Statement of Commissioner Mark P. Wetjen on the Proposed on Cross Border Margin (Washington, DC)
June 29, 2015
Today’s release lays out a proposed framework for the application of the commission’s margin rules to un-cleared swaps (the “Margin Rule”) in cross-border transactions. Interestingly, the release states that there was no consensus among those who filed comments in response to the commission’s Advance Notice of Proposed Rulemaking (“ANPR”) last fall, which laid out three alternative, cross-border approaches: the Guidance Approach, the Prudential Regulators’ Approach, and the Entity Approach. To the extent, therefore, that the release was designed to identify a consensus view concerning which of these three approaches was best, it failed.
The comment letters, however, provided a great deal of useful discussion that has aided the commission’s thinking about the extra-territorial application of its rules. Ultimately, the agency was guided by those comments to propose today an approach that is essentially an entity approach, but because of more availability of substituted compliance, appears most similar to the Prudential Regulators’ Approach in terms of its practical implementation.
I am comfortable supporting today’s release, but for the reasons discussed below, continue to harbor some doubts as to whether we have selected the approach that best balances the commission’s interests in protecting the financial system and U.S. taxpayers, meeting its statutory mandate to preserve an appropriate competitive landscape for participants in the global swaps market, and adopting policies whose costs to those affected do not exceed their benefits.1
The Commission’s Responsibilities Regarding the Margin Rule
To begin, it is important to understand the scope of the commission’s responsibilities with respect to implementing and enforcing the Margin Rule. As was made plain by the proposal seeking comment on the Margin Rule released last fall, the rulemaking is one of the most important component parts of the risk-focused requirements under Title VII of Dodd-Frank. The statute divides up responsibilities for implementing and enforcing the Margin Rule among this commission, the U.S. prudential regulators, and the Securities and Exchange Commission. Those responsibilities are weighty, requiring, among others, the review and approval of margin methodologies submitted by the covered swap entities under each authority’s jurisdiction.
As of today, five U.S. bank holding companies regulated by the Board of Governors of the Federal Reserve System (the “Board”) have 17 U.S. registered swap dealers that would fall exclusively within the CFTC’s jurisdiction for margin purposes. These same five U.S. bank holding companies have 15 non-U.S. registered swap dealers that would fall exclusively within the CFTC’s jurisdiction for margin purposes (the “U.S. Foreign-Affiliate Dealers”). That is a total of 32 registered swap dealers that the commission would have to oversee, supervise, and enforce compliance with respect to the Margin Rule.
There are another three non-U.S. parent entities regulated by the Board, which altogether have four entities registered with the commission as swap dealers, due to the level of swap-dealing activity they engage in with U.S. counterparties (“Non-U.S. Dealers”). There are only three non-U.S. registered swap dealers that do not have a parent entity regulated by the Board and that would fall exclusively within the CFTC’s jurisdiction for margin purposes (the “Truly Foreign Dealers”), or just a fraction of the number of firms that are either based in the U.S. or controlled by a U.S. regulated parent. This brings to 39 the total number of swap dealers whose un-cleared swap activities would be subjected to the commission’s Margin Rule.
The commission’s regulatory interests in each of these categories of registered swap dealers is different, notwithstanding the fact the commission has responsibility over all of them. In most respects, the commission (and other U.S. policymakers and swap-market stakeholders) should be primarily concerned about the U.S. Foreign-Affiliate Dealers when thinking through and developing a cross-border framework to determine when these entities should follow U.S. law. This statement is based on the fact that concerns about risk importation into the U.S. are much lower, relatively speaking, when it comes to the activities of the Non-U.S. Dealers and Truly Foreign Dealers (none of the Non-U.S. Dealers or Truly Foreign Dealers would appear to meet the control test under the prudential regulators’ September 2014 margin rule proposal). Instead, these latter categories of swap dealers raise different issues related to the commission’s mandates to enhance market integrity and promote fair competition.2
Appropriately, when Non-U.S. Dealers and Truly Foreign Dealers face other non-U.S. counterparties, they are excluded from having to comply with the Margin Rule under the proposal, so long as neither the registered swap dealer’s nor its counterparty’s obligations benefit from a guarantee by a U.S. person. Under the Guidance Approach, these Non-U.S. Dealers and Truly Foreign Dealers would be excluded from the Margin Rule as well, so long as neither the swap dealer’s nor its counterparty’s obligations benefit from a guarantee by a U.S. person.
I review the scope and weight of these responsibilities here because the context to deciding how much supervisory responsibilities to assert over the cross-border swap activities of entities located outside of the U.S. is important, both in understanding the practical implications of claiming those responsibilities as well as the potential effect on international comity. The review of the different categories of swap-dealer registrants also makes it clear to me that to pursue the Entity Approach without allowing substituted compliance, as some commenters suggested, is neither necessary for the commission to meet its statutory responsibilities nor advisable, not to mention impractical.
When the commission voted on the ANPR, I noted the potential benefits of the proposal set forth by the Prudential Regulators’ Approach, which would effectively apply the margin rule as an entity-level rule with certain exclusions for foreign swap activities. At that time, however, I expressed my view that applying the margin rule as a transaction-level requirement under the Guidance Approach was the better option. In part, that view was shaped by the practical reality that it would be difficult for the commission to meet its challenge to supervise U.S. swap dealers’ compliance with the margin rule, let alone the activities of the U.S. Foreign-Affiliate Dealers and Truly Foreign Dealers.
Policy Advantages of Today’s Proposal
As it relates to the Truly Foreign Dealers, compliance obligations under today’s proposal would be effectively the same as under the cross-border guidance, so presumably no new burdens or competitive considerations would be created here for those firms (as discussed above). Additionally, as it relates to the U.S. Foreign-Affiliate Dealers (some of which have affiliates not supervised by the commission and engaged in swap activities), today’s proposal could dis-incentivize firms from moving swap activity transacted by an affiliated entity regulated by a U.S. prudential regulator, into the U.S. Foreign-Affiliate Dealer. Such a market response is conceivable given the fact there could be different compliance obligations under the proposal as compared to the Guidance Approach depending on whether the U.S. Foreign-Affiliate Dealer is a Foreign Consolidated Subsidiary, and whether the dealer’s un-cleared swap is supported by a guarantee. Presumably, there is swap activity of some of these U.S. Foreign-Affiliate Dealers that would be required to comply with the Margin Rule under today’s proposal, that would not have been subjected to the Margin Rule under the Guidance Approach.
U.S. domestic regulators should not knowingly create an opportunity for affiliates within a U.S. bank holding company to move swap activity from one affiliate to another for no other reason than to avoid application of U.S. law (even if there are legitimate policy reasons that U.S. law would not apply). Indeed, this is why the Dodd-Frank Act requires the relevant agencies implementing the Margin Rule to coordinate their efforts as closely as possible. Knowingly allowing such a result also would be inconsistent with the commission’s statutory duty to promote fair competition.3
Similarly, the commission should be careful to avoid adopting a significantly different cross-border approach from the U.S. prudential regulators if it would incentivize affiliates of U.S. Foreign-Affiliate Dealers to move their swap activity to the U.S. Foreign-Affiliate Dealer in order to exploit the relative dearth of resources available to the commission for supervising and enforcing compliance. The CFTC currently is under-staffed. Meeting the challenge to monitor compliance with the complex and technical requirements of the Margin Rule as it applies to the swap activity conducted by U.S. Foreign-Affiliate Dealers today would be difficult. A cross-border approach that is substantively similar to the Prudential Regulators’ Approach may facilitate the commission in meeting its supervisory challenge.
Relatedly, I am also cognizant of market efforts to develop a standard initial-margin methodology for un-cleared swaps, which I believe would be supported by the hybrid approach set forth in today’s proposal. I am in favor of these efforts because the use of a standard initial margin methodology has the potential to reduce dispute burdens by using a common approach for reconciliation, promote the efficient use of limited market resources, and enhance fairness and transparency in the global OTC derivatives markets. As such, the commission should, if possible, avoid adopting a cross-border approach that would discourage the development of a standard initial-margin methodology, or would otherwise encourage the development of different margin methodologies across affiliated entities and/or the broader marketplace. This outcome would complicate the jobs of all supervisory authorities involved, perhaps especially the U.S. prudential regulators.
Policy Advantages of the Guidance Approach
Generally speaking, the commission in adopting its cross-border guidance intended to strike a reasonable balance in assuring that the swaps markets were brought under the new regulatory regime as directed by Congress and consistent with section 2(i) of the CEA.4 We should not depart from those important policy judgments without a compelling reason to do so.
One advantage of the Guidance Approach, therefore, is that it would harmonize the commission’s own cross-border policies as they related to both cleared and un-cleared swap activity. Because many firms under the commission’s jurisdiction have incurred significant costs by building systems and practices designed to follow the commission’s cross-border guidance, overall costs to registered swap dealers might be lower if the Guidance Approach were adopted, which obviously is relevant to the commission’s mandate to consider the benefits and costs of its policies. But of course, with harmony of the commission’s cross-border policies comes disharmony with the U.S. prudential regulators.
Another advantage to the Guidance Approach is that it provides a more elegant way for U.S. Foreign-Affiliate Dealers, Non-U.S. Dealers and Truly Foreign Dealers to comply with their regulatory obligations when the commission has made a substituted-compliance determination regarding another jurisdiction’s margin requirements. Under the Guidance Approach, an affected swap dealer’s obligations to post margin and collect margin would follow the same law or regulation of another jurisdiction if the commission had made such a substituted-compliance determination; which is to say, margin payments going in both directions would follow the same set of rules. This outcome has the added benefit of being consistent with the Basel Committee on Banking Supervision’s (“BCBS”) and the Board of the International Organization of Securities Commissions’ (“IOSCO”) final margin policy framework for margin requirements for non-centrally cleared derivatives (the “BCBS-IOSCO Framework”), which states that when a transaction is subject to two sets of rules, the regulators should endeavor to harmonize their rules to the extent possible.5
Given the relatively broad agreement among key jurisdictions about how the global framework for margin requirements ought to be structured, such a result should be an acceptable way to address any remaining concerns about risk from overseas activity transferring back to the U.S. Again, those concerns primarily would arise from the un-cleared swap activities of the U.S. Foreign-Affiliate Dealers. The proposal, on the other hand, would require a non-U.S. covered swap entity guaranteed by a U.S. person to follow U.S. initial margin rules, but only permit substituted compliance for the posting of initial margin when such non-U.S. covered swap entity trades with a non-U.S. counterparty.
In this scenario, it would be possible for two separate laws to apply to the same transaction. Under this framework, I question whether market participants engaging in un-cleared swaps would have the necessary legal certainty as to which margin requirements they would face. While this framework is proposed ostensibly to help ensure the safety and soundness of covered swap entities and to support the stability of the U.S. financial markets, these goals arguably will be accomplished only if the framework is workable. The Guidance Approach would arguably provide greater certainty as to the law applicable to a particular transaction, and render the commission’s policy more consistent with the BCBS-IOSCO Framework.6
To that end, I look forward to hearing additional comments on whether a swap between a non-U.S. covered swap entity and a non-U.S. counterparty should receive substituted compliance for the entire swap, rather than subject the swap to both U.S. and foreign margin requirements. Ideally, such comments would give the commission a better understanding of the feasibility of designing systems to assist the covered swap entity comply with two separate margin requirements for the same transaction.
To the degree that the commission should be concerned about deferring to other regulators to supervise the posting and collecting of margin for un-cleared swaps – as it would in the wake of a substituted-compliance determination – context again is important to remember here. As mentioned, there is relatively broad agreement among key jurisdictions about how the global framework for margin requirements should be structured, as a result of the issuance of the BCBS-IOSCO Framework. It’s equally important to remember that the commission’s capital rule is treated as an entity-level rule under the commission’s cross-border guidance.7 As I stated when the commission released its proposal for the Margin Rule, credit risks not addressed through the Margin Rule could be addressed, at least in part, through indirect capital requirements at the holding company level, and direct capital requirements at the registrant level for those swap dealers relying on substituted compliance (or otherwise).
Yet another advantage to the Guidance Approach is that it might better avoid further diminishments to liquidity that the marketplace has experienced recently, as well as better avoid regulatory market fragmentation that materialized after the commission’s new swap-execution framework went into effect. Several commenters expressed strong concerns that the Entity Approach could further fragment the swaps markets and impair liquidity, promote regulatory arbitrage, and place the foreign affiliates of U.S. entities at a competitive disadvantage beyond the circumstances they face in the cleared swap environment under the commission cross-border guidance. I have recognized and spoken about market fragmentation for years, and so do not take lightly such concerns being raised again in this context.
Clarifications of the Commission’s Definition of “Guarantee” and “U.S. Person”
The proposal includes two important clarifications for market participants that I would like to acknowledge. First, I am supportive of the proposed removal of the U.S. majority-ownership prong from the U.S. person definition. For certain types of funds, it is extremely difficult for advisors or administrators to accurately determine whether, and how many of, the beneficial owners of fund entities within the fund structure are U.S. persons. Given this complexity and the other elements of the U.S. person definition that would capture those funds that have a substantial nexus to the U.S. markets, I believe this exclusion is necessary and appropriate. I also support the release’s proposed definition of “guarantee”. This clearer definition will help market participants better identify those transactions that raise or implicate greater supervisory interest by the commission.
The questions asked in this proposal are intended to solicit comment in hopes of further clarifying the most appropriate way for the commission to meet its regulatory objectives as well as finding more consensus on the important issues raised in the release. As discussed above, I am open to the approach taken in this proposal and recognize its merits. I look forward to seeing whether comments filed in response to today’s release can further build the case for the commission adopting the proposal, rather than the Guidance Approach.
1 See 7 U.S.C. 19(a).
2 See section 3(b) of the Commodity Exchange Act (“CEA”), 7 U.S.C. 5(b).
3 See section 3(b) of the Commodity Exchange Act (“CEA”), 7 U.S.C. 5(b).
4 See section 2(i) of the CEA, 7 U.S.C. 2(i).
5 See BCBS and IOSCO, Margin requirements for non-centrally cleared derivatives (Sept. 2013) at 22, available at http://www.bis.org/publ/bcbs261.pdf. The BCBS-IOSCO Framework also provides that regulators should recognize the equivalence and comparability of their respective rules and apply only one set of rules to the transaction.
6 See id.
7 See Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations, 78 FR 45292 (July 26, 2013).
Last Updated: June 29, 2015