Harvard Business Law Review (HBLR)

The Harvard Business Law Review (HBLR) aims to be the premier journal covering the laws of business organization and capital markets. HBLR will publish articles from professors, practitioners, and policymakers on corporate law and governance, securities and capital markets law, financial regulation and financial institutions, law and finance, financial distress and bankruptcy, and related subjects.

CFTC

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Bitcoin and Virtual Currencies: Welcome to Your Regulator

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Matthew Kluchenek†

I.               Introduction

Among all the U.S. regulators interested in regulating Bitcoin and virtual currencies, the Commodity Futures Trading Commission (CFTC) is determined to be at the forefront. Since the announcement by CFTC Chairman Timothy Massad in late 2014 that Bitcoin derivatives should fall within the scope of the CFTC’s jurisdiction,[1] the CFTC has been aggressive in addressing not only wrongful conduct involving Bitcoin derivatives, but also wrongful conduct involving certain spot Bitcoin transactions.

The CFTC’s actions are a clarion call for market participants to understand the broad breadth of the CFTC’s jurisdiction, and to take notice of the requirements that may apply both to derivatives and to certain physical transactions involving Bitcoin and other virtual currencies.

II.              Scope of CFTC’s Jurisdiction

The U.S. Commodity Exchange Act (CEA),[2] as amended by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act),[3] regulates transactions in “commodity interests.”[4] The CFTC, an independent federal agency, is charged with administering the CEA and has exclusive jurisdiction over transactions involving commodity interests.[5] Throughout the history of the CFTC, and particularly with respect to the Dodd-Frank Act, Congress has ceded broad power to the CFTC to interpret and promulgate rules regarding commodity interest products, transactions, and market participants.[6]

As a general matter, the CFTC’s jurisdiction flows from the definition of a “commodity” under the CEA.[7] At bottom, if a “commodity” is not involved in a contract, agreement, or transaction, the CFTC lacks the statutory basis to regulate the contract, agreement, or transaction.[8] The definition of a “commodity,” however, is exceedingly broad under the CEA. The definition delineates a laundry list of agricultural products, but also sweeps in “all services, rights, and interests (except motion picture box office receipts, or any index, measure, value or data related to such receipts) in which contracts for future delivery are presently or in the future dealt in.”[9] As a result, almost anything except onions[10] and movie box office receipts[11] can constitute a “commodity” under the definition, including bottles of wine, baseball cards, reference rates, indices, mathematical permutations, services, intangibles, and contingencies that would not seemingly fall within the traditional view of a commodity.[12]

If, however, a commodity is involved, then the CFTC may only assert jurisdiction if a “commodity interest” is based on the commodity.[13][ A “commodity interest” refers to the types of instruments that are subject to the CFTC’s regulation, which are: (i) futures contracts, (ii) options on futures contracts, (iii) swaps, (iv) leveraged retail foreign exchange contracts, (v) leveraged retail commodity transactions, and (vi) certain other leveraged products.[14] Importantly, the CFTC’s jurisdiction is thus not—as many assume—limited to “derivatives,” but rather also extends to certain spot, or physical market, transactions.

As a result, in seeking to assert jurisdiction over a contract, agreement, or transaction involving a commodity, the CFTC’s jurisdictional hook is premised upon whether a commodity interest is involved. If so, and assuming that no exclusions or exemptions apply, the CFTC has a basis to assert regulatory authority.

III.             Bitcoin as a “Commodity” under the Commodity Exchange Act

In the context of Bitcoin (and other virtual currencies), the threshold issue is whether Bitcoin is a “commodity.” If Bitcoin is a commodity, then the CFTC may regulate commodity interests based on the commodity. If Bitcoin is not a commodity, then the CFTC lacks the authority to so regulate.

In December 2014, CFTC Chairman Timothy Massad telegraphed the CFTC’s intent to regulate Bitcoin derivatives, stating that “derivatives contracts based on a virtual currency represent one area within [the Commission’s] responsibilit[ies].”[15] Little elucidation was given. However, in September 2015, the CFTC took a significant step in asserting jurisdiction when it issued an order determining that “Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.”[16]

The CFTC’s determination did not arise out of a rulemaking or an interpretation, but rather via an enforcement action against an online Bitcoin trading platform called “Derivabit,” which was owned by Coinflip, Inc.[17] Coinflip operated the trading platform, which was designed for risk management purposes, in an effort to bring together buyers and sellers of Bitcoin option contracts.[18] Coinflip was not registered with the CFTC.

In making the pronouncement that Bitcoin is a commodity, the CFTC effectively determined that Bitcoin is not a currency. According to the CFTC, “Bitcoin and other virtual currencies are distinct from ‘real’ currencies, which are the coin and paper money of the United States or another country that are designated as legal tender, circulate, and are customarily used and accepted as a medium of exchange in the country of issuance.”[19]

Importantly, the CFTC’s determination is not limited to Bitcoin, but extends to “other virtual currencies,” which the CFTC broadly defines as “a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but does not have legal tender status in any jurisdiction.”[20] Thus, the definition of “virtual currency” could also engulf Litecoin and Dogecoin, among others yet to be created.

Based on its determination that Bitcoin is a commodity, the CFTC applied the CEA’s provisions to the Derivabit trading platform, finding that Coinflip unlawfully offered commodity options by operating a facility for the trading of such options without being registered as a designated contract market (that is, a futures exchange) or a swap execution facility (SEF).[21] Importantly, because Coinflip offered commodity options, which are derivatives, the CFTC had an ostensibly clear basis to assert jurisdiction once the agency determined that Bitcoin is a commodity.[22]

Just one week after the Coinflip settlement, and armed with its determination that Bitcoin is a commodity, the CFTC brought its second Bitcoin-related enforcement action, this time against TeraExchange, LLC (Tera), an SEF.[23] In the action, the CFTC alleged that Tera failed to enforce its prohibition on wash trades by facilitating the prearrangement of a single Bitcoin swap transaction.[24]

As with the Coinflip matter, the CFTC’s enforcement action against Tera involved a derivative—that is, here, swaps based on Bitcoin. The presence of the swap, coupled with Tera’s provisional registration with the CFTC as an SEF, provided the CFTC with an unambiguous pathway to assert jurisdiction. Soon thereafter, however, the CFTC’s path would take a different, and more aggressive, turn.

IV.             The CFTC’s Enforcement Action Against Bitfinex

In June 2016, the CFTC filed charges against a Hong Kong-based company called Bitfinex, which operates an online platform for trading in cryptocurrencies, including Bitcoin.[25] Unlike Coinflip and Tera, however, Bitfinex did not list or permit the trading of derivatives, such as futures, options, or swaps.[26] Rather, Bitfinex merely facilitated spot transactions in cryptocurrencies.[27] Generally, a “spot” transaction is the everyday transaction of buying and selling a good, much like one does when purchasing an item on eBay. Payment is made for the item, and the item is promptly delivered to the buyer. The CFTC is generally not authorized to regulate spot transactions.[28] However, by adding a couple of characteristics to an otherwise vanilla spot transaction, the transaction can be transformed into a commodity interest transaction subject to the full panoply of provisions under the CEA.

The basis for the CFTC’s authority to regulate certain spot transactions derives from the jurisdictional hook that the agency has used so successfully to prosecute retail precious metals transactions[29]—the so-called “retail commodity transaction” provision under the CEA.[30] The retail commodity transaction provision is a relatively short provision set forth in CEA section 2(c)(2)(D). It provides:

(D) Retail commodity transactions

(i) Applicability[.] Except as provided in clause (ii), this subparagraph shall apply to any agreement, contract, or transaction in any commodity that is—

(I) entered into with, or offered to (even if not entered into with), a person that is not an eligible contract participant or eligible commercial entity; and

(II) entered into, or offered (even if not entered into), on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.[31]

The elements of a retail commodity transaction are thus threefold—the agreement, contract, or transaction must:

(1)  involve a commodity;

(2)  be entered into with, or offered to, a person that is not an eligible contract participant (ECP);[32] and

(3)  be entered into, or offered, on a leveraged, margined or financed basis.[33]

All three elements must be present for there to be a retail commodity transaction. Any person that deals in commodities subject to the retail commodity transaction provision is required to be registered with the CFTC as a futures commission merchant (FCM).[34]

While a retail commodity transaction is a form of commodity interest, such a transaction is fundamentally different from a derivatives transaction, the latter of which derives its value from an underlying commodity and contains an element of futurity. Critically, where a derivative is not involved, market participants are often caught off-guard with respect to the broad scope of the CFTC’s jurisdiction.

Like so many requirements under the CEA, however, there are exceptions to the retail commodity transaction provision. One such exception involves the timely “actual delivery” of a commodity to the buyer.[35] If a seller offers to enter, or enters into, a commodity transaction with a non-ECP on a leveraged basis, the transaction will not fall under the retail commodity transaction provision if the seller actually delivers the commodity to the buyer within 28 days of the date that the contract is entered into.[36] The meaning of “actual delivery” has been the subject of extensive interpretation by the CFTC.[37]

In determining that Bitfinex violated the CEA, the CFTC’s order found that the transactions executed on the Bitfinex platform fell within the purview of the retail commodity transaction provision, and that no “actual delivery” occurred. According to the CFTC:

  • Bitcoin is a commodity;
  • Bitfinex did not limit its customers to ECPs, but rather sold Bitcoins to retail persons;
  • Bitfinex facilitated the financing of Bitcoin transactions;[38] and
  • Bitfinex did not actually deliver Bitcoins to the buyers.[39]

In addressing the most controversial aspect of the order—whether actual delivery of the Bitcoins occurred—the CFTC explained that Bitfinex held its customers’ Bitcoins in an omnibus private wallet that was controlled solely by Bitfinex, not the customers.[40] Through the use of a private key, only Bitfinex had access to the omnibus wallet.[41] Consequently, because Bitfinex solely controlled access to the wallet, the CFTC found that Bitfinex’s customers did not actually receive delivery of any Bitcoins.[42] The CFTC’s explanation seems to suggest that satisfying the requirement of “actual delivery” would require that virtual currencies be delivered to a deposit wallet for which the recipient controls the private key.[43] However, neither the CEA, the CFTC’s rules, nor the CFTC’s guidance on “actual delivery” discuss or contemplate the delivery requirements of virtual currencies.[44]

Nonetheless, based on the satisfaction of the elements of the retail commodity transaction provision, coupled with the absence of actual delivery, the CFTC found that Bitfinex violated the CEA’s retail commodity transaction provision by failing to register as an FCM.[45] The CFTC’s action against Bitfinex marks the agency’s initial foray into the regulation of Bitcoin via the retail commodity provision transaction. If the history involving the CFTC’s regulation of retail precious metals transactions is any guide, more enforcement actions should be expected.

V.              What’s Next?

In at least one respect, the CFTC should be given credit for taking the lead in seeking to regulate a novel product under its jurisdiction. With such an effort, however, comes responsibility. The CFTC should clearly articulate, through an interpretation rather than ad hoc enforcement actions, the manner in which the agency intends to apply the actual delivery exception to virtual currencies. Such an interpretation is necessary so as not to stymie innovation.

At the same time, the CFTC should strive to coordinate the regulation of virtual currencies with other federal agencies, some of which have shown an interest in regulating such products.[46] For example, if the Securities and Exchange Commission were to classify Bitcoin or another virtual currency as a “security,” market participants could be compelled to comply with two fundamentally different, and in some ways redundant, regulatory regimes. We have seen dual jurisdiction applied to certain other products—security futures and mixed swaps come to mind—and the outcomes have not been ideal. Here, as before, the CFTC should be aggressive in seeking to address regulatory harmonization.

Finally, for market participants, the CFTC has sounded the bell. In offering virtual currencies to customers, market participants must understand and be sensitive to the scope of the CFTC’s jurisdiction. If a swap or futures contract is involved—including a seemingly innocuous embedded option in which the customer has the right to cancel or offset a purchase—or a retail spot transaction involves any form of financing, margin or leverage, the CFTC has shown its willingness to take action—even in the absence of allegations of fraud or other wrongdoing.

 

† Partner, Global Head of Derivatives, Baker & McKenzie LLP.

[1] The Commodity Futures Trading Commission: Effective Enforcement and the Future of Derivatives Regulation Before the S. Comm. on Agric., Nutrition, and Forestry, 111th Cong. 55 (2014) (statement of Timothy Massad, Chairman of the Commodity Futures Trading Commission).

[2] Commodity Exchange Act of 1936, Pub. L. No. 74–675, 49 Stat. 1491 (codified as amended in scattered sections of 7 U.S.C.) (replacing the Grain Futures Act of 1922).

[3] See generally Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111–203, 124 Stat. 1376 (2010).

[4] See 17 C.F.R. § 1.3(yy) (2016).

[5] See Commodity Futures Commission Trading Act of 1974 § 101, 7 U.S.C. § 2(a)(1)(A) (2012). When Congress created the CFTC in 1974, it “confer[red] on the CFTC ‘exclusive jurisdiction’ over commodity futures and options thereon, which means that these instruments cannot be regulated by any other federal or state agency (except in certain limited circumstances where the CEA explicitly contemplates shared authority between the CFTC and another agency).” President’s Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act (1999). The purpose of the exclusive jurisdiction provision “was to separate the functions of the new CFTC from those of the SEC and other regulators.” Leist v. Simplot, 638 F.2d 283, 314 (2d Cir. 1980).

[6] See, e.g., Binyamin Appelbaum, On Finance Bill, Lobbying Shifts to Regulation, N.Y. Times (June 26, 2010), http://www.nytimes.com/2010/06/27/business/27regulate.html? (noting that the Dodd-Frank Act is “basically a 2,000-page missive to federal agencies, instructing regulators to address subjects ranging from derivatives trading to document retention” and observing that “it is notably short on specifics, giving regulators significant power to determine its impact—and giving partisans on both sides a second chance to influence the outcome”).

[7] See 7 U.S.C. § 1(a)(9) (2012).

[8] See id. at § 2(a)(1)(A).

[9] See id. at § 1(a)(9).

[10] In 1958, as a result of rife manipulations in the onion market, Congress enacted the Onion Futures Act to ban futures trading in onions. Id. at § 13-1; see also Bd. of Trade of Chi. v. SEC, 677 F.2d 1137, 1142 n.9 (7th Cir. 1982) (discussing the onion carve out from the CEA).

[11] As part of the Dodd-Frank Act, Congress banned—at the urging of associations representing the motion picture industry—the trading of derivatives on motion picture box office receipts. See 7 U.S.C. § 13-1 (2006), amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.L. No. 111-190, § 721(e)(10), 124 Stat. 1376, 1672 (2010); see also Daniel Frankel, 10 Key Moments in the Life of Movie Derivatives, THE WRAP (Aug. 13, 2010, 6:53 PM), http://www.thewrap.com/movies/article/10-key-moments-life-movie-derivatives-20122.

[12] See 7 U.S.C. § 1a(9).

[13] See 7 U.S.C. § 2(a)(1)(A).

[14] See 17 C.F.R. § 1.3(yy) (2016) (“Commodity interest . . . means (1) Any contract for the purchase or sale of a commodity for future delivery [a futures contract]; (2) Any contract, agreement or transaction subject to a Commission regulation under section 4c [commodity options] or 19 of the Act [leveraged contracts]; (3) Any contract, agreement or transaction subject to Commission jurisdiction under section 2(c)(2) of the Act [retail foreign exchange and commodity transactions]; and (4) Any swap as defined in the Act, by the Commission, or jointly by the Commission and the Securities and Exchange Commission [a swap as defined in CFTC Rule 1a(47)].”).

[15] The Commodity Futures Trading Commission: Effective Enforcement and the Future of Derivatives Regulation Before the S. Comm. on Agric., Nutrition, and Forestry, 111th Cong. 55 (2014) (statement of Timothy Massad, Chairman of the Commodity Futures Trading Commission).

[16] In re Coinflip, Inc., CTFC No. 15-29, 2015 WL 5535736, at *3 (Sept. 17, 2015).

[17] Id. at *2.

[18] Id.

[19] Id. at *n.2.

[20] Id.

[21] Id. at *3–4. A swap execution facility is a trading system or platform, other than a designated contract market, in which multiple participants have the opportunity to enter into swaps by accepting bids and offers made by multiple participants on the facility. See Commodity Exchange Act of 1936 § 1a(50), 7 U.S.C. § 1a(50) (2012).

[22] See id. at *5 (explaining that under the terms of settlement, the defendants agreed to cease and desist from future violations of the CEA and the CFTC’s rules, but no financial penalty was imposed).

[23] In re TeraExchange LLC, CFTC No. 15-33, 2015 WL 5658082 (Sept. 24, 2015).

[24] Like the Coinflip matter, the CFTC and the defendants agreed to a settlement involving a cease and desist order, but no financial penalty. Id. at *8–9.

[25] In re BFXNA Inc., CFTC No. 16-19, 2016 WL 3137612 (June 2, 2016).

[26] See id. at *2.

[27] See id. at *3.

[28] The CFTC staff has defined a spot transaction as one where immediate delivery of the product and immediate payment for the product are expected on or within a few days of the trade date. See CFTC No-Action Letter, CFTCLTR No. 98-73, 1998 WL 754623 (Oct. 8, 1998). The Supreme Court has defined a spot transaction as a purchase or sale agreement for a commodity that is intended to settle in the period that is ordinary for dealings in the relevant type of commodity. See Dunn v. CFTC, 519 U.S. 465, 472 (1997). As noted by the Sixth Circuit, “because the CEA was aimed at manipulation, speculation, and other abuses that could arise from the trading in futures contracts and options, as distinguished from the commodity itself, Congress never purported to regulate ‘spot’ transactions (transactions for the immediate sale and delivery of a commodity) or ‘cash forward’ transactions (in which the commodity is presently sold but its delivery is, by agreement, delayed or deferred).” CFTC v. Erskine, 512 F.3d 309, 321 (6th Cir. 2008). Spot transactions are, however, subject to the anti-manipulation provisions under the CEA and the CFTC’s rules to the extent that such attempted or actual manipulations affect prices in commodity interests. See, e.g., 7 U.S.C. §§ 9, 15 (2012); 17 C.F.R. § 180.1(a) (2016); see also CFTC v. Atlantic Bullion & Coin, Inc., C.A. No. 8:12-1503-JMC (D.S.C. 2010), http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfatlanticcomplaint060612.pdf.

[29] See, e.g., CFTC v. Hunter Wise Commodities, 21 F. Supp. 3d 1317 (S.D. Fl. 2014); CFTC v. Palm Beach Capital, No.14-cv-80636 (S.D. Fl. 2014), http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfpbeachorderdf073114.pdf.

[30] See 7 U.S.C. § 2(c)(2)(D).

[31] Id.

[32] An ECP is defined to include, among others, (i) an organization with total assets in excess of $10 million; (ii) a corporation that (a) has a net worth in excess of $1 million and (b) uses commodity interests in connection with its business or to hedge commercial risk; (iii) an individual who has amounts invested on a discretionary basis, the aggregate of which is in excess of $10 million; or (iv) an individual who has amounts invested on a discretionary basis, the aggregate of which is in excess of $5 million, where such individual is using the instrument in order to manage the risk associated with an asset owned or liability incurred, or reasonably likely to be owned or incurred, by the individual. 7 U.S.C. § 1a(18). An eligible commercial entity is defined in § 1a(17).

[33] The CFTC takes a broad view of the scope of this element. Essentially, if the purchaser of the commodity is not required to fully pay for the commodity upon purchase, then the CFTC will likely presume that leverage or financing is involved in the transaction. See Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426, 52,426 (Aug. 23, 2013) (to be codified in 17 C.F.R. pt.1) (“New CEA section 2(c)(2)(D) of the CEA broadly applies to any agreement, contract, or transaction in any commodity that is entered into with, or offered to (even if not entered into with), a non-eligible contract participant or non-eligible commercial entity on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.”) (emphasis added).

[34] See 7 U.S.C. § 6d.

[35] See Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426, 52,426 (Aug. 23, 2013) (to be codified in 17 C.F.R. pt.1).

[36] See id. at 52,427.

[37] See Retail Commodity Transactions Under Commodity Exchange Act, 76 Fed. Reg. 77,670 (Dec. 14, 2011) (to be codified in 15 C.F.R. pt. 922); Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426 (Aug. 23, 2013) (to be codified in 17 C.F.R. pt.1).

[38] The Bitfinex platform permitted maximum leverage of 3.33-to-1 (that is, a 30% initial margin requirement). See In re BFXNA Inc., CFTC No. 16-19, 2016 WL 3137612, at *2 (June 2, 2016).

[39] Id. at *5.

[40] Id.

[41] A “private key” is a secret number associated with a deposit wallet that allows Bitcoins in that wallet to be accessed and spent. The private keys, which are randomly assigned, are mathematically related to all Bitcoin addresses generated for the wallet. See Private Key, Bitcoin Wiki, https://en.bitcoin.it/wiki/Private_key (last visited Oct. 26, 2016).

[42] See In re BFXNA Inc., 2016 WL 3137612, at *5.

[43] See Letter from Steptoe & Johnson LLP to Commodity Futures Trading Comm’n (July 1, 2016) (on file with author).

[44] Cf. In re BFXNA Inc., 2016 WL 3137612. The Bitfinex order prompted a petition that requests the CFTC to clarify the “actual delivery” requirements in the context of virtual currencies. See Letter from Steptoe & Johnson LLP to Commodity Futures Trading Comm’n (July 1, 2016) (on file with author).

[45] Under the terms of the settlement, Bitfinex agreed to pay a civil money penalty of $75,000 and cease and desist from further violations of the subject CEA provisions. Id. at *6.

[46] See, e.g., Investor Alert: Bitcoin and Other Virtual Currency-Related Investments, U.S. Sec. & Exch. Comm’n (May 7, 2014), https://www.sec.gov/oiea/investor-alerts-bulletins/investoralertsia_bitcoin.html.

By

New Margin Requirements for Uncleared Swaps

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Craig Stein & Paul N. Watterson, Jr.*

One of the fundamental changes that the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”)[1] made in the financial markets has been to force most over-the-counter swap transactions onto exchanges and impose regulations on transactions that remain uncleared by a central counterparty.  At the same time, laws and regulations adopted by the European Commission and other nations have imposed similar, but by no means identical, requirements on swap markets outside the United States.  This article reviews one aspect of these changes in the over-the-counter swap markets:  the new margin requirements for uncleared swaps.  Because margin for uncleared swaps has to date been set by each dealer in negotiations with individual customers, the transition to margin requirements imposed by regulators is likely to be difficult.  There have also been predictions that the discrepancies between the margin requirements proposed by U.S. regulators and those proposed by regulators outside the U.S. will result in fragmentation of the uncleared swap markets.

I.          Background

The Dodd-Frank Act, enacted on July 21, 2010,[2] requires swap dealers, major swap participants, security-based swap dealers and major security-based swap participants (each, a “swap entity” and, collectively, “swap entities”) to register with the Commodity Futures Trading Commission (“CFTC”) or the Securities and Exchange Commission (“SEC”).[3]  The Dodd-Frank Act also requires the Office of the Comptroller of the Currency Treasury (“OCC”), the Board of Governors of the Federal Reserve System (“Board”), the Federal Deposit Insurance Corporation (“FDIC”), the Farm Credit Administration (“FCA”) and the Federal Housing Finance Agency (“FHFA”) (collectively, “the Prudential Regulators”) to adopt joint rules for swap entities under their respective jurisdictions imposing initial and variation margin requirements on all swaps not cleared by a central counterparty (“CCP”).[4]  The Dodd-Frank Act also requires the CFTC and the SEC separately to adopt rules imposing margin requirements for swap entities for which there is no Prudential Regulator.[5]

In April 2011, the CFTC proposed rules to implement the foregoing provisions of the Dodd-Frank Act,[6] and two weeks later the Prudential Regulators proposed substantially similar rules.[7] The SEC is not expected to propose similar rules for security-based swaps until next year.  Before these rules became effective, in July 2012, the Basel Committee on Banking Supervision (“BCBS”) and the board of the International Organization of Securities Commissions (“IOSCO”) proposed an international framework for margin requirements on uncleared swaps with the goal of creating an international standard for uncleared swaps.[8]  This international framework, finalized in September 2013[9], articulates eight key principles for uncleared swaps margin rules:[10]

  1. Appropriate margining practices should be in place with respect to all uncleared derivative transactions;
  2. Financial firms and systemically important non-financial entities (covered entities) that engage in non-centrally cleared derivatives must exchange initial and variation margins;
  3. The methodologies for calculating initial and variation margins should be consistent across covered entities and ensure that all counterparty risk exposures are covered with a high degree of confidence;
  4. To ensure that collateral will generate proceeds sufficient to protect against losses in the event of a counterparty default, collateral should be highly liquid and should, after accounting for an appropriate haircut, be able to hold its value in a time of financial stress;
  5. Initial margin should be exchanged on a gross basis and held in such a way as to ensure that: (a) the margin collected is immediately available to the collecting party in the event of the counterparty’s default; and (b) the collected margin is subject to arrangements that fully protect the posting party;
  6. Requirements for transactions between affiliates are left to the national supervisors;
  7. Requirements for margining uncleared swaps should be consistent and not duplicative across jurisdictions; and
  8. Margin requirements should be phased in over an appropriate period of time.

In September and October 2014, the CFTC[11] and the Prudential Regulators[12] re-proposed rules for margin requirements for uncleared swaps (the “CFTC Proposal” and the “PR Proposal,” respectively).  In reproposing the rules, the regulators clearly took into account the BCBS/IOSCO framework, but nonetheless there are important discrepancies between the proposed rules and the framework.

II.         Scope of Coverage

The BCBS/IOSCO framework applies to all uncleared OTC derivatives.[13]  The PR Proposal imposes initial and variation margin requirements on prudentially regulated swap entities such as registered swap dealers that are U.S. or foreign banks (“PR Covered Swap Entities”) entering into uncleared swaps and security-based swaps with the types of counterparties discussed below.[14] PR Covered Swap Entities would be required to post and collect initial and variation margin when facing these counterparties even if the counterparties themselves are not subject to regulation under the Dodd-Frank Act.[15]  The Prudential Regulators are proposing to adopt what they refer to as a risk-based approach.[16]

The CFTC Proposal imposes initial and variation margin requirements on swap dealers and major swap participants that are not regulated by a Prudential Regulator, such as registered swap dealers that are not U.S. or foreign banks (“CFTC Covered Swap Entities”).[17]  The CFTC Proposal generally applies only to uncleared swaps.  However, deliverable foreign exchange forwards and foreign exchange swaps are not considered swaps under the Commodity Exchange Act as amended by the Dodd-Frank Act for purposes of uncleared swap margin requirements, as determined by the U.S. Department of Treasury in 2012.[18] As a result, PR Covered Swap Entities may be required to pay variation margin for foreign exchange forwards and foreign exchange swaps while CFTC Covered Swap Entities will not be required to pay it.[19]

III.        Counterparties

Both the PR Proposal and the CFTC Proposal distinguish among four different types of swap counterparties:

  1. Counterparties that are themselves PR Covered Swap Entities;
  2. Counterparties that are financial end users with a material swaps exposure;
  3. Counterparties that are financial end users without a material swaps exposure; and
  4. All other counterparties.[20]

The PR Proposal provides a list of entities that would qualify as financial end users[21] as well as a list of entities excluded from that definition.[22]  It is not consistent with the definition of a “financial entity” in Section 2(h) of the Commodity Exchange Act[23], which on its own is likely to cause confusion in the markets. In addition, the enactment of the Business Risk Mitigation and Price Stabilization Act of 2015 (the “RMPS Act”) on January 13, 2015 appears to have heightened the significance of such confusion.  By way of background, the RMPS Act amends sections 731 and 764 of the Dodd-Frank Act to provide that rules with respect to initial and variation margin requirements adopted by the CFTC, the SEC and the Prudential Regulators will not be applicable to entities that qualify for the end-user exception to the mandatory clearing requirement set forth in section 2(h)(7)(A) of the Commodity Exchange Act and corresponding section 3C(g)(1) of the Securities Exchange Act.  This statutory exemption  is available to any entity that: (i) is not a financial entity; (ii) uses swaps to hedge or mitigate commercial risk; and (iii) notifies the CFTC regarding the manner in which it generally meets its financial obligations in respect of uncleared swaps.  The “is not a financial entity” condition is with reference to the definition of “financial entity” set forth in section 2(h)(7)(C) of the CEA.  However, in an attempt to avoid difficulties experienced in determining which market participants should qualify as “financial entities” pursuant to the statutory language, the CFTC and the Prudential Regulators sought in the PR Proposal and the CFTC Proposal to provide clarity about whether particular entities would be subject to the margin rules by including in the reproposed rules the alternative concept of “financial end user.”  But at the time of this writing, considering that the RMPS Act specifically refers to “financial entity” instead of “financial end user”, it is unclear whether the CFTC and the Prudential Regulators will continue to rely in the final rules on the current definition of “financial end user” or will instead conform to the statutory definition of “financial entity”.

Under the PR Proposal, financial end users include banks; credit unions; broker-dealers, investment advisers, CPOs, CTAs or FCMs; investment funds, including a private fund under Section 202(a) of the Investment Advisers Act; investment vehicles operating in reliance on Section 3(c)(5)(C) or Rule 3a-7 of the 1940 Act; and insurance companies.[24]  “Financial end user” is defined in the CFTC Proposal in substantially the same way as in the PR Proposal[25], but there are slight differences.

In the PR Proposal and the CFTC Proposal, “material swaps exposure” is defined to mean that a counterparty has a consolidated average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, foreign exchange forwards and foreign exchange swaps with all other counterparties for June through August of the previous year that exceeds $3 billion.[26]

The definition of financial end users is so broad that it will require exceptions to be made, either in the final rules or in no-action letters, in order to avoid unintended disruptions of markets.  For example, it includes securitization vehicles[27], and these entities do not currently post margin on uncleared swaps and in most cases are prohibited by their transaction documents and rating agency criteria from doing so.  Structured finance transactions where the swap counterparty is either secured by a senior claim on pledged collateral held by a special purpose vehicle or is otherwise entitled to a senior priority claim on the assets of the special purpose vehicle do not pose systemic risk to the broader market.  Such credit support arrangements protect swap counterparties without the use of initial margin or variation margin as required under the proposed rules.

IV.         Margin Requirements by Counterparty

PR Covered Swap Entities must collect and post a minimum amount of initial margin when entering into an uncleared swap with any other PR Covered Swap Entity and with any financial end user that has a material swaps exposure.[28]  Variation margin requirements would apply to swap transactions where a PR Covered Swap Entity enters into a trade with another PR Covered Swap Entity or a financial end user (regardless of whether the financial end user has a material swaps exposure).[29]  A PR Covered Swap Entity may make its own credit judgment about whether to collect initial margin or variation margin from other types of counterparties based on the credit risk posed by the counterparty and the risks of such swaps or security-based swaps.[30]

The CFTC Proposal requires CFTC Covered Swap Entities to post and collect initial margin for uncleared swaps from any counterparty that is a CFTC Covered Swap Entity or financial end user with material swaps exposure.[31]  A CFTC Covered Swap Entity must post and collect variation margin in transactions with another CFTC Covered Swap Entity or a financial end user (regardless of whether the counterparty has material swaps exposure).[32]  There is no requirement for CFTC Covered Swap Entities to exchange margin with non-financial end users.  However, CFTC Covered Swap Entities are permitted to agree to initial and variation margin requirements and thresholds with such non-financial end users.

This aspect of the proposed rules represents a departure from the BCBS/IOSCO framework, under which initial margin is not required to be posted or collected by entities with an average daily aggregate notional amount of uncleared swaps below approximately $11 billion.[33]

V.          Initial Margin Calculation Methodology

For initial margin, the PR Proposal would require a PR Covered Swap Entity to calculate its minimum initial margin requirement in one of two ways.  It may use a standardized margin schedule set forth in the PR Proposal, or it may use an internal margin model that satisfies criteria set forth in the PR Proposal and has been approved by the Prudential Regulator.[34]  Like the PR Proposal, the CFTC Proposal permits CFTC Covered Swap Entities to calculate initial margin by using either a risk-based model or a standardized table method.[35]

In their comment letters, many swap market participants argued that each covered swap entity should be permitted to use its proprietary initial margin model, rather than being required by the proposed rules to use a model from a vendor or clearing organization or a model that has been approved by the Prudential Regulators.[36]

VI.         Calculating Variation Margin

Unlike the PR Proposal, the CFTC Proposal requires control mechanisms for the calculation of variation margin.[37]  A CFTC Covered Swap Entity must create and maintain documentation setting forth its calculation methodology to allow the counterparty, the CFTC and any Prudential Regulator to calculate a reasonable approximation of the margin requirement independently.[38]  It is also required to evaluate the reliability of its data sources at least annually and make adjustments, as appropriate.[39]  In addition, the CFTC Proposal requires a CFTC Covered Swap Entity to have in place alternative methods for determining the value of an uncleared swap in the event of the unavailability of any input required to value a swap, and the CFTC may at any time require a CFTC Covered Swap Entity to provide further data or analysis concerning the methodology or data source used to value a swap for variation margin purposes.[40]

VII.        Thresholds

Under the PR Proposal, initial margin must be posted and collected on a daily basis (with the collection and posting of initial margin beginning no later than the business day following the day of entry into the swap) in response to changes in portfolio composition or other factors that would change the required initial margin amounts.[41]  PR Covered Swap Entities are permitted to adopt a maximum initial margin threshold of $65 million, below which they need not collect or post initial margin from or to other PR Covered Swap Entities or financial end users with material swaps exposure.[42]  The threshold would be applied on a consolidated basis and would apply both to the consolidated PR Covered Swap Entity as well as to the consolidated counterparty.[43]  With respect to variation margin, no threshold amounts would be permitted; but a minimum transfer amount of $650,000 is permitted (the minimum transfer amount applies to all margin posted, initial and variation margin combined).[44]  Variation margin also would be required to be posted and collected on a daily basis.[45]

The CFTC Proposal, like the PR Proposal, permits a CFTC Covered Swap Entity to reduce the amount of initial margin by a threshold amount that is established by the CFTC Covered Swap Entity but that may be no greater than $65 million.[46]  The initial margin threshold amount must be applied on a consolidated basis.  Initial margin must be posted and collected on a daily basis commencing on or before the business day after execution of an uncleared swap.[47]

Swap market participants have objected to these standardized thresholds, arguing that instead the rules should permit each covered swap entity to determine the relevant thresholds for its counterparties, subject to regulatory review.[48]

VIII.       Eligible Collateral

Although the BCBS/IOSCO framework does not distinguish between forms of initial and variation margin collateral[49], the proposed rules permit a wide variety of securities to be delivered as initial margin while restricting variation margin to cash.  Under the PR Proposal, eligible collateral is limited to high-quality assets that are expected to remain liquid and retain their value, after accounting for an appropriate risk-based haircut.  Eligible collateral for variation margin is limited to cash in U.S. dollars or the currency in which payment obligations under the swap are required to be settled.[50]  Eligible collateral for initial margin includes cash, U.S. treasuries and agencies, certain foreign government debt securities, certain corporate debt securities, certain listed equities or gold.[51]  The value of any eligible collateral that is collected and held to satisfy initial margin requirements is subject to the haircuts described in the PR Proposal.[52]  A PR Covered Swap Entity is required to monitor the market value and eligibility of all collateral to satisfy the initial margin requirements.[53]  To the extent that the market value of such collateral has declined or if it is no longer eligible collateral, the PR Covered Swap Entity must promptly collect additional eligible collateral.[54]

The list of eligible collateral (including haircuts) in the CFTC Proposal is substantially the same as in the PR Proposal.[55]  CFTC Covered Swap Entities also are required to monitor the market value and eligibility of all collateral collected to satisfy initial margin requirements.

This is another aspect of the proposed rules where swap market participants have commented that the rules should permit covered swap entities to determine eligible collateral and relevant haircuts for such collateral, subject to regulatory review.[56]

IX.         Custodial Agreements and Segregation

Under the PR Proposal, initial margin must be segregated at custodians that are not affiliates of the PR Covered Swap Entity or the counterparty.[57] On the other hand, variation margin is not required to be segregated at an independent third-party custodian.[58]  The segregation requirement applies only to the minimum amount of initial margin that a PR Covered Swap Entity is required to collect from a swap entity or a financial end user with material swaps exposure; however, it applies to all collateral (other than variation margin) that the PR Covered Swap Entity posts to any counterparty.[59]  The custodial agreement must prohibit rehypothecating, repledging, reusing or otherwise transferring any of the funds the third-party custodian holds.[60]  Substitution of collateral and reinvestment of posted collateral is permitted.[61]  Unlike initial margin, variation margin may be rehypothecated by the recipient.[62]

Similar to the PR Proposal, the CFTC Proposal requires any initial margin posted by a CFTC Covered Swap Entity, and the initial margin that is required to be collected by a CFTC Covered Swap Entity, to be held by an independent third-party custodian.[63]  The CFTC Proposal, like the PR Proposal, requires the custodian agreement to limit rehypothecation and to permit substitution and reinvestment of collateral.

Under the BCBS/IOSCO framework, the customer has the option to segregate initial margin[64] and the customer may consent to rehypothecation.[65]  The PR Proposal and the CFTC Proposal are therefore more restrictive than the BCBS/IOSCO framework since under the PR Proposal and the CFTC Proposal segregation is required and rehypothecation is prohibited.

In comment letters swap market participants have expressed a desire to continue the current practice, which these segregation requirements would ban, of allowing parties to agree that the custodian for their margin will be an affiliate of either counterparty.[66]

X.          Interaffiliate Swaps

The PR Proposal and the CFTC Proposal do not provide an exemption from these margin requirements for uncleared swap transactions between affiliates.  The BCBS/IOSCO framework left the decision to national supervisors[67], so if national supervisors outside the United States provide an exemption, it could place U.S. entities at a competitive disadvantage.

The exemption of inter-affiliate swaps is an issue that swap market participants, particularly global financial entities that have historically used back-to-back swaps to consolidate and manage market risk exposures centrally at a single affiliate, have consistently (and almost universally) requested.[68]  The generally expressed rationale for such an exemption is that inter-affiliate swaps do not increase systemic risk because losses on a trade that accrue to one affiliate are equally offset by gains to the affiliate on the other side of the trade, resulting in a net wash for the consolidated entities.  So posting of collateral for inter-affiliate swaps is not necessary to control systemic risk.

XI.         Netting and Treatment of Legacy Trades

Under the PR Proposal and the CFTC Proposal, the margin amounts posted and received for transactions made under an eligible master netting agreement could be fully netted.  While the margin requirements would not be applicable to trades entered into prior to the effective date of the new rules, if such “legacy” trades were made under the same master netting agreement as new trades made after the effective date, such legacy trades would be required to satisfy the new margin requirements.[69]

The proposal by the U.S. regulators to condition grandfathering of legacy trades on the documentation of those swaps under separate eligible master netting agreements from new swaps, would increase credit risk and systemic risk by reducing the netting of trades.[70]  Cross-product portfolio margining arrangements across cleared and uncleared swaps and other non-derivative products remain a critical issue for market participants.[71]

XII.        Trading Documentation

The PR Proposal requires the trading agreements between a PR Covered Swap Entity and a counterparty that is either another PR Covered Swap Entity or a financial end user to include credit support provisions that meet the requirements of the rule.[72]  Such credit support arrangements must specify the methods, procedures, rules and inputs for determining the value of each swap and contain dispute resolution procedures.[73]  In contrast, the CFTC Proposal requires CFTC Covered Swap Entities to enter into trading agreements that contain such credit support provisions with all uncleared swap counterparties, including non-financial end users.[74]

CFTC rules and regulations already require swap trading documentation to include methods, procedures, rules and inputs for swap valuation and a valuation dispute resolution process and disclosure of the methodology and assumptions used to prepare the daily mark.[75]  The proposed rules are duplicative and impose additional documentation requirements related to valuation that are unnecessary and will be burdensome for swap market participants.

XIII.       Effective Dates

If the proposed rules are implemented, as currently drafted, PR Covered Swap Entities and CFTC Covered Swap Entities will need to comply with the margin requirements for swaps entered into on or after December 1, 2015 with respect to variation margin.[76] For initial margin the compliance date is December 1, 2015 if both the PR Covered Swap Entity (and its affiliates) or the CFTC Covered Swap Entity (and its affiliates), as applicable, and the counterparty (and its affiliates) have an average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, foreign exchange forwards and foreign exchange swaps for June through August 2015 that exceeds $4 trillion.[77]  However, if a party has a lower volume of uncleared swap and foreign exchange trading, the effective date is deferred to December 1, 2016, if for June through August 2016 such volume exceeds $3 trillion; December 1, 2017, if for June through August 2017 it exceeds $2 trillion; and December 1, 2018, if for June through August 2018 it exceeds $1 trillion.[78]  The new requirements will become effective for all counterparties on December 1, 2019.[79]

It is unlikely that the final rules will be finalized before mid-2015.  As a result, market participants will have very little time before the December 1, 2015 deadline to put the necessary legal, operational, risk management and technology in place to implement these new regulations.  A deferral of the proposed effective dates is needed to provide additional time after the finalization of the rules is necessary to ensure a smooth and efficient implementation of the rules.

However, on March 18, 2015 the BCBS and IOSCO jointly announced that the implementation schedule set forth in the international framework was being extended by nine months.  In addition, the requirement to exchange variation margin was made subject to a six month phase-in period.[80]  The U.S. regulators have not yet officially followed suit, but CFTC Commissioner Timothy Massad has been quoted as stating that the CFTC is also considering pushing back its implementation timeline by a matter of months.[81]

XIV.        Extraterritoriality

The PR Proposal excludes any foreign non-cleared swap or foreign non-cleared security-based swap of a foreign covered swap entity.[82]  A “foreign non-cleared swap” is an uncleared swap of a foreign covered swap entity where neither the counterparty nor any guarantor of either party is:  (1) organized under the laws of the United States or any state (including a U.S. branch, agency or subsidiary of a foreign bank); (2) a branch or office of an entity organized under the laws of the United States or any state; or (3) a PR Covered Swap Entity controlled by an entity organized under the laws of the United States or any state.[83] A “foreign covered swap entity” is a PR Covered Swap Entity that is not:  (1) organized under the laws of the United States or any state (including a U.S. branch, agency or subsidiary of a foreign bank); (2) a branch or office of an entity organized under the laws of the United States or any state; or (3) a PR Covered Swap Entity controlled by an entity organized under the laws of the United States or any state.[84]  In addition to the foregoing exclusion, the PR Proposal would permit “substituted compliance”:  Foreign covered swap entities could meet the requirements of the rule by complying with the requirements of a non-U.S. regulator in the event that a comparability determination is made by the Prudential Regulators, provided that the covered swap entity’s obligations under the swap are not guaranteed by a U.S. entity.[85]

Unlike the PR Proposal, the CFTC Proposal does not include exemptions to its margin requirements for transactions outside the United States markets.  The CFTC Proposal includes an advance notice of proposed rulemaking and asks for public comment on alternative approaches including:  (1) application of the rules according to the PR Proposal; or (2) application of the uncleared swap margin CFTC rules according to the “transaction-level requirements” of the CFTC’s earlier cross-border guidance or the “entity-level requirements.”[86]

One issue on which all swap market participants agree is “harmonization”:  margin rules should be consistent across different jurisdictions and within the United States or, at a minimum, require a transaction to comply with only one jurisdiction’s rules where such harmony is lacking.[87]  In the U.S., the SEC has yet to re-propose its rules on margin.  And with respect to the CFTC Proposal, there has been no determination to permit substituted compliance for non-U.S. margin rules that are consistent with the BCBS/IOSCO framework.  Substituted compliance is necessary to avoid having margin rules from two different jurisdictions with inconsistent requirements applying simultaneously to the same collateral transfer.

Swap market participants have argued that swaps between non-U.S. covered swap entities and non-U.S. counterparties should not be subject to the U.S. margin rules, even if such entities are affiliated with U.S. companies.[88]  The definition of what is a “non-U.S.” entity is also crucial:  non-U.S. covered swap entities should include non-U.S. branches, offices, subsidiaries and other non-U.S. affiliates of U.S. entities, and non-U.S. counterparties should include non-U.S. funds or other entities with a U.S. advisor and non-U.S. entities guaranteed by a U.S. entity.

XV.         Impact of Re-Proposed Margin Rules

Margin requirements today are established through bilateral negotiations between a dealer and its counterparty, and two-way margining is not current market practice for many participants in the swap market.  As a result, market participants will be required to make changes in longstanding business practices as well as significant investments to improve their collateral infrastructure. Collateral account control agreements with third-party custodians will need to be negotiated. Systems will need to be updated to support the new margin calculations, and reporting capabilities will need to be enhanced to track collateral.

Mandatory margin requirements are expected to lead to higher costs and reduced liquidity for uncleared swaps.  Since initial margin will not be permitted to be rehypothecated, industry participants will need a consistent supply of eligible collateral, which may result in a shortage of, and possibly a squeeze on, eligible collateral.  Counterparties may be increasingly reliant on transformation services if this shortage of eligible assets develops; dealers providing transformation services will lend eligible collateral to counterparties for a fee.

In addition, risk may also increase as the cost of customizing risk management tools will increase, causing counterparties to use more standardized swaps, which are less tailored to reduce the specific risks to which counterparties are exposed.  Risk will concentrate at central counterparty clearing houses as trades move away from the more expensive uncleared swaps market.  Such concentration at the central counterparties may have adverse consequences if risk management is not improved at central counterparties.  If the margin requirements for uncleared swaps become too costly, the markets for uncleared swaps may become disrupted and no longer viable, thereby adversely affecting the ability of market participants to manage risk effectively.

XVI.        Conclusion

ISDA estimates that as much as $1 trillion of new collateral may need to be posted if the rules for margin for uncleared swaps proposed by the CFTC and Prudential Regulators are adopted.[89]  This increased collateral demand would have a significant impact on financial markets.  While most swap market participants generally support measures to reduce risk in the swaps markets and incentivize clearing of swaps, many have expressed concerns that the proposed rules will have unintended consequences that will increase systemic risk and disrupt these markets.  The rules need to appropriately address the particular risks posed by uncleared swap transactions.  As currently proposed, the margin rules for uncleared swaps may be too costly and punitive.  If the market for uncleared swaps loses its viability, market participants will not be able to manage risk effectively.  Market participants need a well-functioning market for uncleared swaps in order to meet their trading and risk management needs, which often require the customized transactions which exchanges cannot by their nature offer.

 

Preferred citation: Craig Stein & Paul N. Watterson, Jr., New Margin Requirements for Uncleared Swaps, 5 Harv. Bus. L. Rev. Online 114 (2015), https://journals.law.harvard.edu/hblr//?p=4029.

* Craig Stein is a partner and co-head of the Structured Finance & Derivatives Group at Schulte Roth & Zabel LLP.  His practice focuses on swaps and other derivative products, including credit- and fund-linked derivatives, prime brokerage and customer trading agreements, and structured finance and asset-backed transactions.  Paul N. Watterson, Jr. is a partner and co-head of the Structured Finance & Derivatives Group at Schulte Roth & Zabel LLP.  He concentrates his practice on structured product and derivative transactions, the formation and representation of credit funds, and capital markets regulation.

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Public L. No. 111-203, 124 Stat. 1376 (2010).

[2] Id.

[3] See 7 U.S.C. § 6s(a) (2012); 15 U.S.C. § 78o-10(a).

[4] See 7 U.S.C. § 6s(e)(2)(A)(ii); 15 U.S.C. § 78o-10(e)(2)(A)(ii).

[5] See 7 U.S.C. § 6s(e)(2)(B)(ii); 15 U.S.C. § 78o-10(e)(2)(B)(ii).

[6] Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 Fed. Reg. 23,732 (Apr. 28, 2011).

[7] Margin and Capital Requirements for Covered Swap Entities, 76 Fed. Reg. 27,564 (May 11, 2011).

[8] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Consultative Document: Margin requirements for non-centrally-cleared derivatives (2012).

[9] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives (2014).

[10] See id. at 5.

[11] Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59,898 (Oct. 3, 2014).

[12] Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57,348 (Sept. 24, 2014).

[13] Except, the Framework does not apply for physically settled foreign exchange forwards and swaps. See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 7 (2014).

[14] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57,350.

[15] See id. at 57,354.

[16] See id.

[17] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59,902.

[18] Determination of Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange Act, 77 Fed. Reg. 69,694 (Nov. 20, 2012).

[19] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57,351.

[20] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,398; Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,926.

[21] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,360.

[22] See id. at 57,362.

[23] See 7 U.S.C. § 2(h)(7)(C)(i).

[24] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,390.

[25] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,926.

[26] See id. at 59,927 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,391.

[27] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,903 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,361.

[28] See Margin and Capital Requirements for Covered Swap Entities,79 Fed. Reg. at 57,391.

[29] See id. at 57,392.

[30] See id. at 57,391,  57,392.

[31] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59,928.

[32] See id.

[33] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 10 (March 2014).

[34] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,393.

[35] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,929.

[36] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (September 14, 2012); SIFMA Comment Letter addressed to Prudential Regulators (March 12, 2014).

[37] See 79 Fed. Reg. at 59,931.

[38] Id.

[39] Id.

[40] Id.

[41] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,391.

[42] See id. at 57,390.

[43] See id. at 57,366.

[44] See id. at 57,392.

[45] See id.

[46] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,927 (defining initial margin threshold amount).

[47] See id. at 59,928.

[48] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (July 11, 2011); ISDA / SIFMA Joint Comment Letter addressed to the CFTC (September 14, 2012); SIFMA Asset Management Group Comment Letter addressed to the CFTC (September 28, 2012).

[49] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 17 (March 2014).

[50] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,392.

[51] See id.

[52] See id.

[53] See id.

[54] See id.

[55] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,931.

[56] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (September 14, 2012); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012).

[57] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,393.

[58] Seeid. at 57,356.

[59] See id. at 57,393.

[60] See id.

[61] See id.

[62] See id.

[63] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932.

[64] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 20 (March 2014).

[65] See id. at 21.

[66] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (September 14, 2012); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012); ISDA Comment Letter addressed to the Prudential Regulators (November 24, 2014); Managed Funds Association Comment Letter addressed to the Prudential Regulators (November 24, 2014).

[67] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 22 (March 2014).

[68] See e.g. SIFMA Comment Letter addressed to the Prudential Regulators (March 12, 2014); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012).

[69] See Margin and Capital Requirements for Covered Swap Entities,79 Fed. Reg. at 57,392.

[70] See Managed Funds Association Comment Letter addressed to the Prudential Regulators (November 24, 2014).

[71] See e.g. Managed Funds Association Comment Letter addressed to the Prudential Regulators (November 26, 2012); Managed Funds Association Comment Letter addressed to the CFTC (July 11, 2011); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012).

[72] See Margin and Capital Requirements for Covered Swap Entities,79 Fed. Reg. at 57,395.

[73] See id. at 57,382.

[74] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932.

[75] See, e.g., 17 CFR 23.504.

[76] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,388.

[77] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,389.

[78] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,388.

[79] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,389.

[80] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 24 (2015)
available at  http://www.bis.org/bcbs/publ/d317.pdf.

[81] Philip Stafford, Hopes quashed of two-year delay for new swaps rules, Financial Times (Mar. 11, 2015), http://www.ft.com/intl/cms/s/0/15a8496e-c80e-11e4-8210-00144feab7de.html?siteedition=intl#axzz3UYwoM5Rn.

[82] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,395.

[83] See id.

[84] See id.

[85] See id.

[86] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,916.

[87] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (July 11, 2011); SIFMA Asset Management Group Comment Letter addressed to the Prudential Regulators (November 26, 2012); Managed Funds Association Comment Letter addressed to the Prudential Regulators (November 24, 2014).

[88] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (July 11, 2011); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012); ISDA / SIFMA Comment Letter addressed to the Prudential Regulators (November 24, 2014).

[89] ISDA/ SIFMA Joint Comment Letter addressed to the Prudential Regulators (July 6, 2011).

By

The Status of Environmental Commodities Under the Commodity Exchange Act

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Matthew F. Kluchenek*

This article examines the role of the Commodity Futures Trading Commission (“CFTC”) in regulating transactions in environmental commodities, such as renewable energy certificates (“RECs”), emissions allowances, carbon offsets and carbon credits. The article examines the general role of the CFTC, the types of products subject to the CFTC’s jurisdiction, the basis for and scope of exclusions to the CFTC’s jurisdiction, and how commodity option transactions could be converted into swaps subject to the CFTC’s jurisdiction.

Ultimately, transactions in environmental commodities may qualify for the forward exclusion from the definition of “swap” under the Commodity Exchange Act[1] (“CEA”)—and thus not be subject to CFTC regulation—if the transactions satisfy certain requirements, the most important of which is the parties’ intent to physically settle each transaction. Such an exemption, however, is relatively narrow, and the active “trading” of an environmental commodity may jeopardize the use of the exemption.

I.         The Role of the Commodity Futures Trading Commission

A.        Jurisdiction and Mission of the CFTC

When Congress created the CFTC in 1974, it conferred upon the CFTC “exclusive jurisdiction” over commodity futures and options thereon.[2] Unless exempted, futures contracts and options thereon must trade on a commodity exchange that has been designated as a contract market—that is, an exchange or market—by the CFTC in order to be legal and enforceable.[3] By contrast, spot and forward transactions—in which the parties intend to make or take delivery of a commodity—are not generally subject to CFTC jurisdiction.[4]

Historically, the CFTC’s regulation of trading in environmental commodities has been relatively limited, but the agency has explored the scope of its boundaries with respect to such commodities. For example, while recognizing that other federal agencies may be better equipped to regulate allocation and recordkeeping requirements associated with the trading of such products, former CFTC Chairman Gary Gensler asserted that oversight by the CFTC of environmental commodities would give it additional experience regulating cash emissions contracts, and claimed that, should Congress seek to regulate cash markets for emission instruments, the CFTC would be well suited to carry out that function. According to Chairman Gensler:

In most respects, emissions contract markets operate no differently than the other commodity markets the CFTC regulates. While each contract – such as sulfur dioxide, soybeans, treasury bills or natural gas – presents its own unique challenges, the regulatory scheme is essentially the same. Carbon markets have similarities to several different markets that fall within our regulatory authority. For example, carbon allowances and offsets are similar to agriculture commodities in that there is a yearly “crop” and important programmatic regulations governing the nature of the product. At the same time, carbon contracts have similarities to financial products. For example, government-issued allowances and offset credits would be similar to Treasury-issued debt instruments. Futures contracts on Treasury debt are among the most actively traded CFTC-regulated products.[5]

Ultimately, Congress did not accept Chairman Gensler’s invitation, but did mandate the formation, via the Dodd-Frank Wall Street Reform and Consumer Protection Act[6] (“Dodd-Frank Act”), of an inter-agency working group to study the oversight of existing and prospective carbon markets.[7]

B.        Dodd-Frank Act

In 2010, Congress enacted the Dodd-Frank Act, which adopted sweeping changes to how the markets in the U.S. for over-the-counter derivatives, and the participants in those markets, are regulated. Many of those changes were implemented by amending the CEA. Through the Dodd-Frank Act, Congress issued a general directive to the CFTC of having as many “swaps” as possible cleared by regulated clearing entities in order to reduce “systemic risk” to the financial markets, and as many “swaps” as possible traded on regulated exchanges, or on or through other regulated entities, in order to increase transparency in the markets.[8] The Dodd-Frank Act thus makes it unlawful for a person[9] to enter into a “swap” without complying with the CEA and the numerous rules promulgated by the CFTC.[10]

The Dodd-Frank Act was important to the environmental commodity market in two respects, both of which are discussed more fully below: 1) it provided and confirmed the basis for excluding environmental commodities from the definition of “swap” and thus from regulation by the CFTC; and 2) it created the inter-agency working group to study the markets.

C.        The Definition of “Swap”

1.         Dodd-Frank Act

The cornerstone of commodity futures trading regulations under the Dodd-Frank Act is the definition of “swap.” Generally, if a transaction involves a swap, regulation follows. The Dodd-Frank Act contains a broad definition of “swap” that encompasses most transactions that transfer financial risk from one party to the other party.[11] The definition of swap specifies several categories, including:

  • Options, including puts, calls, caps, floors and collars;
  • Event contracts;
  • Swap structures in which a fixed payment is exchanged for a floating payment on one or more scheduled dates, with payments linked to the value or level of one or more rates, currencies, commodities, quantitative measures or other financial or economic interests, and which transfers risk associated with a future change in the value or level of the foregoing between the parties without also conveying a current or future ownership interest in an asset; and
  • Instruments that become commonly known to the trade as swaps or by more specific names linked to an underlying commodity or financial measure.[12]

2.         The CFTC’s Further Definition of “Swap”

In July 2011, the CFTC and the SEC adopted joint final rules further defining the term “swap” and other terms in the Dodd-Frank Act (“Product Release”).[13] The Product Release provides important guidance on the classification of various types of derivative instruments. These classifications determine whether the instruments are subject to regulation by the CFTC or the SEC (or both) or whether they fall outside of either agency’s general regulatory authority under the CEA, as amended by the Dodd-Frank Act.[14] As discussed below, the Product Release examines whether environmental commodities may be subject to federal regulation by the CFTC and the basis for any exemption.

II.        The Forward Exclusion

A.        Generally

Since its inception in 1936, the CEA has excluded so-called “forward contracts” from federal regulation. The CEA defines the term “forward contract” by excluding such contracts from the term “future delivery”—i.e., from the definition of futures contracts. The operative provision provides that “‘future delivery’ does not include any sale of any cash commodity for deferred shipment or delivery.”[15] This language provides the basis for the so-called “forward exclusion,” which refers to the exclusion of forward contracts from regulation under the CEA and the jurisdictional auspices of the CFTC.[16]

Notably, the Dodd-Frank Act amended the CEA to add a forward exclusion to the definition of “swap.”[17] The exclusion applies to “any sale of a nonfinancial commodityor security for deferred shipment ordelivery, so long as the transaction isintended to be physically settled.”[18] To fall within the exclusion, a transaction must include the following three components:

  • a nonfinancial commodity,
  • deferred shipment or delivery of the nonfinancial commodity, and
  • an intent to physically deliver the nonfinancial commodity.

The CFTC has stated that it intends to interpret the forward exclusion for nonfinancial commodities in the “swap” definition in a manner consistent with its historical interpretation of the existing forward exclusion with respect to futures contracts.[19] The CFTC’s historical interpretation has been that forward contracts are “commercial merchandising transactions,” the primary purpose of which is to transfer ownership of the commodity and not to transfer solely its price risk.[20]

B.        Nonfinancial Commodities

In the Product Release, the CFTC interpreted the scope of the term “nonfinancial commodity” in the forward exclusion. According to the CFTC, a “nonfinancial commodity” is a “commodity that can be physically delivered and that is an exempt commodity or an agricultural commodity.”[21] Exempt commodities, including energy commodities, metals and agricultural commodities, are nonfinancial by nature.

The requirement that a commodity be able to be physically delivered is designed to prevent market participants from relying on the forward exclusion to enter into swaps based on indexes of exempt or agricultural commodities outside the bounds of the Dodd-Frank Act and settling them in cash, which the CFTC believes would be inconsistent with the historical limitation of the forward exclusion to commercial merchandising transactions.[22]

C.        Intangible Commodities

The CFTC has interpreted the term “intangible commodity” to qualify as a nonfinancial commodity so long as “ownership of the commodity can be conveyed . . . and the commodity can be consumed.”[23] The CFTC has emphasized that, for an intangible commodity to qualify for the forward exclusion, there must be an intent to physically settle the transaction.[24] As discussed in greater detail below, an example of an intangible nonfinancial commodity that qualifies under this interpretation is an environmental commodity that can be physically delivered and consumed (e.g.,by emitting the amount of pollutant specified in the allowance).[25]

D.        Deferred Delivery

An essential element of a forward contract is that the delivery of the nonfinancial commodity is deferred.[26] Delivery is typically deferred for commercial convenience or necessity.[27]

To the extent that a transaction results in immediate or near-immediate delivery of the commodity, the contract is likely to be characterized as a “spot” transaction. The CEA excludes “spot” or “cash” transactions from the CFTC’s jurisdiction.[28] The CFTC staff has defined a spot transaction as one where immediate delivery of and payment for the product are expected on or within a few days of the trade date.[29]

According to the Sixth Circuit, “because the CEA was aimed at manipulation, speculation, and other abuses that could arise from the trading in futures contracts and options, as distinguished from the commodity itself, Congress never purported to regulate ‘spot’ transactions (transactions for the immediate sale and delivery of a commodity) or ‘cash forward’ transactions (in which the commodity is presently sold but its delivery is, by agreement, delayed or deferred).”[30] Accordingly, transactions in environmental commodities on a spot basis would not be subject to the CEA.

E.        Intent to Deliver

Because a forward contract is a commercial merchandising transaction, intent to deliver has been the critical element of the CFTC’s analysis of whether a particular contract is a forward contract.[31] In assessing the parties’ delivery intent, the CFTC has applied a “facts and circumstances” test in which the CFTC “reads the ‘intended to be physically settled’ language . . . to reflect a directive that intent to deliver a physical commodity be a part of the analysis of whether a given contract is a forward contract or a swap, just as it is a part of the CFTC’s analysis of whether a given contract is a forward contract or a futures contract.”[32]

A good example of the line of cases interpreting the intent to deliver requirement is CFTC v. Co Petro Mktg. Group, Inc.[33] In 1982, the Ninth Circuit considered a claim by the CFTC that Co Petro, an operator of retail gasoline outlets and a petroleum broker, was unlawfully selling off-exchange futures contracts, under which Co Petro sold petroleum “at a fixed price for delivery at an agreed future date,” but “did not require its customer to take delivery of the fuel.”[34] As explained by the Ninth Circuit, the customer could designate Co Petro, at a future date, to sell the fuel on its behalf and not take delivery of the fuel. If the cash price rose during the interim period, Co Petro would remit to the customer the difference between the original purchase price and the subsequent sale price. If the cash price decreased, Co Petro would deduct from the customer’s deposit the difference between the purchase price and the subsequent sale price and remit the balance of the deposit to the customer.[35]

The CFTC alleged that these transactions constituted transactions in futures and thus were required to be traded on an exchange subject to CFTC jurisdiction. In response, Co Petro contended that the CFTC did not have jurisdiction over the transactions because they constituted forward contracts and were thus expressly excluded from the CEA.[36]

Based upon the CEA’s legislative history, the Ninth Circuit concluded that Congress intended “that a cash forward contract is one in which the parties contemplate physical transfer of the actual commodity.”[37] In finding that the parties to the Co Petro agreements did not contemplate actual delivery in the future, the court of appeals held that the forward contract “exclusion is unavailable to contracts of sale for commodities which are sold merely for speculative purposes and which are not predicated upon the expectation that delivery of the actual commodity by the seller to the original contracting buyer will occur in the future.”[38]

Importantly, subsequent book-outs or alternative settlement methods generally will not alter the original character of the agreement as a commercial merchandising transaction so long as the original agreement contemplated physical delivery of the commodity.[39] In addition, the presence of certain provisions such as liquidated damages and renewal or evergreen provisions does not necessarily render an agreement ineligible for the forward exclusion.[41]

III.      Environmental Commodities

A.        Interagency Working Group’s Carbon Oversight Study

Prior to the issuance of the Product Release, the Interagency Working Group for the Study on Oversight Carbon Markets (“Interagency Working Group”), led by the CFTC, issued a report on the oversight of existing and prospective carbon markets (“Carbon Report”), fulfilling a requirement established in the Dodd-Frank Act.[41]

In its report, the Interagency Working Group recommended that the following four objectives guide the oversight of existing and prospective carbon markets:

  1. Facilitate and protect price discovery in the carbon markets.[42]
  2. Ensure appropriate levels of carbon market transparency.[43]
  3. Allow for appropriate, broad market participation.[44]
  4. Prevent manipulation, fraud and other market abuses.[45]

Based on its study, the Interagency Working Group issued the following recommendations in its report regarding the oversight of existing and prospective carbon markets:

  • Rely on the existing regulatory oversight program, as enhanced by the Dodd-Frank Act, for both existing and prospective carbon allowance and offset derivatives markets.[46]
  • Ensure that appropriate oversight mechanisms are in place for primary and secondary allowance and offset markets, reflecting the above objectives and the interdependence of primary, secondary and derivative carbon markets and any unique characteristics or circumstances of such markets.[47]

B.        Environmental Commodities Under the Forward Exclusion

Building on the findings and recommendations in the Carbon Report, the CFTC noted in its Product Release that the Carbon Report “suggested that the forward exclusion could apply to agreements, contracts or transactions in environmental commodities” such as emissions allowances, carbon offsets/credits and RECs.[48] The Carbon Report specifically states:

No set of laws currently exist that apply a comprehensive regulatory regime—such as that which exists for derivatives—specifically to secondary market trading of carbon allowances and offsets. Thus, for the most part, absent specific action by Congress, a secondary market for carbon allowances and offsets may operate outside the routine oversight of any market regulator.[49]

Further, in discussing environmental commodities, the CFTC noted in its release that it:

understands that market participants often engage in environmental commodity transactions in order to transfer ownershipof the environmental commodity (and not solely price risk), so that the buyercan consume the commodity in order to comply with the terms of mandatory or voluntary environmental programs.Those two features—ownership transfer and consumption—distinguish such environmental commodity transactions from other types of intangible commodity transactions that cannot be delivered, such as temperatures and interest rates. The ownership transfer and consumption features render such environmental commodity transactions similar to tangible commodity transactions that clearly can be delivered, such as wheat and gold.[50]

As a result, the CFTC found that “environmental commodities can be nonfinancial commodities that can be delivered through electronic settlement or contractual attestation. Therefore, an agreement, contract or transaction in an environmental commodity may qualify for the forward exclusion from the swap definition if the transaction is intended to be physically settled.”[51]

Conversely, as described by an industry participant, to the extent that emissions allowances, carbon offsets/credits and RECs are not physically settled (i.e., consumed), but traded in secondary market fashion like a stock or bond, the forward exclusion would likely not apply to the transaction.[52] Moreover, the CFTC has stated that, if a contract were to include the right to unilaterally terminate an agreement under a pre-arranged contractual provision permitting financial settlement, the forward exclusion would not apply.[53]

Importantly, the CFTC does have authority over forward contracts under the CEA’s anti-manipulation provisions prohibiting manipulation, making false and misleading statements and omissions of material fact to the CFTC, fraud and deceptive practices, and false reporting.[54]

IV.      Commodity Options

A.        Generally

To the extent that an environmental commodity transaction is structured as either a commodity option or is embedded with a commodity option, the contract may be subject to CFTC regulation. Further, commodity option contracts that function as “trade options” are subject to limited CFTC oversight.

B.        CFTC Jurisdiction over Commodity Options

Under the CEA, the CFTC has plenary authority to regulate commodity option transactions.[55] Commodity options are illegal unless and until the CFTC specifically authorizes them.[56] The CEA, as amended by the Dodd-Frank Act, defines the term “swap” to include “a put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of 1 or more . . . commodities.”[57] Options on physical commodities are included in the statutory definition of swap.[58]

Under the CFTC’s part 32 rules, any person is permitted to transact commodity options on or subject to the rules of a designated contract market, while only an eligible contract participant(“ECP”) is permitted to transact commodity options bilaterally or on a swap execution facility.[59]

C.        CFTC Jurisdiction over Trade Options

CFTC Rule 32.3 provides an exemption from certain of the swap regulations for trade options on exempt commodities (such as energy and metal commodities) and agricultural commodities (such as grain and soft commodities) if the parties to, and the characteristics of, the commodity options satisfy certain requirements.[60] In order to be eligible for the trade option exemption, three requirements must be met:

  1. the offeror of a commodity option must be either an ECP or a commercial market participant;
  2. the offeree must be a commercial market participant; and
  3. the commodity option must be intended to be physically settled, so that, if exercised, the option would result in the sale of an exempt or agricultural commodity for immediate or deferred shipment or delivery.[61]

While most of the CFTC’s swap rules do not apply to trade options, some rules do apply to each trade option counterparty.[62]

D.        CFTC Jurisdiction over Forward Contracts with Embedded Volumetric or Price Optionality

Under the CFTC’s interpretations, a forward contract may be considered a swap because it is embedded with optionality—either volumetric or price optionality. According to the CFTC, a transaction with volumetric optionality is a forward contract (i.e., not a swap) if it meets the following seven-part test:

  1. the embedded volumetric optionality does not undermine the overall nature of the agreement as a forward contract;
  2. the predominant feature of the agreement is delivery;
  3. the embedded volumetric optionality cannot be severed and marketed separately;
  4. the seller of the underlying nonfinancial commodity intends to make delivery of the commodity if the option is exercised;
  5. the buyer of the underlying nonfinancial commodity intends to take delivery of the commodity if the option is exercised;
  6. both parties are commercial parties; and
  7. the exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors or regulatory requirements that are outside the control of the parties.[63]

Further, the CFTC has stated that a contract embedded with price optionality is likely a forward contract (i.e., not a swap) if the option:

  1. may be used to adjust the forward contract price but does not undermine the overall nature of the contract as a forward contract;
  2. does not target delivery terms, so that the predominant feature of the contract is actual delivery; and
  3. cannot be severed and marketed separately from the overall forward contract in which the option is embedded.[64]

A contract with an embedded option that satisfies the applicable test(s) will qualify for the forward exclusion and will not be regulated as a swap. As with other transactions, whether price or volumetric options qualify for the forward contract exclusion will be based on overall facts and circumstances.[65]

Ultimately, to the extent that any contracts are deemed to be swaps because of embedded optionality, the full panoply of the CEA’s swap regulations would be triggered. In such a circumstance, the contract would be subject to the various clearing, execution, reporting and recordkeeping requirements under the CEA, and the parties to the transactions may be subject to registration, business conduct and numerous other requirements.[66]

 

Preferred citation: Matthew F. Kluchenek, The Status of Environmental Commodities Under the Commodity Exchange Act, 5 Harv. Bus. L. Rev. Online 39 (2015), https://journals.law.harvard.edu/hblr//?p=3939.

* Matthew F. Kluchenek is a Partner at Baker & McKenzie LLP, and heads the Firm’s North America Derivatives practice.

[1] Commodity Exchange Act of 1936, Pub. L. No. 74–675, 49 Stat. 1491 (1936) (codified as amended in scattered sections of 7 U.S.C.), replacing the Grain Futures Act of 1922.

[2] Commodity Futures Commission Trading Act of 1974, Pub. L. No. 93-463, 88 Stat. 1389 (1974) (codified as amended in scattered sections of 7 U.S.C.). The CEA does not define the term “futures” or “futures contract,” but such contracts are generally defined as standardized contracts to buy or sell a commodity for a specified price in the future. In a futures contract, only the price and the quantity of the contracts are negotiated; all of the other terms are standardized and not negotiable. Importantly, a futures contract does not involve the sale of a commodity, but the sale of a contract, which permits the purchaser to buy or sell the commodity (unless the contract is cash-settled). From a statutory perspective, Congress refers to “futures contracts” in the CEA as “transactions involving . . . contracts of sale of a commodity for future delivery.” 7 U.S.C. § 2(a)(1)(A) (2012). The CEA defines “contract of sale” broadly to include “sales, agreements of sale, and agreements to sell.” See id. § 1a(13). The term “future delivery” is defined as excluding “any sale of any cash commodity for deferred shipment or delivery.” Id. § 1a(27).

[3] Id. § 6(a).

[4] See Dunn v. CFTC, 519 U.S. 465, 472 (1997) (noting that forward contracts are agreements in which participants “anticipate the actual delivery of a commodity on a specified future date,” while spot contracts are “agreements for purchase and sale of commodities that anticipate near-term delivery”).

[5] Global Warming Legislation: Carbon Markets and Producer Groups Before the S. Comm. on Agriculture, Nutrition, and Forestry, 111th Cong. 3 (2009) (statement of Gary Gensler, Chairman, Commodity Futures Trading Comm’n).

[6] Pub. L. No. 111-203, 124 Stat. 1376 (2010) (codified as amended in scattered sections of 7, 12, and 15 U.S.C.).

[7] See Dodd-Frank Act § 750.

[8] See 7 U.S.C. §§ 2(h)(1)(A), 2(h)(8)(B).

[9] Under 7 U.S.C. § 2(e), each counterparty to a swap transaction that is not executed on or pursuant to the rules of a designated contract market is required to be an “eligible contract participant,” or “ECP.” The definition of ECP is set forth in 7 U.S.C. § 1a(18), and 17 C.F.R. § 1.3(m) (2014).

[10] See, e.g., 7 U.S.C. §§ 2(h), 2(h)(8)(B).

[11] See 7 U.S.C. § 1a(47)(A).

[12] See id.

[13] 77 Fed. Reg. 48,208 (Aug. 13, 2012).

[14] See id.

[15] 7 U.S.C. § 1a(27) (emphasis added).

[16] The “forward exclusion” has a lengthy history, originating in the Futures Trading Act of 1921 (“FTA”), Pub. L. No. 67-66, ch. 86, 42 Stat. 187 (1921) (held unconstitutional by Hill v. Wallace, 259 U.S. 44 (1922)). As proposed by Congress, the FTA sought to impose a tax on futures contracts—a term not defined in the FTA. During the bill’s Congressional hearings, however, farmers expressed concern over the possible taxation of forward transactions, which farmers replied upon as a critical commercial hedging tool. See Hearing on H.R. 5676 Before the S. Comm. on Agriculture and Forestry, 67th Cong. 8-9, 213-14, 431, 462 (1921); CFTC v. Co Petro Mktg. Group, 680 F.2d 573, 577 (9th Cir. 1982). In response, the Senate added a provision to the FTA that excluded from the definition of “future delivery” “any sale of cash grain for deferred shipment or delivery.” See Pub. L. No. 67-66, 42 Stat. 187. According to the Senate report, the “addition was made in order that transactions in cash grain when made for deferred shipment or delivery, would not fall within the provisions for taxing imposed in Section 4 of the bill.” S. Rep. No. 212, at 1 (1921). In discussing the scope of the provision, Senator Capper, the bill’s sponsor, made clear that “the bill does not concern itself at all with the sale or purchase of actual grain, either for present or future delivery. The entire business of buying and selling actual grain, sometimes called ‘cash’ or ‘spot’ business, is expressly excluded. It deals only with the ‘future’ or ‘pit’ transaction, in which the transfer of actual grain is not contemplated.” 61 Cong. Rec. 4762 (1921) (statement of Sen. Capper). The cash forward exclusion was carried forward without change into the Grain Futures Act of 1922, Pub. L. No. 67-331, § 2(a), ch. 369, 42 Stat. 998 (1922), which replaced the FTA, and thereafter was incorporated into the CEA, 7 U.S.C. § 1a(27). The language remains unchanged from inception through today.

[17] See id. § 1a(47)(B).

[18]Id.§ 1a(47)(B)(ii).

[19] See 77 Fed. Reg. at 48,227.

[20] See id. at 48,235 (“[A] transaction entered into by a consumer cannot be a forward transaction.”).

[21] Id. at 48,232. The CEA defines an “exempt commodity” as “a commodity that is not an excluded commodity or an agricultural commodity.” 7 U.S.C. § 1a(20). The CFTC defines the term “agricultural commodity” in Rule 1.3(zz). See 76 Fed. Reg. 41,048, 41,056 (Jul. 13, 2011).

[22] See 77 Fed. Reg. at 48,232.

[23] See id. at 48,233 (emphasis added).

[24] See id.

[25] See id.

[26] See 7 U.S.C. § 1a(27).

[27] See 77 Fed. Reg. at 48,228.

[28] See Commodity Futures Trading Comm’n, Div. of Trading & Markets, CFTC Letter No. 98-73 (Oct. 8, 1998) (stating the CEA “does not provide the Commission with jurisdiction over true ‘spot’ transactions”).

[29] See id. (“In a spot transaction, immediate delivery of the product and immediate payment for the products are expected on or within a few days of the trade date.”).

[30] CFTC v. Erskine, 512 F.3d 309, 321 (6th Cir. 2008).

[31]The CFTC observed in its decision inWright that “it is well-established that the intent tomake or take delivery is the critical factor indetermining whether a contract qualifies as aforward.” Wright, CFTC Docket No. 97–02,2010 WL 4388247 at *3 (Oct. 25, 2010).

[32]Further Definition of “Swap;” “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, Securities Act Release No. 9204,Exchange Act Release No. 64372 [FSLR Transfer Binders—2002 to Current] Fed. Sec. L. Rep. (CCH) ¶ 89,429 (April 29, 2011). See also Andersons, Inc. v. Horton Farms, 166 F.3d 308, 318-17 (6th Cir. 1998) (“The purpose of this ‘cash forward’ exception is to permit those parties who contemplate physical transfer of the commodity to set up contracts that (1) defer shipment but guarantee to sellers that they will have buyers and vice versa, and (2) reduce the risk of price fluctuations.”).

[33]680 F.2d 573, 576 (9th Cir. 1982).

[34]Id.

[35]Id.

[36]Id. at 576-77.

[37]Id. at 578 (emphasis added).

[38]Id. at 579. However, while most courts have adopted the CFTC’s reasoning, in CFTC v. Zelener, 373 F.3d 861, 865 (7th Cir. 2004), the Seventh Circuit (and several lower courts) disregarded any intent or physical delivery consideration. Rather, the Seventh Circuit held that the relevant inquiry was whether the transaction involved “a sale of the commodity,” in which case it would be deemed to be a forward contract, or whether the contract was “a sale of the contract,” in which case it would be considered a futures contract. As a proxy for such an inquiry, the court looked to whether the contract was fungible or, absent fungibility, whether the seller promised to allow the buyer to enter into an offsetting contract on demand. If either condition applied, the contract would be regarded as a futures contract. Id. at 868. Nonetheless, the CFTC has continued to adhere to the intent to deliver requirement, as evidenced in the Product Release and subsequent CFTC enforcement actions.

[39] See 77 Fed. Reg., at 48,227-32.

[40] Id. at 48,240.

[41]See Interagency Working Group for the Study on Oversight of Carbon Markets, Report on the Oversight of Existing and Prospective Carbon Markets (Jan. 2011) [hereinafter Carbon Report], http://www.cftc.gov/ucm/groups/public/@swaps/documents/file/dfstudy_carbon_011811.pdf. The interagency group is composed of the following members: the Chairman of the CFTC, who serves as the group’s Chairman, the Secretary of Agriculture, the Secretary of the Treasury, the Chairman of the Securities and Exchange Commission, the Administrator of the Environmental Protection Agency, the Chairman of the Federal Energy Regulatory Commission, the Chairman of the Federal Trade Commission and the Administrator of the Energy Information Administration.

[42] Id. at 49.

[43] Id. at 50.

[44] Id.

[45] Id.

[46] Id. at 51.

[47] Id.

[48] 77 Fed. Reg. at 48,233 n.277. The CFTC chose not to define the term “environmental commodity” because “any intangible commodity—environmental or otherwise—that satisfies the terms of the interpretation [in the Product Release] is a nonfinancial commodity, and thus an agreement, contract or transaction in such a commodity is eligible for the forward exclusion from the swap definition.” Id. at 48,233. Regarding a REC, for example, the commission reasoned the “forward sale of a REC transfers ownership of the REC from the producing entity to another entity that can use the REC for compliance with an obligation to sell a certain percentage of renewable energy. Many times, this forward sale takes place prior to the construction of a project to enable developers to secure related project financing.” Id. at 48,233 n.285.

[49] Carbon Report, supra note 28, at 42.

[50] 77 Fed. Reg. at 48,233–34 (emphasis added). The CFTC has previously indicated that environmental commodities can be physically settled. Id. at 48,233 n.277.

[51] 77 Fed. Reg. at 48,234 (emphasis added).

[52] See id. at 48,235 n.291 (citing a comment letter explaining that, “unlike a stock or a bond, which can be resold for its cash value, purchasers of environmental commodities intend to take delivery of RECs or carbon offsets for either compliance purposes or in order to make an environmental claim regarding their renewable energy use or carbon footprint”); see generally, 77 Fed. Reg. at 48,233-35.

[53] See id. at 48,235 n.292.

[54] See, e.g., 7 U.S.C. § 12(d) (directing the CFTC to investigate the marketing conditions of commodities and commodity products and byproducts); id. §§ 9, 13b, 13(a)(2), 15 (proscribing any manipulation or attempt to manipulate the price of any commodity in interstate commerce and enabling the CFTC to take action against violators). In particular, the CEA prohibits any person to (i) “use or employ, or attempt to use or employ . . . any manipulative or deceptive device or contrivance”; (ii) “make any false or misleading statement of material fact” to the CFTC or “omit to state in any such statement any material fact that is necessary to make any statement of material fact made not misleading in any material respect”; and (iii) “manipulate or attempt to manipulate the price of any swap, or of any commodity in interstate commerce.” Id. § 9(1)-(3); see also 17 C.F.R. § 180.1(a) (prohibiting manipulation, false or misleading statements or omissions of material fact, fraud or deceptive practices or courses of business, and false reporting in connectionwith any swap, or contract of sale of any commodity in interstate commerce).

[55] See 7 U.S.C. § 6c(b).

[56] See 17 C.F.R. § 32.2.

[57] See id. § 1a(47), amended by the Dodd-Frank Act § 721.

[58] See id.

[59] See 17 C.F.R. § 32.3(a)(1)(i).

[60] 17 C.F.R. § 32.3.

[61] Id. § 32.3(a).

[62]Such applicable regulations include: part 20 (large trader reporting); part 151 (position limits); subpart J of part 23 (duties of swap dealers and major swap participants); sections 23.200 through 23.204 (reporting and recordkeeping requirements for swap dealers and major swap participants); and section 4s(e) of the CEA (capital and margin requirements for swap dealers and major swap participants). Id. § 32.3(c)(1)-(5). Each counterparty to a trade option must comply with recordkeeping and reporting requirements under part 45. Id. § 32.3(b).

[63] Commodity Futures Trading Commission, CFTC Division of Market Oversight Responds to Frequently Asked Questions Regarding Commodity Options—Commodity Options FAQ (Sept. 2013), https://forms.cftc.gov/_layouts/TradeOptions/Docs/TradeOptionsFAQ.pdf; see also 77 Fed. Reg. at 48,238-40.

[64] Id.

[65] Id.  On November 20, 2014, the CFTC published a proposed interpretation that would clarify the CFTC’s views with respect to forwards with embedded volumetric optionality.  See 79 Fed. Reg. 69,073 (Nov. 20, 2014).  The proposal targets the seventh element of the volumetric optionality test.  In this respect, the CFTC would delete the reference to “the exercise or non-exercise” of the option, which would clarify that the focus of this element is on the intent of the parties, rather than the exercise or non-exercise of the option.  The proposal would also delete the requirement that the “physical factors or regulatory requirements” be outside the control of the parties.  Id. at 69,075-76.  Thus, if ultimately approved by the CFTC, the seventh factor would read: “The embedded volumetric optionality is primarily intended, at the time that the parties enter into the agreement, contract, or transaction, to address physical factors or regulatory requirements that reasonably influence demand for, or supply of, the nonfinancial commodity.”  Id. at 69,074.  If enacted, such language would represent a significant improvement over the CFTC’s extant interpretation.

[66] See, e.g., 7 U.S.C. § 2(a) (recordkeeping and reporting requirements); § 2(h) (clearing mandate); § 2(h)(8) (trade execution mandate); § 6s(h) (business conduct requirements); § 6s(e) (margin and capital requirements).

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An Evaluation Of The U.S. Regulatory Response to Systemic Risk and Failure Posed by Derivatives

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Kimberly Summe*

Derivatives, understood by few but disparaged by many, are often blamed for the collapse of the United States economy in the wake of Lehman Brothers’ bankruptcy in September 2008.[1] A legislative response to the crisis was inescapable and on July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)[2] was signed into U.S. law. While the Dodd-Frank Act addresses many aspects of the financial markets, this Article will focus on Titles II and VII in order to examine how transacting in derivatives has changed in the aftermath of this legislation and to assess how the bankruptcy of a systemically important financial institution engaged in derivative transactions will be approached.

A Bid to Limit Systemic Risk and Failure

The Dodd-Frank Act has two primary objectives that relate to derivatives: first, to limit the systemic risk of modern finance, in part by changing the locus of trading in derivatives and the conduct of derivatives market participants; second, to limit the damage caused by the failure of a systemically important financial institution.[3] With respect to the first objective, the Dodd-Frank Act’s principal strategy required that certain derivatives be “cleared.” With respect to the second objective, the Dodd-Frank Act singled out the entities most likely to cause systemic problems if they failed and subjected them to a new bankruptcy process. This Article will focus on the second objective of the Dodd-Frank Act and in particular on how the failure of a systematically important financial institution would relate to the treatment of derivatives.

Reducing Systemic Risk

The estimated $632 trillion notional over-the-counter derivatives market[4] is in the early transformational stage of where and how such transactions are executed. Title VII of the Dodd-Frank Act requires that all eligible derivatives be cleared through a central clearinghouse, known colloquially as a “central counterparty” or “CCP.” Unlike an over-the-counter derivative transaction where each of the two parties face the risk that its counterparty might fail to perform its obligations, a cleared derivative transaction mitigates this risk of performance failure by having a third party, the CCP, stand between the two parties and absorb that risk.[5]

Two years after the passage of the Dodd-Frank Act, the Commodity Futures Trading Commission (CFTC) proposed that certain credit default swaps and interest rate swaps be cleared. The CFTC’s decision to focus initially on these two products was a function of their importance in the market and the fact that a significant percentage of those swaps were already being cleared. End users of derivatives, such as corporations, are not, however, required to clear swaps if such entities can demonstrate that the swap is being used to hedge or to mitigate commercial risk, the CFTC (or the Securities and Exchange Commission (SEC)) was notified as to how the end user generally meets the financial obligations associated with entering into uncleared swaps, and the entity’s Board of Directors approved such an approach.

Clearinghouses perform a valuable function in their mitigation of counterparty risk. To sustain this function, the clearinghouse’s financial resources must be sufficiently robust to meet its members’ obligations notwithstanding the default of one of its members. Given that J.P. Morgan Chase Bank, Citibank, Goldman Sachs Bank USA, and Bank of America are the four largest derivative counterparties in the United States, the collapse of any one of those institutions could mean the termination of anywhere between a $42.67 and $71.28 trillion notional derivatives portfolio—roughly seven to eleven percent of global notional derivatives value.[6] In addition to the financial resources marshaled by each clearinghouse, another critical component of the clearing model is the provision requiring collateral. The requirement that the parties post collateral every day underpins the purported safety of the clearing model.

Policymakers were correct to focus on collateralization as a risk-mitigation technique. The collateralization of over-the-counter derivative transactions has existed for twenty years, so the posting of collateral for cleared and uncleared transactions to mitigate exposure is not new. Before the economic crisis began, the International Swaps and Derivatives Association (ISDA) reported in its 2006 Margin Survey that the gross amount of collateral in use for over-the-counter derivative transactions was $1.335 trillion, with fifty-nine percent of mark-to-market credit exposure covered by collateral.[7] Today, large dealers reported that eighty percent of over-the-counter derivatives are subject to collateral arrangements, with ninety-six percent of credit derivatives exposure being collateralized.[8] The type of collateral is important as well. Cash has long been the preferred form of collateral. At the end of 2006, nearly eighty percent of collateral was cash, mostly provided in U.S. dollars, and nearly seven years later, similar percentage is true today.[9]

What shifted under the Dodd-Frank Act is that the CCP’s calculation of required collateral is substituted for the individual counterparty’s assessment of its risks. Counterparties to cleared swaps will be required to post initial (or upfront) collateral to the CCP based on the CCP’s assessment of the risk profile of that transaction.[10] In addition, each day the CCP will set the variation margin associated with each transaction by recalculating the value of the transaction and accordingly calling for or releasing collateral, ensuring that counterparties have neutral risk positions in relation to the value of the underlying asset. In other words, the goal is that the CCP receives margin payments every day from counterparties whose contracts moved against them to ensure that the CCP and those that participate through the CCP always have funds to satisfy their obligations under contracts.

The posting of collateral is closely related to how the derivative transactions of an insolvent clearinghouse member are handled. For example, LCH. Clearnet Group’s contract and related rules state that upon a clearing member’s default, the clearinghouse may close out and terminate the cleared transactions and will not transfer such positions. CME Clearing and ICE Trust, by contrast, allow cleared transactions and associated collateral to be transferred to another consenting clearinghouse member.[11] Had Lehman Brothers been a clearing member of CME Clearing, for example, upon its insolvency its $35 trillion notional derivatives portfolio (and associated collateral) would have been ported to another clearinghouse member. The concern in a marketplace where major participants such as Bank of America, Citibank and Morgan Stanley, among others[12] were vulnerable at that same time means that the portability of Lehman Brothers’ derivatives portfolio may not have allayed counterparty risk to the non-defaulting party population because arguably an equally unstable counterparty was receiving those transactions. Alternatively, a stronger clearing member may have rejected the transactions being proposed for transfer without some sort of government backstop for the unknowable counterparty risk being assumed.

Albeit one of the Dodd-Frank Act’s goals was to reduce systemic risk through clearing and collateralization of derivatives, little has changed in terms of how collateralization operates both before and after Lehman Brothers’ bankruptcy. A clearinghouse will determine the collateral required for cleared trades while for over-the-counter derivatives, the counterparties will agree to the extent of such collateralization. As the OCC Quarterly Reports demonstrate, there have actually been very limited counterparty credit losses incurred from over-the-counter derivatives trading activity by U.S. banks. At the end of June 30, 2013, eighteen U.S. banks (out of 1,400) reported a total of $61 million in charge-offs of over-the-counter derivatives exposures, down from $84 million in the first quarter of 2013.[13] Net current credit exposure or the netted amounts of contracts with positive values against those with negative values was reported as $339 billion at the end of the second quarter of 2013—a figure that peaked at $800 billion at the end of 2008.[14] These figures reflect the importance of collateralization and netting in the over-the-counter context and indicate that a very small fraction of the gross notional outstanding of derivatives held at U.S. banks is subject to net current credit exposure. Even with these high collateralization rates in place, at least as reported by U.S. banks, it should be noted that no consensus has formed as to whether there is sufficient collateral in place to mitigate counterparty loss. Researchers at the International Monetary Fund estimated that under-collateralization of derivatives relative to risks in the financial system may be $2 trillion.[15] The TABB Group contended that interest rate and credit derivative transactions’ migration to a clearinghouse would require an additional $240 billion in collateral.[16]

Dealing with Failure

If the Dodd-Frank Act’s first objective was to limit risk before an institution collapses, the second objective was to limit destruction after a systemically important financial institution has failed or is in danger of failing. To accomplish this second objective, the Dodd-Frank Act introduced a new framework in Title II to facilitate the “orderly liquidation” of systemically important financial institutions.[17] The population of systemically important financial institutions includes bank holding companies that have at least $50 billion in assets and nonbank financial institutions such as investment banks or insurance holding companies that the new Financial Stability Oversight Council (Council) deems to be systemically important.[18] At present, there are eight U.S. banks deemed systemically important, along with three Japanese banks, seventeen European banks, and one Chinese bank. Before the Title II orderly liquidation authority procedures apply, however, it must be demonstrated that the use of the U.S. Bankruptcy Code would not be appropriate in the resolution of the institution without the destabilization of the U.S. financial system or a resort to a taxpayer bailout being likely.

It seems certain that all systemically important financial institutions will transact in derivatives and those transactions are more likely today than in 2008 to be booked with a U.S. commercial bank. U.S. banks dominate as derivatives counterparties. The most recent OCC Quarterly Report on Bank Trading and Derivatives Trading reported that out of the 1,400 U.S. banks engaged in derivatives trading, four U.S. commercial banks hold ninety-three percent of that exposure.[19] The concentration of a small number of financial institutions in the derivatives market has not shifted much in many years, including prior to Lehman Brothers’ bankruptcy.[20] The vast majority of this derivatives trading activity focuses on interest rate swaps: in the OCC’s First Quarter Report in 2008, that figure was seventy-nine percent, whereas in the OCC’s Second Quarter Report in 2013, it was eighty-one percent.[21] Interest rate swaps are perhaps the least complicated derivative instrument, particularly as compared to the challenges historically associated with credit derivatives in terms of credit event triggers and settlement, the complex calculations and dependencies of equity derivatives, and the inherent volatility of commodity derivatives, so presumably there is less risk in trading interest rate swaps than other derivatives. In addition, the OCC reports that fifty-nine percent of the top four commercial banks’ net current credit exposure is to other banks and securities firms, with corporates representing thirty-two percent and hedge funds, the most overly collateralized group at 325 percent, being two percent of net credit exposure.[22]

Thus, our financial landscape is dominated by the world’s largest banks, which in turn are among the world’s largest derivatives counterparties. While these banks will be more closely regulated under Title I of the Dodd-Frank Act, the way in which their insolvency will be handled has shifted.

Banks have historically been excluded from application of the U.S. Bankruptcy Code[23] and instead bank insolvencies were addressed under the Federal Deposit Insurance Act (FDIA). The FDIA provides that the Federal Deposit Insurance Corporation (FDIC) may operate as a conservator to preserve the value of a failing bank and return it to financial health or the FDIC may operate as a receiver in order to liquidate a failed bank.[24] Unlike a proceeding under the U.S. Bankruptcy Code, an FDIC receivership or conservatorship is not subject to direct supervision by the courts.[25] In large part, this policy choice was designed to ensure that bank failures were not subjected to the assumed-to-be lengthy proceedings under Chapter 11 of the U.S. Bankruptcy Code and placed more discretion with the FDIC to act expeditiously.

Under an FDIC regime, upon bankruptcy the FDIC has limited repudiation and avoidance powers with respect to derivatives. For example, regardless of whether the FDIC is acting as a conservator or a receiver, it must either disaffirm or repudiate all or none of the qualified financial contracts (derivatives) between the failed bank and the same counterparty, together with associated credit support or collateral.[26] In addition, the FDIC has the right to transfer qualified financial contracts to creditworthy bridge depository institutions.[27] If the FDIC is acting as receiver, it must provide notice of the transfer by 5:00 p.m. EST on the business day after its appointment as receiver.[28] At that time, the counterparty to the failed bank may elect to terminate the qualified financial contract (that is, the non-defaulting counterparty to the failed bank could follow the termination and close-out provisions in Section 6 of the ISDA Master Agreement for derivative transactions). If the FDIC is acting as conservator, there is no time limit on its right to transfer qualified financial contracts and the counterparty may not terminate the qualified financial contracts unless the conservator defaults to a degree that would permit termination under applicable non-insolvency law.[29]

From available reports, it appears that in every recent case where a large U.S. bank has become subject to a receivership proceeding, all qualified financial contracts and associated collateral of the failed bank were transferred in their entirety to a single bridge bank or third party acquirer. When the assets of Washington Mutual Bank, the largest U.S. bank failure to date, were sold in September 2008 to J.P. Morgan Chase, the FDIC transferred to J.P. Morgan Chase all qualified financial contracts to which Washington Mutual Bank was a party. While that process seemed to go well, Washington Mutual was not exactly a powerhouse derivatives market participant. Thus, it is not known whether the FDIC is resourced effectively to be able to handle a systemically important financial institution’s bankruptcy, a clearinghouse’s bankruptcy or multiple simultaneous bankruptcies. To date, the FDIC has fortunately not had the opportunity to deal with a derivatives portfolio approaching anything even near the size of Lehman Brothers’ derivatives portfolio—and Lehman Brothers was not as significant a derivatives market participant as the four largest U.S. commercial banks that trade derivatives.

While it is impossible to know whether the FDIC could effectively administer the bankruptcy of a systemically important financial institution, it is known that Title II’s orderly liquidation authority shifts away from the legal certainty of the bankruptcy processes under the U.S. Bankruptcy Code by permitting the FDIC to engage in ad hoc interventions under Title II. In addition, Title II allows the FDIC to discriminate among similarly situated secured creditors in a bankruptcy. Under Section 506(a)(1) of the U.S. Bankruptcy Code, a creditor’s secured status is determined when the collateral securing the claim is sold or when the Chapter 11 plan is judicially confirmed.[30] In contrast, under the regulations implementing the Dodd-Frank Act, the collateral securing the debt of the covered financial company is valued as of the date of the receiver’s appointment.[31] If the FDIC is unable to find a third party to purchase the collateral, the FDIC may transfer that collateral to a bridge financial company that the FDIC has organized.[32] While the bankruptcy process under the U.S. Bankruptcy Code mandates that the use or sale of the debtor’s property can only occur after there has been due notice and hearing, thereby ensuring the highest price is paid for such assets, Title II allows the FDIC to be on both sides of the transaction and to determine the consideration paid for the assets, with no court or creditor oversight.

The deficiencies of Title II resulted in the development of a proposed new U.S. Bankruptcy Code Chapter 14.[33] Chapter 14 offers two distinct approaches: either a conventional reorganization or a two entity recapitalization of a holding company. Under the Dodd-Frank Act, the FDIC focused on a two entity recapitalization, with a systemically important financial institution’s holding company being recapitalized through the transfer of its assets and liabilities to a new bridge financial company, and this bridge financial company in turn dealing with its operating subsidiaries. By contrast, Chapter 14 provides that if a motion is approved for the transfer of assets and liabilities in the first forty-eight hours of a bankruptcy, then the systemically important financial institution’s operations and ownership of subsidiaries shifts to a new bridge company that is not in bankruptcy. Qualified financial contracts such as derivatives would be kept intact and transferred to the bridge company. Through the transfer, the new bridge company will be effectively recapitalized by leaving the long-term unsecured debt behind in the bankruptcy proceeding.

Conclusion

It was a foregone conclusion that policymakers would respond to the economic crisis in the aftermath of Lehman Brothers’ bankruptcy and the near-collapse of other financial institutions. While it is arguable that the effort to prevent systemic risk through the mandate of clearing derivatives is a useful step, it is not a prophylactic. It remains entirely possible that a clearinghouse itself is capable of failure, as several have failed in the past, and the concentration of derivatives trading in the largest global financial institutions has exacerbated this possibility. Certainly, having the clearinghouse as the counterparty mitigates counterparty credit risk, but there may be costs involved if we have simply migrated to a more focused nucleus of systemically important financial institutions that could possibly fail. In addition, addressing the potential or eventual failure of a systemically important financial institution could have been addressed in a more judicially sound manner than the ad hoc approach policymakers chose to burden the FDIC with. There are attractive features of Title II, such as coordination with foreign regulators, but not at the expense of due process and judicial review. While the markets have already moved to accommodate the clearing of mandated derivative transaction types, it is hoped that efforts can be made to revise Title II as it relates to how the failure of a systemically important financial institution is handled.

 

Preferred citation: Kimberly Summe, An Evaluation of the U.S. Regulatory Response to Systemic Risk and Failure Posed by Derivatives, 4 Harv. Bus. L. Rev. Online 76 (2014), https://journals.law.harvard.edu/hblr//?p=3779.

[*] Kimberly Summe is the Chief Operating Officer and General Counsel at a multi-billion dollar San Francisco based investment advisor, Partner Fund Management, LP. She previously served as a Managing Director at Lehman Brothers and General Counsel at the International Swaps and Derivatives Association. Ms. Summe is a lecturer in law at the Stanford Law School and is a member of the Resolution Working Group at the Hoover Institution, which focuses on bankruptcy reform.

[1] On April 20, 2010, U.S. Treasury Secretary Timothy Geithner testified to the House of Representatives Financial Services Committee that “the market turmoil following Lehman’s bankruptcy was in part attributable to uncertainty surrounding the exposure of Lehman’s derivatives counterparties.” See Treasury Secretary Tim Geithner Written Testimony before the House Financial Services Committee, U.S. Dept. Treasury, (Apr. 20, 2010) http://www.treasury.gov/press-center/press-releases/Pages/tg645.aspx.

[2] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

[3] See id at 1376.

[4] Bank for Int’l Settlements, Quarterly Review, Table 19, (June 2013), http://www.bis.org/statistics/dt1920a.pdf. Notional, of course, does not reference the amount that is at risk and does not account for the effect of netting and the provision of collateral.

[5] See Dodd-Frank Act §723(h) at 1676.

[6] See Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013 (2013) available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq213.pdf.

[7] Int’l Swaps and Derivatives Ass’n, ISDA Margin Survey 2007, 4, (Apr. 15, 2007) available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/. The ISDA Margin Survey covers U.S. and non-U.S. market participants. In 2007, for example, twenty-five percent of respondents were based in the United States, while fifty-two percent were based in Europe or South Africa. The OCC Quarterly Reports, by contrast, only cover U.S. national banking associations. Id.

[8] International Swaps and Derivatives Association, ISDA Margin Survey 2013, 2, (Jun. 21, 2013) available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/.

[9] See id at 9; International Swaps and Derivatives Association, ISDA Margin Survey 2006, 4, (Apr. 15, 2006), available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys.

[10] As it relates to uncleared swaps, the Dodd-Frank Act requires swap dealers and major swap participants to notify their uncleared swap counterparties of their right to segregate their initial margin with an independent third-party custodian. See Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 77 Fed. Reg. 6336-01 (Feb. 7, 2012).

[11] See CME Clearing Financial Safeguards, CME Group, (2012), http://www.cmegroup.com/clearing/files/financialsafeguards.pdf.

[12] Federal Reserve chairman Ben Bernanke testified to the U.S. Financial Crisis Inquiry Commission: “If you look at the firms that came under pressure in that period . . . out of . . . thirteen of the most important financial institutions in the United States, twelve were at risk of failure within a period of a week or two.” See Thomas Russo and Aaron J. Katzel, The 2008 Financial Crisis and Its Aftermath: Addressing the Next Debt Challenge, Group of Thirty 7, 11 (2011).

[13] See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6 at 8.

[14] Id at 6.

[15] Manmohan Singh and James Aitken, Counterparty Risk, Impact on Collateral Flows and Roles for Central Counterparties, (International Monetary Fund, Working Paper 09/173, 2009).

[16] E. Paul Rowady Jr., The Global Risk Transfer Market: Developments in OTC and Exchange Traded Derivatives, TABB Group, 6 (November 2010), http://www.world-exchanges.org/files/statistics/pdf/V08-030%20Global%20Risk%20Transfer%20Market.pdf.

[17] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §204, 123 Stat. 1376 1454 (2010).

[18]  Title II is not limited to financial companies already designated as “systemically important” but can apply to any potentially failing entity the Council determines is systemically important and “in default or in danger of default.”

[19] Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6, at Graph 4.

[20] In the OCC Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, the five largest commercial banks represented ninety-seven percent of the total banking industry notional amount of derivatives trading activity. In order by notional, those institutions were JPMorgan Chase Bank, Bank of America, Citibank, Wachovia Bank, and HSBC Bank USA. In the OCC Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, Table 1, the five largest commercial banks in order by notional were JPMorgan Chase Bank, Citibank, Goldman Sachs Bank USA, Bank of America and HSBC Bank USA. The number of insured U.S. commercial banks engaged in derivatives trading has increased: at the end of the first quarter of 2008 there were 1,003 banks, see Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, 7, (2008) available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq108.pdf, whereas at the end of the second quarter of 2013, there were 1,400. See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6.

[21] See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6, at 1; Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, supra note 20, at 1.

[22] See id. at 7.

[23] See 11 U.S.C. § 109(b)(2) (2010).

[24] See 12 U.S.C. § 1821(c)(1) (2013).

[25] See § 1821(c)(6).

[26] See § 1821(e)(1)-(3).

[27] See § 1821(e)(9), (10)(C).

[28] See § 1821(10)(B)(i)(I).

[29] See § 1821(10)(B)(ii).

[30] See 11 U.S.C. §506(a)(1) (2005).

[31] See 12 C.F.R. § 380.1-380.53 (2011).

[32] See 12 U.S.C. §5390(h)(1) (2010).

[33] The Hoover Institution established a Resolution Project Working Group in 2009 (of which this author is a member) to develop an alternative approach to bankruptcy and related issues.

By

The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime

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James Schwartz*

The derivatives market was seen as having contributed substantially to the financial crisis of 2007–08.[1] This led to efforts to regulate derivatives in many of the countries in which their use was commonplace.[2] Historically, the swaps market consisted primarily of bilateral transactions agreed upon by telephone or electronic messages, which, in the absence of any reporting or clearing requirement, remained known only to the two principals.[3] At a September 2009 summit in Pittsburgh, however, G-20 leaders agreed in concept to wholesale reforms.[4] These reforms included the requirements that by the end of 2012, “all standardized OTC [over-the-counter] derivative contracts should be traded on exchanges or electronic trading platforms[] where appropriate,” “cleared through [a] central counterpart[y]” standing between the two original parties, and “reported to [a] trade repositor[y].”[5]

The G-20’s original timeframe did not hold, and today, almost a year after the G-20’s 2012 year-end target date, implementation of the contemplated reforms remains problematic.[6] Many of the delays reflect issues on the national level—mainly that the derivatives market is large, complex, and not especially familiar to many policymakers. However, beyond the need for action at the national level, the regulation of the swaps market, in which transactions between counterparties in wide-ranging jurisdictions have long been routine, requires international coordination and cooperation. If this were lacking, the consequences could include regulatory arbitrage, outsized compliance costs for, or incomplete compliance by, market participants, the fracturing of liquidity among different jurisdictions, and perhaps even political tensions.

The most aggressive regulator of the swaps market to date has been the U.S. Commodity Futures Trading Commission (CFTC), the primary U.S. regulator of derivatives. The CFTC is empowered to regulate the swaps market under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).[7] The CFTC’s rules are significantly closer to being implemented than those of many regulators outside the U.S.[8] As a result of the CFTC’s guidance regarding the extraterritorial application of its regulations[9] and the timeframe that the CFTC has set for implementation of that guidance, December 21 of this year may be a key date for many market participants.[10] On that day, according to the CFTC’s current timetable, many of the CFTC’s rules may become applicable to many transactions involving U.S. counterparties acting through non-U.S. offices or non-U.S. swap dealers registered with the CFTC by reason of their substantial U.S.-facing swap activities.[11]

Under the terms of the CFTC exemptive order issued on July 22, 2013, many such market participants are exempted from compliance with a number of the CFTC’s rules until the earlier of December 21, 2013 or thirty days following the issuance of an applicable substituted compliance determination.[12] As detailed below, a substituted compliance determination is an assessment by the CFTC that the relevant foreign jurisdiction’s rules are sufficiently comprehensive and comparable to the CFTC’s own rules to be followed in lieu of the CFTC’s rules.[13]

The CFTC’s timeframe, and the uncertain prospects of such substituted compliance determinations,[14] have put many market participants in an uncomfortable position. Because foreign swaps regulations are generally in a less advanced state than the CFTC’s own rules, the extent to which substituted compliance determinations may even be possible by December 21 is not entirely clear. Where the corresponding non-U.S. rules are in place, it is unclear whether the CFTC will actually make substituted compliance determinations related to those rules. Where the corresponding foreign rules are not yet in place, these could come into effect shortly after December 21. If the CFTC on December 21 requires compliance with U.S. rules, this could mean that market participants will be required to comply with both sets of rules. Moreover, the CFTC’s cross-border guidance contemplates requirement-by-requirement determinations on comparability of non-U.S. swaps regulatory regimes.[15] This mix-and-match approach makes it likely that many market participants will be required to comply both with certain (as yet unspecified) elements of the CFTC’s rules and certain (as yet unspecified) elements of non-U.S. regulatory regimes.

Issues in the cross-border market brought about by the CFTC’s mandatory clearing requirement, which went into effect on October 9 of this year for many market participants,[16] indicate that a significant delay in substituted compliance determinations could be the worst outcome for the U.S. swaps market. Upon the CFTC’s clearing requirement becoming effective, the absence of a substituted compliance determination with respect to clearing prompted certain non-U.S. market participants to avoid dealing with U.S. swap dealers.[17] This has moved swap trading activities with non-U.S. market participants into non-U.S. affiliates.[18] A further, related concern that may be limiting trading by swap dealers through their non-U.S. branches, in the absence of a substituted compliance determination, is that if transactions entered into by such branches are subject to mandatory clearing, they may soon also be subject to U.S. rules which in certain cases will likely require execution on a swap execution facility.[19]

The CFTC’s approach to cross-border matters is complex and nuanced. It divides the CFTC’s requirements into two separate categories: Transaction-Level Requirements and Entity-Level Requirements.[20] It then splits each of these categories into two subcategories.[21] The Transaction-Level requirements are split into Category A Transaction-Level Requirements (which include clearing and swap processing, trade execution, swap trading relationship documentation, and real-time public reporting of swap data) and Category B Transaction-Level Requirements (which consist of the CFTC’s external business conduct standards).[22] Similarly, the Entity-Level Requirements are divided into First Category Entity-Level Requirements (which include capital adequacy, chief compliance officer, risk management, and most swap data recordkeeping) and Second Category Entity-Level Requirements (which include, among others, swap data repository reporting and reporting for large traders of swaps linked to certain commodities).[23]

The CFTC’s regime, with respect to the Transaction-Level Requirements, may be summarized—albeit in a vastly simplified manner—as a continuum.[24] At one end of the spectrum such requirements will apply to swaps involving a CFTC-registered swap dealer (whether or not a U.S. Person[25]) acting through a U.S. branch or a U.S. Person other than a swap dealer.[26] Contrariwise, at the other end of the spectrum, such requirements will not apply (unless one party is a swap dealer acting through a U.S. branch[27] or a U.S. Person[28]) to swaps involving a party that is not a U.S. Person and not otherwise linked to the U.S. as a “guaranteed affiliate”[29] or an “affiliate conduit.”[30] With respect to swaps that do not fall at either end of the spectrum, such as swaps involving a CFTC-registered swap dealer acting through a non-U.S. branch, a substituted compliance determination is possible in relation to many such requirements.[31] With respect to the Entity-Level Requirements, for U.S. dealers, such requirements will apply, and for non-U.S. CFTC-registered swap dealers, substituted compliance determinations will be possible for many such requirements.[32]

On its face, this approach has a certain logic to it—the more closely linked to the U.S. a counterparty or transaction is, the more likely it is that the CFTC’s rules or similar rules, by way of substituted compliance, should apply. In practice, however, the approach seems likely to cause significant issues in the absence of substantial and close coordination among regulators—which, to date, does not appear overly abundant.[33]

These issues can be illustrated using the first cross-border example above, a transaction involving a U.S. swap dealer acting through a U.S. branch. If the swap were transacted between, for example, the New York head office of a U.S. swap dealer and the Paris head office of a French swap dealer, the EU’s rules should presumably govern the transaction to the same extent the U.S. rules do. If the EU were to take a position parallel to that of the CFTC and require the application of the EU’s rules to a transaction involving an EU swap dealer, the transaction would be governed by both U.S. and EU rules. Any material differences between these two sets of rules could be a significant issue for the parties to such a transaction and, by extension, for the swaps market as a whole.

Even in this relatively straightforward case, some understanding among relevant regulators with regard to cross-border swaps would seem highly desirable. The genius of the CFTC’s approach is that, by implementing its rules first and, by means of substituted compliance determinations, setting a bar for other regulators to reach, it has claimed the power to shape significantly discussions in foreign jurisdictions regarding the substance of swaps regulations. On the other hand, by making its own rules without agreements from other regulators and then delaying compliance dates, the CFTC is putting pressure on other regulators to fall into line to avoid causing conflict.[34] Given the need for cooperation, this approach seems incongruous and even slightly imperious.[35] There is a distinct lack of an institutional framework for making international regulatory swaps determinations,[36] in the absence of which the CFTC contemplates that foreign regulators, industry groups and even individual market participants may request a substituted compliance determination.[37]

Even for requirements in which substituted compliance is possible, the CFTC’s guidance is unclear. It offers scant insight into whether the CFTC will in fact make a substituted compliance determination, and, if it does make such a determination, what conditions it may impose on market participants seeking to rely on such determination. In order for a party to a swap to substitute compliance with the requirements of a non-U.S. jurisdiction for compliance with the CFTC’s own requirements, the CFTC must determine that the foreign jurisdiction’s requirements “are comparable with and as comprehensive as the corollary area(s) of regulatory obligations encompassed by the Entity- and Transaction-Level Requirements.”[38] However, they need not be “identical requirements to those established under the Dodd-Frank Act.” [39] In cases where the CFTC does not find foreign laws and regulations to merit substituted compliance, the relevant non-U.S. Person or foreign branch of a U.S. Person “may be required to comply” with the applicable CFTC regulations.[40]

The CFTC may consider both swap-specific regulations of the relevant foreign regulator and other provisions that may “achieve comparable and comprehensive regulatory objectives as the Dodd-Frank Act requirements, but on a more general, entity-wide, or prudential, basis.”[41] Moreover, the CFTC may vary its approach depending on the particular foreign jurisdiction.[42] In certain cases it may seek to influence the contents of foreign regulations by “coordinating with the foreign regulators in developing appropriate regulatory changes or new regulations, particularly where changes or new regulations already are being considered or proposed by the foreign regulators or legislative bodies.”[43] In other cases, the CFTC “may include conditions that take into account timing and other issues related to coordinating the implementation of reform efforts across jurisdictions”[44] or otherwise “include in its substituted compliance determination a description of the means by which certain swaps market participants can achieve substituted compliance within the construct of the foreign regulatory regime.”[45]

The CFTC does not intend to make substituted compliance determination with respect to foreign regulations as a whole, but instead with respect to particular foreign regulations.[46] Partly because “many foreign jurisdictions” are in the process of implementing derivatives market reforms “in an incremental manner,” a “comparability analysis will be based on a comparison of specific foreign requirements against specific” provisions of the Dodd-Frank Act and CFTC regulations for each of the categories of regulatory obligations for which substituted compliance may be available.[47] As a result, the swap counterparties to whom substituted compliance may apply will likely be expected to comply with a mixture of U.S. and non-U.S. regulations.

At the same time, however, the CFTC, somewhat puzzlingly, has stated that it expects to “rely upon an outcomes-based approach to determine whether these requirements achieve the same regulatory objectives of the Dodd-Frank Act.”[48] In this context, “outcomes-based” is often understood to refer not to what regulations state, but instead to the actual consequences that they cause.[49] It is not clear why an outcomes-based approach would necessitate a requirement-by-requirement review such as the CFTC contemplates. The SEC, in contrast to the CFTC, stated in its proposed cross-border rules that it would not focus on “a rule-by-rule comparison” but instead “on regulatory outcomes” with a “holistic approach.”[50]

If the CFTC guidance regarding substituted compliance sounds vague enough to support whatever ad hoc arrangement the regulator believes is warranted in any particular case, perhaps that is exactly the point. A commitment to the substituted compliance regime did not prevent the CFTC from agreeing to another approach entirely just days before the release of its cross-border guidance.[51] In one of the relatively few concrete signs of cooperation with foreign regulators, the CFTC and EU authorities agreed in July of 2013 to an understanding known as the “path forward.”[52] In that understanding, they agreed to a “stricter-rule-applies” approach with regard to mandatory clearing, one of the fundamental reforms sought by the G-20.[53] This approach, not referenced in the CFTC’s cross-border guidance, would be applicable “where exemptions from mandatory clearing would exist in one jurisdiction but not in the other.”[54] Although this approach may indeed “prevent loopholes and any potential for regulatory arbitrage,”[55]imposing stricter regulations on cross-border swap transactions than on transactions undertaken in a single jurisdiction would seem not to promote a liquid international market.

In the longer run, it seems likely that the swaps regulations of the major jurisdictions will converge. For the foreseeable future, however, both before and after December 21, questions will continue to abound, and the swaps market will continue to be burdened by regulatory uncertainty. As it was the G-20 process that delineated and put in process the swaps market reforms in G-20 member nations, international bodies such as the Basel Committee on Banking Supervision and the Financial Stability Board could likely play a productive role in minimizing confusion and disruption and in bringing much needed clarity to the swaps market.[56]

 

Preferred citation: James Schwartz, The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime, 4 Harv. Bus. L. Rev. Online 52 (2013), https://journals.law.harvard.edu/hblr//?p=3676.

* Of Counsel, Morrison & Foerster LLP.

[1] See, e.g., Colin Barr, Geithner to Rein in Derivatives, CNNMoney (May 13, 2009), http://money.cnn.com/2009/05/13/news/derivatives.fortune/.

[2] See, e.g., G-20, Leaders’ Statement: The Pittsburgh Summit (September 24–25, 2009) [hereinafter Leaders’ Statement], available at http://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.

[3] See, e.g., Randall Dodd, Derivative Study Center, The Structure of OTC Derivatives Markets 2 (2002), http://www.financialpolicy.org/dscotcstructure.pdf.

[4] See Leaders’ Statement, supra note 2.

[5] Leaders’ Statement, supra note 2.

[6] See, e.g., James K. Jackson & Rena S. Miller, Cong. Research Serv., Comparing G-20 Reform of the Over-the-Counter Derivatives Markets (2013), http://www.fas.org/sgp/crs/misc/R42961.pdf.

[7] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 701–74, 124 Stat. 1376, 1641–802 (2010) (codified as amended in scattered sections of 7, 12 and 15 U.S.C. (2012)). The Dodd-Frank Act permits the U.S. Commodity Futures Trading Commission (CFTC) to exercise authority with respect to activities outside of the United States if those activities “have a direct and significant connection with activities in, or effect on, commerce of the United States” or “contravene such rules or regulations as the [CFTC] may prescribe [] as are necessary or appropriate to prevent the evasion of any provision of [the Dodd-Frank Act]”. Id. at § 722(d) (codified at 7 U.S.C. § 2(1)). Title VII of the Dodd-Frank Act gives the CFTC jurisdiction over “swaps” and the U.S. Securities and Exchange Commission (SEC) jurisdiction over “security-based swaps.” Id. at §§ 722(a), 761(a) (codified at 7 U.S.C. § 2(a)(1), 15 U.S.C. § 78c(a)). The Dodd-Frank Act defines each term, id. at §§ 721(a), 722(a), and a joint rulemaking by the CFTC and the SEC has further defined them. See Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208 (Aug. 13, 2012) (to be codified at 17 C.F.R. pts. 1, 230, 240, and 241). Unlike the CFTC, the SEC has not yet finalized its rules regarding extraterritoriality, and its proposed cross-border rules are outside the scope of this article. See Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249). More broadly, in contrast with the CFTC, the SEC has finalized few of its rulemakings under the Dodd-Frank Act, and has postponed the application of many provisions that would treat security-based swaps as “securities” or would otherwise subject security-based swaps to the Dodd-Frank Act. See Extension of Exemptions for Security-Based Swaps, 78 Fed. Reg. 7,654 (February 4, 2013); Order Extending Temporary Exemptions Under the Securities Exchange Act of 1934 in Connection With the Revision of the Definition of “Security” to Encompass Security-Based Swaps, and Request for Comment, 78 Fed. Reg. 10,218 (February 13, 2013); Temporary Exemptions and Other Temporary Relief, Together With Information on Compliance Dates for New Provisions of the Securities Exchange Act of 1934 Applicable to Security-Based Swaps, 76 Fed. Reg. 36,287 (June 22, 2011).

[8] As the CFTC has noted, “many foreign jurisdictions have been implementing OTC derivatives reforms in an incremental manner,” and “because many jurisdictions are in the process of finalizing and implementing their derivatives reforms incrementally,” the CFTC’s determinations, discussed infra text accompanying notes 38–50, as to which foreign rules are sufficiently comprehensive and comparable to the CFTC’s own rules “may need to take into account the timing of regulatory reforms that have been proposed or finalized, but not yet implemented.” Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,343–44 (July 26, 2013) (to be codified at 17 C.F.R. § 1). For an analysis of one area in which there is a significant difference in timing between U.S. rules and analogous foreign rules, see James E. Schwartz, Marissa N. Golden & Robert J. Dilworth, First Steps on the Path Forward, 32 Int’l Fin. L. Rev. 36, 36–37 (2013), available at http://www.iflr.com/Article/3247985/The-path-forward-for-EU-US-derivatives-regulation.html (analyzing the status of the trade execution mandate in the U.S. and the EU, and noting that while the CFTC’s mandate will be in effect shortly, the EU’s is not expected to be in place until possibly as late as 2016).

[9] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292.

[10] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 43,785, 43,794–95 (July 22, 2013) (stating that numerous requirements for certain non-U.S. market participants and certain non-U.S. branches of U.S. swap dealers will go into effect on the earlier of December 21, 2013 or 30 days after the issuance of an applicable substituted compliance determination).

[11] See id.

[12] See id.

[13] See id. at 43,789.

[14] Even close followers of regulatory matters could be forgiven for not recognizing the words “substituted compliance” when the CFTC used and defined the term in its 2012 proposed interpretive guidance regarding cross-border matters. See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. 41214, 41229 (proposed July 12, 2012). The term appears to have its origins in a seminal 2007 article in the Harvard International Law Journal, in which the authors argued that foreign stock exchanges and broker-dealers should be able to provide services in the United States “based on their compliance with substantively comparable foreign securities regulations and laws and supervision by a foreign securities regulator with oversight powers and a regulatory and enforcement philosophy substantively similar to the SEC’s,” instead of based on compliance with U.S. securities regulations and SEC supervision. Ethiopis Tafara & Robert J. Peterson, A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework, 48 Harv. Int’l L.J. 31, 32 (2007). Although the SEC signed a “mutual recognition agreement” with Australian regulators in 2008, it apparently shelved its plans to increase mutual recognition activities shortly thereafter, driven partly by the financial crisis. See Jerry Ellig & Houman B. Shadab, Talking the Talk, or Walking the Walk? Outcome-Based Regulation of Transnational Investment, 41 N.Y.U. J. Int’l L. & Pol. 265, 268 (2009).

[15] See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. at 41,229.

[16] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 43,794.

[17] See, e.g., Anish Puaar, EU Firms Forced to Take Action to Avoid US Clearing Rules, Financial News (October 10, 2013), http://www.efinancialnews.com/story/2013-10-10/eu-firms-forced-to-take-action-to-avoid-us-clearing-rules?ea9c8a2de0ee111045601ab04d673622 (“[S]ome European buyside firms are not prepared to clear their swap trades, leading them to either switch to US banks’ European entities or stop trading with them altogether.”).

[18] See id.

[19] The Dodd-Frank Act amended the Commodity Exchange Act, 7 U.S.C. §§ 1–27f (2012), to provide that swaps that the CFTC subjects to mandatory clearing must be executed on either a swap execution facility or a designated contract market, unless no swap execution facility or designated contract market makes the swap available to trade. See Dodd-Frank Act at § 723(a)(8); 7 U.S.C. § 2(h)(8). Mandatory execution on a swap execution facility for certain transactions is expected to commence in the near future, as swap execution facilities have started submitting “made available to trade” determinations, which the CFTC will consider pursuant to its rules. See Process for a Designated Contract Market or Swap Execution Facility To Make a Swap Available to Trade, Swap Transaction Compliance and Implementation Schedule, and Trade Execution Requirement Under the Commodity Exchange Act, 78 Fed. Reg. 33,606 (June 4, 2013) (to be codified at C.F.R. pts. 37 and 38); Provisions Common to Registered Entities, 76 Fed. Reg 44,776, 44,793-96 (July 27, 2011) (to be codified at C.F.R. pt. 40); Silla Brush, Javelin Files to Trade Interest-Rate Swaps, Spurring Sef Shift, Bloomberg (October 19, 2013), http://www.bloomberg.com/news/2013-10-19/javelin-files-to-trade-interest-rate-swaps-spurring-sef-shift.html.

[20] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,331–40 (July 26, 2013) (to be codified at 17 C.F.R. § 1).

[21] See id. at 45,335–36.

[22] See id. at 45,336.

[23] See id. at 45,335–36.

[24] See id. at 45,369 apps. D & E.

[25] The CFTC’s cross-border guidance defines a U.S. Person “generally to include, but not be limited to: (i) Any natural person who is a resident of the United States; (ii) any estate of a decedent who was a resident of the United States at the time of death; (iii) any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any form of enterprise similar to any of the foregoing (other than an entity described in prongs (iv) or (v), below) (a ‘legal entity’), in each case that is organized or incorporated under the laws of a state or other jurisdiction in the United States or having its principal place of business in the United States; (iv) any pension plan for the employees, officers or principals of a legal entity described in prong (iii), unless the pension plan is primarily for foreign employees of such entity; (v) any trust governed by the laws of a state or other jurisdiction in the United States, if a court within the United States is able to exercise primary supervision over the administration of the trust; (vi) any commodity pool, pooled account, investment fund, or other collective investment vehicle that is not described in prong (iii) and that is majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v), except any commodity pool, pooled account, investment fund, or other collective investment vehicle that is publicly offered only to non-U.S. persons and not offered to U.S. persons; (vii) any legal entity (other than a limited liability company, limited liability partnership or similar entity where all of the owners of the entity have limited liability) that is directly or indirectly majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v) and in which such person(s) bears unlimited responsibility for the obligations and liabilities of the legal entity; and (viii) 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 prong (i), (ii), (iii), (iv), (v), (vi), or (vii).” Id. at 45,316–17.

[26] See id. at 45,369 apps. D & E.

[27] See id. at 45,350 n.513.

[28] See id. at 45,369 apps. D & E.

[29] A “guaranteed affiliate” is a “non-U.S. person that is an affiliate of a U.S. person and that is guaranteed by a U.S. person.” Id. at 45,318.

[30] See id. at 45,369 apps. D & E. The CFTC has not precisely defined “affiliate conduit” but has stated that certain factors are relevant to the consideration of whether a non-U.S. Person constitutes an affiliate conduit. See id. at 45,369 app. D n.1. Such factors include “whether (i) the non-U.S. person is majority-owned, directly or indirectly, by a U.S. person; (ii) the non-U.S. person controls, is controlled by, or is under common control with the U.S. person; (iii) 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 such U.S. affiliate(s) in order to transfer the risks and benefits of such swaps with third-party(ies) to its U.S. affiliates; and (iv) the financial results of the non-U.S. person are included in the consolidated financial statements of the U.S. person.” Id.

[31] See id. at 45,369 app. D. Substituted compliance does not apply with respect to the external business conduct rules that constitute the Category B Transaction-Level Requirements. See id. at 45,369 app. E. This may be partly because such rules, which require dealers in certain transactions to provide pre-trade and daily mid-market marks, and, upon request, scenario analyses, are not expected to have analogs in many non-U.S. jurisdictions. See Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties, 77 Fed. Reg. 9,734 (February 17, 2012) (to be codified at 17 C.F.R. pts. 4 and 23).

[32] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations,78 Fed. Reg. at 45,368.

[33] Even with regard to the EU, one of the only foreign regulators with which the CFTC has appeared to have tangibly productive discussions, see infra n.51–53 and accompanying text, the lack of a detailed agreement between regulators is reportedly harming the negotiation of a U.S.-EU free trade agreement. Luke Baker & Stephen Adler, Derivatives Dispute Harming EU-U.S. Free-Trade Talks, Reuters (October 29, 2013), http://uk.reuters.com/article/2013/10/29/uk-eu-us-regulation-idUKBRE99S0G220131029.

[34] See Edward F. Greene & Ilona Potiha, Issues in the Extraterritorial Application of Dodd-Frank’s Derivatives and Clearing Rules, the Impact on Global Markets and the Inevitability of Cross-Border and US Domestic Coordination, 8 Cap. Mkts. L.J. 338, 353 (2013).

[35] See id.

[36] See id. at 386.

[37] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 45,344.

[38] Id. at 45,342.

[39] Id. at 45,342–43. “In evaluating whether a particular category of foreign regulatory requirement(s) is comparable and comprehensive to the applicable requirement(s) under the [Commodity Exchange Act] and Commission regulations, the Commission will take into consideration all relevant factors, including but not limited to, the comprehensiveness of those requirement(s), the scope and objectives of the relevant regulatory requirement(s), the comprehensiveness of the foreign regulator’s supervisory compliance program, as well as the home jurisdiction’s authority to support and enforce its oversight of the registrant.” Id. at 45,343.

[40] Id. at 45,344.

[41] Id. at 45,343.

[42] See id.

[43] Id. at 45,343–44.

[44] Id. at 45,343.

[45] Id. at 45,344.

[46] See id. at 45,343.

[47] Id. at 45,343–44.

[48] Id. at 45,342.

[49] See Ellig & Shadab, supra note 14, at 282 (“Outcomes are the actual benefits created, or harms avoided, for citizens. . . . [R]egulations issued are outputs that may affect outcomes, but they are not outcomes.”).

[50] Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968, 30,975 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249).

[51] See Press Release, U.S. Commodity Future Trading Commission, The European Commission and the CFTC Reach a Common Path Forward on Derivatives (July 11, 2013), available at http://www.cftc.gov/PressRoom/PressReleases/pr6640-13.

[52] Id.

[53] Id.

[54] Id.

[55] Id.

[56] See Greene & Potiha, supra note 34, at 385–92.

By

Regulation of Cross-Border Swaps

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David Felsenthal and Lily Chu*

I. Introduction

At a recent Washington roundtable on derivatives regulation, a senior staff member of the European Commission took the unusual step of publicly telling U.S. regulators: “Washington, we have a problem.”[1] The problem is U.S. regulation of cross-border swaps. Specifically, the U.S. Commodity Futures Trading Commission (CFTC) has issued proposed rules that subject any swap between a U.S. person and a non-U.S. person to U.S. swap regulation generally. This presents obvious conflicts with foreign regulation. For example, a cross-border swap cannot be cleared in both a U.S.-registered clearinghouse and separately in a different clearinghouse registered in the European Union (EU). We suggest below an alternative regulatory approach to cross-border swaps: U.S. regulators should consider each transaction-level requirement (including clearing and margin) and propose specific cross-border solutions that recognize both the U.S. policy goals and the potential for conflicts with foreign laws and regulations.

II. International Swap Regulation

A. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)

The Dodd-Frank Act amended section 2(i) of the Commodity Exchange Act (CEA) and section 30(c) of the Securities Exchange Act of 1934 (Exchange Act) to address jurisdiction over swaps and security-based swaps (SB Swaps).[2] However, the provisions do not provide clear guidance as to how the Dodd-Frank Act and related regulation govern derivatives trades between U.S. persons and non-U.S. persons, which we refer to as “cross-border swaps.” Section 2(i) provides that regulation under the Dodd-Frank Act does not apply to swap activity conducted outside the United States, unless that activity has a “direct and significant connection with activities in, or effect on, commerce of the United States.”[3] Similarly, section 30(c) of the Exchange Act provides that regulation adopted under the Dodd-Frank Act does not apply to SB Swaps transactions executed “without the jurisdiction” of the United States unless the activity contravenes other regulation enacted to counter evasion of Dodd-Frank Act provisions.[4] While the language of these amended sections of the CEA and the Exchange Act recognizes that there should be limits on the extraterritorial reach of these statutes, it does not define “outside” or “without” the U.S. or give guidance as to how the relevant statutes should be interpreted in the specific case where a swap trade is between a U.S. person and a non-U.S. person.[5]

B. Treatment of Cross-Border Transactions Before the Dodd-Frank Act

Prior to the adoption of the Dodd-Frank Act, there was no U.S. regulation of swaps. U.S. regulation of similar financial products (such as futures and options) offers helpful insights in fashioning a workable approach to cross-border swaps. For example, the CFTC has adopted rules under the CEA that govern the sale of foreign exchange-traded futures and options to U.S.-based investors.[6] Under section 30.5 of these rules, a non-US broker involved in foreign futures and options transactions with U.S. persons may apply to the CFTC for an exemption from otherwise applicable registration requirements.[7] Similarly, Rule 15a-6 adopted by the Securities Exchange Commission (SEC) provides that foreign broker-dealers engaging in securities transactions with U.S. investors may be exempt from SEC registration if the foreign broker-dealer complies with specified requirements (such as selling only to registered U.S. broker-dealers or banks).[8] These exemptions demonstrate acknowledgement by the CFTC and the SEC that some aspects of cross-border transactions ought not be subject to full U.S. regulation.

Just prior to the enactment of the Dodd-Frank Act, the U.S. Supreme Court ruled on a case regarding the scope of extraterritorial application of U.S. securities regulation. In Morrison v. National Australia Bank Ltd., the Supreme Court held that the anti-fraud provisions of U.S. securities laws do not apply to purchases by non-U.S. investors of securities of a foreign issuer traded on a foreign exchange—despite the investors’ claim that the fraud was committed in the United States.[9] The Court adopted a transactional test to determine whether section 10 of the Exchange Act applied: “whether the purchase or sale is made in the United States, or involves a security listed on a domestic exchange.”[10] In this case, the Court rejected the notion that the Exchange Act governs conduct taking place in the United States that affects exchanges or transactions abroad based in part on “[t]he probability of incompatibility with the applicable laws of other countries.”[11] While Morrison does not address whether U.S. regulation under the CEA should apply to a swap between a U.S. person and a non-U.S. person, it does discuss considerations that should limit the extraterritorial reach of U.S. regulators.

C. Regulation Under the Dodd-Frank Act

Transaction-Level Requirements: The CFTC has proposed and adopted a number of requirements directly applicable to swaps transactions (transaction-level requirements) as well as rules applicable to regulated entities such as swap dealers (entity-level requirements). Because entity-level requirements do not apply directly to cross-border swaps (except with respect to reporting, as described further below), this Article focuses on transaction-level requirements. The transaction-level requirements are: (i) mandatory clearing of swaps; (ii) mandatory execution (i.e. trading) on a centralized exchange or swap execution facility; (iii) collection of margin on uncleared swaps; (iv) requirements for swap documentation; (v) requirements regarding portfolio reconciliation and portfolio compression; (vi) real-time public reporting of swaps activity; (vii) requirements regarding confirmation of trades; (viii) retention of daily trading records; and (ix) standards for business conduct between swap dealers and their counterparties.[12]

Reporting: In addition to the transaction-level requirements, the CFTC has adopted rules requiring regular and timely reporting of swaps transactions and life-cycle information.[13] While these rules are listed among the entity-level requirements, they clearly affect cross-border transactions and are therefore discussed below.

CFTC interpretive guidance and exemptive order: The CFTC has issued several interpretative guidances and orders related to cross-border swaps. In July 2012, the CFTC issued proposed guidance on extraterritorial application of swap regulation.[14] This was accompanied by a proposed exemptive order to provide relief from certain requirements for cross-border swaps.[15] In December, the CFTC issued a final exemptive order and further proposed guidance regarding cross-border swaps.[16]

The effect of the proposed guidance is that all U.S. transaction-level rules apply, with one exception, to any swap to which a U.S. person is a party.[17] The exception is that non-U.S. branches of U.S. swap dealers that face non-U.S. persons are exempt from transaction-level requirements at least until July 2013.[18]

The broad extraterritorial reach of these requirements has resulted in considerable criticism. In her concurring statement at the time the final exemptive order providing cross-border relief was adopted, CFTC Commissioner Jill Sommers commented that the CFTC’s extraterritorial reach seemed to have been guided by the “Intergalactic Commerce Clause.”[19] In October 2012, ministerial-level representatives of the U.K., Japan, France, and the European Commission sent a joint letter to the Chairman of the CFTC expressing concerns about the CFTC’s regulation of cross-border swaps and urging the CFTC to “take the time to ensure that US rulemaking works not just domestically but also globally.”[20] They advocated coordination among their respective regulatory agencies to adopt cross-border rules that would avoid fragmentation of global markets.[21] More recently, Michel Barnier, a Member of the European Commission, publicly criticized the reach of U.S. derivatives regulation as follows: “expanding interpretation of home-grown rules to [derivatives] transactions that are already covered by equally solid foreign rules will only lead to legal conflicts. It will create uncertainty, increase costs and push trade to less well regulated places.”[22]

This international criticism is troubling in light of the international cooperation mandate found in section 752 of the Dodd-Frank Act.[23] This provision requires relevant U.S. regulators, including the CFTC and the SEC, to consult and coordinate with foreign regulatory authorities on the establishment of consistent international standards with respect to the regulation of swaps, SB Swaps, swap entities, and SB Swap entities as appropriate to promote effective and consistent global regulation of swaps and SB Swaps.[24] To address the likely incompatibility of U.S. derivatives regulation of cross-border swaps with other countries’ derivatives regulations, the extraterritorial reach of the CFTC swap considerations should be reconsidered.

SEC: The SEC has authority over SB Swaps similar to that of the CFTC has over swaps.[25] At the time of writing, however, the SEC has not yet finalized its regulations governing SB Swaps under the Dodd-Frank Act and has yet to address the treatment of cross-border SB Swaps.

D. Proposal

We do not believe that there is any simple, one size-fits-all remedy for regulation of cross-border swaps. We recognize that some U.S. regulatory oversight is appropriate for cross-border swaps involving a U.S. person as a party. Obviously, harm can be inflicted on the U.S. economy and U.S. market participants through swaps between a U.S. person and a non-U.S. person.[26] The CFTC cites the collapses of AIG and Lehman Brothers as examples of such harm.[27] AIG, an insurance company incorporated in the U.S., suffered enormous financial losses related to credit default swaps entered into with non-U.S. counterparties via its operations in London.[28] Similarly, Lehman Brothers was forced into bankruptcy at least in part due to losses on swaps positions held by its European subsidiary, Lehman Brothers International (Europe), positions that were guaranteed by the U.S. parent company, Lehman Brothers Holding Inc.[29] At the same time, other countries also have an interest in regulating cross-border swaps. Simply requiring that all U.S. requirements apply to any cross-border swap that involves a U.S. person will result in inevitable conflicts with other laws and would effectively terminate, or at least sharply reduce, the cross-border swap market. To repeat the example given above, a swap can only be cleared once and therefore cannot be cleared in both a U.S. clearinghouse and a European clearinghouse. Imposing U.S. requirements without regard to foreign rules would also conflict with the international cooperation mandate found in Title VII of the Dodd-Frank Act.[30]

We propose therefore that each transaction-level requirement be considered separately, and that specific rules be adopted for each type of transaction-level requirement. These rules, when applied to cross-border swaps involving a U.S. person as a party, should reflect the objectives of the relevant transaction-level requirement while taking into account the likelihood (and likely practical impact) of conflict with other countries’ laws. We set out our specific suggestions below.

1. Clearing

Requirement: If the CFTC designates a swap as subject to mandatory clearing, the swap must be cleared through a derivatives clearing organization (DCO) registered with the CFTC or a DCO that is exempt from registration.[31]

Proposal: In two recent no-action letters, the CFTC has recognized clearinghouses in Singapore and Japan as eligible to clear U.S. swaps.[32] The no-action relief granted by these letters is conditioned on a requirement that the non-U.S. clearinghouses apply to be registered with the CFTC as DCOs. We suggest that the CFTC establish an application procedure for recognizing other non-U.S. clearing organizations. Under section 2(h)(1) of the CEA, mandatory clearing can occur through a clearing organization that is exempt from registration.[33] In addition, section 5b(h) of the CEA provides that the CFTC may exempt a DCO from registration if it is subject to “comparable, comprehensive supervision and regulation . . . in the home country of the [DCO].”[34] As a result, the CFTC need not require registration as a DCO in all cases where non-U.S. clearinghouses propose to clear U.S. swaps.

2. Margin for Uncleared Swaps

Requirement: The Dodd-Frank Act requires swap dealers to comply with margin requirements for uncleared swaps as prescribed by the applicable regulators.[35] The CFTC, the SEC, U.S. prudential regulators,[36] and the BCBS/IOSCO Working Group on Margining Requirements (WGMR) have proposed margin requirements, [37] which have not yet been finalized.

Proposal: The margin requirements for uncleared swaps will impose standards on the amount of collateral, the models used to determine amounts, the eligible types of collateral, the time for posting of collateral and other issues. Given the many different detailed operational requirements for collateral positing, it will become difficult, if not impossible, for either party in a cross-border transaction to comply with margin requirements imposed by two jurisdictions.

The most recent WGMR release supports the idea of using only the margin requirements applicable to the collecting entity.[38] In addition, the release suggests that if the relevant regulators for each party find the other jurisdiction’s rules to be consistent, then the regulators should allow the parties to choose the margin rules of one jurisdiction or another.[39]

The WGMR’s suggestion appears to be a sensible idea of dealing with a difficult issue. The CFTC should establish a procedure for reviewing margin requirements of other jurisdictions as they are adopted. Such a procedure could recognize the different categories of swap counterparties—inter-dealer, between dealer and financial users, and between dealer and corporate end-users—and check for consistency within each category.

3. Trade Execution

Requirement: Swaps subject to the mandatory clearing requirement must be executed on a centralized trading facility, which may be a designated contract market (DCM), a registered swap execution facility (SEF), or a SEF that is exempt from registration.[40]

Proposal: As with clearing, if the parties to a swap are subject to trade execution requirements in different jurisdictions, an impossible situation can arise. The swap cannot be executed in both jurisdictions. We propose a similar cross-border approach to the approach suggested above for clearinghouses. U.S. regulators can propose a procedure for approving individual foreign DCMs or SEFs. For SEFs, like DCOs, the swaps can be executed through exempted SEFs as well as registered SEFs. The CEA specifically permits the CFTC to exempt a SEF from registration if it is subject to “comparable, comprehensive supervision and regulation . . .  in the home country of the facility.”[41] This would be consistent with the approach taken in part 30 of the CFTC’s rules under the CEA, which exempts a broker who trades in foreign futures and options that are executed on a foreign board of trade from certain requirements under the CEA.[42]

4. Swap Documentation and Confirmation

Requirement: Pursuant to CEA section 4s(i), the CFTC has adopted rules that prescribe standards for documentation of the swap counterparty relationship and trade confirmations.[43] These rules specify which documents and information must be exchanged between counterparties to a swap. The required documentation includes trade confirmations and the rules establish time frames during which confirmations must be executed.[44]

Proposal: Conflicting requirements regarding swap documentation in the respective jurisdictions of the counterparties will hinder trade execution and market liquidity. These requirements are primarily driven by the need for dealers to maintain appropriate records. As a result, we propose the following: if only one counterparty to the swap is a swap dealer, defer to the regulation of the swap dealer’s jurisdiction. If both parties are swap dealers, regulators should apply a similar rule to that proposed by the WGMR with respect to margin regulations: the U.S. should evaluate and identify other jurisdictions that have rules that are consistent with U.S. rules. For cross-border swaps involving a U.S. party and a party in such a jurisdiction, the parties should be able to choose which rules will apply.

5. Business Conduct

Requirement: Pursuant to section 4s(h) of the CEA, the CFTC has adopted standards for business conduct by swap dealers entering into swaps with counterparties.[45] These standards include disclosure and due diligence requirements regarding counterparty eligibility and institutional suitability.[46]

Proposal: The application of divergent business conduct requirements to cross-border swaps exposes swap dealers to greater risk of violating regulatory requirements and the potential for compliance costs to outweigh the economic benefits of entering into swaps. We propose that the applicable business conduct standards should be those of the jurisdiction of the party that is not a swap dealer. This approach provides the non-dealer counterparty the assurance that it will receive the protections afforded by its home jurisdiction.

6. Recordkeeping

Requirement: All parties to swaps are required to retain records related to swaps transactions under parts 45 and 46 of the CFTC’s rules under the CEA.[47] According to these rules, parties are to retain records of certain historical swaps and new swaps for the life of the swap and for a period of at least five years after the termination of the swap.[48]

Proposal: Swap dealers are required to keep records as prescribed by the rule. However, the language of the recordkeeping rule is unclear as to its application to counterparties that are not swap dealers and are not U.S. persons. The rule states that counterparties that are not swap dealers but that are “subject to the jurisdiction of” the CFTC shall keep records as required under the rule.[49] It is not clear from this language whether a party outside the U.S. would be required to keep records under these CFTC regulations. Because the recordkeeping requirements apply to any swap party (and not just dealers), applying this requirement to non-U.S. parties is potentially very onerous. To alleviate this and other issues that are likely to arise with cross-border trades, we propose that the applicable recordkeeping requirements should be those of the jurisdiction of the party keeping the records.

7. Swap Data Repository Reporting and Real-Time Public Reporting

Requirement: Information on swaps transactions must be reported to a swap data repository (SDR) within time frames specified in the CFTC’s SDR reporting rules.[50] The CFTC’s rules also require SDRs to disseminate specified trade information to the public on a real-time basis.[51]

Proposal: If different reporting requirements apply to a cross-border trade, issues may arise if counterparties report inconsistent information to SDRs. In addition, market participants may have difficulty in accessing and analyzing complete trade records if information is reported to and housed in different SDRs in different jurisdictions. We suggest that for swaps executed on an SEF or cleared through a DCO, the rules of the jurisdiction of the SEF or DCO apply. For all other swaps, we suggest that the regulators make every effort to harmonize their reporting requirements so that the same information can be used for U.S. and non-U.S. SDRs.

8. Portfolio Reconciliation and Compression

Requirement: Swap dealers are required to reconcile with their counterparties on a regular basis, with minimum frequencies established by the CFTC’s rules.[52] Swap dealers are also required to establish procedures to perform portfolio compression exercises.[53]

Proposal: These portfolio-related requirements generally require participation and cooperation of both counterparties to a swap. If parties to a cross-border trade are subject to inconsistent portfolio-related requirements, compliance may not be possible. We propose that, if only one party to the cross-border swap is a swap dealer, the rules of the swap dealer’s jurisdiction apply. If both parties to the cross-border swap are swap dealers, then we suggest, as for margin and swap documentation, that the U.S. regulators determine which foreign jurisdictions have rules consistent with U.S. rules. For cross-border swaps involving a U.S. party and a party in such a jurisdiction, the parties should be able to choose which rules will apply.

III. Conclusion

The broad extraterritorial reach currently espoused by the CFTC for cross-border swaps is inconsistent with the Dodd-Frank Act’s international cooperation mandate and has the potential to significantly disrupt the swaps markets. If a cross-border swap were made to comply with divergent regulations of two countries, it would expose swap dealers to the risk of violating regulatory requirements and could make compliance cost outweigh the economic benefits of entering into swaps.

We recognize that some U.S. regulatory oversight is appropriate for cross-border swaps that involve a U.S. person and acknowledge that there is no simple, one size-fits-all approach for regulating cross-border swaps. To avoid significant practical obstacles to cross-border swap transactions, we suggest a framework that applies each type of transaction-level requirement to non-U.S. persons on a rule-by-rule basis, taking into account the objectives of the relevant transaction-level requirement and the likelihood of incompatibility with other countries’ regulations.

 

 

Preferred citation: David Felsenthal & Lily Chu, Regulation of Cross-Border Swaps, 3 Harv. Bus. L. Rev. Online 142 (2013), https://journals.law.harvard.edu/hblr//?p=3232.

* David Felsenthal Partner, Clifford Chance US LLP and Lily Chu Associate, Clifford Chance US LLP. Thanks to Mary Johannes, Rebecca Hoskins and Chris Bates for their assistance.

[1] Patrick Pearson, Head of Unit, Fin. Mkt. Infrastructure, European Comm’n, Remarks at Global Market Advisory Committee Meeting (Nov. 7, 2012) (transcript available at http://www.cftc.gov/ucm/groups/public/@aboutcftc/documents/file/gmac_110712_transcript.pdf).

[2] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 722, 772, 124 Stat. 1376, 1672–75, 1801–02 (2010).

[3] Id. § 722(d).

[4] Id. § 772(b).

[5] There is also a question of who is a “U.S. person” for these purposes. This question, which has been extensively discussed in CFTC releases, is beyond the scope of this Article.

[6] 17 C.F.R. §§ 30.1–.13 (2012).

[7] Id. § 30.5.

[8] Id. § 240.15a-6.

[9] 130 S. Ct. 2869, 2888 (2010).

[10] Id. at 2886.

[11] Id. at 2885.

[12] Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. 41,214, 41,225 (proposed July 12, 2012) (to be codified at 17 C.F.R. ch. I).

[13] See Swap Data Recordkeeping and Reporting Requirements, 77 Fed. Reg. 2136 (Jan. 13, 2013) (to be codified at 17 C.F.R. pt. 45); Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps, 77 Fed. Reg. 35,200 (June 12, 2012) (to be codified at 17 C.F.R. pt. 46).

[14] See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, supra note 12.

[15] Exemptive Order Regarding Compliance with Certain Swap Regulations, 77 Fed. Reg. 41,110 (proposed July 12, 2012).

[16] Final Exemptive Order Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg 858 (Jan. 7, 2013); Further Proposed Guidance Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg. 909 (proposed Jan. 7, 2013) (to be codified at 17 C.F.R. ch. I).

[17] This result is indicated in the summary tables at the end of the Proposed Guidance and the Final Order. See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, supra note 12, at 41,237 (Category B table).

[18] Final Exemptive Order Regarding Compliance with Certain Swap Regulations, supra note 16, at 861.

[19] Jill E. Sommers, Comm’r, U.S. Commodity Futures Trading Comm’n, Statement of Concurrence: (1) Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, Proposed Interpretive Guidance and Policy Statement; (2) Notice of Proposed Exemptive Order and Request for Comment Regarding Compliance with Certain Swap Regulations (June 29, 2012) (transcript available at http://www.cftc.gov/PressRoom/SpeechesTestimony/sommersstatement062912).

[20] Letter from George Osborne, Chancellor of the Exchequer, UK Gov’t, et al., to Gary Gensler, Chairman, U.S. Commodity Futures Trading Comm’n (Oct. 17, 2012), available at http://www.fsa.go.jp/inter/etc/20121018-2/01.pdf.

[21] Id.

[22] Michel Barnier, Member responsible for Internal Mkt. & Servs., European Comm’n, Why Global Markets Require Global Rules—and US-EU Cooperation (Feb. 15, 2013) (transcript available at http://europa.eu/rapid/press-release_SPEECH-13-125_en.htm).

[23] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 752, 124 Stat. 1376, 1749–50 (2010).

[24] Id.

[25] Id. § 712.

[26] We believe there are also significant issues in defining the term “U.S. person” for these purposes, but those issues go beyond the scope of this Article.

[27] Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, supra note 12, at 41,215.

[28] Id.

[29] Id.

[30] Dodd-Frank Act § 752.

[31] 7 U.S.C. § 2(h) (2012).

[32] Japan Sec. Clearing Corp., CFTC No-Action Letter, CFTC Letter No. 12-56, (Dec. 17, 2012), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-56.pdf; Singapore Exch. Derivatives Clearing Ltd., CFTC No-Action Letter, CFTC Letter No. 12-63, (Dec. 21, 2012), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-63.pdf.

[33] 7 U.S.C. § 2(h).

[34] Id. § 7a-1(h).

[35] Id. § 6s(e).

[36] The “prudential regulators” include the Treasury Department (Office of the Comptroller of the Currency), Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Farm Credit Administration and the Federal Housing Finance Agency. See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 731, 764, 124 Stat. 1376, 1703–12, 1784–96 (2010); 7 U.S.C. § 6s(e).

[37] Basel Comm. on Banking Supervision & Bd. of the Int’l Org. of Sec. Comm’ns, Consultative Document: Margin Requirements for Non-Centrally-Cleared Derivatives (July 2012), available at http://www.bis.org/publ/bcbs226.pdf; Basel Comm. on Banking Supervision & Bd. of the Int’l Org. of Sec. Comm’ns, Second Consultative Document: Margin Requirements for Non-Centrally Cleared Derivatives (Feb. 2013), available at http://www.bis.org/publ/bcbs242.pdf.

[38] Basel Comm. on Banking Supervision & Bd. of the Int’l Org. of Sec. Comm’ns, Second Consultative Document, supra note 37, at 19–21.

[39] Id.

[40] See 7 U.S.C. § 7b-3.

[41] Id.

[42] See 17 C.F.R. § 30.3(a) (2012).

[43] Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants, 77 Fed. Reg. 55,904 (Sep. 11, 2012) (to be codified at 17 C.F.R. pt. 23).

[44] Id. at 55,945–46.

[45] Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties, 77 Fed. Reg. 9734 (Feb. 17, 2012) (to be codified at 17 C.F.R. pts. 4, 23).

[46] Id. at 9823–24.

[47] Swap Data Recordkeeping and Reporting Requirements, supra note 13; Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps, supra note 13.

[48] See Swap Data Recordkeeping and Reporting Requirements, supra note 13, at 2197–99; Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps, supra note 13, at 35,226–28.

[49] See Swap Data Recordkeeping and Reporting Requirements, supra note 13, at 2198.

[50] See id. at 2199–2202; Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps, supra note 13, at 35,227–28.

[51] See 7 U.S.C. § 2(a)(13) (2012); Real-Time Public Reporting of Swap Transaction Data, 77 Fed. Reg. 1182 (Jan. 9, 2012) (to be codified at 17 C.F.R. pt. 43).

[52] Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants, supra note 43, at 55,927–28.

[53] Id. at 55,932–36.