A proposed rule change to liberalise and clarify exemptions from intermediary registration for persons outside the US by the Commodity Futures Trading Commission ("CFTC") may benefit Asian financial institutions, lawyers said. The amendment would help clear up a lingering issue stemming from the Dodd-Frank Act's enactment.
The proposed rule change was published in the Federal Register on 5 August and would clarify current registration exemptions for those acting as futures commission merchants ("FCM"), introducing brokers ("IB"), commodity trading advisers ("CTA") or commodity pool operators ("CPO") outside the US, relating to transactions on behalf of persons located outside of the US, such as financial hubs like Hong Kong, Singapore and Tokyo.
"There was previously a great deal of uncertainty of how this would pan out in practice in Asian financial markets," said a compliance head with an asset management company in Hong Kong, speaking on condition of anonymity. "Dodd-Frank was not well thought out before being implemented and many people locally were not aware of the rule and its impact."
Presently, CFTC Regulation 3.10(3)(c)(i) exempts a person from IB, CTA or CPO registration if they and the commodity interest transaction concerned – in connection with which the person engages in the otherwise registered activity – meet three conditions.
They must be located outside the US and its territories or possessions, they act only on behalf of persons located outside of US jurisdiction, and the commodity interest transaction must be submitted for clearing through a registered FCM. Regulation 3.10(c)(2)(i) provides a similar exemption from registration for any foreign intermediary acting as an FCM. Historically speaking, the exemption for 3.10(c)(3) existed before the Dodd-Frank Act.
John Ruark, a partner at law firm Funkhouser, Vegosen, Liebman & Dunn in Chicago, said removing the clearing requirement, which did not add a great deal in terms of customer protection, was prudent.
"This was one of those areas where the new rules arising from Dodd-Frank did not mesh well with the existing regulatory structure," he said. "This removes a potential problem for financial institutions in Asia, in which an institution could have found itself inadvertently in violation of the rule in effecting certain swaps due to the clearing requirement."
The amendment would remove a condition that commodity interest transactions be submitted for clearing and would make the exemptions available to those outside the US that act on behalf of certain international financial institutions, law firm Mayer Brown said in a recent client briefing. Compliance and legal staff at Asian institutions should know the proposed amendments would generally codify certain relief the CFTC staff has granted through no-action letters over the past year under the registration exemption provided by 3.10(c)(3).
"It should result in less required compliance. However, transactions and advisory relationships will still need to be reviewed to determine their eligibility for the new proposed relief," said Paul Forrester, a partner with Mayer Brown in Chicago.
The Investment Company Institute, a fund-sector advocacy group, has supported the CFTC's proposed amendment because it would remove a restriction that limits the intermediary registration exemption's utility. "For operators of regulated funds located outside the US that meet the CFTC's definition of a CPO or CTA, but act solely on behalf of persons located outside the US, the proposed amendments would remove a condition to the exemption that has limited its usefulness and does not make much sense," said Sarah Bessin, the group's associate general counsel in Washington, DC.
Pre- and post-rule changes altered the wording and the structure of the provision, but grammatically, the changes did not work to preserve a consistent scope for the exception, said Ian Cuillerier, a partner with law firm White & Case in New York. "The issue is that some swaps and other over-the-counter ("OTC") derivatives are not cleared," he said.
The CFTC was, therefore, correcting a grammatical mistake made during the drafting process. With 3.10(c)(3), when you are dealing completely offshore and you are an offshore commodity pool operator, and the funds you deal with are offshore, and you come to the US to deal in a cleared product or swap, you are likely doing so for the deeper liquidity pool in the US for that trade. If you came to New York to do an uncleared swaps deal, you were previously faced with the difficult choice of doing that trade in New York and registering as a commodity pool operator, or not.
Most people did not know the rule before and many in the market did not know they had to register. So, in a sense, the new rules leveled the playing field: some did not know registration was required, others knew the rules and made hard choices, and some chose not to trade in the US and went elsewhere.
"The amended language preserves the original intent of consistently applying the exception across the broader scope of regulated derivatives contracts," Cuillerier said.
Previously, only futures were covered, but now the exemption extends to swaps. To the extent contracts are cleared, they must now be cleared through an FCM. From a compliance perspective, certain products cannot trade in the US. Offshore funds managed by an offshore CPO cannot do a capital contract; they are just not offered for clearing, so trading them requires registration.
"Contracts subject to the clearing requirement are still obligated to clear and the exception does not change that fact," Cuillerier said.
Looking ahead, the exception will be available for both futures and swaps. Parties will, however, face the broader decision of whether to clear a swap or capital contract or not.
The way the rule was drafted before only made it applicable to futures and listed option contracts – as the CFTC's jurisdiction only extended to listed contracts and generally, did not cover OTC swaps. The draft made reference to the extent that the contracts in question were cleared through a registered FCM. The exception was universally applicable only to clearing contracts. Following Dodd-Frank's adoption, the implementing rules adjusted the provision. Explanatory text accompanying the actual rule made reference to preserving the swaps exception. The scope was to extend consistently from the pre-Dodd-Frank world of regulated futures and listed options to newly regulated swaps. However, the way the CFTC modified the language actually narrowed it in some respects – conflicting with the text of the released rule.
In February this year, the CFTC issued no-action letter 16–08, granting relief, with respect to swaps that were not subject to clearing requirements, from the condition of 3.10(c)(3)(i) that commodity interest transactions be submitted for clearing. In an earlier no-action letter (15–37) from 4 June 2015, the CFTC provided relief for those outside the US from IB registration for activities involving swaps for customers that were certain specified international financial institutions. It also provided registration relief for CTAs providing advice that was solely incidental to their activities.
The proposed rule would codify and, somewhat, expand such no-action relief by eliminating the condition that commodity interest transactions be submitted for clearing, and removing references to the manner in which the commodity interest transaction is executed, Mayer Brown said in the briefing.
"The proposed relief consolidates, harmonises and expands upon prior no action relief and reduces immaterial differences in existing relief and makes the regulatory scheme more consistent across regulated parties acting in similar roles," Forrester said.
The no-action letter this past February contained an expiration provision that contemplated future rule amendments. This, Forrester said, was in keeping with the CTFC’s objective of codifying and systematising the extensive body of no-action relief that resulted from Dodd-Frank's implementation.
The CFTC's position is that the registration exemptions did not themselves excuse any person – including international financial institutions – from complying with the clearing requirement or any other CFTC regulation or provision of the Commodity Exchange Act to which they were subject. In its cost-benefit analysis, the CFTC said the proposed regulation should foster legal certainty, competitiveness and greater depth in swaps markets accessed by US persons.
It was Time for Action
The timing of the CFTC's action appears to be driven more by a need to address the revision of the drafting of a rule to have the exception applied consistently across swaps.
Ruark said there was no significance to the timing of the rule proposal. "The first request for no-action relief in this area came to the CFTC slightly over one year ago, with a second request coming about six months. Presumably, fixing this issue has been on the CFTC's ‘to-do list' for about the same length of time. Since this proposed rule change is both relatively simple and non-controversial, that likely made it easier to get it into the queue," he said.
"It is not otherwise clear why the CFTC decided to propose rules on this topic at this time, while earlier no-action relief on other topics has yet to be codified," Forrester said.
Comments on the proposed regulation must be received on or before 6 September 2016.