Remarks of CFTC Commissioner Brian D. Quintenz at 2019 ISDA Annual Japan Conference

“Significant’s Significance”

October 25, 2019

Thank you for that very kind welcome.  Before I begin, let me quickly say that the views contained in this speech are my own and do not represent the views of the Commodity Futures Trading Commission (Commission or CFTC).

Deference:  The Antidote to Market Fragmentation

Since the G-20 met in Pittsburgh over a decade ago, the world’s largest swap markets have made substantial progress toward implementing derivatives market reforms, including clearing, margin, capital, and trade reporting requirements.

However, jurisdictions implemented these reforms at different paces, and sometimes, in different ways.  Some of the implementation choices have created competitive disadvantages for one jurisdiction’s entities to participate in another jurisdiction’s markets.  This has led to a new challenge for regulators: regulatory-driven market fragmentation.  Liquidity pools have fractured in response to regulatory disputes over the extraterritorial application of jurisdictions’ rules, with counterparties from one jurisdiction unwilling to transact with counterparties from another jurisdiction if conflicting or overly punitive sets of regulations apply.  In order to avoid inconsistent, overlapping rules, counterparties – in particular derivatives end-users – are forced to restrict their activities by trading solely with domestic firms in their home markets.  Regionalized derivatives markets exacerbate liquidity risk, remove competitive pricing pressures, amplify volatility in times of market stress, and ultimately make the markets less efficient.

However, this concerning trend toward market fragmentation is not irreversible.  The key to fostering a global, vibrant swaps market lies in each jurisdiction’s recognition of, and deference to, the sovereignty of other jurisdictions, as well as other regulators’ supervisory interests in regulating their own local markets.  The good news is that the antidote to regulatory-driven fragmentation is within our reach, provided jurisdictions are collectively motivated to re-evaluate the extraterritorial application of their regulations.  This is one reason why I was so pleased that Japan chose to highlight and prioritize the harmful effects of market fragmentation across global financial markets during its G-20 presidency.[1]

Japanese leadership on this topic has encouraged international standard-setting bodies, like the International Organization of Securities Commissions (IOSCO) and the Financial Stability Board (FSB), to examine the fragmentation of derivatives markets.[2]  Both reports suggest that deference between regulators is crucial to mitigating or avoiding the adverse effects of fragmentation.  I strongly agree.  We must acknowledge and embrace the comparable regulation present in other jurisdictions.  The full promise of the G-20 reforms cannot be realized by a single nation acting alone, but progress can be actively defeated if each jurisdiction expects all others to adopt the breadth, depth, and detail of their rulesets.

A New Approach

For our part, the CFTC has not always embodied a deference-based cross-border approach.  Now, some claim the Commission’s expansive extraterritorial posture was the result of historical context and jurisdictional rulemaking timing differences.  I disagree.  Personally, I saw a consistent theme overarching the CFTC’s cross-border policies from 2011 through 2016: never miss a chance to ignore the word “significant.”

When the CFTC first adopted many of its post-crisis swaps reform rules, including its cross-border guidance in 2013, the agency raced ahead of other G-20 nations, despite a clear directive from Congress in Dodd Frank to “consult and coordinate with foreign regulatory authorities on the establishment of consistent international standards with respect to the regulation [of swaps]”.[3]  As of 2013, many jurisdictions had not yet enacted comparable regulatory frameworks, and some had enacted none.  Perhaps taking advantage of that unfinalized international regulatory landscape, the 2013 cross-border guidance and subsequent agency actions appeared grounded in a belief that almost every swap a U.S. person enters into, regardless of location or counterparty, should be subject to, and presumably protected by, CFTC regulation.

In my opinion, the foundational principle underlying any CFTC regulation of cross-border swaps activity, and the prism through which all extraterritorial reach by the CFTC must be viewed, is the statutory directive from Congress that the agency may only regulate those activities outside the United States that “have a direct and significant connection with activities in, or effect on commerce of, the United States.” [4]   Congress deliberately placed a clear and strong limitation on the CFTC’s extraterritorial reach, recognizing the need for international comity and deference in a global swaps market.

Pursuant to this statutory limitation, it is not sufficient for activities beyond the borders of the United States just to have a “direct” connection with activity in the United States or to have some effect on U.S. commerce.  Instead, in order to warrant the extraterritorial application of CFTC rules to other jursidictions’ markets, Congress requires the connection or effect to be both direct and significant. Both of these modifiers are consequential, though an examination of recent agency history may not lead one to think so.

Post-crisis CFTC actions, proposals, rules, guidance, or advisories placed almost their entire focus on seeking a “direct” connection between foreign activity and U.S. activity, with very little, or no, focus on weighing the “significance” of that activity or its potential effect on U.S. commerce as a whole.  How else to explain the 2013 staff advisory, which focused simply on whether a swap was “arranged, negotiated, or executed” in the U.S. (ANE transactions), or the 2016 cross-border proposed rule that based its expansive reach solely on the accounting practice of financial statement consolidation? [5]

With respect to the treatment of foreign consolidated subsidiaries (FCS), the 2016 proposal would have treated FCS with ultimate U.S. parents like U.S. persons and required them to include both their U.S.- and non-U.S. -facing swap dealing activity in their de minimis count.  This approach would have required these entities to include dealing activity occurring entirely outside the United States between two non-U.S. persons in their swap dealer registration calculation.  The 2016 proposal found that this non-U.S. activity had a “direct and significant” effect on the U.S. financial system - irrespective of the parent’s size, the entity’s size relative to the parent, or the risk of the entity’s activity - simply due to the consolidated financial reporting required by U.S. GAAP.[6]

I fundamentally disagree with the expansive interpretation of the Commodity Exchange Act (CEA) in the 2016 proposal, and I’m pretty sure it wasn’t what Congress intended when it inserted the word “significant.”  Although FCS activity, through accounting statements, may create a direct connection to the U.S. parent, I do not believe that consolidated financial reporting, by itself, automatically establishes that this connection is significant.

Before exerting its jurisdiction, I think the Commission should examine the following factors to determine if an FCS’ activities could pose a significant risk to the U.S: 1) the size of the U.S. parent entity itself (and therefore the parent’s significance to commerce in the United States), 2) the relative size of the FCS to that parent, 3) the scope of the subsidiary’s extraterritorial swaps activities, and 4) whether the FCS is already subject to consolidated supervision and regulation by another U.S. regulator, such as the Federal Reserve, or is located in a jurisdiction with comparable capital and margin requirements.  These domestic and foreign regulators have a strong supervisory interest in regulating the swap activity of these entities.  Deference to their purview is more than appropriate.

Secondly, and as previously mentioned, a 2013 staff advisory suggested that non-U.S. swap dealers must comply with certain transaction-level requirements, like clearing, margin, or trade reporting, with respect to ANE transactions.[7]  Subsequently, in response to great market uncertainty, staff issued a no-action letter relieving non-U.S. SDs from complying with certain transaction-level requirements for their ANE transactions.[8]

It is my view that CFTC transaction-level requirements should not attach to ANE transactions, which are, by definition, executed between two non-U.S. persons.  The swaps regime created by Dodd Frank is based on location of risk, not location of activity.  If the dealer or the counterparty to a swaps trade is U.S.-based, then the risk of that transaction resides in the U.S. and implicates U.S. rules.  However, the risk of ANE trades resides outside of the United States.  Therefore, those transactions are most appropriately managed by those foreign firms and their local supervisory authorities.

Applying discrete rules on a case-by-case basis using a vague construct that must be continuously interpreted is the definition of poor public policy.  If anything should apply to these transactions, it should apply to the U.S. personnel, such as business conduct standards, and not to the trades themselves.  Under no circumstances should such a diluted application of the word “significant” brought forward by the “ANE” standard warrant any additional U.S. regulatory consideration.

Conclusion

Market fragmentation poses serious risks to the liquidity and health of the derivatives markets.  The antidote is deference.  And one of the lynchpins to successful deference is appropriately scoping in, as well as out, the correct cross-border activities and entities.  Keeping in mind the paramount statutory limitation on the Commission’s extraterritorial reach, I am hopeful the Commission will codify a limited, but appropriate, regulatory framework for cross-border swap dealing.  Through deference and engagement, the Commission can work alongside our other like-minded international counterparts to ensure a well-regulated, liquid, global swaps market.