On the 11th July, the European Commission and the US’s Commodity Futures Trading Commission (CFTC) ended months of uncertainty for the banking sector by announcing the ‘Path Forward’ for the regulation of over-the-counter (OTC) derivatives between the two jurisdictions.
More OTC derivatives are transacted within and between the EU and the US than anywhere else in the world, and agreement on a common approach to cohesive regulation applicable to both territories has been a long time coming. Under the ‘Path Forward’, the two regulators will continue to work together to ensure that their rules relating to cross-border OTC derivatives are aligned to an extent which will permit each to rely on the other, where necessary, for adequate supervision and enforcement.
The current state of flux in the EU and the US in OTC derivatives regulation is driven by the G20 nations’ agreement in 2009 that risk be reduced and transparency increased in OTC derivatives by requiring:
- all standardised OTC derivative contracts to be traded on exchanges or electronic trading platforms and cleared through central counterparties;
- OTC derivatives to be reported to trade repositories; and
- contracts that are not centrally cleared to be subject to higher capital requirements.
As such, a unified approach is required to ensure that the extra-territorial effect of the rules in each jurisdiction does not lead to international market participants being obliged to comply with more than one regulatory regime, and to legal uncertainty. The recent announcements aim to allay these fears.
Title VII of the US Dodd-Frank Act of 2010 governing OTC derivatives can have extra territorial effect where activities related to CFTC regulated swaps have a direct and significant connection with activities in, or effect on, commerce of the United States. Dodd Frank transaction level rules will impact EU registered dealers who are not affiliated to or guaranteed by a US person in respect of transactions with US persons or US guaranteed affiliates.
The European Market Infrastructure Regulation (EMIR) and proposed amendments to the Markets in Financial Instruments Directive (MIFID2) applicable to OTC derivative contracts eligible for clearing/trading on trading venues may also have extra territorial effect where activity in relevant contracts could have a direct, substantial and foreseeable effect within the EU or where it is necessary or appropriate for such rules to apply to prevent the evasion of any provision of the rules.
The principle of reliance on the domestic regulator where justified by the quality of its rules and enforcement
The thrust of the Path Forward announcements is that the EU Commission and the CFTC have confirmed their view that jurisdictions and regulators should be able to defer to each other when that is justified by the quality of their respective regulation and enforcement regimes.
Where EMIR requirements are complied with and those requirements are considered essentially identical to the equivalent CFTC requirements, the CFTC will issue no-action relief letters for transaction based requirements, to exempt relevant participants from compliance with Title VII of Dodd Frank. The CFTC is expected to issue final guidance on substituted compliance in cross border OTC derivatives very shortly to add flesh to these bare bones.
Similarly the EU will apply its existing system of equivalence – a broad outcomes-based assessment of the regulatory framework of a third country – to enable market participants to elect to comply either with Dodd Frank rules or EMIR. The EU’s equivalence assessments of Dodd Frank are underway.
EU and US rules essentially the same in key areas
The Path Forward press releases emphasise the similar approaches of the EU and the CFTC in many key regulatory areas as result of collaboration to date, and confirm the intent for future collaboration:
- covered market participants: EMIR applies essentially to financial counterparties and large non-financial counterparties, whilst Dodd Frank focusses on financial entities not using relevant transactions as hedges to commercial risk. The EU Commission and the CFTC have agreed that on this issue, the stricter rule should apply;
- covered swaps: the EU rules are likely to cover same classes of swaps as the Dodd Frank rules;
- mandatory clearing obligations: the processes for mandatory clearing in EMIR and Dodd Frank are essentially identical;
- trade execution: Dodd Frank requires swap contracts to be traded on a swap execution facility (SEF), a derivatives contract market (DCM) (for swaps) or a national securities exchange (for security based swaps). The CFTC and the EU Commission are collaborating on new rules re mandatory trade execution and trading platforms under MIFID 2, to ensure harmonization;
- central counterparties: initial margin coverage is only material difference between the EMIR and Dodd Frank approaches. The EU and CFTC are working to resolve this so as to reduce opportunities for regulatory arbitrage.
- straight-through processing: the EU Commission and the CFTC continue to work together on STP (seamless integration of systems and processes to automate the trade process from end-to-end trade execution, confirmation and settlement) in order to reduce risk to the system;
- rules for large swap participants: EMIR rules relating to confirmations, portfolio reconciliation, portfolio compression, valuation, dispute resolution etc. for major swap participants are essentially identical to the Dodd Frank rules.
Interim Clearances for EU MTFs
The CFTC also announced that it will ensure EU regulated multilateral trading facilities (MTFs) and clearing houses remain able to clear derivatives for clearing members pending recognition/ registration under Dodd Frank. To facilitate this, MTFs will be granted appropriate time-limited transitional relief by the CFTC if the execution requirement (ie the Dodd Frank obligation to trade on a swap execution facility (SEF), a derivatives contract market (DCM) (for swaps) or a national securities exchange (for security based swaps) is triggered before 15th March 2014.
The MTF must have a multilateral trading scheme, price transparency pre and post trade, non-discriminatory access, and appropriate oversight. Two EU clearing parties, LCH Clearnet Limited and ICE Clear Europe are already registered with the CFTC. Two more, Eurex Clearing and LCH Clearnet SA will receive no-action letters so as to be able to clear interest rate swaps and credit default swaps for US clearing members
The news that, having been locked in discussion for some time, EU and US regulators will continue to collaborate to ensure a cohesive, non-duplicative regulatory system can only be positive for the market as it faces the administrative and cost burden of new regulation. The hope is that, by setting an example for cross-border collaboration, other markets may ultimately follow suit. There is of course still a long way to go as both jurisdictions continue to promulgate detailed rules. How the broad principles of the Path Forward announcements translate into practice remains to be seen, the devil, as always, being in the detail.
Energy and Commodities Group
Hill Dickinson LLP
The Broadgate Tower, 20 Primrose Street, London, EC2A 2EW
Tel: 0207 280 9213