Cross-Border at the Crossroads: The SEC’s “Middle Ground”

John Ramsay is acting director of the Division of Trading and Markets at the U.S. Securities and Exchange Commission. This post is based on Mr. Ramsay’s remarks at the New York City Bar Association, available here. The views expressed in the post are those of Mr. Ramsay and do not necessarily reflect those of the Securities and Exchange Commission, the Commissioners, or the Staff.

I’d like to describe the Commission’s recent set of proposals on the cross-border regulation of derivatives. First, though, I’ll describe the state of play among international regulators, both in developing their derivatives regimes and in grappling with the thorny cross-border aspects of derivatives trading.

Status of International Regulatory Efforts

Countries are at various stages of implementing their derivatives regimes in response to the G20 commitments.

The U.S. is further along in this effort. The SEC has now proposed substantially all of the rules required by Title VII, and we have adopted the foundational definitional rules and those governing swap clearing agencies standards, among others. The CFTC is further along in the adoption mode and is on track to complete the adoption of their rules later this year.

Other jurisdictions are further behind, which means that it is difficult to assess at this point how similar their requirements may be to those that the U.S. is implementing.

At the same time, regulators are grappling with the cross-border impact of their individual requirements. Last year, the CFTC proposed an interpretive statement describing how their rules would apply off-shore, and we were able to consider the comments received on their proposals in fashioning our own. No other jurisdictions have laid out a comprehensive view of how their rules would apply to cross-border activity.

There are however, various so-called “equivalence” efforts underway. In general, an equivalence assessment looks at the full sweep of another jurisdiction’s rules to determine whether they should be deemed comparable. If they are, participants trading cross-border have the choice of which country’s rules to apply.

One problem with this approach is that it requires an “all or nothing” determination. If another regime is found to be comparable notwithstanding significant gaps in coverage, the markets are ripe for regulatory arbitrage, since participants will always opt for the lower-burden alternative.

On the other hand, if an equivalence assessment requires that rules be mostly identical, it will be very difficult to ever make that determination, which would fail to recognize legitimate differences that are likely to arise among global regimes.

Even more problems can arise if an equivalence review is coupled with a reciprocity element. In that case, one jurisdiction makes its own equivalence decision dependent on the decision of the other jurisdiction to make the same finding. To me, that looks less like a comparability review than a trade negotiation. A reciprocity condition could be used as a cudgel to coerce other regimes to adopt regulations that are very close to those of the country that is making the determination. Or, on the other hand, it could be used as a protectionist measure to wall off markets from the impact of another country’s rules.

Then-Chairman Elisse Walter laid out these concerns in more detail, when she previewed our cross-border approach in a recent speech, and I commend those remarks to you if you haven’t read them.

There are also various multi-lateral and bilateral efforts underway to find some convergence on these issues, and notwithstanding some differences in how individual jurisdictions approached these questions at the outset, there does seem to be genuine interest in finding common ground.

You may have read that a number of foreign finance ministers sent a letter recently to the Secretary of the Treasury on this topic. Although the reason for the letter was to express concern about slow progress in finding an international solution to overlapping or conflicting rules, there were some positive messages. All of the signatories expressed support for the development of regimes consistent with the G20 goals and their desire to avoid cross-border conflicts. They also committed to staying “vigilant against regulatory arbitrage”, which is a good cause to rally around.

Principles Driving the Cross-Border Proposal

Those are just a few of the key undercurrents of the global efforts to reform the derivatives markets. And it is within that context that the SEC has proposed its rules and interpretations pertaining to cross-border derivatives transactions and activities.

They may seem complicated because the subject matter is complicated, but our approach proceeds from some pretty simple principles and observations.

First, financial crises tend to be global in scope. That was true in 2008, and it is likely to be true in the future. It was the recognition of this truth that gave birth to the G20 commitments, which led to Title VII.

Second, much if not most of the trading in derivatives markets tends to have an international component. Therefore, I don’t think it is much of a stretch to suggest that Congress did not expect that our rules would only apply to activity that occurs exclusively within the United States. That would lead to the lion’s share of much security-based swap activity that impacts the United States being beyond the reach of our rules. That simply doesn’t make sense as a matter of statutory interpretation or regulatory policy.

At the same time, we don’t view the statute as calling on U.S. regulators to export Dodd-Frank to the world. Doing so could well lead to geographic segmentation of the market. That won’t make the global trading markets safer. Global dealers today allocate positions around the globe based on their assessment of where their own risk can best be managed. That’s a mindset we want to encourage; erection of geographic barriers distorts the way that risk is managed, which is bad for the global system.

In this regard, there are already warning signs in global markets about the potential for protectionist or retaliatory measures to be adopted. For example, the Fed’s proposal to impose capital surcharges on large foreign banking organizations in the U.S. has raised concerns about possible protectionist responses or retaliation. I’m not speaking to the merits of that particular proposal, only noting that there are various pressures that could push global markets toward fragmentation.

So our proposed cross-border rules try to fulfill the goals of Title VII in light of the realities of global trading and the goal of preserving the benefits of integrated markets. In general and as I will explain in just a moment, we have proposed to answer the question by applying our registration and other threshold requirements to activities that in some respects occur in the United States, but provide the ability to make broad substituted compliance determinations or grant exemptions to allow foreign firms to comply with home requirements, or to clear or execute trades through offshore facilities, where the foreign regimes aim at the same outcomes as ours.

As Commissioner Walter put it in her speech, we have tried to find a “middle ground”.

In putting forward this proposal, we are conscious of the importance of the Title VII provisions in reducing risk throughout the system, but we also know that we are not the only game in town. We in the U.S. are further along in this effort, but it should be possible to attain strong global standards in a cooperative way, and it should be possible to lead without arrogance.

Overview of the Proposal

We proposed the cross-border rules and interpretations relating to all of the Title VII requirements at the same time so that people could consider how the individual parts relate to each other and decide if they work as a coherent scheme. Also, we proposed our approach in the form of rules and interpretations subject to notice and comment and backed up by a very thorough economic analysis. In fact, the economic analysis substantially accounts for the length of the release.

The proposal covers many topics but primarily it addresses:

  • Regulation of dealers and major participants, which includes both entity requirements like capital and transaction requirements like certain business conduct rules;
  • Registration of infrastructure entities (data repositories, clearing agencies and execution facilities);
  • What I think of as “market-wide transaction requirements”, which apply to dealers and non-dealers, including regulatory reporting and trade dissemination, mandatory clearing requirements, and mandatory trade execution.
  • We also proposed a way to avoid adverse impacts from the provision of Dodd-Frank that asks for regulators to indemnify trade repositories before obtaining data from them.

In broad terms, it may be best to understand the proposal by separating two main questions that are addressed. The first is whether particular entities or transactions are captured by the rules because there is a sufficient nexus to the U.S. The second question is how they comply with the rules when the tripwire is crossed. It is in answer to the second question that the idea of substituted compliance comes into play.

Specifics of the Proposal

Territorial Approach and the Definition of “U.S. Person”

As to the first question, in general we have taken a “territorial” and “entity-based” approach. A key issue under that first heading is whether an entity is conducting enough business to require it to register as a dealer in security-based swaps, after considering the rules we’ve previously adopted requiring that an entity conduct more than a threshold amount of dealing activity to trigger registration.

In answering that question, dealers located in the U.S. consider all of the business they conduct, foreign and domestic. Also, consistent with the treatment of bank branches in other contexts, branches located overseas are considered part of the U.S. entity they are attached to.

In contrast, entities located off-shore count only the business they conduct within the United States or with U.S. persons. In defining the term “U.S. person”, we took a simple, straightforward approach: U.S. persons are residents, those that are incorporated or organized here, and those that have their principal place of business in the U.S.

We proposed to treat transactions executed, solicited, negotiated, or booked in the U.S. as U.S. business because that reflects common sense and in order to level the playing field. Consider a scenario that reflects trades that happen every day. A bank based in the U.K. uses its New York mid-town office to negotiate and document a CDS trade with a German hedge fund. If this trade was not considered to be U.S. business, a U.S. dealer with offices in the very same building might have to operate under a very different set of rules if it did precisely the same trade with the same counterparty.

To summarize, U.S. dealers have to register if they conduct more than a minimal amount of dealing business in derivatives that we regulate, while foreign-based firms need to register if they do more than a minimal amount of dealing business either with U.S. persons, or where key aspects of the business occur in the U.S.

The Treatment of Foreign Branches and Guaranteed Subsidiaries

We gave a lot of thought as to how Title VII should apply to foreign branches of U.S. banks and guaranteed subsidiaries of U.S. holding companies. We considered how to best account for the risk conducted in those entities while avoiding competitive distortions.

First, as to branches, foreign dealers would not be required to count trades with foreign branches of U.S. banks as U.S. business, even though for most purposes a branch is considered to be a part of the larger corporate entity. Our concern was that otherwise, foreign firms would curtail their business with those branches in order to avoid being subject to the U.S. dealer regime.

Also, in many cases those branches would not be subject to U.S. clearing, trade execution, and dissemination requirements when they deal with foreign counterparties. Again, we thought it made sense to give some flexibility for those firms to do business outside the U.S. on the same basis as their competitors.

Similarly, our proposal would not require guaranteed foreign subsidiaries of U.S. holding companies to register as dealers if they conduct no or minimal U.S. business. We understand that the fact of a U.S. guarantee could transfer risk back to the U.S. But, instead of applying the full raft of U.S. dealer rules to those entities, we thought that risk was better accounted for by the major participant regime.

So, in the case of a U.S. holding company guaranteeing trades of its foreign subsidiary, which does not itself conduct U.S. business, the guarantee would not cause the subsidiary to register as a dealer, but the holding company might well need to register as a major security-based swap participant and be subject to the standards of that regime.

Triggering of Other Regulatory Requirements

We also addressed the application of U.S. rules to what I’ll call “infrastructure” entities – the clearing agencies, data repositories and swap execution facilities. Subject to the ability to obtain exemptions where they are subject to comparable regulation off-shore, which I’ll address in a moment, each would be required to register if there are specific identified activities in the U.S.

The extent and nature of the required U.S. activity would depend on the type of entity. For example, clearing agencies could be subject to U.S. rules if they have any U.S. members, on the theory that U.S. membership transfers the risk of the clearing house directly to U.S. markets.

Registration of execution facilities could be required if the facility provides U.S. persons with the direct ability to trade on a foreign market. This is consistent with the approach that has been followed before in determining whether more traditional trading venues are subject to U.S. requirements.

We also proposed to apply what I call the “market-wide” transaction requirements – trade reporting and transparency, clearing, and trade execution – to trades where there is specific and identifiable U.S. activity.

The nature and extent of U.S. activity, again, depends on the specific requirement. The proposal contains a fair amount of complexity in this regard. We were concerned that, by making it simpler, we might capture more activity than was warranted, or else cede authority over transactions that directly involve participants and markets here.

The rules on trade reporting would be somewhat more broadly applied than the others, given the regulatory interest in having a complete view of all transactions that impact U.S. markets.

The Use of Substituted Compliance and Exemptions

To this point, I’ve been talking about what may trigger the U.S. requirements. I’d now like to address the second question: how may parties located outside the U.S. comply with those requirements?

In general, we have proposed a method whereby participants in cross-border transactions could “substitute” compliance with home country rules in place of the U.S. requirements if the Commission has found those home country rules to be comparable.

This determination would be made considering the similarity of outcomes under each set of rules. This scheme would not involve a granular or rule-by-rule comparison and would recognize that it is possible to get to the same place by more than one path.

Also, unlike the equivalency assessments I described earlier, this would not be an “all or nothing” process. The Commission would consider comparability according to four general categories – 1) regulation of non-U.S. dealers; 2) regulatory reporting and public dissemination of trade data; 3) mandatory clearing of security-based swaps; and 4) mandatory trade execution.

Under our plan, a participant or group could request a substituted compliance determination for one or all of these categories on a jurisdiction-by-jurisdiction basis. If granted, the determination would be available to all participants who trade in that jurisdiction.

Because this would not be an “all or none” exercise, for example, the Commission could allow foreign participants to follow the capital and margin rules of their home country if they were found to be comparable. At the same time, if the same regime did not have comparable reporting and transparency requirements, the SEC rules governing those elements would apply.

Also, as I mentioned earlier, clearing agencies, trade repositories, and swap execution facilities could be the subject of exemptions if their home countries are found to have comparable rules in place to those that govern the same entities here.

So, for example, a trade between a foreign dealer and a U.S. fund that is required to be cleared under the U.S. regime could be cleared instead at a non-U.S. registered European clearing agency if that entity was subject to a comprehensive and comparable system of oversight in its home country.

What I like about the substituted compliance concept is that it recognizes that different regulatory regimes can have different ways of achieving the same outcomes. More than that, it allows U.S. regulators to encourage continuing dialogue with our colleagues in other countries in aiming at strong global standards that reduce risk everywhere. If we insisted on applying U.S. rules to all cross-border trades, regulators in other places may feel they have no incentive to continue the conversation. Instead, they may have a big incentive to erect barriers against the long arm of the U.S. laws.


In closing, I want to emphasize that in crafting our cross-border approach, our aim has been to apply our laws in a way that achieves the financial stability, market transparency, and investor protection objectives of the Dodd-Frank Act while preserving the globally-integrated, dynamic character of the OTC derivatives market. We have done our best to frame a proposal that achieves these twin goals, and we look forward to your comments as well as comments from others.

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