The OTC trading space is being kept on its toes by the Commodities and Futures Trading Commission (CFTC); recent developments mean that more market participants worldwide are in scope of US derivatives rules than ever before. In our previous piece, JWG analysed the CFTC’s rules on who is a ‘US person’ for their purposes, and the rules’ applicability on a global level. However, if you decide you are not a ‘US person’, there is then question of whether your trade meets the criteria for transaction-level requirements under Dodd-Frank. And as no-action relief letters begin to expire, financial institutions need to have a firm understanding of how the rules apply to them and how this affects their trading strategy.
As per the Commission’s original guidance, non-US persons who are considered to be ‘guaranteed by’, or ‘affiliate conduits’ of, US entities are also subject to some of the same rules, depending on their level of involvement with US persons and their business (see chart here). A ‘guarantee’ is loosely defined as: ‘an agreement or arrangement under which a person commits to provide a financial backstop or funding against potential losses that may be incurred by another person in connection with a swap.’ But the definition of an affiliate conduit is more complex. In the Commission’s definition, an entity may be an affiliate conduit where: 1) it is a non-US person that is majority-owned, either directly or indirectly by a US entity; 2) it is a non-US person who has control of or falls under the control of a US entity; 3) it is a non-US person acting as an agent to trade, mitigate risk, or enter into swaps contracts with other non-US entities on behalf of a US affiliate through the regular course of business; and 4) the financial results of the non-US person are calculated in the consolidated earnings reports of a US person.
There is also a de minimis exemption from the requirements if the trading activity of the entity does not breach a certain threshold. However, there are complex rules related to the calculation of this threshold: Following the CFTC’s guidance, non-US persons that are guaranteed or affiliate conduits of US persons need to include swap dealer (SD) transactions into its de minimis calculations, under rule 1.3(ggg)(4), to determine the value of their trading threshold. Any swap between a conduit and a US person, another guaranteed affiliate (with the position guaranteed by a US person), or a guaranteed affiliate with another US person-backed guaranteed affiliate should be considered in the calculations for the rule. Exemptions take place if the entity does not enter more than $100 million worth of contracts, execute more than 20 swaps as a dealer, enter into swaps with more than 15 counterparties, or engage with the CFTC-defined ‘special entities’ in a capacity exceeding $25 million – all within the preceding 12 months.
The reason these rules are so far-reaching is that firms from other countries should be able to benefit from substituted compliance, a form of mutual recognition whereby the firm’s home country rules are considered sufficient for US compliance. However, the DSIO, a division of the CFTC, recently issued guidance saying that some types of conduit affiliate (namely agents of third country entities) would, on occasion, be subject to US transaction-level requirements, with no substituted compliance available. But this only occurs when that non-US person ‘regularly arranges, negotiates or executes swaps on behalf of a swap dealer’. Therefore, firms carrying out activities in US markets will have to examine this guidance to see if they might be caught. Fortunately, no-action relief has been granted to such persons but only until 14 January 2014 while the CFTC answers a lawsuit brought by ISDA and SIFMA on the basis that they failed to consider the full effects of their rulemaking.
There are also further questions outstanding on the matter of substituted compliance. By 21 December 2013, the CFTC expects to have substituted compliance in place for the jurisdictions of Hong Kong, Australia, Canada, Switzerland, Japan, and the EU, as that is the day that exemption from the rules expires. General consensus in the EU is that Gensler and his team have broken the ‘path forward’ agreement, but the EU’s own efforts to create a system of mutual recognition (‘equivalence’) have also introduced complexity into the system. As it currently stands, we are awaiting the Commission’s response to ESMA’s draft equivalency decisions on a number of jurisdictions, including the US.
This nightmare scenario has been decried by IOSCO and other regulators as a failure to come to terms with the globalised nature of trading. But what does this mean for market participants until these rules are finalised? Simply put, change is imminent and the industry will have to adapt sooner rather than later. In the meantime, markets such as Asia have faced fragmentation issues given the necessity to start registering on SEFs by 2014, and non-US persons have avoided trading with SEFs and US persons for fear of compliance issues. As the rules become finalised and swaps participants move their businesses onto organised platforms, non-US persons looking to do business outside of the scope of the Dodd-Frank reforms will have an increasingly difficult time finding business – a prospect that could almost certainly lead to significant global consolidation.
As we reach the end of the year, there are numerous loose ends that need to be tied up on both sides of the Atlantic. No-action relief is quickly expiring while new regulations are being put into place. As such, it is essential for those trading swaps to plan for how these changes could affect their business, and to follow closely the US’s future announcements.