Article
Dodd-Frank vs. EMIR: The reality of substituted compliance

Millions of hours have already been spent aligning Dodd-Frank and EMIR implementation in the OTC space.  However, in July, regulators changed the game.  By declaring certain sections of Dodd-Frank and EMIR to be equivalent, they broke a worrying stalemate between the EU and US which threatened to leave US entities unable to clear through European infrastructure and vice versa.  The agreement settled the dispute between the US and EU that will allow firms operating internationally to comply with one complete set of OTC trading requirements, rather than implementing both Dodd-Frank and EMIR.  But what does that set of requirements really look like?

For a long time it seemed that there would be no agreement on the ‘equivalency’ between Dodd-Frank and EMIR OTC derivatives rules, meaning that firms would need to implement two sets of conflicting regulations at the same time.  Though both sets of rules are ‘essentially identical’, in terms of their intentions, there are differences that could create huge costs if the rules were to be implemented concurrently.  With this in mind, the Commodity Futures Trading Commission’s (CFTC), final cross-border guidance is welcome, and provides clarity on a number of these issues.

However, it also generates a host of new questions.  Firms will have to beware being sucked into a false sense of security and assuming that substituted compliance amounts to a blanket amnesty for international firms.  In actual fact, substituted compliance simply constitutes a change in scope of the different rules, which, once finalised, will require the usual gap analysis to assess to what extent your firm is compliant.

For instance, the CFTC’s guidance has significantly expanded the definition of ‘US person’ in order to broaden the reach of the rules.  Under the new definition, a foreign branch of a US person or an entity with a US beneficial owner is considered to be an extension of its parent and thus subject to the same rules.  This has a significant impact on firms’ implementation of Dodd-Frank, requiring banks to reclassify their customers under the new definition.

In order to balance this, however, the CFTC has limited the scope of ‘Entity’ and ‘Transactional-Level’ rules relative to the status of the entity in question, setting out a new set of conditions to determine when a trade is made by a foreign branch of a US bank.  To add to the complexity, in a footnote (fn. 513) the CFTC takes the (somewhat contradictory) view that a US branch of a non-US SD or MSP would be subject to transaction-level requirements.  What this means is that an entity will only be eligible for substituted compliance if it meets the criteria for location, the nationality of its counterparties, applicable regulatory requirements, or status.

The EU’s new technical standards on extraterritoriality also complicate the issue further.  In the EU, EMIR’s central clearing and risk mitigation requirements apply to any third country firm trading with an EU entity as well as trades purely between two third country entities where such trades have a ‘direct, substantial and foreseeable effect with the Union’.  On 17 July, ESMA released draft technical standards for consultation which attempt to clarify this definition as applying to trades between EU branches of non-EU firms and entities guaranteed by EU institutions.  These new rules extend the scope of EMIR and add additional complexity to the equation.

This means more KYC requirements for third country firms who trade derivatives in and around Europe, in order to answer questions around your counterparty’s status.  Fortunately for the corporates, the obligation only affects entities guaranteed by those institutions classed as being financial counterparties (FCs) under EMIR.  Unfortunately, those corporates will still have to prove that this is the case.  The only way out of all this is for individual jurisdictions to be deemed ‘equivalent’ by the EU.

As it stands for EMIR, only the US and Japan will have been declared equivalent by 15 September.  Therefore firms in other jurisdictions will have to be prepared for compliance from as early as then.  Under the CFTC guidance, only Australia, Canada, the EU, Hong Kong, Japan and Switzerland can be considered equivalent and will not require banks to obtain substituted compliance approval.

In short, EMIR vs. Dodd-Frank is not a simple case of pick one and move on; firms must know and manage their regulatory deltas.  As a result, this is not a problem that can be managed from a single room within the organisation, but requires forward thinking at the highest level, especially with three quarters of the G20 countries left to sort out.

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• The US and EU are in the late stages of talks to hammer-out the details of an agreement
• A clearer picture of the global rule set is quickly emerging
• But OTC trading will become more complicated before it gets simpler

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