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relief to certain swap dealers that are subject to both U.S. and European margin requirements for uncleared swaps, is no longer applicable.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.

CFTC Chair Giancarlo Warns European Officials against Unilateral Changes to CCP Regulation

CFTC Chair J. Christopher Giancarlo raised significant concerns related to European CCP regulation in the wake of the UK’s Brexit referendum, and encouraged global regulatory cooperation to enhance the vitality, liquidity and durability of the global financial markets. His remarks were delivered at the Global Forum for Derivatives Markets Bürgenstock Conference in Lucerne, Switzerland.

Mr. Giancarlo highlighted the importance of the collective G-20 commitment, made at the Pittsburgh summit, to work together to support economic recovery through implementing global standards contained in the “Framework for Strong, Sustainable and Balanced Growth.” Mr. Giancarlo restated a desire to show deference to home-country regulation rather than “regulatory uniformity,” particularly in matters of market practices, transparency and price formation. He praised prior cooperation between the CFTC and the European Commission (“EC”) on derivatives reform, specifically in reaching an agreement on CCP equivalence (see previous coverage).

Commenting on a recent EC proposal to amend European Market Infrastructure Regulation to introduce a CCP location policy, Mr. Giancarlo acknowledged that Brexit has spurred various regulatory challenges, but cautioned that any unilateral change to the CFTC-EC Equivalence Agreement would be viewed as a violation of trust between the U.S. and Europe:

“If Brexit is indeed the trigger for a new approach in Europe regarding the supervision of cross-border CCPs, then it must be an approach developed with the cooperation and support of the CFTC – cooperation and support the CFTC is prepared to offer. If the EU must reconsider its approach to cross-border supervision of systemically important CCPs, then we cannot have piecemeal and contradictory rulemaking. Instead, we should together strive for a comprehensive and universal solution that supports strong cross-border markets, recognizes and builds upon the strengths of our respective supervisory programs, and preserves as much as possible the basic tenets of the CFTC-EC Equivalence Agreement.”

Mr. Giancarlo committed to pursue swaps reforms, and promised that a CFTC Swaps Reform Version 2.0 framework will improve on earlier efforts and remedy some of the deficiencies presented by the previous framework. He underscored LabCFTC as a demonstration of CFTC commitment to keeping pace with financial innovations and corresponding challenges in monitoring and overseeing financial markets, and said that he remains dedicated to working with other regulators to “foster safe, sound and vibrant” global markets.

Lofchie Comment: In a somewhat more assertive tone than he struck in yesterday’s remarks, Chair Giancarlo demonstrates awareness that he can best advance U.S. economic interests neither by bullying Europeans nor by acquiescing to European regulations that disadvantage U.S. firms.

CFTC Chair Giancarlo Advocates for Increased Cross-Border Deference

CFTC Chair J. Christopher Giancarlo reviewed the implementation of swap reforms over the past eight years and advocated for increased cross-border regulatory deference. In an op-ed published by French newspaper Les Échos, Mr. Giancarlo said that many of the reforms in the derivatives markets undertaken after the 2008 financial crisis have been implemented successfully, but added that cross-border supervision is an area in need of regulatory attention in light of the increased globalization of markets.

Mr. Giancarlo focused on the regulation of central clearing. He said that “diverging regulatory views” on the effective supervision of global central counterparty clearinghouses (“CCPs”) can cause “regulatory redundancies” and “legal uncertainty.” He expressed concern that these unwelcome effects may lead to increased costs and discourage market participants from centrally clearing trades. He advocated for cross-border deference as the most effective regulatory strategy for futures and swaps regulation. The CFTC, Mr. Giancarlo stated, “has a long history of regulatory deference to overseas regulatory counterparts in the futures and swaps markets.” He noted that this approach gives foreign firms access to U.S. customers. In addition, Mr. Giancarlo described how regulatory cooperation between jurisdictions allows parties to operate in accordance with the rules of their home jurisdictions. This contributes to the resiliency of global markets and, with proper coordination, ensures that CCPs operating across multiple jurisdictions are “held to the same high standards.” Mr. Giancarlo detailed the various benefits of deference arrangements, but explained that the CFTC wants to build stronger relationships with regulators from other jurisdictions and will continue to develop the deference-based framework. He also said that certain circumstances call for an alternative approach, such as when a CCP is systemically important in multiple jurisdictions.

In addition to focusing on clearing, Mr. Giancarlo noted, CFTC staff members are in the process of considering ways in which the Commission can incorporate deference into “other parts” of its regulatory framework.

Lofchie Comment: Under former CFTC Chair Gary Gensler, the CFTC essentially tried to bully the rest of the world into adopting the same rules that the United States had adopted under Dodd-Frank. This simply resulted in the rest of the world pushing back. Seee.g.Joint Cautionary Letter from the EU, France, Japan and the UK to the CFTC on U.S. Cross-Border Swaps Regulation (with Lofchie Comment)European Commissioner Barnier on U.S.-EU Cooperation [or the Lack Thereof] (with Lofchie Comment). The CFTC eventually conceded that this was not a workable strategy. The CFTC and the European Commission on Common “Path Forward” for Regulating Derivatives (with Lofchie Comment).

Chair Giancarlo has to figure out a workable strategy that affirms both U.S. regulatory interests and U.S. economic interests. U.S. financial intermediaries have a very strong interest in the results of this strategy. Too loose, and it puts U.S. firms at a competitive disadvantage in competing for business. Too restrictive, and no one wants to trade with U.S. firms.

U.S. Imposes Economic Sanctions against Venezuela

On August 24, 2017, The White House imposed a new round of economic sanctions against Venezuela.

In an Executive Order titled “Imposing Additional Sanctions with Respect to the Situation in Venezuela,” the government levied restrictions intended to “prevent U.S. persons from contributing to the Government of Venezuela’s corrupt and shortsighted financing schemes while mitigating market disruptions and harm to investors” (see U.S. Treasury Department Office of Foreign Assets Control (“OFAC”) FAQs on Sanctions and Corresponding General Licenses).

Specifically, the Executive Order bans transactions related to the following:

  • new debt with a maturity of longer than 90 days of Petroleos de Venezuela, S.A. (“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).

OFAC also issued four General Licenses to allow for (i) a wind-down period for contracts and other agreements that were effective prior to the Executive Order’s effective date; (ii) transactions involving CITGO Holding, Inc. (which is owned by PdVSA); (iii) dealings in certain specified Government of Venezuela bonds that would otherwise be prohibited; and (iv) all transactions that relate to “the provision of financing for, and other dealings in new debt related to the exportation or reexportation . . . of agricultural commodities, medicine, medical devices, or replacement parts and components for medical devices.”

Regulatory Agencies to Review Volcker Rule Provisions for Foreign Funds

Five federal financial regulatory agencies will review the treatment of certain funds under section 13 of the Bank Holding Company Act (“BHCA”), as added by the Volcker Rule.

According to a joint statement, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the SEC, and the CFTC (collectively, the “agencies”) will undertake a coordinated review of how the Volcker Rule (codified at BHCA Section 13) applies to certain foreign funds that are excluded from the definition of “covered funds.” The purpose of the review is to examine “possible unintended consequences” and impacts of the Volcker Rule.

The agencies stated that market participants are concerned about potential competitive disadvantages that could arise as a result of certain foreign funds being subjected to the Volcker Rule’s requirements due to their affiliations with a foreign banking entity, while other foreign funds remain exempt from the Volcker Rule’s requirements because they are not affiliated with a banking entity. Such foreign funds often fall outside (or are excluded from) the Volcker Rule’s definition of “covered fund,” and thus foreign banking organizations are free to invest in or sponsor such funds without violating the Volcker Rule. Nonetheless, the act of sponsoring or investing in the so-called “foreign excluded funds” can create certain problems for the funds themselves.

A foreign banking entity’s investment in or sponsorship of such a foreign excluded fund can cause the fund to be viewed as “affiliated” with the foreign banking entity. If deemed to be affiliated, foreign excluded funds are themselves “banking entities” and the funds themselves must comply with the Volcker Rule’s requirements – in particular, such funds are prohibited from engaging in proprietary trading or investing in other covered funds, absent an exception in the Volcker Rule. In addition, such funds must maintain a Volcker compliance program.

In this regard, the agencies noted that the Volcker Rule incorporates the BHCA’s existing concept of “affiliation.” For example, a foreign excluded fund would be “affiliated” with a foreign banking entity if the foreign banking entity were the general partner of the foreign excluded fund, or if the foreign banking entity were to own more than 25% of the voting shares of the fund.

The agencies also are not willing to simply exempt all foreign excluded funds from the scope of the Volcker Rule. There is no clear definition of what is a “foreign excluded fund” – other than an entity that isn’t a Volcker Rule regulated “covered fund.” The agencies expressed concern that exempting all foreign excluded funds from the “banking entity” definition could enable foreign banking organizations to use structures self-described as foreign excluded funds to engage in proprietary trading or covered fund investing in a manner that the foreign banking organization could not do so directly.

The agencies stated that until July 21, 2018, the agencies will not treat as a “banking entity” any foreign excluded fund that meets the agencies’ definition of a “qualified foreign excluded fund.” A “qualified foreign excluded fund” is defined as an entity that:

(1) Is organized or established outside the United States and the ownership interests of which are offered and sold solely outside the United States;

(2) Would be a covered fund were the entity organized or established in the United States, or is, or holds itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in financial instruments for resale or other disposition or otherwise trading in financial instruments;

(3) Would not otherwise be a banking entity except by virtue of the foreign banking entity’s acquisition or retention of an ownership interest in, or sponsorship of, the entity;

(4) Is established and operated as part of a bona fide asset management business; and

(5) Is not operated in a manner that enables the foreign banking entity to evade the requirements of the Volcker Rule or its implementing regulations.

The agencies further noted that ultimately any relief may require Congressional action to amend the Volcker Rule itself.

CFTC Acting Chair Giancarlo Appoints Chief Innovation Officer

CFTC Acting Chair Christopher J. Giancarlo named Daniel Gorfine as Chief Innovation Officer and Director of the LabCFTC initiative (see previous coverage). Mr. Gorfine will be responsible for coordinating with U.S. regulators and international regulatory bodies as the CFTC develops digital regulatory frameworks and strives to “promote market-enhancing FinTech innovation and incorporate emerging regulatory technologies.”
Most recently, Mr. Gorfine served as director of financial markets policy and legal counsel at the Milken Institute think tank.

Foreign Exchange Working Group Outlines Standards for Forex Market Participants

A group of central bank representatives and private sector market participants known as the Foreign Exchange Working Group (“FXWG”) released a new version of the “FX Global Code,” a set of conduct standards and principles for foreign exchange (“forex”) market participants. The FXWG was formulated in 2015 in order to “promote a robust, fair, liquid, open, and appropriately transparent market.”

The new version of the FX Global Code expands the topics covered by Phase One of the Code (ethics, information sharing, certain aspects of trade execution, and trade confirmation and settlement) published on May 26, 2016 (see Cadwalader Clients & Friends Memorandum, June 1, 2016). The new version includes: aspects of execution on e-trading and platforms, prime brokerage, governance, and risk management and compliance. Other important topics covered in the new version of the FX Global Code include “pre-hedging” and last-look practices.

As a whole, the FX Global Code covers six broad areas:

  • ethics;
  • governance;
  • execution;
  • information sharing and confidentiality;
  • risk management and compliance; and
  • transaction confirmation and settlement.

Lofchie Comment: The appropriate standards of conduct in the forex market have long been ambiguous, given (1) the absence (until Dodd-Frank) of much of a statutory/regulatory framework, (2) the fact that it is largely a principal market, (3) the limited involvement of lawyers and compliance personnel who might have served as “gatekeepers,” and (4) limited trade reporting information that might have served as a check on misconduct. That period of ambiguity is ending. While the FX Global Code may not have the force of law, regulators and private litigants are likely to point to it as establishing the required standard of conduct.

Many of the principles established in the FX Global Code are basic; e.g., one should strive to do the right thing, firms should manage risk appropriately, and trade disputes should be promptly resolved. Other standards, particularly those related to executing and information walls, will need to be carefully considered as to how they are implemented. Firms should review (or establish) compliance procedures for their FX desks and should compare those procedures to those governing other similar but perhaps more regulated markets.

Sargen: Time to Consider Europe

Highlights

  • Emmanuel Macron’s election as President of France has buoyed European markets, as it is the third election this year in which populist candidates have been defeated.  Moreover, with Angela Merkel’s party scoring key wins in regional elections, her chances of being re-elected in the fall are high.
  • In addition to lessened political risks, investors have been attracted by better-than-expected economic performance in the European Union (EU) this year.  Germany’s economy has been the locomotive, and Macron’s election has raised hopes that France will finally embark on much-needed structural reforms and that a renewed Franco-German partnership will revive the EU, as well.
  • Weighing these considerations, this may be a good time to add exposure to European equity markets: Profit growth has surged recently and political risk has lessened, while the discount on European stocks relative to the U.S. is in line with long-term norms.  The main risks are that Macron may not be able to deliver reforms and a populist leader could become Italy’s next President.

Background: EU Political Risks Lessen, while European Economies Improve

At the start of this year, a key issue relating to Europe was the prospect that elections in several countries – notably, Austria, Holland, France, Germany and Italy – could result in populist victories that would threaten the EU’s viability in the wake of last year’s vote in the UK in favor of Brexit.  France’s election was perceived to be the most important, because Marine Le Pen, the far right candidate, advocated that France should leave the EU and the euro.  While the odds of this happening were low, investor concerns heightened leading up to the first round elections, when there was a possibility Le Pen and far-left candidate, Jean-Luc Mélenchon, could be the two finalists.  In the event, Emmanuel Macron, a centrist politician who campaigned as a reformer, emerged as the front runner and went on to defeat Le Pen handily in the run-off.

In the wake of these developments, European equity markets rallied at one point by 5%, led by an 8% advance for the CAC.  The rally not only reflects investor relief that France will remain a core member of the EU, but also that the tide of populism on the continent has been contained:  The French election is the third in a row in which populist candidates were defeated, and recent state elections in Germany indicate that Angela Merkel’s prospects for being re-elected Chancellor appear very good.

At the same time, the EU has experienced better-than-expected economic performance, led by Germany: The 2.5% annualized rise in German GDP in the first quarter was the biggest in four quarters, and was well above potential (1.8% according to European Commission estimates.)  Investment in machinery and equipment also picked up in the quarter, suggesting a broadening of the expansion, which had been led by personal consumption.  German GDP in real terms is now 8.5% above its pre-crisis peak in 1Q 2008, well above other EU members.  Meanwhile, unemployment in Germany has fallen below 4% from a peak of more than 10% during the crisis.

For the EU as a whole, real GDP growth was 2% annualized, the best showing in the past two years. The improvement in growth is linked to the European Central Bank’s policies to keep interest rates near zero while expanding its balance sheet via asset purchases.  In addition, the 10% depreciation of the euro against the dollar in the past three years helped boost exports.

As in the United States, so-called “soft data” such as purchasing managers’ indexes and sentiment readings show a marked pick-up since the latter part of 2016.  Indeed, according to Credit Suisse, the latest PMI readings are consistent with EU growth accelerating to 3% (see Figure 1).  We would note, however, that hard economic data does not yet indicate the improvement in business sentiment.  Nonetheless, the latest EC forecast calls for the EU to grow by 1.7% this year, which is a considerable improvement from the past few years.

Figure 1:  European PMI Surveys Point to Stronger Growth 

Source: Thomson Reuters, Markit, Credit Suisse.

Another positive development is headline CPI has accelerated this year and is approaching the ECB’s 2% target, after running close to zero in 2015-2016.  This suggests the threat of deflation is waning, and the ECB can consider normalizing interest rates if this pattern continues.  That said, we believe the ECB will be very cautious about tightening monetary policy.


Will Macron Transform France and the EU?

To some extent, the boost in European equities since the first round of the French elections can be attributed to a relief rally that Marine Le Pen was not elected.  Beyond this, in the wake of Macron’s very decisive victory, some observers have asked whether the election could represent a turning point for France and the EU: Macron is a reformer who also seeks closer ties between France and Germany, which constitute the core of the euro-zone.

Soon after his election, Macron visited German Chancellor Angela Merkel, and both pledged to work closely to draw up a “road map” of reforms for the EU, including the possibility of implementing treaty changes, if necessary.  Merkel noted that work first needed to be conducted on reforms that are needed before changes in the EU treaty would be implemented.  One of the most important is the need for greater fiscal sharing if the EU is to evolve from a monetary union to a fiscal union. To go down that route, however, Germany wants to be confident France is committed to structural reforms that will make its economy more dynamic.  The reason: Germany undertook a comprehensive set of labor market reforms in the previous decade that are credited for reviving its economy.

For his part, Macron has called for a “revolution” to simplify France’s Labor Code, which is a 3,600 page document that regulates nearly every aspect of employer-employee relations.  This will not be easy to pull off, however, as he will encounter strikers and protesters, as previous French Presidents have.  For example, Francois Hollande, Macron’s processor, backed away from embarking on labor reforms in the face of stiff opposition.  Other reforms being considered include cutting the corporate tax rate from 33% to 25%, and reducing the size of France’s bloated government.  The latter goal, however, is modest, as Macron seeks to slow the expansion of government rather than to reduce its size, which is the largest among the leading industrial countries.

Having formed a new political party, Macron must first build a coalition with existing parties, so that he can gain a legislative majority in the parliamentary elections in June.  Those he has recruited so far lean strongly to the left, with many coming from the reform faction of the Socialist Party.  To appeal to the right, Macron is credited with making a wise choice of Édouard Philippe as Prime Minister.  Still, it appears unlikely Macron will win an outright majority, and he therefore may have to rule with a coalition.  Consequently, it remains unclear how successful he will be in achieving reforms that France desperately needs.

The Case for European Equities

The principal reasons for considering European equities are that (i) earnings prospects have improved with the economic upturn, while (ii) Macron’s election and the rejection of populism in several key European countries have lessened political risk.

The improvement in European corporate profits is shown in Figure 2.  It illustrates how far they lagged the U.S. market when economic growth trailed that in the U.S., and how they have improved recently.  Among developed countries, European stock markets traditionally have been the most levered to economic performance, and this continues to be the case, as earnings growth in Europe has exceeded that in the U.S. recently.  Moreover, the percentage of European companies beating expectations is the highest in a decade.  An additional factor supporting corporate profitability has been the weak euro.  Although it has firmed against the dollar recently, it is still relatively cheap on a purchasing-power basis.

Figure 2:  European Corporate Profits Lag the U.S. Until Recently
12-month trailing EPS, Index, Jan 2006 = 100


Source: Datastream, JPMAM. April 28, 2017.

On the surface, it appears European equities may offer good relative value, as the discount of European multiples to the U.S. is about 15%.  The latter, however, is close to the average of the past decade or so, when one takes into account differences in the sector compositions.  Therefore, we consider European equities to be reasonably valued relative to the U.S.

The other major consideration is that political risk in Europe has diminished considerably with Macron’s election and the likelihood that Angela Merkel will be re-elected Chancellor of Germany.  This has contributed to inflows of funds into European markets recently.  The principal risk for investors is disappointment that Macron may not be able to deliver on his reform agenda.  Another risk is that populism could resurface in the Italian presidential elections that must be held no later than a year from now.

Weighing these considerations, I believe now may be a good time to add to European equities, after years of being cautious about European markets.

Report on Repo Market Financing Raises Concerns

The Bank for International Settlements (“BIS”) published a Report that found that changes in the availability and cost of repurchase agreement (“repo”) financing are affecting the ability of repo markets to support the financial system. The Report was prepared by a study group organized by the BIS Committee on the Global Financial System (“CGFS”) that included staff members from international regulatory agencies, the Board of Governors of the Federal Reserve System and the New York Fed.

The study group examined repo transactions backed by government bonds and concluded that banks in some jurisdictions appear to be less willing to undertake repo market intermediation than they were before the crisis. Key “drivers” behind these changes include “exceptionally accommodative monetary policy” and regulatory changes that have made intermediation more costly. However, the study group cautioned that it would be premature to establish correlations between policy changes and changes in the market given “differences in repo markets across jurisdictions and the fact that repo markets are in a state of transition.”

To improve repo market functioning, the study group recommended that a series of temporary measures be implemented, including steps to reduce the “scarcity of certain collateral.”

Lofchie Comment: It seems regulators are beginning to acknowledge that new regulations may have had some negative effects on the financial markets, financial market participants, investors and the economy. Seee.g.Federal Reserve Governor Daniel Tarullo Reconsiders the Volcker RuleComptroller Reviews Regulatory Environment for Community Banks and Mutual Associations. This is a welcome development. It is the start of a conversation about the fact that some rules do more harm than good and that not every examination of a rule has to be a partisan or political event.