Will the United States regulation of derivatives apply to non-US parties?
March 2013 | PROFESSIONAL INSIGHT | FINANCE & INVESTMENT
Financier Worldwide Magazine
In 2010 the US enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) which, in part, was designed to completely transform the over-the-counter derivative market. The law charged the US Commodity Futures Trading Commission, the US Securities and Exchange Commission and other US regulators with the task of implementing the goals of the statute – which is to regulate certain over-the-counter derivatives labelled as ‘swaps’ and ‘security-based swaps’. The statutory goals include mandating central clearing and exchange trading of certain swaps, registration requirements for dealers and major participants in the swaps market, capital and business conduct requirements for dealers and major participants, and margin, reporting, recordkeeping and position limits for swaps. Since the adoption of the Dodd-Frank Act, regulators have been actively promulgating rules to implement the provisions of the statute. More rules are yet to be promulgated, but many rules are already effective and will require compliance. Jurisdictions outside of the US are also adopting similar regulations, but global harmonisation of rules and regulations is still an aspiration and not reality.
Under the US laws, dealers in swaps will carry the greatest burden of the regulations promulgated under the Dodd-Frank Act. Consequently, dealers have invested significant resources in both time and money over the past two years to comply with the new regulatory regime. Additional compliance costs will certainly be incurred by dealers and the sheer amount of those costs is likely to drive some of the current participants out of the market. Those added compliance costs will need to be recovered, and the recovery of compliance costs will likely be achieved by the dealer passing those costs through to counterparties when pricing transactions. As a result, there is a significant likelihood that certain swap transactions may become uneconomic to the consumer of those products. Because the costs of being a dealer are so substantial, non-US persons are rightly concerned about conducting their activity in ways which ensure that the provisions of the Dodd-Frank Act do not apply to their activities. It will not be an easy task for some non-US persons. Costs are not the only concern for non-US persons who may be required to register as dealers in swaps under US law. Conflicts of law are also a significant issue, because once a non-US swap dealer is subject to US regulation, its duties under US law may conflict with the laws of its home country. This conflict has been recognised by many in the industry and numerous requests have been made to the applicable regulators to appropriately consider a harmonised cross-border approach to swap regulation.
Derivative reform contained in the Dodd-Frank Act has extraterritorial reach, but the exact limits of its reach are still uncertain. The US Commodity Futures Trading Commission issued proposed rulemaking on this topic that was not well received, even by some of the Commission’s commissioners. In fact, Commissioner Scott O’Malia acknowledged that the proposed regulation was controversial; that it was overbroad in capturing activities outside of the US; that it failed to promote global coordination; and that the Commission had received comments from European and Asian regulators questioning both the Commission’s authority and its commitment to recognising the adequacy of non-US regulations as a substitute for complying with US laws.
In late December, the CFTC released further rulemaking addressing cross-border issues. Under the rulemaking, a non-US person who regularly deals in swaps with US persons is considered to be a swap dealer if its activities exceed certain thresholds and, as a result, the non-US person would be subject to the registration, capital, business conduct, reporting and recordkeeping requirements of the Dodd-Frank Act. Under the rules, the term ‘US person’ includes natural persons who are US residents; legal entities organised under US law or having a principal place of business within the US; pension plans for employees of the foregoing; accounts owned by US persons; estates of decedents who were residents of the US at the time of death; and trusts governed by US law if a US court is able to exercise supervision over its administration.
Under the rules, in order to properly analyse a non-US person’s possible status as a swap dealer subject to US regulation, the non-US person must determine which of its transactions constitute swaps, and then, the level of its swap activity with US persons. If the activity rises above a de minimis level – currently $8bn in notional amount but subject to reduction in future years – then the person would be considered to be a swap dealer under the rules.
Further complicating the cross-border application of the Dodd-Frank Act is the status of FX swaps and FX forwards under the statute. FX swaps are transactions where there is an exchange of two different currencies on a date, at a fixed rate that is agreed upon at the inception of the contract, followed by a reverse exchange of those two currencies at a later date, at a fixed rate that is also agreed upon at the inception of the contract. FX forwards are transactions that solely involve the exchange of two different currencies on a future date, at a fixed rate agreed upon at the inception of the contract. When the Dodd-Frank Act was first adopted, both FX swaps and FX forwards were considered to be swaps unless the Secretary of the United States Treasury determined that they should not be swaps. On 16 November 2012 the Secretary of the Treasury finally made a determination that FX swaps and FX forwards would not be swaps for purposes of the clearing and exchange trading requirements under the Dodd-Frank Act, but that FX swaps and FX forwards would be subject to the reporting and business conduct requirements of the Dodd-Frank Act. As a result, although a person does not have to include FX swaps and FX forwards when determining whether it is required to register as a dealer, if a person is otherwise required to register as a dealer, they will have to comply with the business conduct requirements and reporting requirements of the Dodd-Frank Act when transacting in FX swaps and FX forwards.
In the December release the CFTC did provide relief to non-US swap dealers (i.e., those persons who are not US persons but who are required to register as swap dealers because of their dealings with US persons) from the obligation to comply with rules relating to capital adequacy, compliance, risk management, recordkeeping and reporting requirements. However, this relief only lasts until mid-July 2013, so non-US swap dealers need to perform the appropriate analyses and prepare accordingly. Fortunately, non-US swap dealers, when dealing with a non-US person, do not have to comply with certain transaction specific requirements and can comply with local laws. These requirements relate to clearing and processing, margining and segregation, trade execution, documentation, portfolio reconciliation and compression, real-time reporting, trade confirmation, daily trading records and external business conduct standards. However, non-US swap dealers must comply with these requirements when dealing with US persons, so the rules cannot be ignored.
Thomas D’Ambrosio is a partner at Morgan, Lewis & Bockius LLP. He can be contacted on +1 (212) 309 6964 or by email: firstname.lastname@example.org.
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