While recognizing that harmonizing CFTC and SEC regulations implementing the derivatives provisions of Dodd-Frank with foreign regulatory counterparts is necessary for reducing systemic risk and limiting regulatory arbitrage, CFTC Commissioner Jill Sommers fears that differences with EU draft legislation regulating derivatives are growing. The Commissioner is concerned that the CFTC is out of step with regard to timing and substance with both the SEC and non-US regulators. On a separate matter of industry concern, the Commissioner said that, as it considers proposals for defining and registering swap dealers, the CFTC is cognizant of the importance of establishing an appropriate regulatory framework for the cross-border swaps activities of foreign banks. More broadly, the Commissioner assured that the CFTC has a long history of recognizing comparable regulatory structures when it comes to cross-border issues and is hopeful that the relationships developed with foreign regulators will be helpful in structuring a rational regulatory regime for the global swaps markets.
It is becoming clear that any execution requirement, if enacted in foreign jurisdictions, will not be in place before the end of 2012 as envisioned by the G-20 deadline. The European Commission is still in the consultation phase on revising its Markets in Financial Instruments Directive (MIFID) to introduce such a requirement, noted the Commissioner, and the proposal it is considering is fundamentally different from the model proposed by the CFTC for swap execution facilities. The MIFID revisions, if adopted as proposed, may allow swaps to be executed through single dealer platforms.
The SEC’s proposed rule likewise would allow requests-for-quotes to be sent to a single dealer, or to multiple dealers depending on the end-user’s preference. The proposal issued by the CFTC would require request-for-quotes to be sent to at least five dealers. The Commissioner supports the more flexible approach being considered elsewhere.
Another area of inconsistency is the setting of position limits, which Dodd-Frank authorizes as appropriate for futures, options, economically equivalent swaps and swaps that serve a significant price discovery function. These limits must be aggregated across all markets in the same commodity, including contracts listed on foreign boards of trade that are linked to U.S. contracts.
The CFTC proposed the establishment of position limits on physical commodity derivatives in two phases: the initial transitional phase would set spot-month position limits only; the second phase would add non-spot-month position limits consisting of aggregate single-month and all-months-combined limits that would apply to futures and options and all swaps. While the European Commission is, for the first time, considering the use of position limits, there are fundamental differences from the CFTC’s approach. In general, the Commission proposes only to give EU national regulators the option of setting position limits, and has suggested that it possibly may require limits only for agricultural commodities. CFTC staff is continually speaking with European Commission staff to inform them of the CFTC’s experience with a position limit regime
The CFTC has also departed from the European Commission in its approach to addressing conflicts of interest that may arise in connection with the execution or clearing of swaps. The Commissioner supports the imposition of rational governance rules for clearing houses and other market infrastructures, including strong rules for mitigating conflicts of interest, but questions the sensibility of the voting equity and ownership limitations proposed by the CFTC. By contrast, the European Commission said in its proposal that such limitations on ownership may have undesirable consequences on market structures.
With regard to the cross-border application of swap dealer regulations, Section 722 of Dodd-Frank states that the provisions of the Act must not apply to activities outside the U.S. unless they have a direct and significant connection with activities in, or effect on, U.S. commerce, or contravene CFTC regulations preventing the evasion of any of the Dodd-Frank requirements. While this gives some direction, noted the Commissioner, the CFTC has not yet addressed how broadly or narrowly it intends to interpret the scope of this limitation.
Comm. Sommers believes that the CFTC should not be directly involved in regulating transactions that are international in scope but only tangentially related to U.S. markets. There are a number of ways in which cross-border swaps markets currently operate, ranging from foreign banks that deal directly with U.S. customers, to transactions between non-U.S. affiliates of a U.S. person. When a foreign bank deals directly with U.S. customers its connection to U.S. commerce is direct and significant within the meaning of Section 722, noted the Commissioner, and should give rise to a registration requirement. On the other hand, there are good arguments for not requiring the registration of a foreign bank that conducts business indirectly with U.S. customers through a U.S.-registered affiliate, where the affiliate is responsible for Dodd-Frank compliance with respect to those customers.
There are other important issues that must be resolved, such as the allocation of supervisory responsibility between and among foreign and domestic regulators for the cross-border banking operations of foreign banks, and whether the Federal Reserve Board’s practice of deferring to home country supervision with respect to capital and margin will carry over in a post Dodd-Frank world. Also, there is no settled opinion on how jurisdictions will split supervisory responsibility for swap entities and swaps transactions that span multiple jurisdictions.