U.S. Banking Agencies Support Finalization of International Capital Standards Reforms

The Basel Committee’s oversight body, the Group of Central Bank Governors and Heads of Supervision, finalized reforms to the Basel III international capital standards. The reforms’ key elements include revisions to (i) the standardized approach for credit risk, (ii) the standardized approach for operational risk, (iii) the internal ratings-based approach for credit risk, (iv) the credit valuation system framework, and (v) the measurement of the leverage ratio and a leverage ratio buffer for global systemically important institutions. In addition, the reforms will modify the floor for calculating banks’ risk-weighted assets that are generated by their internal models. The final standards text detailing the reforms and a summary document containing short descriptions were made available by the Basel Committee.

In an interagency release, U.S. banking agencies (the Board of Governors of the Federal Reserve Board, the FDIC, and the Office of the Comptroller of the Currency) expressed support for the final reforms. The agencies explained that the reforms “are intended to improve risk sensitivity, reduce regulatory capital variability, and level the playing field among internationally active banks.” The agencies will assess how to appropriately apply the reforms in the United States and propose any changes through the standard rulemaking process.

European Commission Recognizes U.S. DCMs and SEFs as “Equivalent”

The European Commission (“EC”) announced a decision recognizing certain CFTC-regulated DCMs and SEFs as “eligible for compliance” with EU trading obligations for certain derivatives. CFTC staff recommended that the CFTC adopt a similar order exempting EU-authorized trading facilities from U.S. registration requirements. The decisions follow the recent agreement between the CFTC and EC to adopt a “common approach” to derivatives trading on certain platforms.

According to the EC, this recognition will allow for EU counterparties to trade derivatives on CFTC-authorized designated contract markets (“DCMs”) and swap execution facilities (“SEFs”) based in the United States. In accordance with the decision, traders will be able to use U.S. trading platforms for such transactions even as MiFID II (and its derivatives trading obligation) becomes applicable on January 3, 2018. The trading obligation will require certain derivatives transactions to be executed on EU venues or venues designated as equivalent by the EC. The European Commission noted that its decision does not affect the ability of EU counterparties to trade on CFTC-regulated DCMs and SEFs with respect to derivatives that are not subject to the EU trading obligation.

CFTC Chair J. Christopher Giancarlo urged his fellow commissioners to “act expeditiously in approving” an exemptive order for EU trading facilities. CFTC Director of the Division of Market Oversight Amir Zaidi added that the CFTC is “close behind” with its own order.

Lofchie Comment: This is a significant success. CFTC Chair Giancarlo had, at once, both reached out to the Europeans in regard to the mutual acceptance of “comparable regulations” and cautioned the Europeans against imposing regulatory requirements that would disadvantage U.S. financial intermediaries.  See CFTC Chair J. Christopher Giancarlo Criticizes “EU Plan to Invade U.S. Markets.”

OFAC Updates FAQs on Venezuelan Economic Sanctions

The U.S. Treasury Department (“Treasury”) Office of Foreign Assets Control (“OFAC”) published two Frequently Asked Questions (“FAQs”) related to economic sanctions against Venezuela.

The first FAQ (No. 547) discusses U.S. person participation in meetings concerning the restructuring of Venezuelan and Petroleos de Venezuela, S.A. (“PdVSA”) debt that existed prior to the effective date of Executive Order 13808 (“E.O. 13808”). The second FAQ (No. 548) addresses the treatment of PdVSA subsidiaries under E.O. 13808.

As previously reported, E.O. 13808 – issued on August 24, 2017 – levied restrictions to prevent U.S. persons from contributing to the Government of Venezuela’s “shortsighted financing schemes.” With certain exceptions reflected in four General Licenses issued by OFAC on the same date, E.O. 13808 generally restricted transactions with respect to the following:

  • new debt with a maturity of longer than 90 days of PdVSA (Venezuela’s state-owned oil and natural gas company);
  • new debt with a maturity of longer than 30 days, or new equity, of the Government of Venezuela;
  • bonds issued by the Government of Venezuela before the effective date of the Executive Order;
  • dividend payments or other distributions of profits to the Government of Venezuela from any entity owned or controlled, directly or indirectly, by the Government of Venezuela; and
  • purchasing securities, directly or indirectly, from the Government of Venezuela, other than new debt with a maturity of less than or equal to 90 days (for PdVSA) or 30 days (for other Government of Venezuela debt).

CFTC Chair J. Christopher Giancarlo Criticizes “EU Plan to Invade U.S. Markets”

CFTC Chair J. Christopher Giancarlo warned of the potential negative effects of European regulatory changes on U.S. financial markets.

In an Opinion/Commentary in The Wall Street Journal, Chair Giancarlo argued that as a result of Brexit pushing London financial markets outside of the European “regulatory umbrella,” the European Commission is proposing to delegate regulation of non-European Union entities to the European Central Bank (“ECB”) and the European Securities and Markets Authority (“ESMA”). Chair Giancarlo is concerned that U.S. financial institutions would now be subject to European regulatory oversight. In particular, he is concerned about potential European Commission regulations that might allow ESMA to conduct on-site inspections of U.S. businesses, like the Chicago Mercantile Exchange, without informing the CFTC.

Chair Giancarlo asserted that such regulatory measures would negatively affect U.S. markets, and potentially “dry up the capital necessary for growth and job creation.” Chair Giancarlo argued that “overlapping” regulation inhibits growth, and said that U.S. acceptance of European regulation would represent a “dangerous precedent.” The “rules-based” European approach contrasts with the “principles-based” U.S. approach, he said, and so any imposition of additional burdens is the “last thing” that the American economy needs.

Lofchie Comment: Not so long ago, CFTC Commissioners were imagining the adoption of U.S. regulations that would have required the rest of the world to acquiesce. CFTC Commissioner Chilton Delivers Speech before International Regulators Conference (with Lofchie Comment). The current Chair is now left to see if peace can be made.

OCC Provides Guidance for Federal Branches and Agencies of Foreign Banks

The Office of the Comptroller of the Currency (“OCC”) updated two documents providing guidance for OCC-supervised branches of foreign banking organizations (“FBOs”): (i) a paper titled The OCC’s Approach to Federal Branch and Agency Supervision (the “paper”), and (ii) the “Federal Branches and Agencies” booklet of the Comptroller’s Licensing Manual. The paper replaces a document from October 8, 2014, while the booklet is an update of a document previously issued in July 2015.

With the passage of the International Banking Act (“IBA”) of 1978, FBOs could opt to conduct banking operations through a branch or agency licensed by the OCC. Such licensed entities are known as “federal branches and agencies.” FBOs acting through federal branches and agencies generally have the same rights and responsibilities as national banks operating at the same locations and are subject to the same laws, regulations, policies and procedures that apply to national banks. There are important differences, however, between an FBO and a full-service bank with respect to OCC supervision.

The paper gives an overview of OCC regulatory practices with regard to FBOs. The OCC International Bank Supervision group of the Large Bank Supervision Department is responsible for the supervision program for these entities. The paper explains the supervisory approach for federal branches and agencies, including a “multifaceted” risk assessment process that takes into account the impact of the parent bank on each supervised entity. Supervision also includes onsite and offsite monitoring, cross-border coordination with home country regulators, and clear communication of examination results. The paper also includes a discussion of resolution and recovery planning, as well as of licensing processes.

The booklet includes all OCC policies and procedures for establishment, operations, and other activities for the federal branches and agencies of FBOs. It provides information regarding establishing branches or agencies, acquisitions, the conversion or contraction of operations, relocations, fiduciary powers, voluntary liquidation, and other relevant topics.

SEC Provides Relief Related to MiFID II Research Payment Provisions

The SEC issued three no-action letters to enable market participants to comply with the research provisions of MiFID II while complying with the applicable requirements of U.S. securities laws. MiFID II is due to come into effect on January 3, 2018. The issues addressed by each letter arose because investment advisers subject to MiFID II (“MiFID Managers“) will be required to separate out payments for research from commissions they pay broker-dealers for execution services.

1. Relief for Broker-Dealers from Regulation as Investment Advisers. The Division of Investment Management issued a letter permitting broker-dealers to receive cash payments for research services from MiFID Managers without being subject to regulation as “investment advisers” under the Investment Advisers Act of 1940 (the “Advisers Act“). The relief is required, as such cash payments may constitute “special compensation” for advisory services that may cause a broker-dealer to fall outside the scope of the broker-dealer exclusion from the definition of “investment adviser” in Section 202(a)(11)(C) of the Advisers Act.

The relief applies both where a MiFID Manager pays for research from its own account, and from a separate MiFID-qualifying “research payment account” (an “RPA“), which is an account funded with client money for the purpose of paying for research. Further, the relief extends to payments by non-EU managers that are contractually required to comply with the research payment provisions of MiFID II (e.g., a non-EU sub-adviser appointed by a MiFID Manager). The Division granted the relief for 30 months from the implementation of MiFID II.

2. Aggregation of Orders by Investment Advisers. The Division of Investment Management issued a second letter permitting investment advisers to aggregate client orders if clients pay the same pro rata share of execution costs, even if they pay different amounts for research. Under prior guidance, the SEC permitted investment advisers to aggregate client orders where clients shared all transaction costs (which could include research costs) on a pro rata basis. As MiFID II will result in different clients paying different sums for research, the SEC relief limits the cost-sharing requirement to execution costs. The letter requires investment advisers to implement specified policies and procedures to ensure that they otherwise aggregate (and subsequently allocate) client orders fairly.

3. Reliance on Section 28(e) Safe Harbor by Advisers Making Cash Payments for Research with Client Funds. Section 28(e) of the Exchange Act establishes a safe harbor that permits investment advisers to use client funds to purchase “brokerage and research services” for their managed accounts without breaching their fiduciary duties to clients. The Division of Trading and Markets issued a letter to permit a MiFID Manager to use client funds to make payments for research through a client-funded RPA in reliance on Section 28(e). The relief was requested because Section 28(e) arrangements typically contemplate that an investment adviser will make a single “bundled” commission payment to a broker-dealer to cover both execution and research services. Under MiFID II, a MiFID Manager will be required to make separate payments for execution and research services, and retain control of any RPA account used to make payments for research services with client money. The letter acknowledges that, notwithstanding these different payment mechanics, a MiFID Manager should be permitted to rely on Section 28(e) provided the executing broker-dealer is contractually obligated to pay for research through use of an RPA, and the arrangement otherwise meets the requirements of Section 28(e).

While SEC Chair Jay Clayton said that the relief represents a “measured approach” that allows U.S. market participants to comply with MiFID II without significantly changing the U.S. regulatory approach, Commissioner Kara Stein argued that the relief merely “kicks the can down the road” without addressing key policy questions regarding the U.S. approach to the transparency of fees relating to research and trading.

Lofchie Comment: Notwithstanding Commissioner Stein’s comment as to kicking the can down the road, kudos to Chair Clayton for adopting a fairly long-term no-action letter that gives both regulators and market participants an opportunity to see what the effects of the MIFID rule changes might be, whether the U.S. rules should be changed, and, if so, what those rule changes should be. It is a waste of Commission and industry resources to adopt short-term no-action letters that must be continually renewed. While thirty months may seem a long time, the reality is that the SEC still has significant Dodd-Frank rulemaking on its plate, as well as numerous other issues that are also pressing, such as market structure and corporate disclosure.

Further, it should be pointed out that the SEC issued the no-action letters because the Europeans have adopted regulations that are inconsistent with the U.S. Securities Exchange Act. While Commissioner Stein is right in asserting that Section 28(e) of the Securities Exchange Act may not be good public policy, there are very good arguments to be made that it is; i.e., that the Section encourages the production of investment research. This is the determination that Congress made when it adopted the statutory provision. If the determination seems no longer correct, then, at least insofar as U.S. market participants are concerned, it is the U.S. Congress that should reverse the determination, not the Europeans.

MFA Recommends Greater Harmonization of CFTC/EU Swaps Trading Rules

The Managed Funds Association (“MFA”) published a comparative analysis of U.S. and European Union (“EU”) derivatives trading regimes, and made recommendations for further cross-border harmonization. The MFA found the two regimes to be aligned in many important areas. The MFA identified two areas where harmonization could be improved: (1) the calibration of the transparency regime in the EU, and (2) whether prearranged trading is permitted for instruments subject to the trading obligation in the EU.

The MFA made the following observations and recommendations:

  • Pre-trade transparency/modes of execution: evaluate European Securities and Markets Authority (“ESMA”) “transitional transparency calculations” to ensure that liquidity classifications are appropriate and market participants receive adequate liquidity. The CFTC should consider allowing greater flexibility for execution on swap execution facilities.
  • Prohibition on prearranged trading: ensure that prearranged trading is prohibited by ESMA except for block trades.
  • Post-trade transparency: the length of public reporting delays differs between EU and U.S. regimes; ESMA should continue to evaluate transitional transparency calculations and should consider limitations on the use of the extended deferral program of four weeks.
  • Straight-through processing: given that U.S. and EU rules are substantially similar, monitor to ensure that rules are faithfully implemented by trading venues.
  • Impartial/non-discriminatory access to trading venues: given that U.S. and EU rules are substantially similar, monitor to ensure that rules are faithfully implemented by trading venues.
  • Process for determining the derivatives subject to a trading obligation: the CFTC should consider undertaking greater oversight of the “made-available-to-trade” process.
  • Scope of instruments covered by a trading obligation: instruments subject to regulation under both U.S. and EU regimes are substantially similar.
  • Access to trading venue rulebooks: EU regulators should encourage trading facilities to disclose their rulebooks to market participants.

Lofchie Comment: CFTC Chair Giancarlo favors greater flexibility as to the means by which swaps are executed. Having a buy-side group support this direction should be further proof that the Chair is going in the right direction.

Another recommendation by MFA that is worth strong support (and Congressional amendment of Dodd-Frank) is the “made available to trade” process under which an exchange can effectively force a particular type of swap to be traded on exchange (if that type of swap is centrally cleared). Giving an exchange this type of power, where the exchange may be completely self-interested in its use of this authority, is, to put it politely, a very bad idea. Only the CFTC should have the authority to force any particular type of swap to be traded only on-exchange.

CFTC Director of International Affairs Talks Cross-Border Regulation

In an interview conducted by CFTC Chief Market Intelligence Officer Andrew Busch, CFTC Director of International Affairs Eric Pan discussed cross-border regulation including the recent equivalence agreement between the U.S. and the European Union (“EU”).

Director Pan explained that regulatory reforms must be developed in a manner that does not fragment the cross-border market or cause significant disruptions. He highlighted deference as an important “cooperative” policy, explaining that “everyone should be responsible for their home market,” but, when jurisdictions are also regulating firms that do business in other jurisdictions, they “should defer to the regulatory authorities of those other jurisdictions.” Mr. Pan stated that regulators want to ensure that no duplicative or conflicting rules exist across jurisdictions. He asserted that regulators all wish to implement robust regulations without also imposing heavy compliance costs and unnecessary burdens.

On recent CFTC and European Commission (“EC”) cooperation efforts (equivalence decisions on margin requirements for uncleared swaps and a common approach for regulating trading platforms), Director Pan said the size of the two markets and complexity of the regulated areas makes the agreements particularly significant. He said that the regulators are not looking to “weaken regulation,” but instead to find the most effective way to deploy agreed-upon high standards. Mr. Pan warned against EU plans to facilitate central counterparty relocation in light of Brexit, saying that it could have consequences for both the United States and EU member nations.

Lofchie Comment: Mr. Pan’s interview is directed largely at an audience of European regulators. He carries a combined message of carrot (deference to European regulators as to home market regulation) and stick (don’t force central counterparties to move to continental Europe in the wake of Brexit). This carrot and stick approach reiterates the message previously delivered by CFTC Chair Giancarlo. See CFTC Chair Giancarlo Warns European Officials against Unilateral Changes to CCP RegulationCFTC Chair Giancarlo Advocates for Increased Cross-Border Deference.

CFTC, EU Make Comparability Determinations on Margin Requirements for Uncleared Swaps

The CFTC approved a comparability determination that European Union (“EU”) margin requirements for uncleared swaps are comparable in outcome to relevant CFTC Regulations. The European Commission announced a similar equivalence decision that the CFTC uncleared margin rules are comparable to the EU’s requirements.

The CFTC determination generally allows swap dealers that comply with the EU margin requirements, in circumstances enumerated in the CFTC Regulation 23.160, to be deemed to be in compliance with CFTC requirements. Such swap dealers would remain subject to CFTC examination and enforcement authority. CFTC Letter 17-22, which extended exemptive relief to certain swap dealers that are subject to both U.S. and European margin requirements for uncleared swaps, is no longer applicable.

In addition, the CFTC announced that the CFTC and the EC have agreed to a “common approach” for certain authorized trading venues. Under the common approach, the CFTC plans to grant relief to certain EU trading venues from the swap execution facility (“SEF”) registration requirement, provided they satisfy the “comparable and comprehensive” standard for exemptive relief under CEA Section 5h(g). The EU would propose a corresponding equivalence decision recognizing CFTC-authorized SEFs and designated contract markets as eligible venues.

CFTC Chair J. Christopher Giancarlo characterized the cooperative efforts as an important step in cross-border harmonization:

“These cross-border measures will provide certainty to market participants. It will ensure that our global markets are not stifled by fragmentation, inefficiencies, and higher costs. Indeed these measures are critical to maintaining the integrity of our swaps markets.”

 

Lofchie Comment: This is a significant step by the CFTC both in improving relationships with the Europeans and in accomplishing Chair Giancarlo’s goals of facilitating the ability of firms to transact globally and undoing the geographic market fragmentation that had resulted from the post Dodd-Frank regulatory regime.  One can guess that the Chair will next turn attention to improving the rules for trading on U.S. swap execution facilities, which will benefit the competitiveness of the United States as a financial center.

SEC Names Chief of Office of International Corporate Finance

The SEC named Robert Evans III as Chief of the Office of International Corporate Finance. The office operates within the SEC Division of Corporation Finance and is responsible for “outreach to non-U.S. issuers that access the U.S. capital markets.”

Prior to the appointment, Mr. Evans was Deputy Director of the Division of Corporation Finance. Before that, worked as a partner in the capital markets practice at Shearman & Sterling LLP.