Extra-Territorial Implications of Dodd-Frank - Part 1

Excellent podcast on the extra-territoriality of Dodd-Frank as it applies to trading, reporting and clearing of OTC derivatives, provided by Julie Schieffer of DerivSource, with Donna Parisi of Shearman & Sterling and John Williams of Allen & Overy.  Below is a summary of the key points, many of which are relevant to choices that clearing houses and CCPs must make in designing their operations, rules and compliance strategies.

Many of the issues for non-US clearing houses and CCPs are similar to those I addressed back in 1996 when I secured for Clearstream, then Cedel, the first exemption from US clearing agency registration which allowed it to clear and settle US Treasuries in Luxembourg.  At a little over two years, it was the fastest SEC determination on a CA-1 Clearing Agency application or exemption application in SEC history. Gaining an exemption from US clearing agency registration is no trivial undertaking, especially when the principles and conditions for such exemptions remain undefined.

• The task of ensuring compliance with US regulations is daunting as many rules remain undefined, and harmonisation of US requirements with those which may apply in Europe and Asia may be problematic for both compliance and commercial reasons.
• The market infrastructure has not yet been built and the interpretation of laws remain uncertain, yet businesses must make decisions on how and where they will contract their derivatives business.
• Title VII of Dodd-Frank defines CFTC and SEC jurisdiction in Section 722, but provides a safe harbour for business without a “direct” US connection or in evasion of US regulation, but there is little guidance on how these provisions would be interpreted in practice.
• Section 725 gives CFTC authority to exempt a clearing house from registration as a Derivatives Clearing Organisation if it can demonstrate that it is subject to an analogous foreign regime, and 752 encourages international harmonisation, but there has been no exemption and the CFTC has not provided guidance on how it might be applied. 
•  Legal extra-territoriality and operational extra-territoriality need to be addressed separately.  Each clearing house operates under a legal regime.  Both ICE Clear and LCH-Clearnet registrations with the CFTC have elected to register as DCOs with the CFTC going forward, so do not provide precedent for the scope or conditions of any exemption.
• Whether brokers need to register as Futures Commission Merchants is also an issue.  CFTC has required DCOs outside the US to change rules to require that clearing members outside the US that handle US clients must register as FCMs with the CFTC.  If a clearing house is not a DCO the CFTC may grant an exemption from clearing member registration as FCMs, but the issue remains unclear.  Exemption authority is not well defined, and may depend on how terms are defined within the regulations.  Needs to be a solution to allow US customers to deal with a foreign clearing member where that clearing member is mandated by foreign law to be domiciled and registered elsewhere.
• Inconsistent and sometimes contrary regulations will require some lead time as well as guidance to resolve.
•  No matter where you are doing business in the world, if you are doing business with a US customer then your business will be subject to Dodd-Frank requirements.  A non-US affiliate of a US person will probably not be subject to the requirements (e.g., a London affiliate of a US bank or corporate).  Branches may raise a more difficult question as branches are typically not treated as separate entities of a bank, so a non-US branch of a US bank may be treated as a US person.  SEC and CFTC interpretations on US persons remain inconsistent.
•  What level of US investor participation in an off-shore fund will trigger treating the off-shore fund as a US person?  Similarly, it may make a difference if there is a US-based investment advisor managing the off-shore fund.
•  The nature of the underlying contract may also have an impact, if the underlying is a US corporate or a US-exchange-traded contract.  The CFTC may be reluctant to carve these out from US jurisdiction.  “contacts and effects” test in 722 of Dodd-Frank may be inconsistent with the US Supreme Court pre-Dodd-Frank decision in the Morrison case which limited extra-territorial scope.
• In addition to CFTC and SEC, Dodd-Frank recognises prudential regulators for the purpose of determining adequate margin and capital.  Institutions subject to Federal Reserve oversight may benefit from a regulator which is more comfortable recognising home country rules on prudential supervision, but this then raises competitive issues for non-banks subject to more restrictive SEC or CFTC regimes.
• It takes quite a long time to sort out the answers to cross-border regulation, and the gaps are often filled by market practice rather than new rules.  Transactional certainty may remain elusive for a long time, which will chill international activity and makes for poor public policy.  Law firms and swap dealers will have to coordinate to fill in the gaps while the agencies deliberate the final rules.
• In the Lehman insolvency, we found great reluctance to cede local interests in times of extreme stress.  There will be various pools of client margin in different pools in different countries leading to lower efficiency and more risk. 
•  Systems and infrastructure should focus in the medium term on cross-margining and netting to reduce margin inefficiencies and provide greater certainty on close-out positions in resolutions.