Proposed Rules for Global Derivatives Market

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s statement at a recent open meeting of the SEC; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Today [May 1, 2013], the Commission considers issuing a release proposing rules and interpretive guidance applicable to certain market intermediaries, participants, clearing agencies, data repositories, and trade execution facilities that are involved in cross-border transactions of security-based swaps. The proposed release is over 1,000 pages, contains over 2,000 footnotes, and requests comments on more than 630 questions with many subparts. Although the questions posed are many, they are intended to be balanced and fair to solicit views from all sides. This is a welcome approach, because it contributes to a healthy debate and dialogue that is vital to the Commission’s processes.

Today, the Commission also votes to reopen the comment period on the various outstanding rulemaking releases and policy statement concerning security-based swaps and market participants to allow the public additional time to analyze and provide comments in light of our cross-border release.

The length of the cross-border release and the reopening of the comment periods reflect the complexity and importance of the issues involved in securities-based swap transactions. In issuing today’s proposal and asking for comments on the Commission’s proposed approach to regulating the securities-based swap market, the Commission recognizes the interactions among many important rules in this area. It is important, therefore, that our rules avoid gaps and loopholes, and that they work together to provide the needed transparency, accountability, and protection to our economy, the markets, and, most importantly, to investors.

During the recent financial crisis, we witnessed the devastating effects of a global derivatives marketplace that, left unchecked, seriously damaged our economy and caused significant losses to U.S. investors. We also witnessed several regulatory bailouts as we dug our way out of the financial crisis, including the bailout of the American International Group (AIG), the rescue of Bear Stearns, and the failure of Lehman Brothers. By one estimate, the financial crisis caused approximately $12.8 trillion in economic damage to our nation – a crisis that hurt American families and communities across our nation. While many factors caused the financial crisis, a major contributor to that crisis was the unregulated global derivatives market.

These events demonstrate the need for the Commission to develop a comprehensive regulatory framework for the oversight of the derivatives market. The derivatives market – a market that is estimated to exceed $630 trillion worldwide – has for a long time operated in an opaque market replete with regulatory gaps. In this regard, Title VII of the Dodd-Frank Act aims to prevent future financial crises by providing the Commission with the necessary rulemaking authority to reduce systemic risks and increase transparency in the derivatives marketplace.

Although the Commission has not moved as quickly to implement Title VII as I would have preferred, and there is still work ahead that remains to be completed, the Commission has taken several steps to implement Title VII. For example, we have adopted joint rules with the Commodity Futures Trading Commission (CFTC) on product and entity definitions; rules that establish the procedure by which clearing agencies submit security-based swaps for purposes of mandatory clearing; and rules that establish standards for registered clearing agencies.

To meet the Title VII requirements, the Commission has also proposed rules in a number of important areas, including rules to move transactions onto regulated platforms, rules to provide trade transparency, rules to reduce systemic risk by requiring central clearing, rules to prevent conflicts of interest from hindering fair access to trading and clearing facilities, rules to bring transparency and fair dealing to the market for security-based swaps, rules for the registration of dealers and major participants, and rules to impose capital, margin, and segregation requirements for dealers and major participants.

A key goal of the Dodd-Frank Act is to increase the transparency and oversight of the derivatives market by, among other things, bringing trading of security-based swaps onto regulated markets. In furtherance of that goal, today’s rule proposal focuses on the application of Title VII to cross-border security-based swap activities of market participants. The rules we propose seek to achieve a number of important objectives, including the following:

  • First, the rules seek to promote Dodd-Frank’s goal of reducing risk, increasing transparency, and improving the integrity of our financial markets by registering and regulating security-based swap dealers and major security-based swap participants involved in cross-border activities within the meaning of Title VII. As with the rules applicable to domestic activities, today’s rules include requirements designed to protect customer assets, lessen the potential impact of institutional failures, and promote a culture of compliance and fair dealing.
  • Second, the rules would require the registration of security-based swap clearing agencies, data repositories, and swap execution facilities involved in cross-border activities within the meaning of Title VII. Moreover, the rules apply Title VII to certain transactional requirements for reporting and dissemination, clearing, and trade execution for security-based swaps.

The proposed cross-border rules we consider are important components to achieve Dodd-Frank’s goal of trying to prevent future crises. However, I have some areas of concern regarding aspects of today’s rule proposal, and I invite public comments on these issues. For example:

Substituted Compliance and External Business Conduct

The rule proposal seems to rely heavily on “substituted compliance,” a framework under which the Commission would permit compliance with comparable regulatory requirements in a foreign jurisdiction to substitute for compliance with the Securities Exchange Act of 1934 (“Exchange Act”) relating to security-based swaps. In particular, non-U.S. dealers that are registered with the Commission would be allowed to comply with the U.S. external business conduct rules through “substitute compliance” as an alternative to complying with the Exchange Act. External business conduct rules are necessary to ensure honesty and high ethical standards in the securities industry, as well as to promote confidence in our securities markets among domestic and foreign investors. The proposed rules would allow these SEC-registered entities to use “substituted compliance” for external business conduct rules, even as to transactions taking place within the United States involving U.S. persons.

In particular, this approach would allow substituted compliance for transactions between registered non-U.S. dealers and a unique class of counterparties that Congress has identified as “special entities” needing enhanced protections. It remains unclear whether these registered non-U.S. dealers, if required, would be able to act in the best interests of special entities in the United States. Under these circumstances, creating a substituted compliance regime may remove these enhanced protections, and, if so, would not seem to be consistent with Congressional intent.

Therefore, I would like commenters’ views as to whether a substituted compliance regime will inappropriately deny American investors the protection of American laws.

Foreign Subsidiaries and Branches

Moreover, while the rule proposal treats “foreign subsidiaries” of U.S. companies differently from “foreign branches” of U.S. banks, the rule proposal would allow “foreign subsidiaries” to be treated as non-U.S. persons under all circumstances and “foreign branches” to be treated as non-U.S. persons under certain circumstances. Foreign subsidiaries are entities incorporated outside the U.S. and considered separate entities from the U.S. parent, while foreign branches are considered part of the U.S. entity.

As to subsidiaries, the proposed rule would exclude from the definition of “U.S. person” all subsidiaries of U.S. persons that are incorporated abroad and have their principal place of business abroad, even if a foreign subsidiary is guaranteed by its U.S. parent. This treatment of foreign subsidiaries seems to overlook the fact that the financial resources of multinational U.S. parent companies are typically integrated with the financial resources of their foreign subsidiaries to be competitive in the global derivatives market. As such, a foreign subsidiary of a U.S. parent company is, in reality, an integral and indistinguishable part of the U.S. parent company.

With respect to foreign branches of U.S. banks, the rule proposal treats them as non-U.S. persons in their foreign businesses, even though they are considered “U.S. persons” for purposes of the proposed rules. For example, if a foreign branch of a U.S. entity transacts with an unregistered non-U.S. dealer outside the United States, then many Title VII requirements will not apply.

These treatments of “foreign subsidiaries” and “foreign branches” may incentivize U.S. companies to conduct their security-based swap business through their foreign subsidiaries and branches, thereby increasing the potential for regulatory arbitrage and creating risks that will ultimately come to our shores. For example, under the proposed rules, two non-guaranteed foreign subsidiaries of two separate U.S. entities could engage in unlimited amounts of security-based swap transactions with each other outside the United States and not be subject to Title VII. The proposed rules seem to assume that any failure by these foreign subsidiaries would not financially affect the U.S. parents. However, even without a legal obligation, a U.S parent company will likely step in to save its financially troubled subsidiaries and protect its reputation. The proposed rules do not appear to address fully these contagion and spillover risks.

For these reasons, I would like to invite public comments on (1) whether a majority-owned subsidiary of a U.S. parent, regardless of any financial guarantee from the U.S. parent, should be included in the definition of “U.S. Person;” and (2) whether a foreign branch of a U.S. parent should be included in the definition of “U.S. Person” for all purposes under Title VII. In particular, commenters should address whether the proposed approach provides sufficient protection to the U.S. financial system.

Counterparty Representations

Finally, the proposed release relies heavily on counterparty representations as to whether a transaction is solicited, negotiated, or executed by a person within the U.S. Specifically, a person receiving the representations would not be liable under Title VII if the person did not have “actual knowledge” of a misrepresentation. These representations are important because they are part of the determination whether a person or transaction is subject to Title VII. I believe that a person receiving such representations should exercise reasonable care and diligence in determining his counterparty’s U.S.-person status and whether the transaction was conducted within the United States. Therefore, I invite public comments on whether such person should be required to undertake some reasonable due diligence and should be liable under Title VII if the person knew or had reason to know about the misrepresentation.

These, and other issues, require additional thought and I am willing to support today’s proposal because putting this proposal out for public comment is an important step forward in developing effective regulatory oversight over a largely nontransparent and unregulated global derivatives market. It is important to get public input on these issues and, at my request, the proposed release includes several questions to solicit public comments in these areas.

I will also vote to reopen the comment period on the other Title VII proposals, so that we can benefit from additional comments now that substantially all of the Title VII rule makings have been proposed and commenters can see how these rules would work together.

As we create our rules, we must be reminded of the desperate efforts and massive taxpayer bailout required in response to the 2008 financial crisis and the role that the derivatives market played in destroying storied investment banks, imposing large losses on market participants, and triggering fear and panic on Wall Street and Main Street. A well-regulated market promotes investor trust and confidence, a necessary ingredient for a vibrant, global financial market. I am hopeful that the final rules will accomplish the goals of the Dodd-Frank Act.

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