The Securities and Exchange Commission (SEC) proposed cross-border regulatory jurisdiction for security-based swaps May 1 that would ease the compliance burden for banks and their corporate customers but could increase counter-party risk.
The proposal, which follows a more aggressive proposal by the Commodity Futures Trading Commission (CFTC), would exempt foreign subsidiaries and branches of US parent companies from US swap regulations and allow them to follow local regulations if those rules are deemed equivalent. The CFTC’s proposal, instead, would apply US rules to any transaction in which there is either a US swap dealer or US end user.
The CFTC proposal would allow foreign rules to apply only if each individual rule were comparable to US rules, said Luke Zubrod, a director at Chatham Financial, and that has raised concerns about duplicative and conflicting rules.
“By contrast, the SEC’s proposal takes a strong step in the direction of judging comparability at the regime level,” Mr. Zubrod said, adding, “So rather than needing to assess whether a complex blend of US and foreign rules apply to a given transaction, the end user can substantially be subject to a single regulatory regime ….”
Mr. Zubrod said the SEC’s proposal does not appear to wholly embrace substituting compliance at the regime level, but it moves in that direction “by boiling the comparability analysis down to four broad categories of rules and by judging comparability based on the outcomes of the rules rather than the rules themselves.”
The CFTC’s proposal was made last July, and the agency issued a final exemptive relief order in December to provide temporary guidance that is effective until July 12. The temporary order narrowed the range of entities required to comply with US swap rules but still included US banks and corporations as well as their foreign branches and agencies. Excluded from the order were “entities for which the owners are responsible for the entity’s liabilities and at least one owner is a US person” and entities such as commodity pools and collective trusts, according to client note provided by Skadden, Arps, Slate, Meagher & Flom.
“The CFTC has signaled an intent to expand the [scope] when it adopts the final cross-border guidance,” the law firm said.
Jiro Okochi, CEO and co-founder of Reval, which provides treasury and risk management software, noted that most nonfinancial corporates are not big users of security-based swaps, including credit default swaps and equity derivatives, which combined constitute a small percentage of the swap market. He said a key element of the proposal is “substituted compliance,” in which regulators are willing to take other countries’ derivatives regulation as a proxy for their own as long as it is similar.
“This should mean lower global compliance costs for swap dealers,” Mr. Okochi said, adding whether that translates into benefits for derivative end users remains to be seen.
Much ground must still be covered before corporates and their service providers will have a clear understanding of which regulations they must comply with. Regulators outside the US are continuing to seek common ground on that question, and US regulators’ proposals could change significantly before they’re finalized.
“It will be interesting to see to what extent and in what ways the SEC proposal will influence the CFTC when it finalizes its own rule,” Mr. Zubrod said.
CFTC chairman Gary Gensler has clearly stated he believes US swap laws should apply abroad if there’s a possibility foreign swap activity could bring risk to the US, and the agency’s proposal reflects that concern. The SEC’s approach appears to afford greater respect to foreign counterpart’s regulatory purview. The 2008 financial crisis was fueled in part the collapse of cross-border swaps, especially credit default swaps, that imperiled major derivative counterparties such as Lehman Brothers and exposed corporates to losses.
“The SEC’s proposed cross-border rule is a major disappointment and puts the American people at grave risk from Wall Street’s overseas activities,” said Dennis Kelleher, CEO of Better Markets, a Washington, D.C., advocacy group, in a statement.
Kelleher says that exempting foreign subsidiaries and branches of US parent companies, even those guaranteed by the parent, will almost certainly result in losses from overseas operations to come back to the US.
“‘Substituted compliance’ should only be allowed if the foreign regulation is equivalent in fact, form, substance, enforcement and over time, and that equivalence must be determined on a regulation-by-regulation basis,” Mr. Kelleher said.