Authors: Joseph M. Motto
On March 29, 2017, the United Kingdom (UK) provided formal notice of its intention to withdraw from the European Union (EU). The deadline for concluding a withdrawal agreement with the EU has been extended twice, and is currently scheduled to occur by October 31, 2019. Following the UK’s withdrawal, financial entities based in the UK will no longer be able to provide financial services involving swaps to U.S. market participants in reliance on existing substituted compliance determinations and other forms of exemptive relief provided to non-U.S. swap market participants by the U.S. Commodity Futures Trading Commission (CFTC).1 Furthermore, UK intermediaries will fall outside the scope of other cross-border agreements that have been negotiated between the CFTC and the UK based on the UK’s compliance with EU regulations.
In preparation for the withdrawal date of the UK from the EU (Brexit),2 the CFTC had considered two possibilities: (1) an orderly withdrawal when, for a period of time, EU law will apply in the UK (“Soft” Brexit), and (2) Brexit without a previously negotiated deal between the UK and the EU (“No-Deal” or “Hard” Brexit).3 In the event of a Hard Brexit, UK entities would immediately lose access to U.S. market participants; however, in the event of the ratification of the current draft withdrawal agreement by the UK and EU (i.e., the Soft Brexit scenario), the current exemptive regimes would continue for a transitional period.
The CFTC has taken three steps to prepare for Brexit (see the appendix below for a summary of other actions undertaken by the CFTC). First, following similar relief by U.S. Prudential Regulators,4 the CFTC issued an interim final rule allowing UK swap dealers to treat as legacy swaps certain uncleared swaps executed before the relevant compliance dates under the CFTC’s margin rules.5 Second, the CFTC issued a no-action letter extending existing regulatory relief available to EU entities to UK entities.6 Third, the CFTC provided time-limited no-action relief extending the availability of substituted compliance under the CFTC’s comparability determinations and exemption orders, which were originally issued to EU entities, to UK entities post Brexit.7 The CFTC will need to finalize its guidance pertaining to the effects of Brexit on derivatives clearing organizations (DCOs) and further assess additional relief to make sure that there will remain no regulatory gaps.8 Further, even though the U.S. regulators, such as the CFTC, have taken actions to ensure the smooth transition, participants should continue taking their part in preparation for Brexit by reviewing their agreements with UK counterparties to ensure continued compliance (e.g., see ISDA Brexit guidance).9
Background on CFTC’s Cross-Border Regulations
Prior to the enactment of the Dodd-Frank Wall Street Reform and Customer Protection Act of 2010 (the Dodd-Frank Act), the Commodity Exchange Act (CEA) and CFTC regulations applied the rules of comity in situations when foreign-regulated entities transacted with U.S. market participants. For example, foreign boards of trade (FBOT) did not have to register with the CFTC and were able to operate so long as the CFTC made a determination by a no-action letter that the foreign board of trade was regulated in a manner comparable to the U.S. regulatory regime.10
Likewise, under CFTC Part 30 regulations, a non-U.S. broker did not need to register as a futures commission merchant (FCM), provided that the CFTC issued an order under Regulation 30.1011 confirming that a foreign regulator or a self-regulatory organization regulated the foreign market in a manner comparable to that of the U.S. regulatory regime. Similar exemptions were available to foreign entities that would otherwise have had to register as introducing brokers (IBs) or commodity trading advisors (CTAs). To qualify for these exemptions, the non-U.S. entity had to demonstrate to the CFTC that it was in good standing with its local regulator and the CFTC had to make a finding that the foreign regulatory regime was comparable to the U.S. regulatory regime.12 This approach changed with the implementation of the Dodd-Frank Act.
Cross-Border Regulation after the Dodd-Frank Act
Under the Dodd Frank Act, the CFTC adopted a more prescriptive set of regulations for swap transactions, including the regulation of swap markets and swap market participants, comparable to the approach taken by EU regulators (for example, it is now necessary to register an FBOT and a foreign entity dealing in swaps with U.S. persons must register if it qualifies as a swap dealer).13 However, as authorized by the Dodd Frank Act, the CFTC adopted a new approach to provide foreign market participants with exemptive relief from the regulatory requirements. To avoid disrupting international trade and duplicative regulations, the CFTC made a number of comparability determinations with foreign regulators, which allowed non-U.S. persons to comply with their local regulations and at the same time comply with U.S. CEA and CFTC regulations.14 The UK, as a part of the EU, was also the beneficiary of these comparability determinations.
Upon the occurrence of Brexit, however, the UK-based market participants will no longer be permitted to rely on any of these exemptions, as the CFTC has not made any comparability determinations with respect to the UK. Furthermore, the CFTC will need some time to make these determinations, as it will need to analyze the UK’s new regulatory regime to determine if it remains comparable to the CFTC’s applicable rules. Accordingly, to help ensure a smooth transition, the CFTC issued stop-gap relief that will allow UK entities to transact with U.S. entities as if Brexit had not occurred until such time when the CFTC issues comparable relief to the UK outside the EU.15
Margin Relief for Uncleared Legacy Swaps
Effective April 1, 2019, the CFTC adopted an interim final rule that provides certain relief from the CFTC’s margin requirements for uncleared swaps (the Margin Rule) in the event of a No-Deal Brexit.16 The Margin Rule requires swap dealers (SDs) and major swap participants (MSPs) for which there is no Prudential Regulator (collectively, CSEs) to collect and post initial margin and variation margin for uncleared swaps.17 The Margin Rule applies to uncleared swaps entered into on or after the compliance date applicable to a particular CSE and its counterparty. An uncleared swap entered into prior to a CSE’s applicable compliance date for a particular counterparty (a Legacy Swap) is generally not subject to the Margin Rule. However, a Legacy Swap may lose its “legacy” status if it is amended in a material or nonmaterial way, it is novated, or it is a new swap that is a result of the portfolio compression of Legacy Swaps.
Financial entities operating in the UK and their counterparties will likely experience increased uncertainty about the regulatory framework that may apply following the UK’s exit from the EU (and, in particular, following a No-Deal Brexit). As a result of this uncertainty, the CFTC has predicted that financial entities may transfer their swaps to affiliated entities located in other EU member states or to entities outside of the EU altogether, or engage in various reorganizations or consolidations of their swaps businesses. The transfer of a swap or reorganization of a swap business may require a financial institution to amend its Legacy Swaps, thereby causing some swaps to lose their legacy status and become subject to the Margin Rule.
The CFTC’s April 1, 2019 interim final rule maintains the status quo for Legacy Swaps with respect to the Margin Rule to the extent that any amendments to such Legacy Swaps are made solely to transfer the Legacy Swaps in response to the occurrence of a No-Deal Brexit. Specifically, the interim final rule amends CFTC Regulation 23.161 to provide that in a No-Deal Brexit scenario, a Legacy Swap may be transferred and amended without revising the date used for purposes of determining whether such Legacy Swap was entered into prior to the applicable compliance date under the Margin Rule.18 Importantly, amendments relying on the interim final rule can only be made under the following conditions:
- EU law ceases to apply to the UK pursuant to Article 50(3) of the Treaty on European Union without conclusion of a withdrawal agreement (i.e., a No-Deal Brexit has occurred);
- solely in connection with a party to the swap’s planning for or response to a No-Deal Brexit, one or both parties to the swap transfers the swap to its margin affiliate, or a branch or other authorized form of establishment of the transferor, and the parties make no other transfers of the swap, and a CSE is a (i) transferee from a party to the swap, or (ii) remaining party to the swap, and the transferor represents to the CSE that the transferee is a margin affiliate, or a branch or other authorized form of establishment of the transferor, and the transfer was made solely in connection with the transferor’s planning for or response to a No-Deal Brexit;
- the amendment does not modify the payment amount calculation method, the maturity date, or the notional amount of the swap; and
- the amendment takes effect no earlier than a No-Deal Brexit, and no later than one year after a No-Deal Brexit or such other date permitted by transitional provisions under Article 35 of Commission Delegated Regulation (EU) No. 2016/2251.19
Comparability Determinations and No-Action Relief (No-Action Letter No. 19-08)20
On April 5, 2019, the CFTC issued two no-action letters extending no-action and exemptive relief and substituted compliance measures to UK-based firms under either a Soft or No-Deal Brexit scenario. In No-Action Letter No. 19-08, the Division of Market Oversight (DMO) and the Division of Swap Dealer and Intermediary Oversight (DSIO) granted no-action relief to entities relying on the following EU Comparability Determinations for EU entity-level, transaction-level, and margin requirements:
- Comparability Determination for the European Union: Certain Entity-Level Requirements;21
- Comparability Determination for the European Union: Certain Transaction-Level Requirements;22
- Comparability Determination for the European Union: Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants (together with items 1 and 2 above, the EU Comparability Determinations);23 and
- In the Matter of the Exemption of Multilateral Trading Facilities and Organised Trading Facilities Authorized Within the European Union from the Requirement to Register with the Commodity Futures Trading Commission as Swap Execution Facilities (the Exemptive Order).24
No-Action Letter No. 19-08 provides that, in the event of a No-Deal Brexit, compliance by registered SDs with certain requirements under EU laws and regulations will constitute compliance with corresponding requirements under comparable CFTC regulations. If there is a Soft Brexit, the DSIO will not recommend that the CFTC take enforcement action against an SD registered with the CFTC if it relies on the EU Comparability Determinations during such transition period despite the fact that the UK is no longer a member of the European Union.
If and when the UK withdraws from the EU, No-Action Letter No. 19-08 also explains that the DMO will not recommend an enforcement action against:
- a multilateral trading facility or organized trading facility that is authorized within the UK and listed in Appendix A to the Exemptive Order, as amended (each, an Eligible UK Facility), for failure to register as a Swap Execution Facility (SEF) pursuant to CEA section 5h(a)(1) and CFTC Regulation 37.3(a)(1); or
- a counterparty that is subject to the trade execution requirement, pursuant to section 2(h)(8) of the CEA, if such counterparty executes a swap that is subject to such trade execution requirement on an Eligible UK Facility.
CFTC Regulatory Relief Extended to UK Entities (No-Action Letter No. 19-09)25
Brexit will also force the CFTC to revisit no-action relief that does not explicitly address UK-based entities. The CFTC has used no-action relief to modify various aspects of the commodity and derivatives regulatory framework, including reporting and registration requirements, clearing rules, and risk mitigation regimes. However, much of the no-action relief applicable to non-U.S. entities deals broadly with the European Union and therefore does not specifically address whether UK-based entities are eligible to claim no-action relief. No-Action Letter No. 19-09 extends to UK-based entities existing regulatory relief that is presently applicable to EU firms.26 Under No-Action Letter No. 19-09, UK-based firms are permitted to rely on the relief contained in the following no-action letters if the UK leaves the European Union:
CFTC No-Action Letter No. 12-70: Registration Requirements
The CEA generally requires persons engaging in IB or CTA activities to register as an IB or a CTA. Accordingly, when SDs engage in conduct that falls within the IB or CTA definitions, they too must comply with the IB/CTA registration requirements. However, in No-Action Letter No. 12-70, the DSIO recognized that, in certain instances, SDs provide IB/CTA-like support to their affiliates, including soliciting, negotiating, structuring, recommending, and accepting as agent, swap transactions (Affiliate Support Activities).27 Although Affiliate Support Activities are similar to IB or CTA functions, the DSIO concluded that, subject to certain conditions, SDs and SD agents that provide support on behalf of an affiliated SD or an affiliate that satisfies the de minimis exemption are not required to register as an IB or CTA. As this relief relates to Brexit, agent affiliates of SDs claiming relief under No-Action Letter No. 12-70 must be licensed with a financial regulator in the European Union, Switzerland, Canada, Japan, Hong Kong, Singapore, or Australia.
CFTC No-Action Letter No. 13-45: Risk Mitigation Rules
The CFTC has also aimed to provide more efficient and effective regulation in areas where U.S. and European regulatory authorities overlap. In No-Action Letter No. 13-45, the DSIO determined that the CFTC’s Risk Mitigation Rules and the European Market Infrastructure Regulation’s (EMIR) Risk Mitigation Rules are comparable.28 The DSIO, therefore, granted relief to U.S. and EU SDs and MSPs from risk mitigation protocols applicable to swaps that are subject to section 4s of the CEA and Article 11 of EMIR. Essentially, the CFTC authorized certain SDs and MSPs to meet their compliance obligations by following the EMIR Risk Mitigation Rules rather than the CFTC Risk Mitigation Rules. The relief provided in No-Action Letter No. 13-45 is available for transactions where: (i) one of the counterparties is established in the EU or otherwise subject to EMIR; (ii) one of the counterparties is a U.S. person; and (iii) one of the counterparties is an SD or MSP registered with the CFTC.
CFTC No-Action Letter No. 17-64: SDR Reporting Rules
In No-Action Letter No. 17-64, the DMO provided relief to SDs and MSPs established in Australia, Canada, the European Union, Japan, and Switzerland from the swap data reporting rules set forth in Part 45 and Part 46 of the CFTC’s regulations (collectively, the SDR Reporting Rules).29 The no-action relief provided in this letter applies to SDs and MSPs from the enumerated jurisdictions that enter into swaps with non-U.S. counterparties that are not guaranteed affiliates, or conduit affiliates, of a U.S. person.
CFTC No-Action Letter Nos. 17-66 and 17-67: Clearing Requirements
Inter-affiliate swaps between certain affiliated counterparties are exempt from the clearing requirements under the CEA and the CFTC regulations. However, outward-facing swaps between unaffiliated counterparties must be cleared. CFTC Regulations 50.52(b)(4)(ii) and (iii), as interpreted by the Division of Clearing and Risk in No-Action Letter No. 17-66, provide two alternative frameworks for complying with this mandate.30 An entity can use CFTC Regulation 50.52(b)(4)(ii) or 50.52(b)(4)(iii) to meet the requirements of the outward-facing swaps condition in the inter-affiliate exemption. Alternatively, an entity can rely on CFTC Regulation 50.52(b)(4)(ii) to meet the requirements of the outward-facing swaps condition in connection with a swap executed with an eligible affiliate counterparty located in the European Union, Australia, Canada, Hong Kong, Mexico, or Switzerland.
Inter-affiliate swaps that satisfy the inter-affiliate exemption under CFTC Regulation 50.52 are not subject to the trade execution requirement under section 2(h)(8) of the CEA.31 Swaps involving eligible affiliate counterparties that do not satisfy CFTC Regulation 50.52(b) or another exception or exemption from the clearing mandate are subject to the trade execution requirement. In No-Action Letter No. 17-67, the DMO broadened trade execution relief to include inter-affiliate transactions that are not otherwise exempted from clearing.32 No-Action Letter No. 17-67 extends the relief from the trade execution requirement to affiliate counterparties that satisfy CFTC Regulation 50.52(a) but do not satisfy CFTC Regulation 50.52(b), (c), or (d) and are not exempt from clearing.32 However, non-U.S. entities seeking this no-action relief must comply with a foreign jurisdiction’s clearing mandate where this is comparable with U.S. regulations, and the non-U.S. entity must qualify for “eligible affiliate counterparty” status.
Brexit has raised significant and legitimate concerns with participants in the global financial markets. The CFTC has taken several recent actions to address these concerns and the uncertainties raised by the occurrence of this unique and first-of-its kind event. As discussed more fully in this client alert, the CFTC has adopted rules to maintain the status quo for covered swap entities in the event of a No-Deal Brexit and issued no-action letters extending existing regulatory relief available to EU entities to UK entities. The CFTC has also issued time-limited relief extending the availability of substituted compliance under the CFTC’s comparability determinations and exemption orders to UK entities post Brexit although there still remain several areas of CFTC regulations that will need to address the effects of Brexit in the future (e.g., comparability determinations of DCOs and designated contract markets in the UK).
For more information on comparability determinations for substituted compliance for the EU please download the Appendix to our Client Briefing.
- Also, entities registered in the UK will not be able to conduct business in the EU in reliance on the passporting regime and therefore U.S. entities will be required to engage EU-registered entities directly to carry out regulated activities in the EU.
- As of the date of this client alert, the Brexit date has been extended to October 31, 2019 and could be further extended. However, EU leaders have stated that, by this date, the UK must choose whether to ratify the exit treaty, opt for a No-Deal Brexit, or cancel its departure from the EU.
- Anticipating the possibilities of the Soft or Hard Brexit, the UK government passed the European Union (Withdrawal) Act of 2018, which will transpose EU law for a period of time into relevant UK laws and regulations and give regulatory authority to UK market regulators.
- See Prudential Regulators Interim Final Rule, Request for Comment, 12 CFR Parts 45, 237, 349, 624, and 1221, Margin and Capital Requirements for Covered Swap Entities (Mar. 19, 2019). The Prudential Regulators include the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation.
- CFTC Interim Final Rule, Request for Comment, 17 CFR Part 23, Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants (Apr. 1, 2019).
- CFTC No-Action Letter, Extension to UK Entities of Regulatory Relief Previously Granted to European Union Entities in CFTC No-Action Letters: 12-70, 13-45, 17-66, and 17-67 (Apr. 5, 2019).
- CFTC No-Action Letter, No-Action Relief in Connection With Certain Previously Granted Commission Determinations and Exemptions, in Order to Account for the Anticipated Withdrawal of the United Kingdom from the European Union (Apr. 5, 2019).
- CFTC No-Action letters Nos. 18-13, 17-36, 13-64, and 13-29 are likely to continue to be applicable to non-U.S. persons even after Brexit without any further actions on the CFTC’s behalf.
- Hard Brexit: An Impact Assessment for US Market Participants and Entities Registered with the CFTC, ISDA (Nov. 2018).
- The Dodd-Frank Act did not alter this principle, but now the CFTC must register an FBOT, provided that the comparability finding is made. See 7 USC § 6(b), as amended by section 738 of the Dodd-Frank Act.
- See 17 C.F.R. § 30.10.
- The CFTC proposed a rule in July 2019 that would allow the CFTC to terminate Regulation 30.10 exemptive relief in certain circumstances. See CFTC Proposed Rule, Foreign Futures and Options Transactions, 17 CFR Part 30 (July 5, 2019). Reed Smith has previously published a client alert on this topic. See Reed Smith client alert, Rulemaking Addressing the Treatment of Foreign Clearing Organizations and Foreign Broker Exemptions, Aug. 21, 2019, available at reedsmith.com.
- CFTC Interpretative Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations, Fed. Reg. 78 No. 144, 45292 (July 26, 2013). See also the proposal for revisions to cross-border regulations – Cross-Border Swaps Regulation Version 2.0, A Risk-Based Approach with Deference to Comparable Non-U.S. Regulation, White Paper, CFTC Chairman Giancarlo (Oct. 1, 2018), available at reedsmith.com.
- This approach contrasted greatly with the CFTC’s previous approach to exemptive relief for foreign market participants, which relied on principles of comity.
- See CFTC Release No. 7876-19, Joint Statement by UK and U.S. Authorities on Continuity of Derivatives Trading and Clearing Post-Brexit (Feb. 25, 2019) (quoting CFTC Chairman J. Christopher Giancarlo as stating that such measures “provide a bridge over Brexit through a durable regulatory framework upon which the thriving derivatives market between the [UK] and the [U.S.] may continue and endure”), available at cftc.gov.
- See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, no. 4, supra.
- See CFTC Final Rule and Interim Final Rule, 17 CFR Parts 23 and 140, Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants (Jan. 6, 2016).
- 17 C.F.R. § 23.161(d).
- 17 C.F.R. § 23.161(d)(2).
- CFTC No-Action Letter No. 19-08, No-Action Relief in Connection With Certain Previously Granted Commission Determinations and Exemptions, in Order to Account for the Anticipated Withdrawal of the United Kingdom From the European Union (Apr. 5, 2019).
- See Comparability Determination for the European Union: Certain Entity-Level Requirements (Dec. 27, 2013), available at cftc.gov.
- See Comparability Determination for the European Union: Certain Transaction-Level Requirements (Dec. 27, 2013), available at cftc.gov.
- See Comparability Determination for the European Union: Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants (Oct. 18, 2017), available at cftc.gov.
- See In the Matter of the Exemption of Multilateral Trading Facilities and Organised Trading Facilities Authorized Within the European Union from the Requirement to Register with the Commodity Futures Trading Commission as Swap Execution Facilities (December 8, 2017), available at cftc.gov. See also In the Matter of the Exemption of Multilateral Trading Facilities and Organised Trading Facilities Authorized Within the European Union from the Requirement to Register with the Commodity Futures Trading Commission as Swap Execution Facilities: Amendment To Appendix A To Order Of Exemption (Dec. 3, 2018), available at cftc.gov.
- CFTC No-Action Letter No. 19-09, Extension to UK Entities of Regulatory Relief Previously Granted to European Union Entities in CFTC No-Action Letters: 12-70, 13-45, 17-64, 17-66, and 17-67 (Apr. 5, 2019).
- CFTC No-Action Letter No. 12-70, Relief for Certain Swap Dealers, De Minimis Dealers, Agent Affiliates, and Associated Persons from Registration as an Introducing Broker under Section 4d or a Commodity Trading Advisor under Section 4m of the Commodity Exchange Act, and Interpretation that Certain Employees of De Minimis Dealers are not an Introducing Broker as defined in Section 1a(31) of the Commodity Exchange Act (Dec. 31, 2012).
- CFTC No-Action Letter No. 13-45, No-Action Relief for Registered Swap Dealers and Major Swap Participants from Certain Requirements under Subpart I of Part 23 of Commission Regulations in Connection with Uncleared Swaps Subject to Risk Mitigation Techniques under EMIR (July 11, 2013).]
- CFTC No-Action Letter No. 17-64, Extension of Time-Limited No-Action Relief from Certain Requirements of Part 45 and Part 46 of the Commission’s Regulations, for Certain Swap Dealers and Major Swap Participants Established under the Laws of Australia, Canada, the European Union, Japan or Switzerland (Nov. 30, 2017).
- CFTC No-Action Letter No. 17-66, No-Action Relief from Certain Provisions of the Outward-Facing Swaps Condition in the Inter-Affiliate Exemption from the Clearing Requirement (Dec. 14, 2017).
- 7 U.S.C. § 2(h)(8) (2012).
- CFTC No-Action Letter No. 17-67, Extension of No-Action Relief from Commodity Exchange Act Section 2(h)(8) for Swaps Executed Between Certain Affiliated Entities that Are Not Exempt from Clearing Under Commission Regulation 50.52 (Dec. 14, 2017).
Client Alert 2019-228