Thursday, August 30, 2012

European Commission Troubled by CFTC Proposed Guidance on Cross-Border Application of Dodd-Frank Derivatives Regulations

The broad definition of US person in the CFTC’s proposed guidance on cross-border application of the Dodd-Frank derivatives provisions poses a significant risk of the duplication of US regulatory requirements with those of the EU, said the European Commission in a letter to the CFTC. For example, under the guidance, an EU dealer could be subject for the same trade to both EU and CFTC regulations, and a collective investment vehicle managed from the EU, but with a majority ownership by US persons, would be subject to regulations in the EU and Dodd-Frank in the US.

Further, while the doctrine of substituted compliance set forth in the guidance is similar to the EU equivalence approach, a decision by the CFTC determining substitute compliance will not apply to jurisdictions, which is the case under the European Market Infrastructure Regulation (EMIR), but only to specific firms and can be withdrawn from a firm at any time. The Commission urged the CFTC to adopt a similar approach to that of the EU based on the recognition of equivalent jurisdictions and not of individual firms. According to the Commission, the approach taken in the proposed guidance would introduce legal uncertainty and higher monitoring costs for EU firms than for US firms that might benefit from an EU equivalence decision. Moreover, the application of substituted compliance on a firm-by-firm basis could lead to different and even discriminatory treatment between firms and jurisdictions.

The guidance introduces the concept of substituted compliance under which, as recently explained by Chairman Gensler at Senate Ag Committee hearings, the CFTC would defer to comparable and comprehensive foreign regulations. The CFTC proposes to permit a non-U.S. swap dealer or non-U.S. major swap participant, once registered with the Commission, to comply with a substituted compliance regime under certain circumstances. Substituted compliance means that a non-U.S. swap dealer or non-U.S. major swap participant is permitted to conduct business by complying with its home regulations, without additional requirements under the Commodity Exchange Act.

Wider application of substituted compliance by the CFTC will be an important consideration in an EU equivalence determination, said the Commission. An equivalence decision that an EU firm may be subject to US regulations and still meet the requirements of EU legislation because US regulations are equivalent is a direct and powerful tool to avoid subjecting EU and US firms to duplicative margin and central clearing requirements.

The application of multiple regulation sets to the same derivatives transaction would have profoundly negative effects, warned the Commission, including regulatory arbitrage and the undermining of the G-20 goal of financial stability. An equivalence decision can avoid these negatives, said the Commission, but only if US and other third-country regulations are applied in an efficient and non-distortive manner. If such cannot be determined, and US regulations are considered to result in an unbalanced state of affairs creating discriminatory treatment between two jurisdictions, the Commission said that it would not be able to grant equivalence.

The Commission also noted a requirement in EMIR for a regulation specifying which transactions between non-EU firms have a direct, significant and foreseeable effect on the EU. There are strong similarities between the potential scope of this regulation, said the Commission, and Section 722(d) of Dodd-Frank. If the EU were to adopt a rule with the same scope as the CFTC proposes in its guidance, said the Commission, swaps between two US affiliates of EU firms would be subject to EMIR, thus leading to the application of multiple regulations to US firms.

In any event, said the Commission, a system of substituted compliance or equivalence will require close cooperation between regulators and necessitate the need for an MOU to establish clear rules and obligations. The Commission stands ready to facilitate a common framework.