University of Houston finance professor Craig Pirrong discussed the ongoing tension between the CFTC and its European counterparts with respect to cross-border issues in his blog post titled “Damage Control at the CFTC.”

According to Professor Pirrong, the failure on both sides to recognize cross-jurisdictional central counterparty clearinghouses (“CCPs”) could make clearing swaps “prohibitively expensive” and increase the “already worrisome fragmentation of swaps markets.” Professor Pirrong asserted that European regulators are “dismayed” at U.S. Regulators’ “rather imperialistic attitude” on derivatives regulation, especially under the leadership of Chair Gensler. He referenced CFTC Commissioner Christopher Giancarlo’s scathing speech,” in which Commissioner Giancarlo pointed out a number of CFTC rules that fail to serve their intended purpose of reducing risk, including:

• trading only on order books and request-for-quote systems to two, then three, counterparties;
• exchange-certified “made available to trade” determinations;
• swap execution facility position-limit maintenance and enforcement;
• limitations on counterparty transparency; and
• CFTC Staff Advisory No. 13-69 (November 14, 2013).

Additionally, Professor Pirrong and Commissioner Giancarlo criticized the recent ruling by the D.C. District Court on the CFTC’s issuance of its “Interpretive Guidance” and a “Staff Advisory,” rather than a formal rule regarding cross-border issues. According to Professor Pirrong, the CFTC is attempting through its recent guidance to “impose its dictates through such procedural legerdemain.” In his speech, Commissioner Giancarlo stated that he intends to do everything he can to encourage the CFTC to replace its cross-border guidance with a final rule. Commissioner Giancarlo also would like to see the CFTC withdraw the November 13 Advisory, which he believes “fails not only the letter and spirit of the ‘Path Forward,’ but also contradicts the conceptual underpinnings of the CFTC’s Interpretive Guidance.”

Professor Pirrong expressed the view that under the new CFTC Commissioner, Timothy Massad, the CFTC could implement a new “more reasonable” approach to derivatives regulation than under his predecessor.

Lofchie Comment: Professor Pirrong’s comments and, more importantly, CFTC Commissioner Giancarlo’s speech, raise two important procedural policy questions for the CFTC. First, is it good public policy for the CFTC to regulate cross-border transactions through the issuance of what it calls “guidance” rather than a formal rulemaking process? While a court affirmed the CFTC’s authority to rely on guidance, the fact that the CFTC has the “authority” to act without going through a rulemaking process does not mean that acting in this manner is good policy. The SEC’s rulemaking on cross-border issues is a better piece of work than the CFTC’s guidance, and that the difference is likely reflected in part by the additional time that the SEC gave to considering difficult issues and the discipline of going through a formal rulemaking process, including responding to public comments and conducting a cost-benefit analysis.

Second, the CFTC must decide this: what are the fundamental policies behind Dodd-Frank? There is no reason to believe that Dodd-Frank was primarily intended to address swap-trading procedures. Thus, there is no reason for the CFTC to seek to impose United States trading rules on European swaps markets (after all, we do not impose our trading rules on European securities markets or futures markets). Accordingly, it follows that the CFTC should scale back its attempts to impose trading procedures on the markets generally, perhaps leaving some room for knowledgeable market participants to decide how they wish to trade.

See: Streetwise Professor Craig Pirrong’s blog post, “Damage Control at the CFTC“.

The Over-the-Counter (“OTC”) Derivatives Regulators Group (“ODRG”) issued a report that provides an update to the G20 on further progress in resolving OTC derivatives’ cross-border implementation issues. 

The ODRG is made up of authorities with responsibility for OTC derivatives markets regulation in Australia, Brazil, the European Union, Hong Kong, Japan, Ontario, Quebec, Singapore, Switzerland and the United States.  The report described two areas in which the ODRG is working to develop approaches to address cross-border issues: (i) potential gaps and duplications in the treatment of branches and affiliates, and (ii) the treatment of organized trading platforms and the implementation of the G20 trading commitment.

The report also addressed four areas in which the ODRG is implementing understandings reached previously: (i) equivalence and substituted compliance, (ii) clearing determinations, (iii) risk mitigation techniques for noncentrally cleared derivatives transactions (margin), and (iv) data in trade repositories and barriers to reporting to trade repositories.

The ODRG stated that it will submit its next report for the G20 Leaders Summit in November 2014.

Lofchie Comment: The report “welcomed the set of understandings of the ODRG Principals on cross-border issues relating to OTC derivatives reforms as a major constructive step forward for resolving remaining conflicts, inconsistencies, gaps and duplicative requirements,” and was signed by the Chairpersons of both the SEC and the CFTC. It is difficult to gauge the extent to which the CFTC is prepared to resolve its jurisdictional disputes with regulators in the G-20 countries. On the positive side, the report notes that the SEC’s adoption of its cross-border rules is a sign of cross-jurisdictional progress. On the negative side, the report notes that the European Union is proposing determinations of regulatory equivalence with respect to central counterparty requirements in Japan, Australia, Hong Kong, India and Singapore (though no mention is made of progress with the United States).

See: ODRG Report on Cross-Border Implementation Issues. 

The Basel Committee on Banking Supervision and the International Organization of Securities Commissions (“IOSCO”) released the final framework for margin requirements for non-centrally cleared derivatives. Under these global standards, all financial firms and systemically important non-financial entities that engage in non-centrally cleared derivatives will have to exchange initial and variation margin commensurate with the counterparty risks arising from such transactions.

Below are key principles set out in the framework.

1. Appropriate margining practices should be in place with respect to all derivatives transactions that are not cleared by CCPs.
2. All financial firms and systemically important non-financial entities (“covered entities”) that engage in non-centrally cleared derivatives must exchange initial and variation margin as appropriate to the counterparty risks posed by such transactions.
3. The methodologies for calculating initial and variation margin that serve as the baseline for margin collected from a counterparty should (i) be consistent across entities covered by the requirements and reflect the potential future exposure (initial margin) and current exposure (variation margin) associated with the portfolio of non-centrally cleared derivatives in question and (ii) ensure that all counterparty risk exposures are fully covered with a high degree of confidence.
4. To ensure that assets collected as collateral for initial and variation margin purposes can be liquidated in a reasonable amount of time to generate proceeds that could sufficiently protect collecting entities covered by the requirements from losses on non-centrally cleared derivatives in the event of a counterparty default, these assets should be highly liquid and should, after accounting for an appropriate haircut, be able to hold their value in a time of financial stress.
5. Initial margin should be exchanged by both parties without netting of amounts collected by each party (i.e., on a gross basis) and held in such a way as to ensure that (i) the margin collected is immediately available to the collecting party in the event of the counterparty’s default; and (ii) the collected margin must be subject to arrangements that fully protect the posting party to the extent possible under applicable law in the event that the collecting party enters bankruptcy.
6. Transactions between a firm and its affiliates should be subject to appropriate regulation in a manner consistent with each jurisdiction’s legal and regulatory framework.
7. Regulatory regimes should interact so as to result in sufficiently consistent and non-duplicative regulatory margin requirements for non-centrally cleared derivatives across jurisdictions.
8. Margin requirements should be phased in over an appropriate period of time to ensure that the transition costs associated with the new framework can be appropriately managed. Regulators should undertake a coordinated review of the margin standards once the requirements are in place and functioning to assess the overall efficacy of the standards and to ensure harmonization across national jurisdictions as well as across related regulatory initiatives.
   

Compared with the near-final framework proposed earlier this year, the final framework includes the following modifications:

• Exempts physically settled foreign exchange (“FX”) forwards and swaps from initial margin requirements;
• Exempts the fixed, physically settled FX transactions that are associated with the exchange of principal of cross-currency swaps from initial margin requirements; and
• Permits limited rehypothecation of initial margin collateral, subject to a number of conditions. 

See: Margin Requirements for Non-Centrally Cleared Derivatives Framework; Press Release.
See also: Basel Committee and IOSCO Issue Near-Final Proposal on Margin Requirements for Non-Centrally Cleared Derivatives (February 20, 2013).

After the CFTC’s continuing back-and-forth with SIFMA, ISDA and the Institute of International Bankers (the “Associations”), the United States District Court for the District of Columbia denied the CFTC’s motion to file a supplemental declaration and two exhibits in the Cross-Border Guidance Case.

The filing consisted of the supplemental declaration of CFTC Assistant General Counsel Martin B. White, as well as two additional documents:  (i) SIFMA’s “Note Regarding Non-U.S. Affiliate Participation in Swaps Market” and (ii) a copy of an article published by POLITICO Pro, titled “Banks Outline Pushback on Swap Guarantee Worries,” which the CFTC believed would serve to weaken the Associations’ argument that the CFTC had improperly adopted a rule regulating cross-border activities without compliance with the appropriate administrative procedures.

Related news: Associations Submit Response to CFTC’s Second Notice of Supplemental Authority in CFTC Cross-Border Guidance Case (July 30, 2014).

SIFMA, ISDA and the Institute of International Bankers (the “Associations”) submitted a response to the CFTC’s second notice of supplemental authority, which brought the Court’s attention to the July 11, 2014 decision in National Mining Association v. McCarthy (“NMA“). 

According to the CFTC’s second notice of supplemental authority, the analysis of NMA reiterates that established law and general statements of policy are not subject to pre-enforcement judicial review under the Administrative Procedure Act, and concludes that the legal effect on regulated entities must be established to determine whether an agency action is a policy statement or legislative rule. 

In their response, the Associations assert that, although NMA concerns an Environmental Protection Agency guidance document (“EPA Guidance”) that is “factually distinguishable” from the Cross-Border Guidance, the legal principles set forth in NMA confirm that the Cross-Border Guidance is “unmistakably legislative.” The Associations state that, unlike the Cross-Border Guidance, the EPA Guidance imposes no requirements and only recommends a consideration to be weighed by state regulators; therefore, the NMA Court concluded that, “as a legal matter,” the EPA Guidance “is meaningless.”

Additionally, the Associations observe, NMA acknowledged the EPA’s notice that state authorities are free to ignore the EPA Guidance. By contrast, the Associations explain, the CFTC maintains that “even courts must defer to the Cross-Border Rule,” and confirmed the legal effect by issuing an “Exemptive Order” to give regulated entities more time to “transition to” and “come into compliance with” the Cross-Border Guidance’s provisions. 

The Associations went on to discuss other distinctions between the EPA Guidance and the Cross-Border Guidance in order to demonstrate that the Cross-Border Guidance cannot be viewed as a general statement of policy. The Associations explain, by way of example, that the EPA Guidance was issued by intermediate agency officials, whereas the Cross-Border Guidance was issued by a full vote of the CFTC’s commissioners.

Lofchie Comment:  Here is the key paragraph from the NMA decision explaining why the “guidance” at issue was merely guidance and not a rule:

“As EPA acknowledged at oral argument, ‘The Guidance has no legal impact.  . . .’  The Final Guidance does not tell regulated parties what they must do or may not do in order to avoid liability. The Final Guidance imposes no obligations or prohibitions on regulated entities. . . . The Final Guidance may not be the basis for an enforcement action against a regulated entity. Moreover, the Final Guidance may not be relied on by EPA as a defense in a proceeding . . . [a]nd the Final Guidance does not impose any requirements in order to obtain a permit or license. As a matter of law, state permitting authorities and permit applicants may ignore EPA’s Final Guidance without facing any legal consequences.”

In short, even if the CFTC “wins” its case (despite some of its arguments seeming quite strained), its reliance on the NMA decision would make it impossible for the CFTC to enforce its guidance/rule, which would seem to render the CFTC’s victory somewhat meaningless.  Given that, in its cross-border rulemaking, the SEC found that the great majority of swaps involved cross-border elements, can it really be the case that the CFTC intended to enforce its derivatives rules without any rules clearly establishing the agency’s jurisdiction?  That would seem a terribly imprudent way to establish regulatory authority.

In light of the above, the CFTC either loses its case or ends up with “guidance” that the CFTC has itself argued has no legal effect. Wouldn’t it make sense for the CFTC to go back to the drawing board and actually propose a rule? The CFTC’s task in this regard should be made significantly easier, since the SEC has already adopted a rule, and it would make sense for the CFTC to piggyback on the SEC’s rulemaking as this would have the added benefit of establishing one set of requirements to which U.S. institutions would be subject, rather than one set of rules under the securities laws and another under the CEA.

See also: These Lofchie YouTube Selections demonstrate one instance of guidance; and another exemplar of guidance.

See: Associations Response to CFTC’s Second Notice of Supplemental Authority. 
Related news: CFTC Submits Reply in Support of Its Motion to File Supplemental Declaration in CFTC Cross-Border Guidance Case (July 26, 2014); Associations Submit Opposition to CFTC Motion to File Supplemental Declaration in SIFMA v. CFTC Cross-Border Guidance Case (July 24, 2014); Parties Submit Supplemental Briefs in SIFMA v. CFTC Cross-Border Guidance Case (July 22, 2014); CFTC Files Supplemental Declaration in CFTC Cross-Border Guidance Case (July 18, 2014).

In response to SIFMA, ISDA, and the Institute of International Bankers (the “Associations”) opposition to the CFTC’s request to file a supplemental declaration, the CFTC submitted a reply to the Court stating that the Associations’ opposition only underscores the declaration’s relevance to the CFTC Cross-Border Guidance case. 

According to the CFTC, the Associations have advanced inconsistent theories regarding how to interpret CEA Section 2(i).  The CFTC explained that one of these theories, which coincides with the CFTC’s interpretation, is supported by an internally-circulated SIFMA document filed in the CFTC’s supplemental declaration (“SIFMA’s Note”).

Additionally, the CFTC explained that despite the Associations’ argument in its opposition that SIFMA’s Note only mentioned the word “guidance” once, it “clearly” refers to the CFTC Guidance as guidance, which is “direct evidence” contradicting the Associations’ claims that “they reasonably believe the Guidance to be a binding rule.”

The CFTC further argued that SIFMA’s Note demonstrates that there were multiple reasons for Plaintiff’s members to de-guarantee swaps.  Consequently, there was no coercion by the CFTC guidance to de-guarantee so there is no standing in this case.  According to the CFTC, “if SIFMA’s Note is not considered, there is no evidence at all of why the Plaintiffs’ members have changed their business practices, disabling the Court from assuring itself of its own jurisdiction.”

See: CFTC’s Reply in Support of Motion to File Supplemental Declaration. Related news: Associations Submit Opposition to CFTC Motion to File Supplemental Declaration in SIFMA v. CFTC Cross-Border Guidance Case (July 24, 2014); Parties Submit Supplemental Briefs in SIFMA v. CFTC Cross-Border Guidance Case (July 22, 2014); CFTC Files Supplemental Declaration in CFTC Cross-Border Guidance Case (July 18, 2014).