CFTC Issues Correction to Procedures in Federal Register That Establishes Appropriate Minimum Block Sizes for Large Notional Off-Facility Swaps and Block Trades

The CFTC corrected a final rule from the May 31, 2013 Federal Register which adopted Dodd-Frank regulations in order to define criteria for grouping swaps into separate categories and establish methodologies for setting appropriate minimum block sizes for each swap category. The correction fixes errors pertaining to certain contract descriptions, block sizes, and block units for interest rate swaps, credit swaps, foreign exchange, and other commodity swaps. 

See:  78 FR 42439.
See also:  Core Principles and Other Requirements for Swap Execution Facilities (June 4, 2013); CFTC Publishes Text of SEF Rules (May 21, 2013).

Comments on TIPS Article in the WSJ

This morning, Min Zeng and Carolyn Cui from the WSJ wrote a terrific piece For Treasury, a Question of Fundamentals / Department Seeks Answers for Inflation-Protected Securities.

I would add that two factors are operative in pushing real yields (TIPS) higher:

First, investors are re-balancing their portfolios from bonds to stocks on the heels of tapering comments.  A Fed less active in purchasing Treasury obligations at some future date reduces the constant bid for all Treasuries – TIPS included.

Second, the TIPS market was mispriced with negative yields.  Inflation is positive at present…and will likely remain substantially above zero for the foreseeable future.  June CPI inflation reached 1.8% on a year-over-year basis up from 1.4% the previous month,

The bottom line is Fed purchases have distorted pricing in the Treasury market.  Changes on the margin prompt swift shifts in pricing and yields.

CFTC Posts “Cross-Border Guidance” and “Cross-Border Exemptive Order” for Swaps

On July 12, 2013, the CFTC adopted further guidance (the “Final Cross-Border Guidance”) and exemptive relief (the “Cross-Border Exemptive Order”) with respect to cross-border swaps activities.  The two documents were published on the CFTC’s website on July 15, 2012, but the CFTC Staff has been authorized to continue making corrections to them prior to their publication in the Federal Register. 

I. Jurisdiction.  The Guidance begins with a discussion of the CFTC’s view of its jurisdiction under Dodd-Frank. Essentially, the CFTC views itself as potentially having jurisdiction over transactions anywhere in the world, albeit limited by considerations of “international comity.”

II. U.S. Person Definition.  More substantively, the Guidance then moves into a discussion of the definition of U.S. person.  This definition is summarized at pages 94-5 of the Guidance to generally include the following:

(i) a natural person who is a U.S. resident;
(ii) an estate of a decedent who was a U.S. resident at the time of death;
(iii) legal entities organized or incorporated in the United States or having their principal place of business in the United States;
(iv) any pension plan for U.S. legal entities unless the pension plan is primarily for foreign employees;
(v) any trust governed by the laws of a state or other jurisdiction in the United States;
(vi) any commodity pool or other collective investment that is majority-owned by persons described above unless it is publicly offered only to non-U.S. persons and not offered to U.S. persons;
(vii) certain legal entities that are directly or indirectly majority-owned by U.S. person(s) 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 U.S. person.

Under this interpretation, (a) the term “U.S. person” generally means that a non-U.S. branch of a U.S. bank or other legal entity is a U.S. person and (b) a non-U.S. fund with majority non-U.S. ownership may be considered a U.S. person by virtue of having a U.S. adviser and thus being deemed to have its principal place of business in the United States.

Under the Cross-Border Exemptive Order, market participants may continue to apply the definition of the term U.S. person contained in the January 2013 Exemptive Order until 75 days after the Final Cross-Border Guidance is published in the Federal Register (i.e., until approximately early October 2013).

III. Swap Dealer De Minimis Calculations as to Aggregation.  The Final Cross-Border Guidance provides that, although U.S. and non-U.S. persons must aggregate their dealing activity with the dealing activity of any affiliate (U.S. or non-U.S.) under common control, swaps of a registered swap dealer may be excluded from its affiliates’ de minimis calculations.  When an affiliated group meets the de minimis threshold on an aggregate basis, at least one affiliate within the group will be required to register as a swap dealer, but the remaining affiliates may remain unregistered for as long as their aggregate dealing activity (excluding the dealing activity of any registered swap dealer) falls below the de minimis threshold.

IV. What Goes into a Non-U.S. Swap Dealer’s De Minimis Calculations.  A non-U.S. person that is guaranteed by a U.S. person or is a so-called conduit affiliate of a U.S. person is required to include in its de minimis calculation all of its dealing swaps with U.S. and non-U.S. person counterparties. Otherwise, a non-U.S. person is required to include in its swap dealer de minimis calculation:

(1) dealing swaps with counterparties who are U.S. persons (but excluding foreign branches of U.S. swap dealers); and
(2) dealing swaps with certain guaranteed affiliates of U.S. persons.

V. Entity-Level and Transaction-Level.  The Guidance generally preserves the distinction between entity-level and transaction-level compliance requirements that was contained in prior CFTC statements, but it significantly expands the large trader reporting requirements as to non-U.S. entities.

VI. Substituted Compliance and the Six Jurisdictions.  In theory, the Guidance establishes the possibility of a broad recognition of substituted compliance but does not provide any details as to how that might work in practice.  However, the exemptive order provides a more definitive plan of substituted compliance for registered swap dealers that are located in the EU, Switzerland, Canada, Japan, Australia and Hong Kong.  These are the only non-U.S. jurisdictions in which any swap dealers are registered with the CFTC.  Under the current regulatory scheme, it would seem doubtful that any swap dealers from outside of the six jurisdictions would register with the CFTC.  Thus, for all practical purposes, the workings of substituted compliance will likely be decided in negotiations between the CFTC and regulators in each of these six jurisdictions.

See:  Link to page containing (i) opening statements of the various Commissioners; (ii) the Fact Sheets published prior to the meeting; and (iii) the pre-Federal Register versions of the Final Cross-Border Guidance the the Cross-Border Exemptive Order.
See also: CFTC Approves Cross-Border Guidance and Exemptive Order.

CFTC Approves Cross-Border Guidance and Exemptive Order

The CFTC approved on Friday its “final guidance” on cross-border issues, as well as a related exemptive order.  The summary below provides some brief descriptions of the guidance and order, and we expect to release a more substantial memorandum later in the day. The final guidance contains (i) an interpretation of the CFTC’s jurisdiction under Dodd-Frank (which the CFTC asserts is very, very expansive); (ii) a revised definition of “U.S. person,” including an explanation of how the definition applies to offshore funds managed by a U.S. adviser (generally the fund is regarded as “U.S.” if either the fund is majority-owned or if the principal decision-makers are based in the United States) – in addition, entities located outside the United States may be deemed to be U.S. persons if either they are guaranteed by a U.S. person or they are deemed to be conduits for swaps activities back into the United States; (iii) effectively, some further changes in what constitutes “transaction-level” vs. “entity-level” requirements (for example, “large trader reporting” is called a transaction-level requirement, but substituted compliance is not available for it); and (iv) a concession that substituted compliance should be available to swap dealers based in various key jurisdictions, but no actual details as to how substituted compliance will work.

The revised definition of U.S. person will have a material effect on the manner in which potential swap dealers and major swap participants calculate the aggregate notional of their swaps for purposes of determining whether they are required to register.  In addition, the guidance changes the manner in which affiliated non-registered entities are required to aggregate their swaps positions for purposes of determining whether they are required to register. 

The revised definition of U.S. person is to come into effect 75 days after its publication in the Federal Register, but during that time market participants would have some ability to comment on the guidance. 

As of today (July 15), non-U.S. swap dealers may be required to comply with Large Trader Reporting for swaps with non-U.S. counterparties even though this result is not consistent with the transition relief afforded by the CFTC for other requirements, including swap data repository reporting. Obviously, this requirement is not likely to be satisfied, given the complete absence of notice.

In conjunction with the final guidance, the CFTC also approved an exemptive order that is available to swap dealers located in six regions or jurisdictions (the European Union, Canada, Japan, Australia, Hong Kong and Switzerland).   Swap dealers in these six jurisdictions may delay compliance with Entity-Level Requirements, and may comply with the requirements of the local jurisdiction in which it is established (and only to the extent required by such jurisdiction) in lieu of complying with any Transaction or Entity-Level Requirement for which substituted compliance is possible, until the earlier of December 21, 2013 or 30 days following the issuance of a substituted compliance determination for the relevant requirements of the jurisdiction in which the non-U.S.swap dealer is established.  As we understand that the only non-U.S. swap dealers that have registered with the CFTC are located in the six jurisdictions, the exemptive order is of much more immediate significance than is the guidance on substituted compliance.

Linked below are the documents that the CFTC had circulated in advance of the meeting.  The final guidance and exemptive order are not yet available, although drafts of these have been circulated (these are not attached).  In addition, in advance of the approval, the CFTC staff has issued four no-action letters dealing with cross-border issues.   See news story with the summary of these letters. 

Lofchie Comment:  The CFTC simply seems indifferent to regulatory process.  According to the CFTC, its actions with respect to cross-border issues are not required to be published as rulemakings for comment in the Federal Register because they are mere “guidance” and not “rules.”  The basis for this distinction is entirely unclear, as the guidance has a material effect on the way in which firms determine whether they are required to register as swap dealers or major swap participants with the CFTC; the guidance will also have a determinative effect on whether non-U.S. CFTC registrants will be required to comply with the CFTC rules or will be subject to substituted compliance.  While calling its statements “guidance,” the CFTC does not seem to be leaving the door open for market participants to reach different interpretations of the law.  The question that follows is whether there is a challenge to the legality of the CFTC’s “guidance” based on a violation of the Administrative Procedures Act – any such challenge seems to have a material basis.  (The Administrative Procedures Act defines as “rule” as “the whole or a part of an agency statement of general or particular applicability and future effect designed to implement, interpret, or prescribe law or policy” – a definition that would seem to include the CFTC’s guidance.”)

Publishing rules for comment in the Federal Register, and addressing public comments on them, is not a matter of mere formality.  Publication and public comment allows the regulator proposing a rule to obtain the benefit of the experience and insight of a far broader group than it can obtain through merely internal conversations.  In this regard, I note that the CFTC’s final guidance as to the application of the definition of “U.S. person” as applied to non-U.S. funds is quite different from any proposal that it has previously made – and there seems to be no reasonable policy basis for it.  That is, the CFTC would treat as a U.S. person any fund with (i) either a U.S. adviser, but wholly foreign ownership or (ii) a foreign adviser but majority U.S. ownership.  Yet the implications of these two situations are entirely different.  In the first case, there is a U.S. sales practice issue, but no direct economic effect on U.S. investors; in the second situation, matters are reversed. 

Publication in the Federal Register would also allow commentary on the incentives that the guidance will create to move jobs outside of the United States.  Certainly, any swap dealer doing business with non-U.S. persons will be very strongly motivated to move its operations to a non-U.S. swap dealer so as to avoid being subject to the CFTC’s transaction-level compliance requirements.  Likewise, advisers to non-U.S. funds are going to be motivated to move their headquarters outside the United States to avoid being deemed a U.S. person.   Conversely, swap dealers and advisers who remain in the United States will be subject to competitive disadvantage in their dealings with non-U.S. counterparties.  Had the CFTC’s proposal been published in the Federal Register, these competitive issues might be at least vetted for public comment.

We will discuss many of the cross-border issues further and in more detail as official documents become available.

See: Documents Issued in Advance of the Meeting: Cross-Border Fact Sheet.; Exemptive Order Fact Sheet.

CFTC Commissioner O’Malia’s Opening Statement at Cross-Border Guidance and Exemptive Order Open Meeting

CFTC Commissioner Scott D. O’Malia delivered a speech to fellow CFTC Commissioners and international regulators thanking them for their work in modifying the Cross-Border Guidance and Exemptive Order. In his remarks, Commissioner O’Malia advocated his preference for engaging international regulators before the release of the Proposed Guidance instead of imposing statutorily weak guidance in haste. In addition, Commissioner O’Malia supported a 75-day comment period on the Exemptive Order in order to market participants to comply with the CFTC’s last-minute guidance. 

See: Commissioner O’Malia’s Opening Statement.

CFTC Commissioner Bart Chilton’s Statement on Cross-Border Guidance and Exemptive Order: “Just Say’n”

Commissioner Chilton commended the CFTC, saying “we’ve done way more than other financial regulators.”

Lofchie Comment:  I agree with Commissioner Chilton that the CFTC has done way more than other financial regulators.  However, financial regulators are better judged on the quality of their work than quantity.  In this regard, according to Commissioner Chilton, the CFTC may “leave a thread hanging loose.”  On this issue, we do not agree.  As I commented separately in regard to the CFTC’s action, the CFTC would have done better by the country in issuing a definitive proposal for public comment; had it done so, it would have received comments going beyond a loose thread.

See: Commissioner Chilton’s Statement.

CFTC Commissioner Wetjen’s Statement on CFTC Cross-Border Guidance and Exemptive Order

Commissioner Wetjen explained how he was persuaded to support the CFTC’s Cross-Border Guidance and Exemptive Order.   As to the timing,  Commissioner Wetjen said (i) on the one hand, the CFTC “was not in a good position to delay these [cross-border] policy judgments any longer and (ii) on the other hand, “it could turn out that these compliance dates are too aggressive with respect to certain requirements,” and thus the CFTC should be prepared to issue delays.

Lofchie Comment:  On the issue of timing, the new requirements can not reasonably be achieved.  Thus, we re-experience this seemingly endless cycle of the CFTC bringing forth requirements with unrealistic compliance dates, and so no-action relief must be issued (often after the compliance date has passed), which restarts the cycle yet again.

See: Commissioner Wetjen’s Statement.

SEC Commissioner Daniel M. Gallagher’s Remarks Primarily on Proxy Issues

Commissioner Daniel M. Gallagher of the SEC delivered a speech that was primarily focused on proxy issues.  Commissioner Gallagher made two major points.  The first one, which he made only briefly, was that SEC requirements have likely increased the number of proxy items that are available for investor vote to the point that the ability to vote is more of a burden than it is an empowerment.  The second, which is the real focus of his talk, is that investment advisers take the view, based on two SEC staff no-action letters, that they are relieved of the burden of considering how to vote on proxies so long as they follow the advice provided by a third-party proxy service.  In Commissioner Gallagher’s view, this has a number of negative consequences: (i) advisers vote in alignment with proxy services so as to avoid compliance actions by the SEC rather than to serve their clients’ interests, (ii) proxy services do as little research as possible, since advisers just want to be given a safe harbor from disciplinary action in exercising their proxies, and do not really care about the results; and (iii) proxy services have too much power.   Accordingly, Commissioner Gallagher urged the SEC to recall the two prior no-action letters and to issue Commission-level (as opposed to staff) guidance on an adviser’s responsibilities to vote proxies.

Somewhat briefly, Commissioner Gallagher criticized the SEC’s resource extraction rule as being too expensive, which was recently struck down by the courts as “arbitrary and capricious.”

See: Commissioner Gallagher’s Remarks.

CFTC Staff Issues Four No-Action Letters on Cross-Border Swaps Issues (Letters 13-43, 13-44, 13-45, 13-46)

The CFTC issued four no-action letters that address certain issues relating to swaps regulation, following the announcement earlier today by European Commissioner Barnier and CFTC Chairman Gensler of a “Path Forward” for how to jointly approach cross-border derivatives.

Two of the letters were issued by the CFTC’s Division of Clearing and Risk (“DCR”) to two European-based clearing organizations, respectively, intended to facilitate their provision of certain clearing services to clearing members that are U.S. persons, during the pendency of their derivatives clearing organization (“DCO”) registration applications. In the respective letters, DCR provided no-action relief as follows:

  • DCR will not recommend that the CFTC take enforcement action against LCH.Clearnet SA (“LCH.C SA”) for failing to register as a DCO under CEA Section 5b(a) with respect to clearing certain credit default swaps on a broad-based index of reference entities (“Index CDS”).
    • In addition, DCR will not recommend enforcement action against U.S. clearing members of LCH.C SA for failing to clear their proprietary Index CDS business through a registered DCO.
  • DCR will not recommend that the CFTC take enforcement action against Eurex Clearing AG (“Eurex Clearing”) for failing to register as a DCO under CEA Section 5b(a) with respect to clearing certain interest rate swaps (“IRS”) and certain Index CDS.
    • In addition, DCR will not recommend enforcement action against U.S. clearing members of Eurex Clearing for failing to clear their proprietary IRS and Index CDS business through a CFTC-registered DCO.

In each case, the relief will be effective until the earlier of (1) December 31, 2013, or (2) the date upon which the CFTC approves LCH.C SA’s or Eurex Clearing’s (as applicable) pending application for registration as a DCO.

A third no-action letter was issued by the CFTC’s Division of Swap Dealer and Intermediary Oversight (“DSIO”), providing relief from certain designated risk mitigation requirements applicable to registered swap dealers (“SDs”) and major swap participants (“MSPs”) organized or established in the United States or European Union with respect to certain transactions, when such transactions are subject to both CEA Section 4s and Article 11 of the European Market Infrastructure Regulation (“EMIR”). Under the terms of the no-action letter, DSIO stated that relief would be extended to SDs and MSPs for whom, under both regimes, the requirements are essentially identical and the SD or MSP complies with the requirements under EMIR. The scope of relief provided in the no-action letter is subject to the specific conditions that are enumerated in the letter, including its limitation to the products and participants described in the letter.

Finally, the CFTC’s Division of Market Oversight (“DMO”) issued a no-action letter that expands the relief previously provided under the terms of the 16 existing direct access no-action letters issued by CFTC staff. Pursuant to the previous no-action letters, a foreign board of trade (“FBOT”) may permit identified members or other participants located in the United States to enter trades directly into the trade matching system of the FBOT only with respect to futures and option contracts. Under the terms of the no-action letter issued today, DMO amended the previous no-action letters to permit those FBOTs to list swap contracts for trading by direct access, subject to certain conditions that are enumerated in the letter.

Lofchie Comment:  These no-action letters are being issued on the eve of the CFTC’s open meeting on cross-border issues.  To the extent that the issuance of these letters and the adoption of the “Path Forward” signals that the CFTC is going to adopt cross-border regulatory rules that have not been subject to public comment or review, that is unfortunate.

See: CFTC Letter 13-43; CFTC Letter 13-44; CFTC Letter 13-45; CFTC Letter 13-46.
See also: Attachment A-Products Offered for Clearing by Eurex Clearing AG.
Related News: The CFTC and the European Commission on Common “Path Forward” for Regulating Derivatives (July 11, 2013).