Friday, June 1, 2012

U.S. to Regulate Foreign Swap Counterparties?


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

The Chairman of the CFTC, Gary Gensler, testified before the Senate Committee on Banking, Housing and Urban Affairs on May 22 on the progress of his agency's regulatory reform of swaps.  Gensler's testimony included details on the CFTC's plans for implementing these reforms cross-border.  

Section 722(d) of the Dodd-Frank Act gives the CFTC, SEC, and other US regulators jurisdiction to apply swaps regulations to activities outside the United States if those activities have “a direct and significant connection with activities in, or effect on, commerce” of the United States. Gensler testified that the CFTC staff would soon be presenting to the Commission a concept release on the cross-border application of swaps market reforms. This release will consist of interpretive guidance on how the CFTC's swaps regulations apply to cross-border swap activities. It also will include an overview as to when overseas swaps market participants, including swap dealers, can comply with Dodd-Frank reforms through reliance on comparable and comprehensive foreign regulatory regimes (sometimes referred to as “substituted compliance”).

Chairman Gensler testified that in the nearly 60 rule proposals the CFTC has issued it has included requests for comment on cross-border application of each.  The comments received on these proposals have helped the CFTC staff to develop the key elements of the staff recommendations in the upcoming concept release: 

  • First, when a foreign entity transacts in more than a de minimis level of U.S. facing swap dealing activity, the entity would register under the CFTC’s recently completed swap dealer registration rules.

  • Second, the release will address what it means to be a U.S. facing transaction. I believe this must include transactions not only with persons or entities operating in the United States, but also with their overseas branches. In the midst of a default or a crisis, there is no satisfactory way to really separate the risk of a bank and its branches. Likewise, I believe this must include transactions with overseas affiliates that are guaranteed by a U.S. entity, as well as the overseas affiliates operating as conduits for a U.S. entity’s swap activity.

  • Third, based on input the Commission has received from market participants, the staff recommendations will include a tiered approach for requirements for overseas swap dealers. Some requirements would be considered entity-level, such as for capital, risk management and recordkeeping. Some requirements would be considered transaction-level, such as clearing, margin, real-time public reporting, trade execution and sales practices.

  • Fourth, such entity-level requirements would apply to all registered swap dealers, but in certain circumstances, overseas swap dealers could comply with these requirements through substituted compliance.

  • Fifth, such transaction-level requirements would apply to all U.S. facing transactions, but for certain transactions between an overseas swap dealer (including a foreign swap dealer that is an affiliate of a U.S. person) and counterparties not guaranteed by or operating as conduits for U.S. entities, Dodd-Frank may not apply. For example, this would be the case for a transaction between a foreign swap dealer and a foreign insurance company not guaranteed by a U.S. person.
Though there are some voices arguing for blanket exemption for off-shore swaps activities, Gensler made clear that no such exemption would be part of the reform effort.  The 2008 financial crisis made clear that too much is at stake to allow market participants to structure their activities to evade oversight.  


Commenters generally say they support reform. But in what some of them call a “clarification,” we find familiar narratives of the past as to why many swaps transactions or swap dealers should not be regulated. Some commenters have expressed the view that if a transaction is done offshore, it should not come under Dodd-Frank. Others contend that as long as an offshore dealer is regulated in some capacity elsewhere, many of the Dodd-Frank regulations applicable to swap dealers should not apply.
The law, the nature of modern finance, and the experiences leading up to the 2008 crisis, as well as the reminder of the last two weeks, strongly suggest this would be a retreat from much-needed reform.
 
When Congress and the Administration came together to draft the Dodd-Frank Act, they recognized the lessons of the past when they expressly set up a comprehensive regulatory approach specific to swap dealers. They were well aware of the nature of modern finance: financial institutions commonly set up hundreds if not thousands of “legal entities” around the globe with a multitude of affiliate relationships. When one affiliate of a large, international financial group has problems, it’s accepted in the markets that this will infect the rest of the group. 
This happened with AIG, Lehman Brothers, Citigroup, Bear Stearns and Long-Term Capital Management.

Gensler indicated that the CFTC is committed to working with market participants in both crafting and implementing these reforms.  The CFTC will not be springing these changes on the market, but rather, will phase implementation, balancing the desire to protect the public while providing adequate time for industry to comply with reforms.
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