Monday, May 13, 2013

How Do You Regulate Locally on a Global Scale?


Author: David Schwartz J.D. CPA David Schwartz J.D. CPA

Over the past few decades, US and other financial regulators have had to think more and more about their regulations not just from a domestic standpoint, but from a global perspective as well.  One prime example is the US Securities and Exchange Commission, whose regulatory mandate has been broadened by the Dodd-Frank Act to include regulation of certain kinds of over the counter (OTC) derivatives.  Virtually unregulated previously, OTC derivative trading is a global phenomenon wherein firms from all over the world write and trade complex financial instruments for a variety of reasons from hedging and liquidity purposes, to more speculative uses.  The Dodd-Frank mandate to the SEC to regulate OTC derivatives is unambiguous: bring security based swaps into some sort of central clearing regime, and make the individual transactions of major swap participants and dealers more transparent. In the case of security based swaps, the SEC has struggled greatly with the cross-border implications of its mandate.  How should the new regulatory regime for US swaps apply when a transaction occurs partially within and partially outside the US?   Last week, the SEC took a stab at this question by proposing rules and interpretive guidance applicable to certain market intermediaries, participants, clearing agencies, data repositories, and trade execution facilities that are involved in cross-border transactions of security-based swaps.

The SEC's proposed rules set forth when security-based swap dealers, major security-based swap participants, and other entities — such as clearing agencies, execution facilities, and data repositories — must register with the SEC.  To address cross-border swaps transactions, the also proposal outlines a “substituted compliance” framework in order to facilitate a well-functioning global security-based swap market. The Commission believes that the "substituted compliance" concept recognizes that market participants may be subject to conflicting or duplicative compliance obligations in the global derivatives market, and tries to alleviate some of this regulatory burden.

The "substituted compliance" concept is far from uncontroversial. SEC Commissioner Luis A. Aguilar, though voting in favor of the cross-border proposal, voiced some skepticism about "substituted compliance." Aguilar fears its application may work against the enhanced risk protections envisioned by the Dodd-Frank Act, and negate many of the protections of the new security based swaps regulatory regime.  He urged commenters to take a rigorous look at the proposed rules, and bring raise issues about the potential for regulatory arbitrage arising from ambiguities in some of the rule's classes of swaps participants.
 

The rule proposal seems to rely heavily on “substituted compliance,” a framework under which the Commission would permit compliance with comparable regulatory requirements in a foreign jurisdiction to substitute for compliance with the Securities Exchange Act of 1934 (“Exchange Act”) relating to security-based swaps. In particular, non-U.S. dealers that are registered with the Commission would be allowed to comply with the U.S. external business conduct rules through “substitute compliance” as an alternative to complying with the Exchange Act. External business conduct rules are necessary to ensure honesty and high ethical standards in the securities industry, as well as to promote confidence in our securities markets among domestic and foreign investors. The proposed rules would allow these SEC-registered entities to use “substituted compliance” for external business conduct rules, even as to transactions taking place within the United States involving U.S. persons.

In particular, this approach would allow substituted compliance for transactions between registered non-U.S. dealers and a unique class of counterparties that Congress has identified as “special entities” needing enhanced protections.  It remains unclear whether these registered non-U.S. dealers, if required, would be able to act in the best interests of special entities in the United States. Under these circumstances, creating a substituted compliance regime may remove these enhanced protections, and, if so, would not seem to be consistent with Congressional intent. 
 
Therefore, I would like commenters’ views as to whether a substituted compliance regime will inappropriately deny American investors the protection of American laws


In addition to the proposed cross-border security based swap rules, the Commission also voted to reopen the comment periods on the various outstanding rulemaking releases and policy statement concerning security-based swaps and market participants to allow the public additional time to analyze and provide comments in light of our cross-border release.  This will give commenters even more opportunities to raise potential weaknesses in the proposed cross-border regime.

Though in command fewer than three weeks, the Commission's new chairman, Mary Jo White, has also been thinking carefully about the SEC's role on the global regulatory stage.  In a recent address before the Investment Company Institute, White said that in her first few weeks she has:

 

 

  • Attended meetings with the Secretary of the Treasury and central bank heads and regulatory chiefs from Canada, China, Europe, Japan, Mexico, Singapore and Switzerland. 
  • Been briefed for a meeting of the Financial Stability Board and a London meeting of the International Financial Reporting Standards Foundation Monitoring Board.
  • Reviewed, shaped, and voted on a thousand-page proposal for regulating cross-border derivatives transactions, which I’ll talk more about in just a few minutes.
  • Held personal meetings with the Vice Chair of the Japan Financial Services Agency and the Australian Securities and Investments Commission Chairman, who also is Chairman of the International Organization of Securities Commissions.
And this is only a partial list of my international activities.


White said that US financial regulations must not be thought of only in isolation because, "though the US has the safest, most resilient and robust markets in the world – we are not the only game in town."

 

 

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