At the end of last week the Commodities Futures Trading Commission approved proposed interpretive guidance regarding the cross-border application of the swaps provisions of the Dodd-Frank Act.
The release went on to say: “The vote was conducted via seriatim, which was approved by all five commissioners.”
However, while the proposed guidance may have been approved by all five commissioners, this is not to say that all five of the commissioners approve of the guidance being given. As reported by FOWintelligence, the proposed guidance has exposed the divide within the CFTC regarding the level of cross-border jurisdiction being claimed by the Commission.
On one side of the debate are Commissioners Gary Gensler and Bart Chilton, who claim that today’s global financial markets mean that risks taken abroad can directly impact the US economy and point to a number of examples where financial failures in non-US countries have done exactly this.
On the other side of the debate ate Commissioners Jill Sommers and Scott O’Malia. They argue that the proposed guidance goes beyond the CFTC’s jurisdictional reach, has not been co-ordinated with the SEC’s approach to these extraterritoriality issues and are critical that the Commission has opted to publish guidance rather than proposing a set of firm rules.
Risk to the US
The debate centres on the possible extraterritorial reach of US regulation governing swap reforms and at the heart of the issue is the interpretation of section 2(i) of the Commodity Exchange Act initially passed in 1936, which states that “provisions of the CEA shall not significantly apply to activities outside the United States unless those activities have a direct and significant connection with activities in, or effect on, commerce of the United States”.
The problem is, according to Gensler and Chilton, that increasingly swaps activities conducted on non-US shores do have a “direct and significant” impact on the US economy.
In a statement issued by Chilton on cross-border jurisdiction he claimed that, while the CFTC remains respectful of other nation’s sovereign right to implement regulations, “we all need to accept that these global financial markets operate all the time and across borders as a matter of course.”
Chilton also warned: “Risk is very portable; it can be shifted around like a shell game. Trading for a firm headquartered in one nation can take place in another.”
This is also what concerns Gensler, who pointed out that in the modern financial environment, large financial institutions will set up numerous legal entities around the world. Gensler claims that they do this for many different reasons, ranging from responding to customer needs and finding new funding opportunities to lowering their taxes and minimizing regulatory, capital and other requirements.
He added that many of these legal entities are still “highly connected” back to the US institutions that they are affiliated with and thus, “During a default or crisis, the risk that builds up offshore inevitably comes crashing back onto US shores.”
Learning from the past
In defense of this argument, Gensler was able to provide a number of examples where swap activities at institutions abroad have had a detrimental effect on the US economy.
AIG’s subsidiary, AIG Financial Products, was run out of London as a branch of a French registered bank and yet technically it was organised in the US. And it was AIG Financial Products that, according to Gensler, “nearly toppled the US economy.”
Lehman Brothers was another example used. It had a complicated web of affiliates, among which its London subsidiary had more than 130,000 outstanding swaps contracts, many of which were guaranteed by Lehman Brothers Holdings in the US.
Gensler was able to rip through whole list of similar examples; CitiGroup, Bear Stearns, Long-Term Capital Management and even the recent and well documented events as JPMorgan Chase in London all illustrate the how risk abroad can flow back to the US in the case of a disaster.
In this view then, the interconnectedness of the global financial markets means is effectively forcing the CFTC to extend its reach beyond the borders of the US in order to protect the national economy.
But Commissioner Scott O’Malia also issued a statement concerning the CFTC’s latest release and he took issue with the interpretation that the proposed guidance takes on section 2(i) of the CEA.
O’Malia argued that section 2(i) was initially intended to act as a limitation on the Commission’s authority by requiring the Commission to prove how and when its jurisdiction should extend outside the US. Instead of this, said O’Malia, “the Commission’s proposed Guidance ignores the literal statutory construction of sections 2(i) and prejudicially switches the analysis” by moving the burden onto market participants to prove why they are not subject to the swap provisions of the US.
Concurring with O’Malia, Sommers said that even the market failures that have prompted the wave of regulation surrounding the financial markets “does not justify the expansive view the Commission has taken of its jurisdictional reach, and does not justify the implication that other nations are not capable of effective regulation.”
From this perspective, the concern is that if the CFTC is perceived to overreach its authority outside US borders then foreign nations will react to this. O’Malia said that the proposed guidelines, as they currently stand are likely to provoke other nations to enact stricter swap rules on US firms in retaliation, therefore burdening these firms and placing them at a disadvantage to market participants.
Lack of harmonisation
Sommers and O’Malia were both also critical of the CFTC’s lack of co-ordination with the Securities Exchange Commission (SEC) and displayed a distinct cynicism about the decision to issue interpretive guidance instead of actual rules.
The SEC recently issued a statement of general policy on the sequence of compliance dates for the final rules applicable to the security-based swaps market. Sommers said that the CFTC should be harmonising with the SEC in both the content and timing of its regulations and yet isn’t, while O’Malia claimed that in contrast to the SEC’s measured approach “the Commission is engaging in what amounts to high-frequency regulation.”
The issue here is that the failure to harmonise rule-making domestically (as well as abroad) is likely to lead to inconsistencies and extra compliance complexities for market participants who trade both swaps and security-based swaps.
According to O’Malia and Sommers, the phrase ‘Proposed Interpretive Guidance’ used by the CFTC is misleading.
In her statement, Sommers admitted that “we are proposing Interpretive Guidance that ultimately has the effect of a rule. No matter what it is called, the Interpretive Guidance is so inextricably linked to the entity definitions and the registration rules that it is part of those rules themselves”.
One reason that was suggested as being behind the decision to issue ‘guidance’ rather than a set of regulations or orders is that by doing so the CFTC is able to circumnavigate the requirements of the Administration Procedure Act, specifically section 15(a), which requires the Commission to conduct a cost-benefit analysis for its regulations.
Sommers claimed that such a decision “needlessly exposes the Commission to litigation” while O’Malia is concerned that once the proposed guidance is finalised it will result in significant costs to the swaps industry that have not been detailed.
Amid all the technical debates about the US regulator’s cross-border jurisdiction, O’Malia made a stark and pertinent point when he stated that: “The Commission does not have the resources to register and regulate all market participants and swaps activities.”
The reality of the situation then is that the CFTC has no choice but to rely on non-US regulators to help them share the burden of ensuring safe and orderly markets, but the question still remains as to what degree the CFTC will co-ordinate effectively with them.
But despite this vociferous criticism from Commissioners Sommers and O’Malia, the interpretive guidance was passed unanimously. So why did they support something that they both appear so strongly opposed to?
Sommers conceded that it was a difficult decision but she said that ultimately it was important to issue the guidance to avoid leaving market participants in a continued state of uncertainty.
O’Malia supported the guidance for the same reason, although he was quick to make the point in his statement that the proposed guidance is only a draft and that if he were asked to vote on it as final that he would vote ‘no’.
“I fear that if we adopt the Proposed Guidance as final, the Commission will take an imperialistic view of the swaps market. I also remain concerned regarding the Commission’s shaky legal analysis,” said O’Malia.
Debate to continue
So is it the case that bad guidance is better than no guidance at all when it comes to the swaps markets? Does the nature of the global financial marketplace mean that regulators need to have a global reach? Is the CFTC protecting the US economy or potentially exposing US firms to extra compliance and expenses with this guidance?
The Commissioners have had their say, but expect the debate to rumble on now that it has been opened up to a wider audience.