ISDA Questions Efficacy of CFTC’s Substituted Compliance Process in Proposed Guidance on Cross-Border Application of Dodd-Frank OTC Derivatives Regulation

In a comment letter to the CFTC, the International Swaps and Derivatives Association (ISDA) said that the substituted compliance process in the Commission’s proposed guidance on the cross-border application of Dodd-Frank derivatives regulations fails to comply with the congressional goals of comity and harmonization and is also too prescriptive to succeed. ISDA noted that the proposed guidance announces limited opportunities for substituted compliance through comparability determinations as virtually its only concessions to principles of comity. ISDA also urged the CFTC to issue final guidance in the form of a rule after conducting a careful cost-benefit analysis assessing the unusually broad effects that an extraterritorial policy is likely to have on the economy and access to markets.

The CFTC guidance introduces the concept of substituted compliance under which, as recently explained by CFTC Chair Gary Gensler at a Senate Ag Committee hearing, 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.

The proposed guidance indicates that the CFTC will review the comparability of non-US regulation of OTC derivatives in fourteen categories corresponding to most of the organizational categories that the Commission has used in developing its own Title VII regulations. The Commission asserts that it may find satisfactory comparability in a given jurisdiction in some, but not all, categories. In any event, the CFTC would retain broad discretion to determine that the objectives of any program element are met despite the fact that the foreign requirements may not be identical to that of the Commission.

In ISDA’s view, the CFTC comparability review process raises concerns. For example, in matters as complex and sweeping as imposing a new regulatory regime on a substantial global derivatives market, a principles-based approach to comparability is most appropriate. The G-20 committed to broad regulatory goals, noted ISDA, not to global adoption of the Commission’s paradigm of detailed regulation. That the CFTC will compare outcomes, stopping somewhere short of identicality with the Commission’s own paradigm, is of little comfort to ISDA.

According to the association, the statutory goal of harmonization is best served by allowing for national differences in good faith fulfillment of common principles. Following a principles-based approach also creates a greater likelihood of success in comparability determinations.

Moreover, the fact that the Commission may find comparability in some areas and not in others raises the prospect of businesses needing to incorporate disparate regulatory requirements piecemeal, with all the uncertainty and risk of error that may bring. A principles-based approach to comparability will ease these concerns and honor principles of comity and the message of restraint embedded in section 721 of the Dodd-Frank Act. More broadly, ISDA has concerns with the CFTC's implicit positing that comparability determinations can be finalized within the one-year exemptive period applicable to non-US based swap dealers. After examining the efforts of major derivatives trading jurisdictions, ISDA questioned if anything other than piecemeal comparability may be determined within the year and urged the CFTC to reconsider the nature and timeline of its comparability determinations.

The European Market Infrastructure Regulation (EMIR), which supplies much of what will be European derivatives regulation, is now law in the European Community. It awaits implementation, however, through publication of standards being developed by the European Securities and Markets Authority. While implementation of EMIR is intended by January 1, 2013, acknowledged ISDA, it is unclear if that will be achieved.

Further, although EMIR provides many parallels with Title VII of the Dodd-Frank Act, noted ISDA, and thus a basis for a partial comparability assessment, other important parallel provisions will follow in the Markets in Financial Instruments Directive II (MiFID II) or amendments of the Capital Requirements Directive. These provisions may deal with risk management and chief compliance officer matters, trade execution venue requirements, expansion of commodity derivatives regulation and wider applicability of capital requirements. MiFID II is still developmental, said ISDA, and is not expected to be in effect until 2015. Thus, a whole comparability determination with respect to Europe will not be possible in the year planned by the Commission, and ultimately nation-by-nation determinations will be required to some degree.

Japan has moved promptly to implement its view of the G-20 requirements by passage of a statute to come into effect late in 2012. The statute is being amended to provide for trade execution, said ISDA, but possibly not effective until mid-2015. The statute does not provide for real-time reporting, confirmation practices, portfolio reconciliation or compression, or margin requirements for uncleared swaps. Further, documentation requirements will apply only to relationships with non-professionals. The statute provides for clearing in a narrow range of transactions between certain types of counterparties. Despite the narrowness of the clearing requirement, observed ISDA, it appears that it may in some cases demand use of a Japanese clearing house, potentially conflicting with US requirements.

Although Hong Kong plans to implement a G-20 responsive regulatory regime by mid-2013, that effort will require passage of, first, primary conceptual legislation and then subsidiary rule-like legislation. According to ISDA, it is not clear that all this can be done in time to meet the mid-2013 goal. At the moment, the Hong Kong legislative package would appear to omit aspects of Title VII dealing with trade execution, risk management and public reporting.

Singapore has published proposed G-20 responsive amendments to law, and has gathered comments, but next steps have not yet crystallized. Ultimately, a legislative process requiring a number of months will be required, and then implementing rules will need to be proposed and finalized. How much of this can be accomplished within the remainder of 2012 and 2013 is unclear. As in the case of Hong Kong, not all major Title VII elements yet have their place in the Singaporean plan. Commodity derivatives generally will be on a separate, later track.