Key Dodd-Frank Regulatory Issues for International Banks: Over-the-Counter Derivatives and the Volcker Rule

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1 Key Dodd-Frank Regulatory Issues for International Banks: Over-the-Counter Derivatives and the Volcker Rule Lisa M. Ledbetter December 7,

2 Presenter Lisa M. Ledbetter Partner, Jones Day Financial Institutions Litigation & Regulation Practice (202)

3 Agenda I. Over-the-Counter Derivatives OTC Margin for Uncleared Swaps Minimum Capital Cross-Border Swap Transactions Legislation II. The Volcker Rule Foreign Covered Funds Trading Outside the U.S. Legislation 3

4 I. OTC DERIVATIVES 4

5 OTC Derivatives The Dodd-Frank Act directed both the CFTC and the SEC to implement swap market rules The CFTC regulates over 90 percent of the combined swap markets The SEC regulates single-name and narrow index credit default swaps 5

6 OTC Derivatives The last two major Dodd-Frank Act rules to be implemented are in progress at the CFTC Ø OTC margin for uncleared swaps; and Ø Swap dealer capital rules The prudential regulators adopt these rules for swap dealers that are banks or bank holding companies The CFTC and the SEC adopt these rules for non-bank swap dealers, including non-bank affiliates of bank holding companies 6

7 OTC Derivatives CFTC rules apply to about 100 registered swap dealers Ø Swap dealers include non-us entities, non-u.s. affiliates of U.S. financial institutions, and non-u.s. affiliates of non-u.s. parents that are not prudentially regulated CFTC and the National Futures Association both maintain a public list of current swap dealers, available at: Ø registerswapdealer Ø regulatory-info-sd-and-msp/sd-msp-registry.html 7

8 OTC MARGIN FOR UNCLEARED SWAPS 8

9 OTC Margin for Uncleared Swaps The CFTC adopted uncleared swaps margin rules earlier this year Ø Required the largest swap dealer families - about 20 global financial enterprises - to begin exchanging initial margin Ø Variation margin requirements begin on March 1, 2017 and phase-in over time; signing necessary Credit Support Annex with numerous other entities is a major undertaking, especially because some jurisdictions have not fully implemented margin rules 9

10 OTC Margin for Uncleared Swaps CFTC margin rules allow substituted compliance by non-u.s. swap dealers, if the CFTC determines the home jurisdiction margining rules are comparable Japan is the only jurisdiction that has formally requested a substituted compliance determination Ø CFTC issued a substituted compliance determination, except for the treatment of affiliate swap margining Ø CFTC margin rules require affiliates to exchange variation margin and collect initial margin under certain conditions (Notice of Comparability Determination, Comparability Determination for Japan: Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 81 Fed. Reg (Sep. 15, 2016).) 10

11 MINIMUM CAPITAL 11

12 Minimum Capital The CFTC proposed rules for public comment that would establish minimum capital requirements for swap dealers and major swap participants The proposed rules would establish minimum levels of qualifying capital for swap dealers and major swap participants that are not subject to the capital rules of a prudential regulator 12

13 Minimum Capital The proposed rules permit application of alternative approaches based on - Ø existing bank capital requirements adopted by the U.S. bank regulators, or Ø the CFTC s future commission merchant and the SEC s broker-dealer net liquid asset capital requirements Swap dealers that are predominantly engaged in nonfinancial activities and major swap participants may elect minimum capital requirements based on tangible net worth 13

14 Minimum Capital The proposed rules would allow use of internal models by swap dealers to compute regulatory capital, provided they obtain prior approval of the CFTC or the National Futures Association Swap dealers and major swap participants would be required to satisfy defined liquidity requirements The CFTC is accepting comments for 90 days following publication in the Federal Register 14

15 CROSS-BORDER SWAP TRANSACTIONS 15

16 Cross-Border Swaps The CFTC issued guidance on cross-border application of certain swap rules in July 2013 Ø Since then, the CFTC has been fine-tuning and codifying parts of that guidance Ø The CFTC s proposed cross-border rule and interpretations (81 Fed. Reg , October 18, 2016) could be impacted by the recent presidential and congressional elections 16

17 Cross-Border Swaps Key features of the proposed rule Ø Define terms; Ø Address which trades count toward the de minimis threshold for swap dealer and major swap participant registration; Ø Change business conduct standards; and Ø Regulate swaps between two non-u.s. persons that are arranged, negotiated or executed by personnel located in the U.S. 17

18 Cross-Border Swaps Important terms U.S. person Ø Includes foreign branches of U.S. banks and consolidated subsidiaries of U.S. parents, thereby expanding application of swap dealer rules for U.S. financial institution activities outside the U.S. Ø Excludes U.S. branches of foreign banks for some purposes Foreign consolidated subsidiary Primary difference between these two definitions is that U.S. person does not include foreign investment vehicles that are majority-owned U.S. persons 18

19 Cross-Border Swaps In a staff advisory issued in 2013, the CFTC Division of Swap Dealer and Intermediary Oversight - Ø Answered the question: If a swap would not otherwise be subject to CFTC oversight because it is between two completely non-u.s. persons, does that change if the personnel are located in the U.S.? Ø Concluded that such a swap is subject to the CFTC s rules if the personnel arranging, negotiating or executing the swap are located in the U.S. (Division of Swap Dealer and Intermediary Oversight Advisory, Applicability of Transaction-Level Require-ments to Activity in the United States, CFTC Staff Advisory No , Nov. 14, 2013) 19

20 Cross-Border Swaps The proposed rule clarifies that back-office activities are not considered to be arranged, negotiated or executed activities Where these personnel are located is deemed irrelevant for purposes of the external business conduct rules However, under the proposed rule, adverse consequences of the 2013 CFTC advisory are not completely eliminated Ø Some rules are not addressed in the proposed rule, making it unclear whether the changes would apply to those rules 20

21 Cross-Border Swaps External business conduct rules generally provide for counterparty protections and transparency covering disclosures, daily mid-market marks and suitability for the counterparty, among other factors The proposed rule applies external business conduct rules if the swap dealer is a U.S. person for all swaps, except those transacted through a foreign branch or subsidiary, as long as the counterparty is not a U.S. person In other words, these rules would not apply if both parties are either non-u.s. persons or are foreign branches of swap dealers 21

22 Cross-Border Swaps Counting of swaps for swap dealer de minimis determinations Ø U.S. persons, foreign consolidated subsidiaries of U.S. persons and non-u.s. persons guaranteed by U.S. persons would count all dealing swaps Ø All other non-u.s. persons would count swaps with U.S. persons, foreign consolidated subsidiaries and guaranteed affiliates of U.S. persons, unless anonymous, exchange traded and cleared In sum, all other non-u.s. to non-u.s. swaps would not count, even if arranged, negotiated or executed in the U.S. 22

23 LEGISLATION 23

24 Legislation Potential legislative changes? Ø Financial CHOICE Act (H.R. 5983, Commodity Futures Trading Commission Reforms, Title IV, Subtitle C, Sections ) Ø Requires notice-and-comment rulemaking for (1) guidance voted on by the CFTC and (2) cross-border regulation of derivatives, including criteria for determining that a category of swaps regulatory requirements are comparable to, and as comprehensive as, U.S. requirements Ø Allows petition to DC Circuit Court for set aside of rulemaking if inconsistent with APA; mandates CFTC-SEC harmonization of derivatives rules 24

25 II. THE VOLCKER RULE 25

26 Volcker Rule The Volcker Rule prohibits banking entities from Ø Acquiring or retaining an ownership interest in, or sponsoring, a covered fund (private equity fund or hedge fund) Ø Engaging in proprietary trading (for their own account) of securities, derivatives and commodity futures and options The statute excludes various activities and the responsible agencies have established a process for obtaining regulatory interpretations 26

27 FOREIGN COVERED FUNDS 27

28 Foreign Covered Funds Foreign covered funds include entities that - Ø Are organized, offered or sold solely outside the U.S. Ø Hold themselves out as raising money from investors primarily for investing in securities for resale or otherwise trading in securities Ø Have a U.S. bank as their sponsor or have issued an ownership interest that is, directly or indirectly, owned by the U.S. bank A foreign fund can be a covered fund with respect to the U.S. bank that sponsors the fund, but may not be a covered fund with respect to a foreign bank that invests in the fund solely outside the U.S. 28

29 Foreign Covered Funds A number of entities are excluded from the Volcker Rule such as foreign public funds, wholly-owned subsidiaries, foreign pension or retirement funds and other issuers identified by the responsible agencies The responsible agencies have issued Frequently Asked Questions ( FAQs ) clarifying the solely outside the U.S. exception s marketing restriction and providing a conformance period for legacy covered funds in place prior to December 31, 2013 (See SOTUS Covered Fund Exemption: Marketing Restriction, FAQ 13, posted Feb. 27, 2015; Metrics reporting during the Conformance Period, FAQ 8, posted Nov. 13, 2014) 29

30 Foreign Covered Funds Is a foreign covered fund a banking entity subject to the Volcker Rule s prohibition on proprietary trading? FAQ 14, posted June 12, 2015, clarifies that foreign public funds will not be considered banking entities merely due to affiliate control of their board of directors, such as an affiliate with a bank holding company that is capable of holding a majority of a fund s director seats Maximum seeding period for foreign public funds controlled by an affiliate may be insufficient (See also Foreign Public Fund Seeding Vehicles, FAQ 5, posted June 10, 2014) Leaves question unanswered regarding foreign private funds Ø Board control provisions may continue to apply 30

31 TRADING OUTSIDE THE U.S. 31

32 Trading Outside the U.S. Foreign bank trading activity that occurs solely outside the U.S. is exempt from the proprietary trading prohibition Ø The Volcker Rule exempts some foreign trading activity that occurs with or through a U.S. entity subject to conditions Reliance on the exemption for trading outside the U.S. is complicated due to different regulatory and market structures Ø For example, many foreign banks engage in securities trading in the U.S. through affiliated broker-dealers; however any transaction with or through a U.S. entity, such as a U.S. securities exchange, may need to be conducted through an unaffiliated market intermediary (e.g., an unaffiliated brokerdealer) to satisfy the exemption conditions 32

33 LEGISLATION 33

34 LEGISLATION Potential legislative changes Repeal of Volcker Rule? Bring back the Glass-Steagall Act? 34

35 Questions? Lisa M. Ledbetter Partner, Jones Day Financial Institutions Litigation & Regulation Practice (202)

36 Jones Day presentations should not be considered or construed as legal advice on any individual matter or circumstance. The contents of this document are intended for general information purposes only and may not be quoted or referred to in any other presentation, publication or proceeding without the prior written consent of Jones Day, which may be given or withheld at Jones Day's discretion. The distribution of this presentation or its content is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of Jones Day. 36