At open meetings on Wednesday, July 22, and Thursday, July 23, the CFTC approved, by a 3-2 vote, two significant final rules implementing provisions in the Dodd-Frank Act. The first rule imposes capital requirements on swap dealers (“SDs”) and major swap participants (“MSPs”) that are not subject to supervision by a banking regulator, as well as financial report requirements for all SDs and MSPs. The second rule addresses the cross-border application of the SD and MSP registration thresholds and establishes a formal process for requesting comparability determinations for such requirements from the CFTC. Each final rule is summarized below.
Capital Requirements of Swap Dealers and Major Swap Participants
The approval of this final rule comes after nearly a decade of rulemaking activity. To implement section 731 of the Dodd-Frank Act, which amended the Commodity Exchange Act to require the CFTC to adopt minimum capital requirements for SDs and MSPs that are not subject to prudential regulation, the CFTC initially proposed a capital rule and financial reporting requirements for SDs and MSPs in 2011, re-proposed the rule in 2016, and reopened the comment period for the rule in 2019. The prudential regulators―i.e., the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration, and the Federal Housing Finance Agency―separately finalized the capital rule for SDs and MSPs subject to their supervision in 2015.
Key features of the final rule include:
- Methods for calculating capital. The CFTC’s final rule will allow SDs to choose from among three methods to calculate their capital. Each method is also subject to a $20 million capital floor.
- Bank-based approach. Comparable to existing Federal Reserve Board capital requirements for bank holding companies, this approach is generally consistent with the approach taken by the prudential regulators for SDs subject to their supervision. Under this method, the SD is required to maintain a minimum amount of regulatory capital that is equal to or in excess of (i) 8% of risk-weighted assets, composed of at least 6.5% of tier 1 common equity; and (ii) 8% of its uncleared swap margin amount. The final rule notes that this method is properly viewed as solvency-based and designed to preserve positive balance sheet equity.
- Net liquid asset measure. Where the above approach is solvency-based, this approach is liquidity-based. Comparable to the SEC’s liquidity-based capital requirements for security-based swap dealers and broker-dealers (as well as the CFTC’s requirements for futures commission merchants), the method requires the SD to maintain minimum net capital of at least 2% of the total amount of its uncleared swap initial margin. The final rule lowered this percentage from 8% in the proposed rule, on the basis that 2% is more appropriate given the differences in the composition of capital relative to other methods―unlike the other methods, this approach includes illiquid capital in the denominator.
- Tangible net worth. This method, which is intended for SDs whose parent companies are engaged in non-financial activities, is based on the SD’s tangible net worth. As computed in accordance with Generally Accepted Accounting Principles (GAAP), net worth must be equal to or greater than 8% of the uncleared swap margin associated with the SD’s swaps positions. To be eligible for this method, the SD must meet the CFTC’s “15% revenue test” and “15% asset test” to demonstrate that it or its parent and/or consolidated entity is primarily engaged in non-financial activities; see 329-330 of the rule text linked above for the precise definition of these tests. The tangible net worth method is also the approach adopted for MSPs.
- Financial reporting and recordkeeping. In addition, the final rule includes requirements for financial reporting and recordkeeping for SDs and MSPs. The rule requires these entities to file periodic unaudited financial statements and an annual audited financial report with the CFTC and with the registered futures association (“RFA”) of which they are a member. The rule also requires these entities to provide notice to the CFTC and RFA if certain designated events occur, such as undercapitalization, a books and records issue, or failure to post or collect required margin.
- Substituted compliance. The final rule allows non-U.S. domiciled SDs to petition the CFTC for substituted compliance with respect to their capital and financial reporting requirements. Substituted compliance is the mechanism by which non-U.S. SDs may satisfy CFTC requirements by complying with comparable foreign requirements. For substituted compliance to be permitted, the CFTC must first have made a determination that the corresponding rules of the non-U.S. jurisdiction are comparable to U.S. rules (called a “comparability determination).
- Applicability. The final rule states that it will apply to 56 SDs; the other 52 SDs are bank SDs subject to prudential regulation. There are currently no registered MSPs, provisionally-registered MSPs, or entities pending registration as MSPs, but the rule notes that it is adopting these capital requirements for MSPs in the event that entities seek this registration in the future.
- Compliance date. The compliance date for the final capital requirements rule is October 6, 2021.
The CFTC approved the final capital rule by a vote of 3-2 along party lines to approve this final rule, with Democratic Commissioners Behnam and Berkovitz dissenting. Chairman Tarbert noted in his statement that he supported the rule because, among other things, it would provide market participants with certainty, flexibility to choose an appropriate capital approach, reduce systemic risk, and enhance customer protections.
Commissioner Berkovitz dissented on the basis that, in his view, the capital standards in the final rule were established without quantitative analysis concluding that they are appropriate, and “appears to be designed with the objective of ensuring that most [SDs] will not need to raise more capital.” Commissioner Behnam dissented on substantive and procedural grounds, arguing that the CFTC did not seek sufficient information during the comment period and that, accordingly, changes made against the proposed rule, such as the capital requirement under the net liquid asset measure method, may not “adequately calibrated.”
Cross-Border Application of the Registration Thresholds and Certain Requirements Applicable to Swap Dealers and Major Swap Participants
Similarly passed on a 3-2 party-line vote, this final rule addresses the cross-border application of SD and MSP registration thresholds and certain requirements applicable to SDs and MSPs. It also establishes a formal process for requesting comparability determinations for these requirements from the CFTC. The rule supersedes the CFTC’s 2013 guidance, which had been supplemented with interpretive guidance and no-action letters, and codifies a proposed rule issued in January 2020.
As background, the final rule observes that many swaps involve at least one counterparty that is located in the United States or another jurisdiction that has adopted comprehensive swap regulations. It highlights that conflicting and duplicative requirements between U.S. and foreign regimes can contribute to potential market inefficiencies, regulatory arbitrage, competitive disparities that may harm the relative positions of U.S. market participants, and market fragmentation.
Accordingly, the final rule is intended to create a cross-border framework that, consistent with section 2(i) of the Commodity Exchange Act, applies only where activities outside the U.S. have “a direct and significant connection with activities in, or effect on, commerce of the United States.” As Chairman Tarbert stated when voting in favor of the proposal: “Because nearly all G20 jurisdictions have adopted similar swaps regulations pursuant to the Pittsburgh Accords, it is unnecessary for the CFTC to be the world’s policeman for all swaps.”
To that end, key features of the final rule include:
- Overview. The rule identifies which cross-border swaps or swap positions a person will need to consider when determining whether it needs to register with the CFTC as an SD or MSP. A U.S. person generally must count the aggregate gross notional amount of the swaps connected with its swap dealing activities toward the de minimis threshold of $8 billion. When the SD (together with its affiliates) exceeds this threshold for the preceding 12 months, it would be required to register with the CFTC. The final rule also identifies related classifications of swap market participants and swaps (e.g., U.S. person, foreign branch, or swap conducted through a foreign branch).
- Definitions. The rule adopts the following key definitions:
- U.S. Person. The final rule aligns the definition of “U.S. Person” with that of the SEC’s cross-border rule for security-based swaps and major security-based swap participants.
- Guarantee. The final rule adopts the definition of “guarantee” as drafted in the January 2020 proposed rule. Accordingly, a non-U.S. person may need to register as a SD and comply with the CFTC’s swap regulations if the swap is “guaranteed” by a U.S. person.
- Significant risk subsidiary. The final rule adopts the concept of “significant risk subsidiary.” Such a subsidiary would be subject to the SD registration threshold calculation as if it were a U.S. Person. The final rule also adopts certain refinements to this concept, such as the exclusion of foreign subsidiaries of intermediate holding companies, which are already subject to consolidated supervision.
- Recordkeeping. The rule requires SDs and MSPs to create and retain records of their compliance with these requirements, consistent with 17 C.F.R. § 23.203.
- No-action relief. Even after it becomes effective, the rule clarifies that any no-action relief or guidance that applies to related requirements not addressed by this rule―including capital adequacy, clearing and swap processing, mandatory trade execution, swap data repository reporting, large trader reporting, and real-time public reporting―will remain effective. Any no-action letter or guidance not specifically revoked remains in effect. In connection with the adoption of the rule, CFTC staff withdrew CFTC Staff Advisory 13-69 and CFTC Staff Letter 17-36, which provided no-action relief regarding certain cross-border situations, and issued new no-action relief to non-U.S. SDs from Transaction-Level Requirements for certain of these transactions.
- Compliance date. The compliance date for the final rule is 60 days after the rule is published in the Federal Register.
As noted above, Chairman Tarbert voted in favor of the proposal because, in his view, it represents “a sensible and principled approach to addressing when foreign transactions should fall within the CFTC’s swap entity registration and related requirements.” Commissioners Stump and Quintenz made similar, strongly worded statements in support of the proposal.
As with the capital rule, Commissioners Berkovitz and Behnam voted against the proposal. Commissioner Berkovitz dissented on the grounds that the final rule would reduce regulatory requirements for SDs, increase systemic risk, and remove protections for customers. He argued that the rule will permit U.S. SDs to book their swaps with non-U.S. persons in offshore affiliates, thereby avoiding the CFTC’s swap regulations. Commissioner Behnam dissented for a range of reasons, including that he does not believe that the final rule aligns with the Congressional intent behind Section 2(i) of the Commodity Exchange Act, which he argues would weigh in favor of a more expansive regime to protect U.S. markets and participants.
The Commissioners noted in their statements that the adoption of the capital and cross-border rules marks the completion of key required rulemakings under the Dodd-Frank Act, which was enacted 10 years ago the same week that the CFTC voted to approve these rules.