The Commodity Futures Trading Commission recently approved cross-border swap margin rules, signaling it is returning to the traditional approach to develop regulations that carries the force of law, even if it reneged on its commitment to do so in conjunction with other regulatory jurisdictions.
The rule was finalized May 24, half a year after the prudential banking regulators finalized similar rules grafted into their core rules on margining uncleared derivatives.
The CFTC’s cross border rule applies to entities that are not regulated by the prudential regulators and are engaging in uncleared derivative transactions. Thus it’s unlikely to affect most corporates, which typically use bank counterparties. However, energy companies and other organizations dealing heavily in commodities, such as farmer co-ops that help farmers hedge crop and livestock risks, submitted numerous letters during the comment period.
For derivative end users in general, however, the regulation’s approval may send a positive signal in term of the regulatory process following the 2008 financial crisis, when regulators were changed with the daunting task of implementing a market framework for cleared derivatives as well as requirements for the uncleared variety.
Since then, the regulators and particularly the CFTC have been criticized for issuing guidance in lieu of pursuing the official regulations, in which there is input from market participants during the comment period and the resulting rules have the force of law. Guidelines, instead, can be charged without warning and provide significant uncertainty that market participants find problematic in their planning process.
“So what we’re seeing here is lessons learned by the CFTC, to make sure they are not only focused on the substance of the rule but also implementing it in a way that withstands scrutiny,” said Luke Zubrod, director of risk and regulatory advisory at Chatham Financial, a Kennett Square, PA-based firm specializing in advisory and technology services for the debt and derivative markets.
Mr. Zubrod said a key issue resolved by the rule is the circumstances in which the CFTC’s margin rules apply. Derivative dealers tend to configure themselves in a variety of ways, including using a central booking model where trades globally are transacted through a single entity, or creating a separate subsidiary that may or may not be guaranteed by the parent.
“The rule has to answer the question: To which of these circumstances does US law apply,” Mr. Zubrod said, adding that another important element was creating the definition for a “US person,” which for cross-border margin is somewhat different than the CFTC’s US person definition for other rules.
A key issue addressed by the rule was US swap dealers with foreign subsidiaries, which in the past may have been guaranteed by their parent companies. Various Dodd-Frank Act requirements, however, prompted some dealers to “de-guarantee” those subsidiaries, so they would fall under only the non-US regulatory regime.
“This set of rules brings them back under US law if the foreign subsidiary consolidates to the US parent,” Mr. Zubrod said. “The reason is that the CFTC judged that the US parent may not have the legal obligation to rescue a failing foreign subsidiary but may feel a reputational obligation, so de-guarantying the subsidiary was deemed insufficient to ensure the risk doesn’t come back to US shores.”
Another important element is substituted compliance, which the CFTC’s regulation permits when specific rules under the US and foreign regulatory regimes are determined to be comparable, and the US rule need not apply. Those determinations must be made on a rule-by-rule basis, resulting in companies at times being subject to both regulatory regimes and at other times only one.
Mr. Zubrod points out, however, that US regulators are ahead of counterparts in Europe and Asia in terms of implementing most derivative rules, thus requiring companies to develop compliance programs for each of the regulatory regimes they operate in.
In fact, the CFTC’s decision to approve the cross border rule ahead of other regulatory regimes prompted CFTC Commissioner J. Christopher Giancarlo’s dissent. He noted that in September 2009, the G-20 countries agreed to launch a framework for strong and sustainable growth, and that agreement included a commitment at the international level to raise standards together to ensure a level playing field that avoids fragmentation of markets, protectionism and regulatory arbitrage.
“Today, instead of recognizing and building upon the strong foundation for mutual recognition of foreign regulatory regimes created by the G20 commitments and the BCBSIOSCO framework, as well as the CFTC’s own history of using a principles-based, holistic approach to comparability determinations, the Commission is adopting a set of preconditions to institute compliance that is overly complex, unduly narrow and operationally impractical,” Mr. Giancarlo said.