations and the sequencing of rules.

The SEC and CFTC plans both exempt swaps trading in the United States by foreign firms if certain criteria is met. One of those exemptions is if the firm is already regulated by a country that has comparable swaps-trading oversight, a concept known as “substituted compliance.”

A debate has erupted, however, over what should be considered comparable. The SEC's approach weighs “regulatory outcomes,” rather than a direct comparison of rules, stressing a holistic approach for meeting requirements of Title VII of Dodd-Frank. By contrast, the CFTC proposes to recognize substituted compliance only when determined to be “comparable and comprehensive” to Dodd-Frank requirements.

The difference between getting close to other regulations, versus mirroring them, has divided CFTC commissioners on whether to move forward with their rules as currently crafted (the adamant position of CFTC Chairman Gary Gensler, although he is soon to step down from the agency), extend the deadline by as much as a year, or split the difference and proceed with an interim plan.

Meanwhile, financial firms here and abroad remain caught in the regulatory quagmire. “Everybody is wondering what is going to happen,” says Michael O'Brien, a partner in corporate law at the firm Winston & Strawn. “If nothing happens by July 12, then it's anything goes.”

International Concerns

Foreign regulators worry that the United States, through the CFTC's approach, is trying to force their countries to abide by U.S. rules for derivatives trading. That could leave derivatives traders subject to multiple, overlapping, and probably conflicting regulatory schemes.

The European Union and European Securities and Markets Authority have urged the CFTC and other officials to extend the temporary exemption for overseas banks. Others, including Michael Barnier of the European Commission and the finance ministers of France and Germany, have expressed dismay about the potential for regulatory overreach by the United States.

“Everybody is wondering what is going to happen. If nothing happens by July 12, then it's anything goes.”

—Michael O'Brien,

Partner,

Winston & Strawn

The Europeans are not alone; in the United States, CFTC Commissioner Scott O'Malia has led the charge to delay implementation. Speaking at a conference in London earlier this month, he said his agency should agree to extend the current delay until the end of the year, to let all parties involved continue efforts “to harmonize the global regulatory framework.”

Gensler, however, has demanded that his agency stick to its current proposal and deadlines. In a recent speech, he blamed unregulated derivatives trading for causing the 2008 financial crisis, and he warned that the “common-sense reforms” of the Dodd-Frank Act could be undone if the overseas affiliates and branches of U.S. firms are allowed to operate outside of those requirements.

Swap dealers that transact with U.S. organizations and individuals must comply with U.S. swaps market reforms and not “sidestep full compliance” because they fall under another jurisdiction's weaker rules, Gensler said. Otherwise, “it's easy for financial institutions to avoid reforms by setting up shop in an offshore locale, even if it's not much more than a tropical island P.O. Box.”

“If Wall Street gets its way, derivatives regulation will largely end at U.S. shores,” warns Dennis Kelleher, president and CEO of Better Markets, a non-profit organization that promotes the public interest in the financial markets. “The global U.S.-based megabank dealers will then just move their business and operations overseas, and the jobs and revenue that go with them. And, just like last time… when things blow up overseas from unregulated, high-risk derivatives deals, they will just send the bill back to the U.S. taxpayers.”

Other Rules Take Effect Soon

While the debate over substituted compliance has held up final rulemaking at the CFTC, there are numerous other requirements from both agencies that businesses are preparing for.

COMPARABILITY DETERMINATION

The following is from the Commodity Futures Trading

Commission's proposed Interpretive Guidance on “substituted compliance” for cross-border swaps regulations.

Process for Comparability Determination

The Commission proposes to recognize substituted compliance in only those areas that are determined to be comparable and comprehensive to relevant Dodd-Frank Act requirements. The Commission would determine comparability and comprehensiveness by taking into consideration all relevant factors, including (among others): the scope and objectives of the regulatory requirement(s), the comprehensiveness of such requirements, the comprehensiveness of the foreign regulator's supervisory compliance program; and the foreign regulator's authority to support and enforce its oversight of the non-U.S. swap dealer or non-U.S. major swap participant.

The Commission expects that a request for a finding of comparability with respect to a particular Dodd-Frank Act requirement would, at a minimum, state the factual basis for such request and include with specificity all applicable legislation, rules and policies. Subsequently, the Commission would expect to receive notifications from non-U.S. swap dealers or non-U.S. major swap participants regarding any material changes to information submitted in support of a comparability finding (e.g., changes in the relevant supervisory or regulatory regime).

With respect to substituted compliance and comparability determinations, the Commission expects that it would enter into an appropriate memorandum of understanding or similar arrangement with the relevant foreign supervisor(s).

Source: CFTC.

The CFTC's final rules on swap execution facilities (SEFs) take effect on Aug. 5. Swap trades are required to be conducted on an SEF or designated contract market if clearing in the swap is mandatory. As a result of block-size trading rules for swaps, starting July 30, nearly half of the swaps market will be subject to real-time reporting for pricing and orders.

SEFs face requirements for operational capability and must have controls in place (such as the ability to halt trading) needed to ensure system integrity. The CFTC is requiring swaps exchanges to devote sufficient internal compliance resources to achieve these safeguards, although outside contractors may be retained as a supplement.

By Oct. 2, all swap trading platforms will need to register, ending the unregulated trading of swaps on trading platforms. This oversight includes new responsibilities for recordkeeping and business conduct standards. Asset managers will be required to request at least two quotes prior to executing a trade.

Gensler is also suggesting that final guidance specify that the definition of a covered “U.S. person” must 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.

The SEC's proposed rules, among other matters, would require compliance with public dissemination, clearing, and trade execution requirements for security-based swap transactions when:

A counterparty is a U.S. person (including foreign branches of U.S. banks).

A counterparty is a non-U.S. person that receives a guarantee from a U.S. person on its performance on security-based swaps.

A transaction is conducted within the U.S. (subject to certain exceptions with respect to clearing and trade execution requirements).

Stuck in Limbo

O'Brien thinks the CFTC will ultimately have no choice but to extend its July 12 deadline, “but who knows?” Gensler, he says, has “very set views that the OTC markets need to be substantially turned on their heads in terms of the regulatory order.”

If there is lingering uncertainty after July 12, many entities may "just start going to the futures markets to the extent they can,"  or decide not to hedge, "which in the long haul, in my opinion, will be worse,” O'Brien says.

Robert Pierson, director of risk management services at Kyriba, which provides corporate treasury services, is also concerned about what effect the CFTC's proposed rulemaking could ultimately have.

“You can't have the SEC saying one thing and the CFTC saying another because then that creates confusion,” he says. “There has to be some sort of collaboration if you want people to follow the rule, and you can't be too restrictive,” he says. “You don't want to drive them away from the marketplace.”

Uncertainty about what happens if the final exemptive order is not extended is “very troubling,” says Annette Nazareth, a partner with the law firm Davis Polk and a former SEC commissioner.

Those seeking a delay in the CFTC's rules are not looking just to put off complying with the new rules, but rather to come up with “a consistent approach that both works for regulators here and abroad with a common understanding of where the primary responsibility lies,” Nazareth adds. “I don't think anybody is questioning the importance of getting this right.”

Jeffrey Stern, a partner and leader of the Structured Products team at the law firm Pillsbury Winthrop Shaw Pittman, says it is “almost inevitable we will end up with a rule more similar to the SEC's approach than that of the CFTC.

“The outlines of an accommodation seem to be emerging,” he says. “The uncertainty is uncomfortable, but most people appear to believe this will resolve itself over time and that the CFTC is going to work with the SEC and their overseas counterparts to develop a coordinated policy that allows for coherent, global regulation.  “It is going to be difficult as we pass from here and there, but many market watchers see that there is a shore in sight.”