Statement of Chairman Heath P. Tarbert in Support of Final Amendments for Derivatives Clearinghouses

December 18, 2019

Clearinghouses—often called central counterparties or CCPs—are what make our futures, options, and much of our swaps markets work.  Once a buyer and seller enter into a derivatives trade, the CCP takes on each party’s credit risk for the duration of the contract.  Hundreds of thousands of trades occur in the United States because market participants never need to worry about counterparties not making good on their payment obligations.  The entire risk of an exchange or even several exchanges is centralized within a given CCP.  As a consequence, CCPs are the “risk controllers”[1] that stand at the very epicenter of our markets.

As Chairman, I have emphasized that one of the most critical responsibilities of the CFTC is supervising CCPs on a daily basis.[2]  When the term “prudential regulators” is thrown around in Washington, the CFTC is usually excluded from the list.  Nothing could be more misleading.  The CFTC’s role as the nation’s prudential regulator for derivatives clearinghouses is part of the reason American CCPs are undoubtedly the strongest and most resilient in the world.[3]

Part 39 of our regulations implements our statutory principles-based framework for the supervision and regulation of derivatives clearinghouses.[4]  Our framework focuses on all key aspects of CCP operations, including financial resources, member eligibility, risk management, and system safeguards.  It is incumbent upon us to revise Part 39 at regular intervals to ensure it remains up-to-date as technology and other market-driven changes come to the fore.

I am therefore pleased to support the final amendments to Part 39 before the Commission today.  The final amendments[5] represent the codification of close to a decade of best practices and procedures adopted by CCPs in accordance with our core principles.  In promulgating these amendments, we are also making good on our promise to strengthen the regulation of CCPs and to make our regulations more transparent to all market participants.

Statement of Chairman Heath P. Tarbert in Support of the Cross-Border Swaps Proposal

December 18, 2019

I am pleased to support the Commission’s proposed rule on the cross-border application of registration thresholds and certain requirements for swap dealers and major swap participants.  It is critical that the CFTC finalize a sensible cross-border registration rule in 2020, as we approach the 10-year anniversary of the Dodd-Frank Act.

Need for Rule-Based Finality

Since 2013, market participants have been relying on cross-border “interpretive guidance,”[1] which was published outside the standard rulemaking process under the Administrative Procedure Act (APA).[2]  Although this policy statement has had a sweeping impact on participants in the global swaps market, it is technically not enforceable.  Market participants largely follow the 2013 Guidance, but they are not legally required to do so.[3]  Over the intervening years, a patchwork of staff advisories and no-action letters has supplemented the 2013 Guidance.  With almost seven years of experience, it is high time for the Commission to bring finality to the issues the 2013 Guidance and its progeny address. 

We call this a “cross-border” proposal, and in certain respects it is.  For example, the proposed rule addresses when non-U.S. persons must count dealing swaps with U.S. persons, including foreign branches of American banks, toward the de minimis threshold in our swap dealer definition.  More fundamentally, however, the proposed rule answers a basic question:  What swap dealing activity outside the United States should trigger CFTC registration and other requirements?

Congressional Mandate

To answer this question, we must turn to section 2(i) of the Commodity Exchange Act (“CEA”), a provision Congress added in Title VII of the Dodd-Frank Act.[4]  Section 2(i) provides that the CEA does not apply to swaps activities outside the United States except in two circumstances: (1) where activities have a “direct and significant connection with activities in, or effect on, commerce of the United States” or (2) where they run afoul of the Commission’s rules or regulations that prevent evasion of Title VII.[5]  Section 2(i) evidences Congress’s clear intent for the U.S. swaps regulatory regime to stop at the water’s edge, except where foreign activities either are closely and meaningfully related to U.S. markets or are vehicles to evade our laws and regulations. 

I believe the proposed rule before us today is a levelheaded approach to the exterritorial application of our swap dealer registration regime and related requirements.  The proposed rule would fully implement the congressional mandate in section 2(i).  At the same time, it acknowledges the important role played by the CFTC’s domestic and international counterparts in regulating what is a global swaps market.  In short, the proposal employs neither a full-throated “intergalactic commerce clause”[6] nor an isolationist mentality.  It is thoughtful and balanced.

Guiding Principles for Regulating Foreign Activities

For my part, I am guided by three additional principles in considering the extent to which the CFTC should make full use of its extraterritorial powers.

1.  Protect the National Interest 

An important role of the CFTC is to protect and advance the interests of the United States.  In this instance, Congress provided the CFTC with explicit extraterritorial power to safeguard the U.S. financial system where swaps activities are concerned.  We need to think continually about the potential outcome for American taxpayers.  We cannot have a regulatory framework that incentivizes further bailouts of large financial institutions.  We therefore need to ensure that risk created outside the United States does not flow back into our country. 

But it is not just any risk outside the United States that we must guard against.  Congress made that clear in section 2(i).  We must not regulate swaps activities in far flung lands simply to prevent every risk that might have a nexus to the United States.  That would be a markedly poor use of American taxpayers’ dollars.  It would also divert the CFTC from channeling our resources where they matter the most:  to our own markets and participants.  The proposal therefore focuses on instances when material risks from abroad are most likely to come back to the United States and where no one but the CFTC is responsible for those risks.

Hence, guarantees of offshore swaps by U.S. parent companies are counted toward our registration requirements because that risk is effectively underwritten and borne in the United States.  The same is true with the concept of a “significant risk subsidiary” (SRS).  An SRS is a large non-U.S. subsidiary of a large U.S. company that deals in swaps outside the United States but (1) is not subject to comparable capital and margin requirements in its home country, and (2) is not a subsidiary of a holding company subject to consolidated supervision by an American regulator, namely the Federal Reserve Board.  As a consequence, our cross-border rule would require an SRS to register as a swap dealer or major swap participant with the CFTC if the SRS exceeds the same registration thresholds as a U.S. firm operating within the United States.  The national interest demands it.[7]

2.   Follow Kant’s Categorical Imperative

Rarely does the name of Immanuel Kant, the famous 18^th century German philosopher, come up when talking about financial regulation.[8]  One of the lasting contributions Kant made to Western thought was his concept of the “categorical imperative.”  In deducing the laws of ethical behavior, i.e., how people should treat one another, he came up with a simple test:  We should act according to the maxim that we wish all other rational people to follow, as if it were a universal law.[9]  Kant’s categorical imperative is also a good foundation for considering cross-border rulemaking here at the CFTC.

What I take from it is that we should adopt a regulatory regime that we would like all other jurisdictions to follow as if it were a universal law.  How does this work?  Let me start by explaining how it does not work.  If we impose our regulations on non-U.S. persons whenever they have a remote nexus to the United States, then we should be willing for all other jurisdictions to do the same.  The end result would be absurdity, with everyone trying to regulate everyone else.  And the duplicative and overlapping regulations would inevitably lead to fragmentation in the global swaps market—itself a potential source of systemic risk.[10]  Instead, we should adopt a framework that applies CFTC regulations outside the United States only when it addresses one or more important risks to our country.   

Furthermore, we should afford comity to other regulators who have adopted comparable regulations, just as we expect them to do for us.  This is especially important when we evaluate whether foreign subsidiaries of U.S. parents could pose a significant risk to our financial system.  The categorical imperative leads us to an unavoidable result:  We should not impose our regulations on the non-U.S. activities of non-U.S. companies in those jurisdictions that have comparable capital and margin requirements to our own.[11]  By the same token, when U.S. subsidiaries of foreign companies operate within our borders, we expect them to follow our laws and regulations and not apply rules from their home country.

Charity, it is often said, begins at home.  The categorical imperative further compels us to avoid duplicating the work of other American regulators.  If a foreign subsidiary of a U.S. financial institution is subject to consolidated regulation and supervision by the Federal Reserve Board, then we should rely on our domestic counterparts to do their jobs when it is a question of dealing activity outside the United States.  The Federal Reserve Board has extensive regulatory and supervisory tools to ensure a financial holding company is prudent in its risk taking at home and abroad.[12]  The CFTC does not have similar experience, and therefore should focus on regulating dealing activity within the United States or with U.S. persons.

3.  Pursue SEC Harmonization Where Appropriate

In the jurisdictional fight over swaps, Congress split the baby between the CFTC and the SEC in Title VII of the Dodd-Frank Act.[13]  The SEC got jurisdiction over security-based swaps, and we got jurisdiction over all other swaps—the vast majority of the current market.[14]  Congress also required both Commissions to consult and coordinate our respective regulatory approaches, and required us to treat economically similar entities or products in a similar manner.[15]  Simple enough, right?  Wrong.

The CFTC and the SEC could not even agree on a basic concept that is not even particular to financial regulation:  who is a “U.S. person.”  In what can only be described as a bizarre series of events, the CFTC and the SEC adopted different definitions of “U.S. person” in our respective cross-border regimes.  I find it surreal that two federal agencies that regulate similar products pursuant to the same title of the same statute—with an explicit mandate to “consult and coordinate” with each other—have not agreed until today on how to define “U.S. person.”  This failure to coordinate has increased operational and compliance costs for market participants.[16]  And that is why I am pleased that our proposal uses the same definition of U.S. person that is in the SEC’s cross-border rulemaking.

To be sure, as my colleagues have said on several occasions, we should not harmonize with the SEC merely for the sake of harmonization.[17]  I agree that we should harmonize only if it is sensible.  In the first instance, we must determine whether Congress has explicitly asked us to do something different or implicitly did so by giving us a different statutory mandate.  It also requires us to consider whether differences in our respective products or markets warrant a divergent approach.  Just as the proposed rule takes steps toward harmonization, it also diverges where appropriate. 

The prime example is the approach we have taken with respect to “ANE Transactions.”[18]  ANE Transactions are swap (or security-based swap) transactions between two non-U.S. persons that are “arranged, negotiated, or executed” by their personnel or agents located in the United States, but booked to entities outside America.  While some or all of the front-end sales activity takes place in the United States, the financial risk of the transactions resides overseas.

Here, key differences in the markets for swaps and security-based swaps are dispositive.  The swaps market is far more global than the security-based swaps market is.  While commodities such as gold and oil are traded throughout the world, equity and debt securities trade predominantly in the jurisdictions where they were issued.  For this reason, security-based swaps are inextricably tied to the underlying security, and vice versa.  This is particularly the case with a single-name credit default swap.  The arranging, negotiating, or execution of this kind of security-based swap is typically done in the United States because the underlying reference entity is a U.S. company.  Because security-based swaps can affect the price and liquidity of the underlying security, the SEC has a legitimate interest in requiring these transactions to be reported.  By contrast, because commodities are traded throughout the world, there is less need for the CFTC to apply its swaps rules to ANE Transactions.[19]

In addition, as noted above, Congress directed the CFTC to regulate foreign swaps activities outside the United States that have a “direct and significant” connection to our financial system.  Congress did not give a similar mandate to the SEC.  As a result of its different mandate, the SEC has not crafted its cross-border rule to extend to an SRS engaged in swap dealing activity offshore that may pose a systemic risk to our financial system.  Our proposed rule does, aiming to protect American taxpayers from another Enron conducting its swaps activities through a major foreign subsidiary.[20]

Conclusion

In sum, the proposed rule before us today represents a critical step toward finalizing the regulations Congress asked of us nearly a decade ago.  I believe our proposal is also a sensible and principled approach to addressing when foreign transactions should fall within the CFTC’s swaps registration and related requirements.

Perhaps President Eisenhower said it best:  “The world must learn to work together, or finally it will not work at all.”[21]  My sincere hope is that our domestic and international counterparts will view this proposal as a concrete step toward working together to provide sound regulation to the global swaps market.

Dissenting Statement of Commissioner Dan M. Berkovitz regarding Cross-Border Application of the Registration Thresholds and Certain Requirements Applicable to Swap Dealers and Major Swap Participants

December 18, 2019

I dissent from today’s cross-border swap regulation proposal (the “Proposal”) because it would significantly weaken the Commission’s existing regulatory framework that protects the United States from risky overseas swaps activity.  The existing cross-border framework has worked well over the past six years to protect the U.S. financial system from risks from cross-border swaps activity, while simultaneously enabling U.S. banks to compete successfully in overseas markets.[1]  The Proposal would create multiple loopholes for U.S. banks to evade the Commission’s oversight of their cross-border activity and pose risks to the U.S. financial system.  With a wink and a nod, U.S. banks could effectively guarantee their overseas swap dealing affiliates from losses while also enabling those affiliates to escape regulation as swap dealers.  The Proposal would enable U.S. banks to book their swap trades in unregistered foreign affiliates that would not be required to report their swaps in the United States, and would not be subject to our capital, margin, and risk management requirements.

The Proposal also sends us down a rabbit hole with a complex new entity designation, “Significant Risk Subsidiary” (“SRS”).  An SRS would be a type of overseas swap dealing affiliate that in theory is subject to greater Commission oversight.  The Proposal admits, however, that there would be “few, if any,” entities in this elusive category.[2]  What is the purpose of creating a complicated category that does not include a single entity?  This is a Seinfeldian regulation—a regulation about nothing.[3]

The Proposal would transform the Commission from a watchdog guarding U.S. shores into a timid turtle, reluctant to poke its head out of its domestic shell.  When the next financial crisis arrives, will foreign governments bail out affiliates of U.S. persons located in their jurisdictions?  Experience has taught us that while finance may be global, global financial rescues are American.  With today’s Proposal, I fear that the U.S. tax payer will once again be called on to bear the costs.  We’ve been down this de-regulatory road before, and it ended in disaster for the United States and the global financial system.  Congress enacted the Dodd-Frank Act to avoid these same mistakes, yet today the Commission is voting out a proposal that ignores both those lessons and the law.

Why Cross-Border Swaps Must be Regulated by the CFTC

It seems that every few years, we must remind ourselves of why regulating cross-border financial transactions, and swaps in particular, is important to managing systemic risk.  If we forget, the financial system delivers its own destructive reminders.  Examples from recent history prove that foreign financial activity, usually involving swaps, can lead to massive losses triggering the need for emergency action by the Department of the Treasury and/or the Federal Reserve System—sometimes at the expense of the U.S. taxpayer.  As described later in my statement, the Proposal would undermine the direction in CEA section 2(i) to regulate cross-border swap activity, and again allow such activity by U.S. financial institutions to go unobserved and unsupervised.

In 1998, the U.S. hedge fund Long-Term Capital Management L.P. (“LTCM”) was saved from failure through an extraordinary bailout by 15 banks.  The bailout was brokered by the Federal Reserve Bank of New York. The near failure of LTCM roiled financial markets.  The financial system could have seized up if LTCM had failed because of the large and opaque derivatives exposures that many U.S. banks had with LTCM.[4]  Although LTCM was mostly managed from Connecticut, it was a Cayman Islands entity with over a dozen affiliates, only $4 billion in capital, and a complex derivatives book with a notional amount in excess of $1 trillion.[5]

In 2007, U.S.-based Bear Stearns provided loans intended to shore up two Cayman Islands hedge funds sponsored by Bear Stearns.  Bear Stearns was not legally obligated to back the funds financially. Those actions were the beginning of a chain of events that eventually led to the fire sale of Bear Stearns to J.P. Morgan in March 2008.  To entice J.P. Morgan to buy a distressed Bear Stearns, the Federal Reserve System provided financial support for the purchase.[6]  This is not to suggest that Bear Stearns failed solely because of swap activity, but to illustrate how financial institutions are essentially obligated to support foreign affiliated entities even when they do not guarantee performance, and how such support can have serious consequences to the U.S. financial system.

Walter Wriston, former chairman and CEO of Citicorp, testified to Congress regarding the obligation of a parent bank to bail out a subsidiary, no matter the degree of legal separation: “It is inconceivable that any major bank would walk away from any subsidiary of its holding company.  If your name is on the door, all of your capital funds are going to be behind it in the real world. Lawyers can say you have separation, but the marketplace is persuasive, and it would not see it that way.”[7]

When Lehman Brothers went bankrupt and triggered the 2008 financial crisis, its London affiliate, Lehman Brothers International Europe, had a book of nearly 130,000 swaps that took many years to resolve in bankruptcy.[8]  Soon thereafter, American International Group would have failed as a result of swaps trading by the London operations of a subsidiary, AIG Financial Products, if not for over $180 billion of support from the Federal Reserve System and the U.S. Department of Treasury. [9]

In 2012, on the eve of the swap dealer regulations going into effect, J.P. Morgan Chase & Co. disclosed multi-billion dollar losses from credit-related swaps managed through its London chief investment office.  While this loss did not require the Treasury or the Federal Reserve System to act, it did result in an enforcement action by the CFTC.  The enforcement order detailed how the trading activity that caused the loss would have been subject to tighter controls and oversight—and likely would not have happened—if the activity had been subject to swap dealer regulation by the CFTC.[10]

Each of these very substantial financial failures occurred at least in part because of overseas activity by U.S. financial institutions.  Although the activity occurred away from the United States, and was not subject to direct U.S. regulatory oversight, the risks and the costs both came back to the United States.

Foreign derivatives activity is of particular concern because derivatives are, by their very nature, contracts that can transfer large amounts of risk between entities and across borders.  Congress recognized this concern when it adopted CEA section 2(i) applying the swaps provisions of the Dodd-Frank Act to regulate cross-border swaps activity that has a “direct and significant connection with activities in, or effect on, commerce of the United States.”  Notably, this cross-border jurisdiction is both activity-based as well as effects-based.  It is the nature of the activity and its connection to commerce in the United States—not simply the level of risk presented—that is the basis for the CFTC’s cross-border jurisdiction.  Congress recognized that we cannot always foresee the risks presented by swap activities.  By supposedly focusing on risk, the Proposal ignores this crucial insight and critical component of the Commission’s cross-border jurisdiction.

But even with respect to activities presenting serious risks to the United States, the Proposal gets it wrong.  The risks incurred by foreign affiliates are transferred, or otherwise inure, to the U.S. parent firms in several ways.  The traditional method was for the U.S. parent to guarantee the swap payment obligations of its foreign affiliates.  Swap dealers removed many of those formal, written guarantees that were executed prior to the financial crisis in 2014 after the 2013 Guidance was issued (more on that later).  Alternatively, using inter-affiliate swaps, a foreign affiliate typically transfers to its U.S. parent all of the risk it incurs in a swaps portfolio.  While the U.S. parent may not be directly liable to the counterparties of its foreign affiliate, any losses of the affiliate are equivalent to losses the parent incurs on its swap with the affiliate.  If the affiliate makes bad bets, the parent pays for them.  Finally, a U.S. parent can be less directly responsible for its foreign affiliate’s swap obligations through capital contribution arrangements (e.g., keepwell agreements or deed-poll arrangements), or simply because letting an affiliate fail and default to numerous foreign entities is untenable as a business matter.  As Walter Wriston noted, as a matter of market survival a U.S. bank would not allow a wholly-owned affiliate to fail and default on its swap obligations.

The Commission’s regulation of cross-border swap activity should address all of these risk transfer conduits.  At the same time, it should be flexible enough to allow U.S. banks to compete in global markets.  In my view, the 2013 Guidance and the attendant no action relief achieved the right balance and is working well.  As noted above, U.S. banks are competing throughout the world.  In fact, they are out-competing their non-U.S. competitors.  There is no persuasive reason to weaken a regulatory standard that is consistent with our law and that has successfully protected the American people for the last six years—while simultaneously witnessing the global preeminence of American banks.  The Proposal snatches defeat from the jaws of victory.

The Proposal would greatly weaken the Commission’s ability to monitor and regulate foreign swap activity by U.S. financial institutions, putting our financial system at risk once again.  Only ten years after the financial crisis, the Proposal tosses aside hard lessons learned at the expense of 10% unemployment, millions of foreclosures, massive bailouts, and lasting damage to the economic fortunes of tens of millions of our fellow citizens.  It does this in the interest of secondary considerations—harmonization, a “workable framework” for regulations, and reducing costs.  Whereas “legal certainty” was the buzzword to limit the CFTC’s jurisdiction over the swaps market in the 1990s and 2000s, today’s de-regulatory mantra includes “harmonization,” “reducing fragmentation,” and “deference.”  Call it what you like, but the results are intended to be the same:  preventing the CFTC from overseeing the swaps activity of major U.S. banks.  Creating the possibility for another taxpayer-funded bailout for overseas swap activity cannot possibly be the right outcome for the American people.

What is Wrong with the Proposal

The Proposal starts on a good note by essentially adopting the interpretation of CEA section 2(i) contained in the 2013 Guidance.  The Proposal also acknowledges that “a global financial enterprise effectively operates as a single business, with a highly integrated network of business lines and services conducted through various branches or affiliated legal entities that are under the control of the parent entity.”[11]  It then explains that the entities in a global financial enterprise provide “financial or credit support to each other, such as in the form of a guarantee or the ability to transfer risk through inter-affiliate trades or other offsetting transactions.”[12]  The Proposal then uses the basic framework of the 2013 Guidance and adopts some of its substantive provisions.

But the Proposal makes a number of changes to key provisions, all geared toward limiting the application of our regulations.  Most concerning are the narrowing of the definition of “guarantee” and “U.S. persons,” and codifying full relief for arranging, negotiating, or executing (“ANE”) swaps in the United States that are then booked in non-U.S. legal entities.  Together, these provisions in the Proposal create a loophole through which U.S. financial institutions can undertake substantial swap dealing activity outside the U.S. swap regulatory regime through unregistered foreign affiliates and bring the risks they incur back to the United States.  In addition, these key provisions allow U.S. persons to undertake substantial dealing activity inside the United States and then evade regulation by booking the trades in foreign entities.  Together, these provisions will codify a framework for circumventing our swap regulations greatly undermining CEA section 2(i) and Title VII of the Dodd-Frank Act.

I am concerned that codifying this result will encourage U.S. banks to book much of their swap dealing activity in foreign affiliates that limit their swap dealing with U.S. persons and therefore will not have to register as swap dealers.  Under the narrowed definition of “guarantee” in the Proposal, the U.S. parents would be able to provide full financial support to these unregistered foreign affiliates, just not in the form of an explicit, direct swap payment guarantee.  Furthermore, these changes will allow two U.S. entities, whether they are, for example, two global banks or a global bank and a large U.S. corporation, insurance company or hedge fund, to trade with each other without subjecting that trade to U.S. oversight so long as the trade is booked in foreign affiliates.  Finally, by largely eliminating the ANE requirement,[13] those U.S. firms can use their employees in the United States for that trading activity and still evade U.S. regulation if the swaps are booked in foreign affiliates.  As discussed above and acknowledged in the Proposal, the U.S. parents will still be on the hook because the risks incurred by the foreign affiliates is transferred back to the U.S. parent through swaps with the affiliate and/or through other capital support mechanisms.

This outcome is not merely an issue of whether the foreign affiliates of U.S. persons need to register as swap dealers.  By not registering, these foreign affiliates will not need to report their swap activity to CFTC registered swap data repositories.  They will not be subject to our margin, capital, and risk management requirements.  These firms will not be subject to the swap dealing best practices that our regulations require.  CEA section 2(i) will be undermined.

The three changes in the Proposal are intended to address unintended effects on previously standard business practices that helped U.S. banks compete in global markets.   A foreign counterparty that is not headquartered in the United States (a “true non-U.S. entity”) may not want to trade with affiliates of U.S. banks, or with bank employees in the United States, if doing so means the true non-U.S. entity would need to count those swaps toward its CFTC swap dealer registration threshold.

Under the 2013 Guidance, guaranteed foreign affiliates of U.S. banks are deemed U.S. persons for purposes of counting dealing swaps with U.S. persons.  The term “guarantee” was defined broadly.  Once it became apparent that true non-U.S. entities did not want to count those swaps, U.S. banks de-guaranteed their foreign affiliate swap dealers.  The 2016 cross border proposal[14] tried to adjust the guidance framework by adding back into the U.S. person definition foreign consolidated subsidiaries (“FCS”) that are consolidated on the books of a U.S. parent.  However, that would have the effect of exacerbating the problem for U.S. banks competing for swap business with true non-U.S. entities.  The Proposal discards the FCS concept and narrows the definition of a “guarantee” to solely an explicit recourse of the counterparty to the U.S. parent for payment on the swap.  The Proposal further narrows the U.S. person definition to delete full recourse subsidiaries and eliminate conduit affiliates treatment for the same reasons.

I am highly skeptical that the status quo will be maintained if the ANE no action relief and de-guaranteeing framework are codified.  Large U.S. banks would have incentives to de-register some of their foreign affiliate swap dealers.  They are likely to maintain only one or two foreign entities that are registered to handle business with U.S. persons operating in foreign jurisdictions who want to trade with registered swap dealers.  Even if they do not de-register those swap dealers, swap activity can easily be moved to other unregistered foreign affiliates that are supported by their U.S. parents in ways other than an explicit swap payment obligation guarantee.

There is a potential alternative for addressing the concerns of true non-U.S. entities without also excluding from oversight all activity of foreign affiliates of U.S. financial institutions.  The regulations potentially could provide that, with substituted compliance determinations in place for key swap regulations (e.g. margin and risk management), true non-U.S. entities can trade with foreign affiliates of U.S. entities without counting those swaps toward U.S. swap dealer registration.  This could be a reasonable balance of systemic safety and competitiveness.

At the same time, foreign entities that are wholly owned by U.S. parents would still be required to count swaps with other wholly-owned foreign affiliates of other U.S. parents.  In this way, U.S. financial institutions can compete for foreign swap business while preventing U.S. firms from evading swap regulation by booking swaps with each other in foreign affiliates.

I invite commenters to address this potential solution.

Seinfeldian Regulation: Significant Risk Subsidiary

The Proposal contains a new regulatory construct called the “Significant Risk Subsidiary” (“SRS”).  It is a putative replacement for a broader definition of guarantee and the FCS alternative.  But it appears to be an empty set.  The Cost-Benefit Considerations project that “few, if any” entities would fall within its ambit.  It would not accomplish anything.

The SRS is a very complicated construct, with no less than six tests for determining whether a firm would qualify for regulation as an SRS.  Bizarrely, none of these tests have anything to do with the amount of the entity’s swap activity.  The basic threshold is that the entity be affiliated with a commercial enterprise with at least $50 billion in capital.  Consider this:  LTCM had $4 billion in capital and a derivatives book with a notional amount of about $1 trillion at the time it was bailed out.

Another hurdle excludes any entity regulated by U.S. or foreign banking regulators.  In effect, the entities that do the vast majority of swap dealing in the world are excluded from the SRS definition.  With so many hurdles for the SRS determination, it appears that the Proposal has little interest in actually contributing to the control of systemic risk exposure in the U.S. financial system.  The reasoning goes, if the entity is regulated by a banking regulator that follows basic Basel capital and supervision standards, then CFTC regulation is unnecessary.[15]  But Congress decided in 2010 when it adopted the Dodd-Frank Act that swap dealing needed to be separately regulated from prudential bank regulation.  The catastrophic cross border financial failures discussed previously in this statement demonstrate why these additional protections are necessary.  Prudential regulation alone was insufficient to prevent those failures and risks to the financial system.  Those failures eventually required emergency action by the Federal Reserve System and/or the Department of the Treasury.

Substituted Compliance Shortcomings

I support the principle of international comity.  The CFTC should continue to recognize the interests of other countries in regulating swap activity occurring within their borders.  The 2013 Guidance has a flexible, outcomes based substituted compliance review process based on a finding that the foreign regulated entities are subject to comparable, comprehensive supervision and regulation.[16]  The standard of review is effectively the same as the standard established by Congress in CEA sections 4(b)(1)(A), 5b(h), and 5h(g) for finding, respectively, foreign boards of trade, swap execution facilities, and exempt derivatives clearing organizations comparable.

The Proposal would apply a lesser standard.  It would permit the Commission to issue a comparability determination if it determines that “some or all of the relevant foreign jurisdiction’s standards are comparable.”  The condition that the regulations be “comprehensive” is dropped.  Furthermore, unlike the 2013 Guidance and the CEA comparability analysis, which require the Commission to make a comparability determination or finding based on the standard, the Proposal says that the Commission can consider any factors it “determines are appropriate, which may include”[17] four factors listed.  This arbitrary, non-standard “standard” creates too much uncertainty and flexibility.  The Commission should not defer regulating U.S. bank affiliates to other regulatory jurisdictions operating under a lesser standard than the Commission has previously used in this context or currently uses in other contexts.

Conclusion

The Proposal would allow U.S. banks to evade swap regulation by booking swaps in non-U.S. affiliates.  The Proposal would enable U.S. banks to arrange, negotiate, and execute swaps in New York, but avoid swap regulation by booking those swaps in their non-U.S. affiliates.  A non-U.S. affiliate of a U.S. bank could enter into trillions of dollars of swaps with non-U.S. affiliates of other U.S. entities without registering with the CFTC as a swap dealer.  The U.S. parent bank could provide full financial support for those non-U.S. affiliates so long as the support does not come in the narrow form of an explicit swap payments guarantee.

Ultimately, the risk from all of those swaps will still be borne by the parent bank in the United States.  These risks can be very large.  The activities of bank affiliates outside the United States have a direct and significant connection with activities in, or effect on, commerce in the United States.  In Title VII of the Dodd-Frank Act, the Congress directed the CFTC to apply its swap regulations to these activities.  Because the Proposal retreats from these responsibilities, I dissent.

Statement of Commissioner Dan M. Berkovitz Regarding Final Rule Amending Part 39: Derivatives Clearing Organization General Provisions and Core Principles

December 18, 2019

I support the final rule to amend part 39 of the Commission’s regulations for derivatives clearing organizations (“DCOs”).  Part 39 codifies eighteen core principles and related regulations with which a DCO must comply to obtain and maintain its registration status.  Part 39 also provides additional standards for systemically important DCOs (“SIDCOs”).

Clearing of futures, options on futures, and swaps at Commission-registered DCOs is a key pillar supporting responsible derivatives risk management.  The G-20 leaders recognized the benefits of central clearing when they adopted central clearing of swaps as a key global response to the 2008 financial crisis.  In the United States, Congress enacted a swaps clearing mandate in section 2(h)(1) of the Commodity Exchange Act and established SIDCOs as a higher regulatory tier for large DCOs as determined by the Financial Stability Oversight Council.  Maintaining strong DCOs through effective risk management and regulation is critical to the safety of derivatives markets and to preventing another financial crisis.

The final rule for part 39 is an example of how the Commission can make tailored amendments to improve the clarity of its regulations and codify staff guidance and relief that has accumulated over time.  The final rule updates the regulations, without undermining the overall effectiveness and protective intent of the rules.

In one area of note, the final rule does not codify the proposal to require DCOs to have a default committee with member participation and to convene the committee in the event of a substantial or complex default.  The Commission received an array of comments on the proposal reflecting strongly held views both for and against the proposed changes.  The preamble to the final rule notes the Commission’s desire to provide the market with additional time to consider this issue, with the goal of attaining a consensus of stakeholders.  I look forward to continued engagement in this area.

Supporting Statement of Commissioner Brian Quintenz Regarding Proposed Rule: Post-Trade Name Give-Up on Swap Execution Facilities

December 18, 2019

I will vote in favor of today’s proposal to prohibit post-trade name give-up practices for swaps that are anonymously executed on a swap execution facility (“SEF”) and cleared (“Proposal”) in order for the Commission to receive further comment on the Proposal’s potential market structure impact. 

In November 2018, the Commission issued a request for public comment regarding the practice of post-trade name give-up.[1] The overwhelming majority of comment letters to that release opposed post-trade name give-up and requested that the Commission explicitly prohibit the practice. The Proposal before us today was heavily informed by those commenters’ perspectives.   

The Proposal rightly notes that for anonymously executed and cleared trades, the need for market participants to know the identity of their counterparties for credit risk, legal, or operational purposes was obviated by the central clearing of swaps. However, I have concerns about the government banning an established trading practice that supports liquidity in the dealer-to-dealer swaps market. Post-trade name give-up serves an important market function in enhancing swap dealers’ own risk management needs resulting from their client exposures. The Commission should understand how banning post-trade name give-up could impact dealers’ ability to hedge efficiently.  

The Proposal assumes, without the benefit of a fulsome analysis of CFTC swap data, that banning post-trade name give-up would promote greater participation, liquidity, and fair competition on SEFs. Hoping to confirm if these assumptions are correct, the Proposal asks a series of basic questions about the differences between SEFs that are predominantly dealer-to-client platforms versus inter-dealer SEFs, including differences regarding liquidity providers, types of products actively traded, and pricing. Mandating changes to market structure in the hopes of increasing competition and liquidity, but without a full understanding of how these changes may implicate fundamental market dynamics, is a path that gives me great pause.

I encourage all interested parties to provide written comments and data wherever possible in order to further the Commission’s understanding of how banning this trading practice may positively or negatively impact the liquidity on these two historically different types of trading platforms and on the dealer-driven liquidity provision of swaps trading generally. I also encourage commenters to consider if there are alternatives to a government-imposed ban that could achieve the same regulatory objectives.    

I would like to thank staff of the Division of Market Oversight for including several additional questions at my request designed to solicit targeted feedback on the potential effects of this Proposal. 

Joint Statement of Chairman Heath Tarbert, Commissioner Rostin Behnam, and Commissioner Dan Berkovitz in Support of Proposed Rule Restricting Post-Trade Name Give-Up

December 18, 2019

It is a hallmark of American exchange-style trading systems that the buyer and seller of a given financial instrument have no reason to know—and do not know—the identity of one another.[1]  Trading anonymity can be viewed as a great equalizer, leveling the playing field for counterparties of all sizes and types by allowing traders to enter and exit the market without exposing their trading positions and strategies.[2]  As a result, markets with pre- and post-trade anonymity are generally not only fairer, but also feature greater liquidity and greater competition between market participants.[3]

Before the adoption of central clearing for standardized swaps, post-trade disclosure of counterparty identities was the norm in swaps markets because of the need to manage counterparty credit risk.  For example, Party A would ask its broker to enter into a five-year interest rate swap to exchange a fixed payment for a floating rate.  The broker would find (often through another broker) Party B, who would be willing to take the other side of the swap. Post-trade, the identities of Party A and B would be revealed to one another.  A five-year bilateral relationship would thus ensue, wherein both parties would need to monitor their counterparty’s respective ability to make good on their obligations. But times have now changed.

The Dodd-Frank Act has encouraged—and in some instances required—centralized clearing for classes of swaps that are sufficiently standardized and liquid to be cleared through a central counterparty, i.e., a derivatives clearinghouse.[4]  As is the case for exchange-listed products, a cleared swap no longer exposes the respective parties to the risk of non-performance.  Rather than Party A and Party B being obligated to one another under the terms of the swap, the clearinghouse steps in between the parties to the trade and takes on the counterparty credit risk of both sides.[5]  Consequently, anonymous trading is now possible for large swaths of the U.S. swaps markets.

Yet a number of swap execution facilities (“SEFs”) still retain a vestige of the old bilateral over-the-counter markets, even for transactions that are centrally cleared: the practice of “post-trade name give-up.”  That is, the SEF will provide the identity of each swap counterparty to the other after a trade has been executed anonymously.  Given the advent of clearing, many have reasonably questioned the policy rationale for post-trade name give-up for cleared swaps, and still others have gone further, criticizing the practice as anticompetitive and an obstacle to broad and diverse participation on SEFs.

We support today’s proposed rule (“Proposal”) to prohibit post-trade name give-up for swaps that are executed anonymously via a SEF and intended to be cleared.[6]  We believe that the Proposal serves two key objectives of the Commission’s governing statute: (1) promoting swaps trading on SEFs[7] and (2) promoting fair competition among market participants, including through impartial access to a SEF’s trading platform.[8]  The Proposal could also help attract a diverse set of additional market participants who have been deterred from trading on these platforms by the practice of post-trade name give-up, but remain interested in bringing liquidity and competition to SEFs if there is a level playing field.

The Proposal is in large part based upon responses to the Commission’s November 2018 request for comment on post-trade name give-up.[9]  A large majority of commenters saw no sufficient justification for the practice with respect to cleared swaps, given the absence of counterparty credit risk attending such swaps.[10]  These commenters acknowledged arguments that dealers use the practice to allocate capital to preferred customers as part of an overall cross-marketing strategy.  However, they either did not find this rationale legitimate or believed that it does not justify potential harms resulting from name give-up.[11]

Commenters identified several such harms.  A principal concern was the risk of information leakage allowing counterparties to glean a SEF participant’s trading positions and strategies.[12]  Commenters also expressed concern that disclosure of counterparty identities could run counter to the “impartial access” requirement for SEFs.  Under this view, SEF participants can (and purportedly do) use name give-up to discriminate against counterparties whose trading practices they believe are harmful.[13]  A large majority of commenters stated that the concerns discussed above have inhibited buy-side participation on SEFs employing name give-up.[14]  In their view, prohibiting the practice would enhance liquidity on SEFs. Empirical studies on the effects of post-trade anonymity—in U.S. securities markets and in a wide range of foreign financial markets—bolster this view.[15]

We note that one response to the request for comment argued that post-trade anonymity could prompt dealers to withdraw from SEFs.  The comment expressed concerns that the prohibition could on net reduce liquidity on SEFs.[16]  Yet we have seen predictions of a drought in liquidity time and time again with respect to swaps regulatory reform.  For example, it was used to oppose the clearing requirement of the Dodd-Frank Act and the Commission’s 2013 SEF trading rules.[17]  Such predictions have not proven accurate thus far.[18]

Thus, to be persuaded that the Proposal would have net liquidity-reducing effects, we will need convincing evidence.  While we remain open to all commenters’ viewpoints, we currently believe that SEF trading that starts anonymous should remain anonymous.  This belief is consistent with the Commission’s past views regarding a swap that is executed anonymously on a SEF.[19]  Demonstrating otherwise will require more than hypothetical scenarios or anecdotal statements.

We look forward to reviewing comments on the Proposal and working with all external stakeholders to address this issue in a way that enhances SEF liquidity, ensures impartial access, and promotes increased and fair competition.[20]

Statement of Commissioner Dawn D. Stump Regarding Proposed Rule:  Cross-Border Application of the Registration Thresholds and Certain Requirements Applicable to Swap Dealers and Major Swap Participants

December 18, 2019

Overview

As I have previously observed from this dais, when the G-20 leaders met in Pittsburgh in the midst of the financial crisis in 2009, they correctly recognized that the derivatives markets are global and that designing a workable solution, though complicated, demands coordinated policies and cooperation.^[1]  To do otherwise would ignore the reality that modern markets are not bound by jurisdictional borders.  Yet, while each country agreed to this coordinated approach, our pace of implementation differed.

It has been over six years since the CFTC adopted its Cross-Border Interpretive Guidance and Policy Statement (“Guidance”).[2]  So much has changed since then.  We have now implemented nearly the entire swap regulatory regime called for by the Dodd-Frank Act[3]; equally important, many of our fellow regulators have implemented commensurate reforms, thus aligning our regulatory principles, just as the G-20 envisioned.  Our deference to the comprehensive swaps regulation of our international colleagues is demonstrated by the fact that since the Guidance was issued, the CFTC has issued 11 comparability determinations regarding the regulation of swap dealers in the European Union, Canada, Japan, Australia, Hong Kong, and Switzerland.

I have long believed that our cross-border Guidance would ultimately prove temporary, and that we would need to update it to reflect current realities.  I also am not surprised that we are undertaking this re-examination of our cross-border approach to swap dealer regulation through a rulemaking.  After all, given the nascent state of post-Pittsburgh derivatives reforms in 2013, the Guidance was just that – guidance.  It is not binding on the CFTC or swap market participants.[4]

Based on our experience during the intervening years, we are now able to replace the Guidance with actual regulations.  This is a substantial step forward in the agency’s implementation of the Dodd-Frank requirements.  We are today proposing rules of the road that, if adopted as final, would impose binding obligations with respect to the cross-border activities of swap dealers and major swap participants (“MSPs”).  And if those rules were violated, we could, and we would, bring enforcement action as a result.

Because they will be binding and enforceable, though, our cross-border rules – like all our rules – must be clear, they must be sensible, and they must be workable.  I believe that the proposed rules before us today meet those standards.  I therefore support them, and I look forward, as always, to receiving the valuable input of market participants and members of the public on ways in which they can be further improved.

Taking Stock

In a moment, I will talk about how a couple of the proposed rules in particular meet the clear, sensible, and workable standard.  But first, it is important to level-set.

There currently are about 107 registered swap dealers, approximately 60% of which (64) are located outside the United States.[5]  These numbers have stayed relatively constant since the CFTC’s swap dealer registration regime “went live” at the end of 2012.  Those 64 foreign swap dealers are located across the globe – in North and South America, Europe, Asia, and Australia.  In other words, although it is non-binding, the CFTC’s Guidance appears to have brought a substantial portion of global swap dealing activity into the CFTC’s swap dealer regulatory regime.

Our intent in issuing these proposed rules – or certainly my intent – is not to sweep an even greater portion of global swap dealing activity within our jurisdiction, nor is it to enable a significant number of currently registered swap dealers to withdraw from registration.  Rather, the intent is to codify the Guidance into our rule set, with a few improvements.

It is somewhat ironic that I would today be supporting a codification of the Guidance.  When the CFTC was considering the Guidance, I shared the view vividly articulated by then-Commissioner Jill Sommers that the Guidance, as it had been proposed, reflected “what could only be called the ‘Intergalactic Commerce Clause’ of the United States Constitution . . .”[6]  Had I been a Commissioner at the time the final Guidance was issued, I likely would have voted against it.

But the question before us today is not whether the Guidance was the right thing to do at the time, but what is the right thing to do now.  As I have noted, regulators in the world’s major financial centers have adopted comprehensive and comparable regulatory regimes governing the conduct of swap dealers, for which the CFTC has permitted substituted compliance in many instances.  And market participants (both those that have registered and those that have had to determine whether they are required to register) have devoted a tremendous amount of human and financial resources to navigating the complicated contours of the Guidance.  Accordingly, in the absence of any evidence that the Guidance is seriously over- or under-inclusive, our role today should be to update and improve the Guidance as we codify it, and not to propose substantially different cross-border provisions that we might wish had been adopted back in 2013.

Section 2(i)

In that regard, let me say a few words about Section 2(i) of the Commodity Exchange Act (“CEA”).  Section 2(i) limits the international reach of CFTC swap regulations by affirmatively stating that they “shall not apply to activities outside the United States unless those activities . . . have a direct and significant connection with activities in, or effect on, commerce of the United States.”^[7]  A common sense reading of this section, aptly titled “Applicability” in the CEA, is that there is a limited extraterritorial reach to the Dodd-Frank swap requirements, and to stretch them beyond the stated statutory criteria impermissibly infringes upon the rule sets of other nations.

That is, the plainly stated congressional intent is to start with U.S. law not applying beyond our borders, and then continue to the limited conditions where extraterritoriality would be deemed appropriate.  The law does not say that CFTC rules govern derivatives market activities around the world if there is any linkage or tie to the United States and should not be interpreted and abused as such.

The proposed rulemaking before us today, because it essentially codifies the Guidance, also reiterates the interpretation of Section 2(i) that was included in the Guidance.  And because I support the proposal for the reasons I have stated, I accept that interpretation in this limited context.  To codify the Guidance while revising the foundation on which it was based would only generate confusion – as opposed to the clarity that, as I have indicated, I hope this rulemaking will bring to one aspect of our cross-border work.

But as we proceed with other aspects of that cross-border work – in areas such as clearing, reporting, and trade execution – I will not view the Section 2(i) interpretation we propose today as a precedent that mandates a particular result.[8]  I agree that Section 2(i) does not require an analysis of every swap transaction to evaluate whether it meets the “direct and significant” test to warrant extraterritorial treatment.  But rigorous analysis of the Section 2(i) test for each rule we adopt is necessary to ensure that the law is followed both to the letter and in spirit.

Clear, Sensible, and Workable Rules

I would now like to briefly highlight two areas in which the proposed rules are more clear, sensible, and workable than the provisions in the Guidance:  1) first, the definition of a “U.S. person;” and 2) second, the concept of a significant risk subsidiary.

Definition of a “U.S. Person”

One aspect of the definition of a “U.S. person” in the Guidance that we are codifying today includes legal entities that are organized or incorporated, or have their principal place of business, in the United States.  That is appropriate.  But the Guidance also included a separate, ill-defined, group of legal entities majority-owned by U.S. persons in which such persons bear “unlimited responsibility for the obligations and liabilities of the legal entity.”

This additional category of legal entities does not appear to have come from any other U.S. statute or regulatory regime, and it is not at all clear what type of legal entities it encompasses.  Ironically, the only two examples in the Guidance of entities that would fall within this prong of the “U.S. person” definition are certain types of entities formed under the laws of the United Kingdom and various Canadian provinces.[9]  The proposed rules provide needed clarity and certainty to the U.S. person definition by omitting this prong of the Guidance definition.

While some aspects of the U.S. person definition in the Guidance were unclear, as just discussed, others were unworkable.  The Guidance stated that the Commission “will interpret the term ‘U.S. person’ generally to include, but not be limited to” the categories of individuals and entities that it identified.  When the entire construct for determining whether an entity must register as a swap dealer hinges on knowing whether the entity or its counterparty is a U.S. person or bears some specified relationship to a U.S. person, the definition of a U.S. person simply cannot be left open-ended.

In order to provide certainty and a workable cross-border regime for the registration and regulation of swap dealers, the proposed rules omit this language of non-exclusivity that was included in the Guidance.  If the Commission subsequently determines that the categories of individuals and entities identified in the proposed U.S. person definition somehow miss a group that should be included, it can amend the definition accordingly.

Significant Risk Subsidiaries

Before getting to the concept of a significant risk subsidiary (“SRS”) in the proposed rules, let me first mention its predecessor from the Guidance:  the “affiliate conduit.”  The Guidance did not actually define an affiliate conduit; rather, it merely presented “certain factors [that] are relevant to considering whether a non-U.S. person is an ‘affiliate conduit.’”

In most cases, the critical factor for determining affiliate conduit status tends to be the last one, which asks whether “the non-U.S. person in the regular course of business, engages in swaps with non-U.S. third-party(ies) for the purpose of hedging or mitigating risks faced by, or to take positions on behalf of, its U.S. affiliate(s), and enters into offsetting swaps or other arrangements with its U.S. affiliate(s) in order to transfer the risks and benefits of such swaps with third-party(ies) to its U.S. affiliates.”  One can only imagine the amount of money that companies have diverted from their business operations to pay lawyers for advice on parsing the multiple facets of that description.

The failure of the Guidance to clearly articulate, let alone define, an affiliate conduit was a signal that this simply was not a sensible approach.  But to be fair, the affiliate conduit concept was a legitimate effort to provide for a situation in which an entity is not a U.S. person and is not guaranteed by a U.S. person, yet presents a significant connection to U.S. commerce and risk to the U.S. financial system.

The proposed rules mercifully abandon affiliate conduits, but propose to achieve their purpose by introducing the concept of an SRS instead.  As the name suggests, a significant risk subsidiary is a significant subsidiary of a U.S. person that can impact its ultimate U.S. parent entity and U.S. commerce, and thereby raises the concerns intended to be addressed by the Dodd-Frank swap requirements.  But as opposed to the vague and ambiguous description of an affiliate conduit, the metrics for determining whether a non-U.S. entity is an SRS are objective, and they are observable or quantifiable.  I welcome comments from the public about whether we have gotten these metrics right.  But proposing rules that focus on the pertinent issue of risk to the U.S. financial system, and that define an SRS through objective and measurable criteria, is a sensible approach.

* * * * * * * *

In sum, I support codifying our prior cross-border Guidance into enforceable rules, and I believe the proposed rules before us today are clear, sensible, and workable.  They improve upon the Guidance based on our experience in administering the Dodd-Frank swap regulatory regime over the past several years, and they appropriately recognize the current state of global regulation of globally interconnected derivatives markets.

I therefore support the proposed cross-border rulemaking.  I want to thank the staff of the Division of Swap Dealer and Intermediary Oversight, the General Counsel’s Office, and the Chief Economist’s Office for their efforts in preparing this rulemaking.  I also appreciate the quality briefings that we have received, and the time spent answering questions and addressing comments from my team.