Sunday, August 19, 2012

Japanese Financial and Banking Regulators Ask CFTC to Broaden Scope of Substituted Compliance Doctrine for Cross-Border Derivatives Regulation


In a letter to CFTC Chair Gary Gensler, the Bank of Japan and the Financial Services Agency urged the CFTC to broaden the application of substituted compliance for OTC derivatives regulation so that any overlap or conflict with Japanese derivatives regulations can be avoided. They also asked the CFTC to clarify the procedure and implementation timeline of substituted compliance and to respect foreign regulations as a whole set and not on a piecemeal basis.

The letter was in response to the CFTC’s proposed guidance on the cross-border application of the derivatives provisions of the Dodd-Frank Act. 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.

While welcoming the use of the substituted compliance concept, the FSA and the central bank of Japan said that, with regard to entity-level regulations, substituted compliance should apply to all types of foreign affiliates of US-based swap dealers, including those with swaps booked in the US. Substituted compliance should also be extended to a broader set of transaction-level requirements. For example, transactions conducted in Japan between Japanese financial institutions and Japanese affiliates of US-based swap dealers should be subject to substituted compliance. In addition, said Japan’s financial regulators, cross-border transactions between the head offices of Japanese financial institutions and US-based swap dealers should be able to benefit from substituted compliance.

The CFTC proposes to make comparability determinations on an individual requirement basis, such as mandatory clearing and trade execution facility, rather than on the foreign  regulatory regime as a whole. The FSA and central bank believe that this determination should be made on a country-by-country basis, and in a comprehensive manner, from the viewpoint of whether or not foreign regulation is broadly in alignment with US regulation and consistent with the overall objectives of the G20 commitments. The determination should also take into account such elements as further regulations to be introduced in a phased manner and the necessity of different regulation in light of divergent practices in non-US markets.

Moreover, the FSA and central bank said that, when requirements under Japanese regulations are not identical to those of the US at a particular point in time, the CFTC should not apply its regulations in addition to Japanese regulations in place to address the differences. In other words, substituted compliance should respect foreign regulations as a set, not on a piecemeal basis.

In addition, the Japanese regulators believe that CFTC regulations, including swap dealer registration should, as a matter of principle, not be applied to Japanese financial institutions established and conducting businesses in Japan. Even if Japanese financial institutions would be required to register as swap dealers under limited circumstances, they noted, these requirements should be the least onerous, and a sufficient preparation period needs to be ensured.

In this regard, according to the CFTC rule, the application for registration as swap dealer will need to be filed within 60 days after the final rule on the definition of swaps is published in the Federal Register. Although this deadline is applied to non-US persons, as well as US persons, the FSA and central bank requested that the swap dealer registration requirement should not apply to non-US persons before the details, including the procedure and implementation timeline of substituted compliance become clear, and  the assessment by the Commission for substituted compliance is completed and agreed with interested parties.

The FSA and central bank believe that only transactions with US persons conducted by Japanese financial institutions established in Japan should be included in determining the need for registration as swap dealer. In other words, transactions with US persons conducted by entities under common control of Japanese financial institutions established outside Japan, such as in the UK or Hong Kong, should not be included in the calculation of swap transactions in regard to the de minimis threshold, with respect to the Japanese financial institutions established in Japan.

As they understand the proposed guidance, Japanese financial institutions established in Japan do not need to include the notional value of swap transactions with US persons in which their US affiliates engage when calculating the swap transactions in regard to the de minimis threshold. In parallel with this, the FSA and central bank  believe that transactions between US branches of Japanese financial institutions and US persons should also be excluded from the de minimis threshold calculation for Japanese financial institutions


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