The Commodity Futures Trading Commissions (CFTC) proposed swap rules under Title VII of the Dodd-Frank Act could result in a shut-out of US persons in Asias over-the-counter (OTC) derivatives markets.
Counsel are alarmed by the rule's broad extraterritorial reach and its strict interpretation of substituted compliance. Non-US regulators have also expressed concerns about non-US persons being subject to CFTC registration and compliance with two sets of regulations that may overlap or conflict.
Although the CFTC has proposed a substituted compliance provision, its requirements are not in line with market structures throughout Asia, which are generally less active and have less liquidity than that of the US.
Robert Chu, partner in Sullivan & Cromwells Melbourne office, said that this period will present opportunities for sophisticated, well-informed and well-advised players, but others will be mired in layers of mind-boggling complexity.
US persons and extraterritorial legislation
The definition of US persons in the CFTCs proposed rules is broader than that of similar laws and regulations, such as the definition included in the SECs Regulation S and the proposed Volcker rule.
Theodore Paradise, head of Davis Polk & Wardwells Tokyo office, said that one significant difference is that its definition of US person includes a collective investment vehicle of which majority ownership is held directly or indirectly by US persons. Moreover, the definition includes an individual account, whether discretionary or not, where the beneficiary is a US person.
Foreign affiliates or agencies of US-based swap dealers such as a branch of an American bank in a foreign country falls under the US person definition. In contrast, a subsidiary or affiliate of an American bank in a foreign country would be a non-US person, even if all swaps were guaranteed by a US person.
But it will be difficult to identify US persons under such broad guidelines, resulting in compliance issues.
Requiring non-US person swap dealers or major swap participants to register if they meet de minimis thresholds makes it difficult to do business with US persons. Chu said that it is a daunting prospect for non-US persons unfamiliar with the US regulatory regime to comply. It may not be simple to determine whether they are subject to the requirements, whether on registration, on execution and clearing or on capital and margin, he added.
In a joint comment letter by the Australian Securities and Investments Commission (ASIC), Reserve Bank of Australian (RBA), Hong Kong Monetary Authority (HKMA), the Securities and Futures Commission (SFC) and the Monetary Authority of Singapore (MAS), the regulatory bodies warned that non-US swap dealers may be unable to continue dealing with US customers in the OTC derivatives market to avoid legal risk.
Sources warn that the rules could result in regulatory overlap, duplication, confusion and fragmentation.
Several jurisdictions have already noted that compliance with the CFTCs rules would violate local law. A comment letter submitted by the Korea Federation of Banks noted that Korean financial institutions would be in violation of Koreas Real Name Act if they submitted trade data to US regulators without specific customer consent.
Why substituted compliance isnt a solution
Although the CFTC has introduced substituted compliance to account for different rules across different jurisdictions, counsel largely believe it may create more problems than solutions.
Francis Edwards, partner at Clifford Chance, said that there is a general dissatisfaction with substituted compliance because each entity must apply separately. It seems to entail a line-by-line review of the laws in each jurisdiction, and entities could be subject to some or all of Dodd Frank anyway, he said.
Substituted compliance would only apply to transactions between two non-US persons: trades involving US counterparties will always be subject to Dodd-Frank, even if another jurisdictions regulations also apply.
CFTC decisions involving substituted compliance would apply to firms rather than jurisdictions. The European Commissions comment letter condemned the firm-by-firm approach, commenting that it lead to different and even discriminatory treatment between firms and jurisdictions.
But most Asian jurisdictions OTC derivatives markets are not prepared for substituted compliance. Edwards said that there is a different market structure in Asia: the OTC derivatives market is not as big and less liquid.
The joint letter by Australian, Hong Kong and Singapore regulators highlighted local market liquidity as an issue, and questioned whether the OTC derivatives markets are large enough to implement mandatory trading on exchanges or electronic trading platforms.
Implementation of the CFTCs rules
Another issue stemming from broad-based, extraterritorial rules is their implementation. Chu noted that regulators have been facing resource constraints and have found their rulemaking responsibility under Dodd-Frank challenging. The CFTC in particular has been resource-constrained in the rulemaking endeavor and theyre not out of the woods yet, he commented.
Under the CFTCs proposed rules, non-US swap dealers with US customers and major swap participants (MSPs) are required to register with the CFTC: the registration deadline was 12 October, but may have been pushed to January. Registered non-US swap dealers and MSPs will be required to comply with swap data reporting and physical commodity swaps reporting requirements.
Though the deadline has been extended, Edwards commented that a lot of Asian banks may not be able to get up to speed that quickly to assess whether they need to register. He said that if theres no resolution of these issues, Asian banks may find themselves in a position where they have to cease trading certain products until they can ensure compliance with US laws.
But the rules are still in flux. Chu warned that completion of the rulemaking process is still a long way off. Although final rules and interpretations have been adopted with respect to certain definitions and products, additional layers of regulatory guidance are still in the works.