By Mark S. Nelson, J.D.
The CFTC approved two proposals that would create an exemption for non-U.S. derivatives clearing organizations (DCOs) and provide for alternative compliance by non-U.S. DCOs. The former proposal proved to be controversial and was approved by a vote of 3-2, while the second proposal on alternative compliance was approved unanimously. The CFTC, along with the SEC, had earlier proposed to adjust downward the amount of margin required for certain security futures, so that proposal was removed from the open meeting agenda.
CFTC Chairman J. Christopher Giancarlo said the agenda for the Commission's meeting was the logical continuation of reforms he proposed in a white paper published last October in which he called for an "objective and risk-focused framework" for CFTC regulations. The Commission approved a proposal on foreign futures and options transactions, the first of four related topics, in late June. The now approved DCO exemption and alternative compliance proposals further develop that framework, while a fourth topic, regulation of swap dealers and major swap participants, remains a work in progress although, according to Giancarlo, it has benefitted from “constructive dialogue” within the agency.
Giancarlo addresses rumors, legacy. The CFTC’s July 11 open meeting was Chairman Giancarlo’s last before his successor, Treasury’s Heath Tarbert, is expected to be sworn in as chairman on Monday, July 15. Giancarlo sought to tamp down rumors that he may be a candidate for the role of governor of the Bank of England. “As I have informed my fellow Commissioners, I have neither sought nor applied for the position, for which I understand the application process formally closed some time ago. *** More broadly, I confirm that I have not and will not, discuss, consider, apply for, or pursue any professional engagement or employment of any kind whatsoever here or abroad until after the completion of my service on the Commission.”
With respect to his legacy, Chairman Giancarlo suggested a few themes in his closing remarks. For one, he characterized his tenure as one that pursued a “recalibration” instead of a “roll-back” of Dodd-Frank Act swaps and derivatives reforms. He also said that he sought to “champion U.S. markets” while also building international cooperation. Lastly, he said that he “consistently” advocated the “value proposition of free markets.” In terms on how the CFTC conducted business during his tenure, Giancarlo acknowledged that he did not always obtain agreement, but that commission business was still conducted in a manner such that matters were not disagreeable.
DCO registration exemption. The CFTC considered the supplemental proposal regarding an exemption from DCO registration after approving the alternative compliance proposal, but the DCO exemption proposal proved to be the more controversial one. DCR staffer Abigail Knauff explained that the supplemental proposal would build on an earlier (still pending) proposal from 2018 regarding DCO registration exemptions. She said the CFTC had received four requests for exemptions and that the earlier proposal would have codified agency policies for handling such requests. The supplemental proposal, Knauff said, reflects comments on the 2018 proposal but does not replace the 2018 proposal.
As Chairman Giancarlo explained in his prepared remarks, the CFTC was proposing to provide an exemption for any non-U.S. DCO that does not pose a substantial risk to the U.S. Giancarlo added that these DCOs would still have to be subject to extensive home-country regulation. But Giancarlo noted that this arrangement contemplates the use of foreign intermediaries rather than registered futures commission merchants (FCMs). As a result, there would have to be disclosures about home country bankruptcy protections made to U.S. eligible contract participants. An adjunct to the proposal would allow persons outside the U.S. to accept funds from U.S. persons for the purpose of margining swaps cleared at exempt DCOs.
Commissioner Dan Berkovitz told fellow commissioners that the proposal relies on foreign intermediaries and exceeds the CFTC’s exemptive authority. In prepared remarks, Berkovitz likened the proposal to a “Bizarro World” in which CFTC regulation would be contrary to expectations. “The CFTC does not have the superpowers to fashion its own de-regulatory planet,” said Berkovitz. “It must stay within the orbit of the laws prescribed by the Congress. It cannot bypass any provision of the CEA that it considers an impediment to a global swaps market. Congress has not provided the CFTC’s with unlimited exemptive authority.”
According to Commissioner Rostin Behnam, the proposal amounts to “denialism.” Specifically, he said the CFTC would grant an exemption but with intermediaries outside of CFTC jurisdiction. He explained that this scenario is contrary to existing data, lacks careful scrutiny, and varies from the Commodity Exchange Act’s customer protection framework.
Alternative compliance and CFTC resources. Although the Commission’s vote to approve a proposal on alternative compliance for overseas DCOs (the vote was unanimous) perhaps suggests the subject matter of the proposal was less controversial than that of the DCO registration exemption proposal, the commissioners’ cohesion may belie a number of concerns that were expressed by individual commissioners during extensive questioning of CFTC staff. One persistent theme, as suggested by Commissioner Behnam, is that the Commission may be entering a phase when it manages its budget by ceding jurisdiction to other regulators.
Division of Clearing and Risk (DCR) staffer August Imholtz explained to commissioners how the test would work for determining a DCO’s eligibility for alternative compliance: (1) is the DCO’s share of initial margin more than 20 percent that of U.S. clearing members; and (2) is more than 20 percent of initial margin at the DCO attributable to U.S. clearing members. A DCO that does not exceed either threshold would be eligible for alternative compliance. By contrast, the CFTC could exercise discretion for a DCO that is near the thresholds. Imholtz also said that the CFTC must determine that home country compliance would be compliance with U.S. core principles, the DCO is in good standing, and there is a memorandum of understanding between the CFTC and the home country regulator.
Departing DCR Director Brian Bussey confirmed for Commissioner Berkovitz that the primary difference between the alternative compliance regime and the DCO registration exemption proposals is that the former will use U.S.-registered FCMs with attendant customer protections while the latter will use foreign intermediaries without similar customer protections. Berkovitz had explained that when a DCO exceeds certain thresholds, the U.S. has a significant enough interest to regulate the DCO. Berkovitz said in his prepared remarks that he could support the proposal because key firms would still be subject to CFTC registration and regulation.
Commissioner Brian Quintenz had opened the Q&A session with CFTC staff by asking whether agency resources and DCR staffing might impact an influx of applications. Bussey said that he expected his successor to receive new applications but that the proposal would reduce resource demand at the DCR level. Bussey further observed that this would be an opportunity for the CFTC to step away from foreign DCOs and focus instead on domestic DCOs for which the CFTC has sole regulatory authority and on foreign DCOs that pose substantial risk to U.S. markets. According to Bussey, two systemically important DCOs (SIDCOs) and two firms that have entered the virtual currency business take up most of the DCR’s resources.
Commissioner Behnam later asked how the DCR arrived at the 20 percent threshold. Imholtz deferred to Bussey on this policy question, which Bussey said focused on the question of when it is appropriate for the CFTC to be a front line regulator of a foreign DCO. Bussey said that mission and limited resources were key considerations and that the data was “stark” in that it showed LCH to be a “massive player” (nearly 50 percent of U.S. cleared swaps) for which the CFTC must be involved, but that other firms accounted for much lower percentages of the cleared swaps market. In further questioning, Behnam said he hoped the CFTC was not going to manage its budget by giving up jurisdiction to other regulators.
Another critical aspect of the alternative compliance proposal is that the required comparison that foreign DCOs must undertake is to the CFTC’s core principles. Commissioner Behnam had questioned what the difference was between alternative compliance and, in other contexts, substituted compliance—he suggested it was the need to compare regulations (not just core principles) under substituted compliance. Picking up on Behnam’s theme, Commissioner Dawn Stump observed that the CFTC was moving away from line-by-line comparisons of regulations, but that the European Securities and Markets Authority was potentially heading toward a system of close regulatory comparisons, a point Quintenz had also made in his prepared remarks.
Security futures. The CFTC also proposed jointly with the SEC to adjust customer margin rules relating to security futures in order to align the minimum amount of required margin with the requirements for other similar products. As a result, the margin required for an unhedged security futures position would be reduced from 20 percent to 15 percent. The SEC had approved the proposal without an open meeting before the CFTC similarly approved the proposal (See, Customer Margin Rules Relating to Security Futures, Release No. 34-86304, July 3, 2019).
Commissioner Berkovitz issued a statement ahead of the CFTC's open meeting expressing support for the security futures proposal. “The 20 percent level was originally set by the Commissions in 2002. Markets have evolved since that time and it is appropriate to reconsider the margin level in light of the subsequent adoption of the risk-based portfolio margining programs,” said Berkovitz. “In doing so, the Proposal has followed the statutory mandate to set the security futures margin requirement at levels consistent with, and not lower than, levels for similar options.”
A brief statement issued by the SEC echoed these reasons for reevaluating the margin requirement. “In light of lower margin requirements that have been established for comparable financial products and the resulting asymmetry, the SEC has determined that it is appropriate to re-examine the minimum margin required for security futures.”
The SEC statement also noted that public comments would be accepted for 30 days following publication of the security futures proposal in the Federal Register.