CFTC Proposes New Registration and Conduct Rules for Cross-Border Swaps
The Commodity Futures Trading Commission (CFTC) recently proposed new regulations that will significantly affect international swap transactions.1 At present, international swap market participants look to the CFTC’s 2013 Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations (Cross-Border Guidance or Guidance)2 in order to determine whether they must register with the CFTC as Swap Dealers or Major Swap Participants (MSPs), and whether and how the CFTC’s business conduct standards apply to their businesses. The proposed new regulations would formally codify certain provisions of the Guidance while refining and superseding some others.
The CFTC has requested comments on the proposal by December 19. The CFTC intends to address other aspects of the Cross-Border Guidance in future rulemakings.
Determining Who Is A “US Person”
Under the Guidance, the application of CFTC rules to international swaps hinges on whether a counterparty is a “US Person.” The CFTC now proposes to adopt a formal regulation that would define a “US Person.” Under the Proposed Rules, a “US Person” would be defined as:
(i) Any natural person who is a resident of the US;
(ii) Any estate of a decedent who was a resident of the US at the time of death;
(iii) Any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any similar form of entity (legal entity), that is organized or incorporated under US law, or that has its principal place of business in the US, including any branch of the legal entity;
(iv) Any pension plan for the employees, officers or principals of a legal entity described above, unless the pension plan is primarily for foreign employees of the entity;
(v) Any trust governed by the laws of a state or other jurisdiction in the US, if a court within the US is able to exercise primary supervision over the trust’s administration;
(vi) Any legal entity (other than an LLC, LLP or similar entity where all of the owners have limited liability) that is owned by one or more persons described in paragraphs (i) through (v) who bear(s) unlimited responsibility for the obligations and liabilities of the legal entity, including any branch of the legal entity; and
(vii) Any individual account or joint account (discretionary or not) where the beneficial owner (or one of the beneficial owners in the case of a joint account) is a person described in paragraphs (i) through (vi).
Any other type of person would be a “Non-US Person.” The definition of a US Person mirrors that provided in the CFTC’s cross-border margin rules.3 It is also consistent with the definition provided in the Cross-Border Guidance but differs in some important respects. In particular:
- The proposed definition does not include a catchall provision (i.e., the definition does not say that it “includes but is not limited to …”). Thus, the definition of a “US Person” will be limited to the persons specified in the regulation.
- The proposed definition does not include commodity pools, investment funds, or other collective investment vehicles that are majority-owned by one or more US Persons, due to the difficulties of identifying and tracking a fund’s beneficial ownership.
- The proposed definition includes legal entities where one or more US Person owner(s) bear unlimited responsibility for the obligations and liabilities of the legal entity. The Guidance provides that a “US person” includes a legal entity “directly or indirectly majority-owned” by one or more US person(s) that bear such unlimited responsibility. The new definition removes the majority ownership component.
- The proposed definition does not include the concept of “conduit affiliates” (in brief, non-US entities that may transfer risk to US affiliates through back-to-back swaps) and the extent to which their swaps would count toward dealing threshold levels.
- The proposed definition, in paragraphs (iii) and (vi), refers to branches of a legal entity. This is intended to make clear that that the definition includes both foreign and US branches of an entity, and not to introduce any additional criteria for determining an entity’s US person status as currently provided in the Guidance.
Foreign Consolidated Subsidiaries
The proposed rules would also include a new definition to be used in identifying certain non-US persons whose swap activities implicate US regulatory interests. Specifically, they would define a “Foreign Consolidated Subsidiary” as a non-US person that is consolidated for accounting purposes (under US Generally Accepted Accounting Principles) with an ultimate parent entity that is a US person.
In November 2013, CFTC staff issued an Advisory expressing the staff’s view that a registered non-US swap dealer that regularly uses personnel or agents located in the United States to arrange, negotiate, or execute a swap with a Non-US Person (ANE Transactions) would generally be required to comply with certain CFTC regulations that were denoted as “Transaction-Level Requirements,” in the Guidance.4 The 2013 Advisory was criticized by market participants, and is currently the subject of extended No-Action Relief.5 However, the CFTC is now proposing to formally adopt it in rule text.
For these purposes, the CFTC considers the terms “arranging” and “negotiating” to refer to market-facing activity. Such back-office activities as processing, preparation of underlying documentation, provision of research to sales and trading personnel outside the US, and ministerial or clerical tasks would not be deemed “arranging” or “negotiating” a swap. “Execution” refers to the market-facing act of becoming legally bound to the swap. In determining whether a swap has been arranged, negotiated or executed by personnel in the US, the CFTC would look to the activities of persons working in a US location, whether working directly for the dealing entity itself, or for a third party acting for or on behalf of the dealing entity.
Swap Dealer Registration Threshold
Under CFTC regulations, a firm is not deemed a “swap dealer” unless the amount of its swap dealing activities during the preceding 12 months exceed a specific de minimis threshold.6 A firm must aggregate and count the notional value of the swap dealing activities of all of its affiliates under common control toward the threshold. The CFTC now proposes to establish rules specifying how threshold levels are to be calculated in the context of cross-border swaps. Under the proposed rules:
- A US Person would count all of its swap dealing transactions (including those by any non-US branch).
- A Non-US Person that is not an FCS would count all swap dealing transactions in which it is a US-Guaranteed Entity (i.e., its obligations under the swap are guaranteed by a US Person).
- An FCS would count all of its swap dealing transactions.
- Any other type of Non-US Person would count its dealing transactions with US Persons (including their non-US branches), US-Guaranteed Entities, and FCSs (except for any executed anonymously on a regulated exchange and subject to central clearing).
- Such Non-US Persons could also exclude swaps with other Non-US Persons that are arranged, negotiated or executed by personnel located in the US.
As noted above, the proposal does not include the concept of “conduit affiliates,” or require their swaps to be counted toward the dealing threshold. This would greatly simplify compliance requirements. However, as noted below, the CFTC has asked whether it should incorporate standards for conduit affiliates in any final rules.
Major Swap Participant Threshold
Under CFTC regulations, a firm is not deemed to be an MSP unless the amount of its swap positions exceeds one of several specified thresholds that measure the entity’s outward swap exposure levels.7 The CFTC now proposes to supersede the Guidance with rules to specify how the MSP thresholds should be calculated in the cross-border context. Under the proposed rules, in making its MSP threshold calculations:
- A US Person would count all of its swap positions.
- A Non-US Person (other than an FCS) would include all swap positions with respect to which it is a US Guaranteed entity.
- An FCS would include all of its swap positions.
- Any other Non-US Person would include all of its swap positions with counterparties that are US persons, US Guaranteed Entities, and FCSs, unless the swap is executed anonymously on a regulated exchange and centrally cleared. It would not include positions with other Non-US counterparties, even if arranged, negotiated or executed by personnel located in the United States.
- All swap positions that are subject to recourse would be attributed to a guarantor (whether a US or a non-US person) unless the guarantor, the guaranteed entity, and its counterparty are Other Non-US Persons.
Business Conduct Standards
Swap Dealers and MSPs are subject to CFTC rules that establish external business conduct standards. These include requirements to conduct due diligence on counterparties, to disclose material information to counterparties, to recommend suitable transactions, and to provide a daily mid-market mark for uncleared swaps.8 The CFTC now proposes to adopt new rules that will specify how these standards will apply in the cross-border context, including in cases where a swap is arranged, negotiated or executed in the US. Specifically, the CFTC proposes to require all Swap Dealers and MSPs to abide by the external business conduct standards in any swap, regardless of the status of the counterparty as a US person, other than with respect to transactions conducted through foreign branches of US Swap Dealers and MSPs. Substituted compliance with local, non-US standards would not be acceptable.
Non-US branches of US Swap Dealers and MSPs, as well as non-US Swap Dealers and MSPs (including FCSs and US Guaranteed Entities) would have to comply with the external business conduct standards, without substituted compliance, to the extent that a counterparty is a US person (other than a foreign branch of a US SD/MSP). However, non-US Swap Dealers and MSPs, and foreign branches of US Swap Dealers and MSPs transacting with counterparties that are foreign branches of US Swap Dealers and MSPs or non-US persons (including FCSs and US Guaranteed Entities), would not be required to comply with the external business conduct rules except that foreign branches of US Swap Dealers and non-US Swap Dealers that use personnel located in the US to arrange, negotiate, or execute such transactions would have to comply with CFTC Rules 23.410 (Prohibition on Fraud, Manipulation, and other Abusive Practices) and 23.433 (Fair Dealing).9
Three years after adopting the Cross-Border Guidance, the CFTC is now beginning the process of codifying its provisions. Market participants should consider engaging with the CFTC during the Proposal’s comment period in order to provide important data and insights to policymakers. In this regard, the Commission has questioned how and whether non-US “conduit” entities should have their swaps counted toward the dealer threshold. One of the Commissioners expressed the view that it should do so. Commissioners also expressed differing viewpoints as to the effects of codifying the 2013 Advisory on ANE Transactions.Market participants should also prepare to engage with the CFTC on other aspects of the Cross-Border Guidance which are expected to be codified in the future, such as the provisions that permit firms to substitute compliance with local, non-US standards in place of compliance with US rules. By reviewing the impact of the Guidance on their current operations, firms should be able to provide useful data and viewpoints to the CFTC, and contribute to the formation of well-tailored regulations.
Staff Advisory No. 13–69, Applicability of Transaction-Level Requirements to Activity in the United States (Nov. 14, 2013) (“2013 Advisory”). The “Transaction-Level Requirements” include (i) Required clearing and swap processing; (ii) margining (and segregation) for uncleared swaps; (iii) mandatory trade execution; (iv) swap trading relationship documentation; (v) portfolio reconciliation and compression; (vi) real-time public reporting; (vii) trade confirmation; (viii) daily trading records; and (ix) external business conduct standards).
CFTC Rule 1.3(ggg)(4); 17 CFR 1.3(ggg). In brief terms, the threshold level is currently set at $8 billion in gross notional swap dealing activity. Without further CFTC action, the threshold level will fall to $3 billion in gross notional swap dealing activity at the end of 2018.