Supporting Statement of Commissioner Dan M. Berkovitz on the Proposed Regulation for Registration with Alternative Compliance for Non-U.S. Derivatives Clearing Organizations

July 11, 2019

I support issuing for public comment the proposed rulemaking (“Proposal”) to permit registration with alternative compliance for non-U.S. derivatives clearing organizations (“non-U.S. DCOs”).

Under the Proposal, a non-U.S. DCO that does not pose “substantial risk to the U.S. financial system” would be permitted to elect to comply with certain Commodity Exchange Act (“CEA”) core principles for DCOs through compliance with its home country regulatory regime.[1]  The non-U.S. DCO still would be required to comply with the CFTC’s customer protection and swap data reporting requirements.  This registration alternative would permit U.S. persons to access foreign swap markets while benefitting from customer protections under the U.S. Bankruptcy Code and CFTC regulations without introducing significant new risks into the financial system.

The alternative compliance framework seeks to satisfy both the CFTC interest in protecting U.S. customers accessing a non-U.S. DCO and the interests of the home regulator in overseeing the activities of the non-U.S. DCO within its jurisdiction.  It maintains key U.S. customer protection requirements and U.S. Bankruptcy Code treatment for U.S. customer funds held by CFTC-registered futures commission merchants (“FCMs”).[2]  At the same time, this framework recognizes the interests of the non-U.S. DCO’s home country regulator by relying on its oversight of other DCO activities.  I look forward to comments on whether the Proposal maintains for the Commission an appropriate level of regulatory oversight for non-U.S. DCOs operating within this framework.

The effective regulation of central clearinghouses for derivatives is critical to managing risk throughout global financial markets.  Under the CEA, the Commission may exempt a non-U.S. DCO from the registration requirement if the Commission determines that the non-U.S. DCO is subject to “comparable, comprehensive supervision and regulation” by its home regulator.[3]  The Exempt DCO Proposal, which the Commission also is considering today, would set forth, for the first time, objective standards for determining whether a particular non-U.S. DCO is eligible for such an exemption.[4]  The threshold for permitting non-U.S. DCOs under the Exempt DCO Proposal to be eligible to elect exemption from registration – that the DCO not pose a “substantial risk to the U.S. financial system” – is the same standard for permitting a non-U.S. DCO to be eligible to register with alternative compliance under this Proposal.  Thus, under the set of proposals the Commission is considering today, a non-U.S. DCO that does not pose substantial risk to the U.S. financial system could apply, at its election, either for an exemption from DCO registration, or for registration with alternative compliance.  Of course, it could apply for full DCO registration as well.

I support the Commission’s movement towards objective standards and defined processes for establishing registration alternatives for non-U.S. DCOs.  Non-U.S. DCOs that conduct a substantial amount of U.S. customer-related activity will remain subject to full CFTC registration and regulation and U.S. customers on such DCOs are generally protected under the U.S. Bankruptcy Code and CFTC customer protection regulations.

For a non-U.S. DCO that is below that “substantial risk” threshold, this Proposal creates an “alternative compliance mechanism” that would permit the non-U.S. DCO to register with the Commission and provide clearing for U.S. customers, but also to comply with certain DCO core principles by complying with its home country requirements.  Under this alternative, the non-U.S. DCO would still be subject to some CFTC customer protection regulations and U.S. customers would continue to receive protections under the U.S. Bankruptcy Code for funds held at the FCMs that must be used as intermediaries.[5]

“Substantial Risk” Threshold Issues

As noted above, only those non-U.S. DCOs that do not pose a “substantial risk to the U.S. financial system” would be permitted to register with alternative compliance.  A non-U.S. DCO would be deemed to present a “substantial risk to the U.S. financial system” if: (1) it holds 20% or more of the required initial margin of U.S. members for swaps aggregated across all registered and exempt DCOs; and (2) 20% or more of the initial margin for swaps required at the DCO is attributable to U.S. members.  The 20/20 criteria would not be a bright line test.  If either of the conditions is present, or close to present, the Commission may nonetheless determine that the non-U.S. DCO presents substantial risk to the U.S. financial system and therefore must fully register.

Although I support issuance of this Proposal, I have significant concerns about adopting the 20/20 criteria as a “risk-based” standard.  Although the 20/20 criteria are characterized as a risk-based standard (i.e., “substantial risk to the U.S. financial system”), the criteria would more accurately be described as establishing an activity-based test.  The proposed 20/20 criteria directly measure the level of initial margin deposited at the non-U.S. DCO rather than risk presented to the U.S. financial system.  The Proposal is devoid of reasoned analysis as to the basis for the 20/20 criteria in terms of actual risk presented to the U.S. financial system.  It is not difficult to envision scenarios in which a lesser amount of initial margin at a non-U.S. DCO by U.S. participants may actually represent increased risk to the U.S. financial system, and a greater amount of margin may represent lesser risk.  In the Proposal, the Commission concedes that “a test based solely on initial margin requirements may not fully capture the risk of a given DCO.”[6]

In my view, an activity-related test is, in fact, the more appropriate standard for determining registration requirements.  In effect, the Proposal gets the result right, but for the wrong reasons.  “Substantial risk to the U.S. financial system” is difficult—if not impossible—to measure in a straightforward, objective formula, especially as markets change over time.  The activity-based thresholds in the Dodd-Frank Act for the regulation of swaps markets and entities were adopted largely due to the spectacular failure of the risk-based approach prior to the financial crisis.  Other registration thresholds and registration exemptions in the CEA and the Commission’s regulations, for example for swap dealers, FCMs, commodity pool operators, and commodity trading advisors, are based on activity rather than risk.  Importantly, the standard in CEA Section 2(i) for the application of the swaps provisions to activities outside the U.S. (“direct and significant connection with activities in, or effect on, commerce of the United States”) is activity-based and not risk-based.  The threshold for exemption from registration for non-U.S. DCOs should be activity-based as well.

It is not apparent from the information provided in the Proposal why the 20/20 test should be the appropriate standard for determining whether a non-U.S. DCO need not fully register with the CFTC.  Do the proposed criteria accurately measure the appropriate level of clearing activity?  Are additional or different metrics more appropriate for measuring when clearing activity for U.S. customers becomes substantial and full registration becomes appropriate?  I look forward to reviewing comments addressing these and the other issues regarding the 20/20 test.

No Substituted Compliance Review

I also am concerned that the Proposal may not establish sufficiently clear or adequate standards for the review of a non-U.S. DCO’s application for alternative compliance.  In contrast to the  standard and proposed process for granting a request for exemption from DCO registration,[7] the Proposal would not require the CFTC to make any determination that the home jurisdiction’s requirements for the DCO are comparable to, and as comprehensive as, the core principles for which alternative compliance is being sought.[8]  It is not clear why a vaguer standard should apply to DCOs seeking registration with alternative compliance.  The Proposal establishes what, in essence, appears to be a regime similar to substituted compliance for certain DCO core principles, yet it does not follow the process the CEA requires and the CFTC has implemented in other circumstances for establishing a substituted compliance regime.[9]  Further, the Proposal does not require that the non-U.S. DCO observe the Principles for Financial Market Infrastructure.  I look forward to comments on, and further clarification of, these issues.

Reciprocity

In this rulemaking the Commission proposes to recognize the interests of other jurisdictions in the regulation of non-U.S. DCOs.  To the extent that non-U.S. jurisdictions adopt similar approaches that recognize the interests of the U.S. in the regulation of DCOs located in the U.S., the global marketplace as a whole will benefit.  However, to the extent that another jurisdiction does not appropriately recognize the interests of the U.S. in regulating U.S. DCOs, then U.S. DCOs could be fully regulated by both the U.S. and the other non-U.S. jurisdiction, subjecting the U.S. DCOs to unnecessary additional costs and potentially conflicting requirements.[10]  Prior to granting any applications for alternative compliance for a non-U.S. DCO, the Commission should determine that the home jurisdiction of the non-U.S. DCO has adopted a comparable approach to the regulation (including exemption from regulation) of U.S. DCOs.[11]  I invite comment on whether reciprocity or a similar mechanism should be incorporated into the regulation.

I thank the staff of the Division of Clearing and Risk for their work on this Proposal and appreciate their professional engagement with my office to address many of our comments.