Though it seemed for a while that the US/EU’s ‘path forward’ agreement on substituted compliance might have simplified OTC compliance for the markets, when it came to writing the rules the SEC and CFTC have somehow managed to make the definition murkier than ever. This is fuelling concern on an international level, and bringing huge uncertainty to global markets. So what do we know, and what do we not know?
First of all, it is important to note that the SEC and CFTC, who govern different types of derivative products, are struggling to agree on who it is that they regulate and who is subject to their regulation. Despite the fact that parties should come under the jurisdiction of a certain US agency based on the types of swaps they trade in (e.g. ‘swaps’ to be handled by the CFTC, ‘security-based swaps’ to be handled by the SEC, as set out in the joint final rule on the further definitions of SDs, MSPs etc.), recent disagreements between the two regulators’ regarding the limits of their individual jurisdictions have brought more headaches to the community. Additionally, there are discrepancies between the two agencies’ definitions of ‘US person’. Therefore, in order to answer the question of whether or not you are a US person or not, you must first determine (or wait for it to be determined) who your regulator is – SEC or CFTC.
Moving ahead with the CFTC’s final guidance, there are five types of entity who are de facto US persons: 1) a natural, legal resident of the United States of America; 2) an enterprise which is either incorporated or has its place of business in the US (with the exception of funds, and CIVs) as of 1 April 2013; 3) pension funds for US employees of the above entities; 4) collective investment vehicles – including hedge funds – that are majority-owned by US persons, or a trust of a US citizen or administered under US jurisdiction; 5) an account in which the beneficiary is any of the above entities. If a firm in question fulfils any of these parameters, it is a US person and is subject to the CFTC’s swap rules.
These persons can operate inside or outside of the borders of the United States, but one does not have to be a US person in order to be subject to part or even all of Dodd-Frank. The CFTC also has provisions for foreign, non-US entities that operate within the US or trade with US counterparties. Foreign entities come into scope of Dodd-Frank in a number of ways, including being classified as so-called ‘affiliate conduits’, foreign branches of US banks, entities guaranteed by US banks, and entities trading with US persons (see tables below).
However, since the rules took effect on 10 October, swaps trading has been slow to hit regulated exchanges (e.g. SEFs). While part of the reason may lie in higher costs (e.g. 2-4% of derivatives swaps needing to have cash down), complex trade restructuring, or problems with client on-boarding, one of the biggest regulatory issues affecting the global market has manifested itself in the interpretation of ‘Footnote 513’ of the CFTC’s final rules. The rule, which is embedded deep within the provisions, states that:
“… the Commission takes the view that a U.S. branch of a non-U.S. swap dealer or MSP would be subject to Transaction-Level requirements, without substituted compliance available. As discussed above, a branch does not have a separate legal identity apart from its principal entity. Therefore, the Commission considers a U.S. branch of a non-U.S. swap dealer or non-U.S. MSP to be a non-U.S. person (just as the Commission considers a foreign branch of a U.S. person to be a U.S. person).”
Essentially, despite the fact that the US has agreed to utilise substituted compliance with several other national entities and is committed to cooperative regulation with other national regimes – notably, the European Union – Footnote 513 has determined that any non-U.S. MSP or SD within the US has to be CFTC-compliant, in addition to non-US branches of US entities dealing swaps. The very specific language of this footnote has caused consternation all over the globe as SDs and MSPs struggle to interpret and apply these rules, and the confusion is understandable. Ultimately, the US government’s position on swaps regulation definitions has created three main problems for firms in the market: 1) defining who fits the “US person” entity; 2) how US persons are regulated with respect to swaps business with non-U.S. persons; 3) and how the definition changes between agencies, namely the SEC and CFTC.
Therefore, going forward, firms will have to revisit their own footprint and their relationships with US counterparties/clients to check whether they could be scoped in. In addition, the extraterritorial aspects create new KYC challenges for firms to identify when they should be applying US rules, or else they face having to avoid US business altogether. Finally, firms should look out for clarification from US regulators on the disputes between the CFTC and SEC and on developments in substituted compliance, as this will be the most straightforward way for firms to simplify their compliance burden.