House Panel Reviews Dodd-Frank Experience Amid Fears of Inconsistent Cross-Border Application of Derivatives Regulation

House Financial Services Committee Chairman Spencer Bachus (R-AL) kicked off a series of hearings on the two-year experience of the Dodd-Frank Act by urging the Senate to pass legislation, HR 2682, codifying and clarifying the end-user exemption from Dodd-Frank derivatives regulation. The House passed the Business Risk Mitigation and Price Stabilization Act by a bi-partisan vote of 370-24 on March 26, 2012, but the bill has not been taken up by the Senate. More broadly, the securities industry expressed concerns that the ``flawed’’ CFTC guidance on the cross-border application of Dodd-Frank derivatives regulation could isolate the US swap market by creating two sets of swap regulations and, more specifically, that the substituted compliance approach could lead to fragmentation as firms establish entities in many jurisdictions.

Similarly, Rep. Robert Dold (R-IL) urged prompt action on the Swap Data Repository and Clearinghouse Indemnification Correction Act, HR 4235, has been approved by the House Financial Services Committee by voice vote on May 9, 2012. HR 4235, which is bi-partisan legislation co-sponsored by Rep. Dold and Rep. Gwen Moore (D-WI), would repeal the indemnification provisions in Sections 725, 728, and 763 of the Dodd-Frank Act to facilitate global regulatory cooperation and ensure that U.S. regulators have access to necessary swaps data from foreign data repositories, derivatives clearing organizations, and regulators.

Sections 728 and 763 of the Dodd-Frank Act require swap data repositories and security-based swap data repositories to make data available to non-U.S. financial regulators, including foreign financial supervisors, foreign central banks, and foreign ministries. Before a U.S. data repository can share data with a foreign regulator, however, the foreign regulator must agree that it will abide by applicable confidentiality requirements that it will indemnify the data repository and the SEC and CFTC for litigation expenses that may result from the sharing of data with the foreign regulator. Section 725 of the Dodd-Frank Act imposes similar requirements for data sharing between derivatives clearing organizations and foreign regulators, including the requirement that foreign regulators indemnify derivatives clearing organizations and U.S. regulators for litigation expenses that may result from the sharing of data with foreign regulators.

According to Committee Report No. 122-471, accompanying HR 4235, these indemnification provisions threaten to make data sharing arrangements with foreign regulators unworkable. Foreign regulators will most likely refuse to indemnify data repositories, derivatives clearing organizations, or their U.S. regulators for litigation expenses in exchange for access to data. As a result, foreign regulators may establish their own data repositories and clearing organizations to ensure they have access to data they need to perform their supervisory duties, which would result in the creation of multiple databases, needlessly duplicative data collection efforts, and the possibility of inconsistent or incomplete data being collected and maintained across multiple jurisdictions.

The security industry is generally concerned with the cross-border implications of Dodd-Frank regulation of derivatives. SIFMA senior official Ken Bentsen said that the initial reading of the recently proposed CFTC guidance appears to be that the extraterritorial application of U.S. regulations could create two sets of rules for swap regulation and could isolate the U.S. swap market from the global market. If transacting with a U.S. financial intermediary or end user puts non-U.S. entities at risk of becoming subject to U.S. regulation globally, cautioned SIFMA, it is clear that such non-U.S. entities will not transact with U.S. entities, denying U.S. firms access to those global markets. This will raise the cost of hedging, warned SIFMA, and if the cost is prohibitive, will lead U.S. firms to decide not to hedge.

SIFMA also noted that the recently proposed CFTC cross border guidance is complex, expansive in scope, and highly prescriptive. It is unsure that the terms of so-called substituted compliance, which theoretically should allow market participants in other well regulated markets to rely on their home market regulation, would actually work in practice.

This substituted compliance process will be different than the mutual recognition model, observed SIFMA, and would require the CFTC to individually review the rules of foreign nations. The industry is concerned about determinations of cross border equivalence that are not outcomes based, but used instead as a tool to export regulations from one jurisdiction to another. If a host country regulator were to extend certain regulations to the global entity, reasoned SIFMA, the entity would be subject to overlapping and potentially inconsistent regulation.

In such an event, the non-U.S. entity may decide that the easiest way to comply with each jurisdiction’s requirements is to register separate entities in many more jurisdictions than it otherwise would. This fragmentation of global firms could lead to inefficient results. With respect to capital, for example, it would remove the benefits of netting, collateral management and centralized risk management, which are key components of systemic risk mitigation.

Further, SIFMA believes that the CFTC’s cross border application approach is flawed in that the Commission chose to do so in the form of guidance as opposed to a regulation, and apparently, without sufficient coordination with the SEC. By failing to put forth a regulation, the CFTC avoided conducting any cost-benefit analysis and formal comment by affected parties. SIFMA believes that a more holistic, rules-based approach, as it understands the SEC is likely to do after all of the Title VII rules have been proposed, is a more prudent approach.