Why the Reach of U.S. Derivatives Law Matters (with important updates on Singapore and Europe)
In Spielberg’s 1982 classic movie E.T., a young boy named Elliott discovers the film’s namesake – a stranded alien – while fetching pizza in the garage. The film takes a dark turn when Elliott and E.T., having developed a psychic connection with each other, become gravely ill. Government agents seize and quarantine them, but they eventually escape and E.T. lifts Elliott’s bike telekinetically to avoid sure capture by the agents.
Now, thirty years later, “E.T.” is all the rage once again. E.T. also refers to “extraterritoriality,” or the question of whether the laws of one jurisdiction apply outside of that jurisdiction. Recently, the application of U.S. law to financial transactions (including derivatives) executed abroad has become a topic of great interest. And though this new E.T. touches on a topic far afield from its Hollywood cousin, each conjures images of government agents descending upon a misunderstood species (i.e. aliens and derivatives).
This month, E.T. was the subject of a Congressional hearing that focused on the Swaps Jurisdiction Certainty Act (H.R. 3283), a bipartisan bill intended to circumscribe regulators’ authority to apply certain of Dodd-Frank’s requirements to foreign transactions that pose little risk to U.S. financial stability. Underlying the bill is recognition that expansive application of U.S. law threatens the competitiveness and efficiency of U.S. capital markets. Such a threat would emerge as a consequence of differing regulatory regimes in the U.S. and other parts of the world and the measures banks take to avoid being competitively disadvantaged abroad. Fed Chairman Bernanke hinted at this threat when he said, “If those [derivatives] margin rules for foreign operations are maintained and Europeans and other foreign jurisdictions don’t match it, that would be a significant competitive disadvantage.”
Indeed, last week Singapore released its derivatives regulatory proposal, offering market participants the opportunity to consider further the scope of differences in worldwide regulatory approaches. Like the U.S. and E.U. regulatory regimes, Singapore’s proposal reveals a determination to implement requirements that reflect lessons learned from the financial crisis. At the same time, however, Singapore has sought to exercise great care to ensure that commerce is not disrupted where there is no systemic risk concern. On this latter priority, Singapore’s proposed approach differs from Dodd-Frank in several noteworthy ways:
1) Financial end users with small derivatives exposures are not subject to clearing requirements
2) Financial entities retain the freedom to transact in the venue they deem most efficient
3) Non-financial end users do not appear likely to be subject to margin requirements on non-cleared trades
4) Transactions are not required to be reported on a real-time basis
In other global news, the European Union last week signaled what would be a notable departure from certain rules proposed by U.S. regulatory authorities. The European Securities and Markets Authority – the key financial rulemaking body in the E.U. – indicated that foreign exchange (FX) forwards would likely be subject to bilateral margin requirements. By contrast, the U.S. Treasury Department (and the Monetary Authority of Singapore) proposed exempting FX forwards from the salient economic requirements of the Dodd-Frank Act. Such differences, when paired with uncertainties around the territorial reach of U.S. and E.U. law, raise important questions about which rules would apply to cross border transactions.
While indeed it cannot be expected that regulatory regimes around the world would be perfectly aligned, it will be important for U.S. and foreign regulators to allow for some variance in requirements applied on transactions executed abroad.
Though market participants remain concerned about whether territorial boundaries will be appropriately drawn, concerns about the adverse consequences of expansively applied U.S. law have not gone unnoticed by U.S. policy makers charged with overseeing implementation of various aspects of Dodd-Frank. In his comments to the Financial Stability Oversight Council earlier this month, Treasury Secretary Tim Geithner observed that “we need to figure out a sensible way to apply [derivatives] rules to the foreign operations of U.S. firms and the U.S. operations of foreign firms.”
And so, although derivatives market participants cannot rely on telekinesis to escape the ill effects of extensively applied U.S. law, they retain some hope that policy makers will thoughtfully craft final rules to ensure that U.S. capital markets remain competitive and efficient.