Introduction

I dissent from today’s final cross-border swap rulemaking (the “Final Rule”).  As described by the Chairman, this Final Rule will “pare[] back our extraterritorial application of our swap dealer regime.”[1]  Over the past seven years, the current cross-border regime has helped protect the U.S. financial system from risky overseas swap activity.  The Commission should not be paring back these protections for the American financial system, particularly now, during a global pandemic.

The Final Rule will permit U.S. swap dealers to book their swaps with non-U.S. persons in offshore affiliates, thereby avoiding the CFTC’s swap regulations, even when they conduct those swap activities from within the United States and the U.S. parent retains the risks from those swap activities.  The structure of the Final Rule practically invites multinational U.S. banks and hedge funds to book their swaps in offshore affiliates to avoid our swap dealer regulations.  This will permit risks to flow back into the United States with none of the intended regulatory protections.

The Commission defends its retreat by citing principles of international comity and asserting that compliance with the laws of another jurisdiction in lieu of the CFTC’s requirements will be permitted only when the CFTC finds that the laws of the other jurisdiction are “comparable” to those of the CFTC.  The Final Rule, however, establishes a weak and vague standard for determining when the swap regulations of another jurisdiction are comparable.  Further, the Final Rule even permits substituted compliance where the swap activity occurs within the United States—such as for swaps between a U.S. branch of a non-U.S. swap dealer and another non-U.S. person, even if those swaps are negotiated and booked in the United States.  The Commission is not permitted to defer to regulators in other jurisdictions when the swap activity is conducted within the United States, nor should it do so even if such deference were permitted.

As I noted in my dissent on the proposed rule, experience has taught us that while finance may be global, global financial rescues are American.  We should not loosely outsource the protection of the U.S. financial system and American taxpayers to foreign regulators that are unaccountable to the American people.

Less regulation of U.S. persons conducting swap activities outside the U.S.

In the Final Rule, the Commission acknowledges that cross-border swaps activities can have a “direct and significant” connection with activities in, or effect on, U.S. commerce.  The Final Rule, however, removes several key protections in the 2013 Cross-Border Guidance (“Guidance”) [2]  that mitigated the risks arising from such cross-border activities.[3]  The Final Rule narrows the definition of “guarantee” in a legalistic manner, permitting banks to craft financing arrangements for their overseas swap activities that bring risks back into the U.S. parent organization without triggering the application of Dodd-Frank requirements for those activities.  The Final Rule also discards the Guidance’s firewalls that were designed to prevent banks from evading Dodd-Frank requirements by using foreign affiliates as the front office for swaps with non-U.S. persons while bringing the risk from those swaps back to the U.S. home office through back-to-back internal swaps (“affiliate conduits”).

The Final Rule creates a new category of entities—the SRS—supposedly to capture the risks arising from the swap activities of very large foreign affiliates of U.S. firms. But the Commission admits that this new category likely will include “few, if any” entities.[4]  Most likely, therefore, the SRS construct will provide no protections to the financial system from the swap activities of overseas affiliates of U.S. entities that bring risks to their U.S. parents and to the U.S. financial system.  Each of these significant deficiencies is discussed in greater detail below.

Swap activity outside the U.S. guaranteed by a U.S. Person.  The Guidance provided that when a swap of a non-U.S. person is guaranteed by a U.S. person, then the Dodd-Frank requirements regarding swap dealer registration and many of the attendant swap dealer regulations would apply to that non-U.S. person in the same manner as they would apply to a U.S. person.  This is because a swap conducted by a non-U.S. person guaranteed by a U.S. person poses essentially the same risks to the U.S. financial system as a swap conducted by a U.S. person.[5]  The Guidance adopted a functional rather than literal approach to the term “guarantee”:

“The Commission also is affirming that, for purposes of this Guidance, the Commission would interpret the term “guarantee” generally to include not only traditional guarantees of payment or performance of the related swaps, but also other formal arrangements that, in view of all the facts and circumstances, support the non-U.S. person’s ability to pay or perform its swap obligations with respect to its swaps.  The Commission believes that it is necessary to interpret the term “guarantee” to include the different financial arrangements and structures that transfer risk directly back to the United States.  In this regard, it is the substance, rather than the form, of the arrangement that determines whether the arrangement should be considered a guarantee for purposes of the application of section 2(i).”[6]

The Final Rule, however, adopts a narrow, legalistic definition of guarantee:

“Guarantee means an arrangement pursuant to which one party to a swap has rights of recourse against a guarantor, with respect to its counterparty’s obligations under theswap.”[7]  The Commission recognizes that this definition is “narrower” than the definition in the Guidance, and that this narrower definition could result in increased risk to the U.S. financial system.[8]  The Commission further acknowledges that this narrower definition “could lead to certain entities counting fewer swaps towards their de minimis threshold or qualify additional counterparties for exceptions to certain regulatory requirements as compared to the definition in the Guidance.”[9]

The Commission asserts, however, that the narrower definition is “more workable” because it is consistent with the definition of guarantee in the Cross-Border Margin Rule, and therefore will not require an “independent assessment.”[10]  The Commission presents no evidence, however, as to why the current definition, which has now been in place for seven years, is not “workable,” or why multinational financial institutions that trade hundreds of billions, and even trillions, of dollars of swaps on a daily basis are not capable of determining whether their overseas affiliates are guaranteed by a U.S. person.  A global financial institution that cannot readily determine or represent whether or not the risks from its overseas swaps are guaranteed by one of its U.S. entities should not be a global financial institution.

Affiliate conduits.  The Guidance also applied the Dodd-Frank swap dealer registration requirements, and many of the attendant swap dealer regulations, to the swap activities of “affiliate conduits”[11] of U.S. persons in the same manner as it applies to U.S. persons.  Under the Guidance, a key factor in determining whether a non-U.S. person would be considered to be an affiliate conduit of a U.S. person is whether the non-U.S. person regularly enters into swaps with non-U.S. counterparties and then enters into “offsetting swaps or other arrangements with its U.S. affiliate(s) in order to transfer the risks and benefits of such swaps with third parties to its U.S. affiliates.”[12]

The affiliate conduit provisions in the Guidance were designed to prevent U.S. entities from booking those swaps in their non-U.S. affiliates to escape the CFTC’s Dodd-Frank requirements that would otherwise apply to the entity’s swap activity in the United States.  The risks and benefits of those swaps booked offshore could then be transferred back to the U.S. with back-to-back internal swaps between the U.S. parent and its non-U.S. affiliate.  Ultimately, risk from the swap would reside on the books of the U.S. entity.  Through this back-to-back process, the U.S. entity could still conduct the swap activity, and bear the risk of the swaps, yet would avoid the application of CFTC requirements that would apply had the swap been booked directly in the U.S. entity.

The Final Rule does not include any comparable provisions to prevent the use of affiliate conduits to avoid CFTC regulation.  This is an invitation to abuse.

Significant risk subsidiary (SRS).  The Final Rule adopts a new construct—the “significant risk subsidiary”—to supposedly encompass overseas affiliates of U.S. entities whose swap activities pose significant risks to the U.S. financial system.  An SRS is defined as any non-U.S. “significant subsidiary” of an ultimate U.S. parent entity where that ultimate parent has more than $50 billion in global consolidated assets.  An entity is a “significant subsidiary” if it has a sufficient size relative to its parent, measured in terms of percentage of either revenue, equity capital, or total assets.[13]  However, the definition then excludes non-U.S. subsidiaries that are either (i) prudentially regulated by the Federal Reserve; or (ii) prudentially regulated by the entity’s home country prudential regulator whose regulations are consistent with the Basel Committee’s capital standards, and subject to comparable margin requirements for uncleared swaps in its home country.  An entity that survives the gantlet of thresholds and exclusions to be considered an SRS would then be subject to the same registration requirements as a U.S. person, and many of the same regulatory requirements that apply to U.S. swap dealers.  That outcome, however, is very unlikely.  The threshold criteria to be a “significant subsidiary” are high, and because entities that meet these high thresholds are typically affiliated with prudentially-regulated banks, it is likely they will be excluded from the SRS definition.  It therefore is improbable that any entities will fall into the SRS category.  The Cost-Benefit Considerations in the notice of proposed rulemaking for the Final Rule concede that “few, if any” entities would fall within its ambit.[14]

Furthermore, the criteria apply to each subsidiary separately.  If an institution has a subsidiary that is approaching the high thresholds set in the Final Rule, it can incorporate another non-U.S. subsidiary and conduct swap dealing activity out of that entity to avoid SRS designation for any of its subsidiaries.

One commenter noted that the qualifications only indirectly address the significance of the subsidiary and suggested the test be modified to assess the extent to which swap risk is accepted by a non-U.S. subsidiary or transferred back to the subsidiary’s U.S. affiliates.[15]  The Commission characterized the suggested test as an activity-based test and rejected the commenter’s proposed fix.  On the other hand, when other commenters noted that subsidiaries that do not engage in any swap dealing activity would potentially be captured by the SRS qualifications—because the qualifications have nothing to do with swaps—the Commission modified the Final Rule with an activity-based end-user test to exempt those entities from the SRS category.

Under the Final Rule, a significant subsidiary that is regulated by U.S. or foreign banking regulators is excluded from the SRS category.  “The Commission is excluding these entities from the definition of SRS, in large part, because the swaps entered into by such entities are already subject to significant regulation, either by the Federal Reserve Board or by the entity’s home country.”[16]

Here the Commission forgets the lessons of the 2008 financial crisis and ignores the mandate of Congress.  Following the financial crisis—and as a result of the lessons learned during the crisis—Congress subjected the swaps markets to both prudential and market regulation.  The Commodity Futures Modernization Act of 2000, which spectacularly failed to prevent the build-up of catastrophic systemic risks within the financial system leading to the 2008 financial crisis, was based on the premise that market regulation is unnecessary to protect against systemic risks for financial entities that are subject to prudential regulation.[17]  Events taught us, however, that prudential regulation alone was insufficient to prevent the build-up of those risks to the financial system. Following the crisis, Congress mandated both prudential regulation and market regulation for banks conducting swap activities.  The safeguards and protections to the financial system afforded under Title VII of the Dodd-Frank Act were to be applied regardless of the extent of prudential regulation.  The prudential regulation in a non-U.S. jurisdiction of an affiliate of a U.S. swap dealer whose swaps risks are transferred back into the U.S. is not an adequate substitute for the protections mandated by Title VII of the Dodd-Frank Act.

The Commission does not dispute that the Final Rule will allow affiliates currently subjected to the Guidance provisions regarding guarantees and affiliate conduits affiliates to operate free of CFTC swap regulations.  The Commission also acknowledges that the activities of these entities may pose risks to the U.S. financial system.[18]  Not only will the Final Rule permit risks to flow into the U.S., but it will provide an incentive for U.S. banks to move their swap activities into these foreign affiliates, where they can conduct the same activities but be free from the CFTC’s regulations.

Less regulation of swap activity in the U.S.

ANE Swaps.  In 2013, the CFTC issued a Staff Advisory addressing the applicability of the “Transaction-Level Requirements” to non-U.S. swap dealers that use persons in the U.S. to facilitate swap transactions with other non-U.S. persons.  The CFTC staff observed that “persons regularly arranging, negotiating, or executing swaps for or on behalf of an SD [swap dealer] are performing core, front-office activities of that SD’s dealing business,” and declared that “the Commission has a strong supervisory interest in swap dealing activities that occur within the United States, regardless of the status of the counterparties.”[19]  The CFTC staff advised that a non-U.S. swap dealer “regularly using personnel or agents located in the U.S. to arrange, negotiate, or execute [“ANE”] a swap with a non-U.S. person generally would be required to comply with the Transaction-Level Requirements.”[20]

The Staff Advisory prompted an outcry from non-U.S. swap dealers, including wholly-owned non-U.S. affiliates of U.S. financial institutions, who objected to the CFTC’s imposition of its clearing, trade execution, reporting, and business conduct standards on their swaps with other non-U.S. persons.  Non-U.S. dealers argued that the risks from these swap activities resided primarily in the home country, and warned that they may remove their swap dealing business from the U.S. if these requirements applied.  Shortly thereafter, the CFTC staff provided no-action relief from the application of the Staff Advisory,[21] and the Commission issued a Request for Comment on whether the Commission should adopt the Staff Advisory, in whole or in part.[22]

The Final Rule discards the ANE concept entirely.  “ANE transactions will not be considered a relevant factor for purposes of applying the Final Rule.”[23]

The ability of non-U.S. persons to use personnel within the U.S., without limitation, to conduct their swap activities with other non-U.S. persons without CFTC regulation or oversight could have a variety of detrimental consequences.  Foremost among these is the possibility, perhaps even likelihood, that U.S. swap dealers will move the booking of their swaps with non-U.S. persons (including non-U.S. affiliates of other U.S. firms) into their own non-U.S. affiliates, while maintaining the U.S. location of the personnel conducting the swap business, in order to avoid the application of the Dodd-Frank requirements to those transactions.  In fact, Citadel noted in its comments on the proposed rule that this may be happening already.  Citadel stated that “market transparency in EUR interest rate swaps for U.S. investors has been greatly reduced based on data showing that, following issuance of the ANE No-Action Relief, interdealer trading activity in EUR interest rate swaps began to be booked almost exclusively to non-U.S. entities, a fact pattern that Citadel believes is ‘consistent with (although not direct proof of) swap dealers strategically choosing the location of the desk executing a particular trade in order to avoid trading in a more transparent and competitive setting.’”[24]

If more than one U.S. swap dealer were to employ this strategy, the result could be that swap activity between two U.S. swap dealers that currently takes place within the U.S. and is fully subject to the CFTC’s swap regulations might then be booked in two non-U.S. affiliates outside the United States.  So long as the U.S. parents do not provide explicit guarantees for the swaps of the subsidiaries,[25] the trading between these subsidiaries would not count toward the dealer registration threshold.  Furthermore, even if one of those non-U.S. entities were a registered swap dealer, the trading would not be subject to any CFTC transaction-level requirements, even though the risk from those transactions is ultimately borne by the U.S. parent through consolidated accounting, and U.S. personnel would be negotiating those transactions.[26]

U.S. banks already conduct a significant amount of inter-bank business through their non-U.S. affiliates.  Data from swap data repositories shows that U.S. bank swap dealers commonly book swaps with each other through their respective non-U.S. subsidiaries.  For a recent one-year period, the data shows that a number of U.S. banks booked more than 10 percent—and in some cases close to 50 percent—of  the reported notional amount of swaps across their entire bank-to-bank swaps books through non-U.S. subsidiaries.  In other words, a number of U.S. banks are already booking material amounts of swaps with each other through their non-U.S. wholly-owned consolidated subsidiaries.

Non-U.S. banks conducting swap activity in the U.S.  The Final Rule reverses the position taken by the Commission in the proposed rule that would have prevented a U.S. branch of a non-U.S. swap entity from obtaining substituted compliance for various transactional requirements for swaps with non-U.S. swap entities that are booked in the U.S. branch.[27]  The cross-border notice of proposed rulemaking upon which the Final Rule is based (“2019 Proposal”) would have permitted substituted compliance only for the foreign-based swaps of a non-U.S. swap entity.  Both under the 2019 Proposal and the Final Rule, a swap conducted by a non-U.S. swap entity through a U.S. branch would not be considered a “foreign-based swap.”

Sensibly, under the 2019 Proposal, substituted compliance would be available only for foreign-based swaps. As the Commission explained in the 2019 Proposal, “[t]he Commission preliminarily believes that the requirements listed in the proposed definitions are appropriate to identify swaps of a non-U.S. banking organization operating through a foreign branch in the United States that should remain subject to Commission requirements. . . .”[28]

Although the Commission repeats nearly verbatim the rationale articulated in the 2019 Proposal for applying CFTC regulations without substituted compliance to transactions booked in the United States, conducted in the United States, and within an organization regulated under the laws of the United States, the Final Rule now excludes swaps booked in a U.S. branch of a non-U.S. swap entity from this general principle, and permits it to obtain substituted compliance for its transactions with non-U.S. persons.[29]

The Commission has no authority to grant substituted compliance for transactions occurring within the United States.  The ability of the Commission to consider international comity in determining whether to apply CFTC regulations or permit substituted compliance with the laws of a foreign regulator only applies with respect to activities outside the United States.  The Final Rule defines a “foreign-based swap” in a manner that does not include swaps booked in the U.S. branch of a non-U.S. swap entity.  The fact that one of the counterparties to a transaction is owned by a non-U.S. entity does not transform activity conducted by that entity within the United States into foreign activity.  Thus, the Final Rule not only retreats from the application of U.S. law to transactions that are arranged, negotiated, and executed in the United States, it even retreats from the application of U.S. law to transactions that are booked in the United States.  This is not in accordance with either Section 2(i) of the Commodity Exchange Act (“CEA”), which limits the application of the swaps provisions of the CEA only with respect to activities outside the United States, or with the principles of international comity, which the Commission recognizes only applies with respect to activity occurring in another jurisdiction.

Weakening the Standards for Substituted Compliance

I agree with the Commission’s interpretation of CEA Section 2(i) that international comity is an important consideration in determining the extent to which the CEA and the CFTC’s swap regulations should apply to cross-border swap activity occurring in another jurisdiction.  I have voted for every substituted compliance determination presented to the Commission during my tenure under the standards adopted in the Guidance.

The standards established in the Final Rule for substituted compliance determinations, however, depart significantly from the current standards.  The Final Rule creates a lesser standard that permits a finding of comparability if the Commission determines that “some or all of the relevant foreign jurisdiction’s standards are comparable . . . or would result in comparable outcomes . . . .”[30] Under the Guidance, however, the Commission must also find that the regulations of the other jurisdiction are as “comprehensive” as the Commission’s regulations.  Furthermore, the Final Rule permits the Commission to consider any factors it “determines are appropriate, which may include”[31] any of four factors listed in the Final Rule.  This “standard for review” is not a standard at all.  It permits the Commission to withdraw the cross-border application of its regulations regardless of the robustness of the other jurisdiction’s regulatory regime, for whatever reasons the Commission chooses.  In the absence of more rigorous, objective criteria, it will be very difficult for the Commission to deny requests from other jurisdictions or market participants for comparability determinations.

Conclusion

The Final Rule is a significant retreat from the robust yet balanced cross-border framework presented in the Guidance.  The current framework has worked well to both protect the U.S. financial system from systemic risks arising from swap activities outside the U.S. and recognize the interests of other nations in regulating conduct within their own borders.  The Final Rule destroys this balance.

I cannot support this abdication of responsibility to protect the U.S. financial markets and the American taxpayer.