Yesterday, the Securities and Exchange Commission finalized a rule on the scope of SEC authority over the cross-border market for credit derivatives. This is a critical issue since the derivatives market is international in scope. Most derivatives transactions by Wall Street banks either already are or could be transacted through foreign subsidiaries. Transactions that played a central role in the financial crisis, such as the credit default swaps that brought down AIG, were conducted in foreign jurisdictions.

Overall, this rule is disappointing. It continues to leave a major gap in regulatory authority regarding the application of U.S. law to foreign subsidiaries of U.S. banks. Specifically, while the rule applies U.S. jurisdiction to cases where a foreign subsidiary’s swap counterparty has legal recourse to the U.S. parent bank for the performance of a specific swap, it does not extend jurisdiction to cases where the parent U.S. bank is implicitly or even explicitly committed to guarantee the subsidiary in general. The need to support subsidiaries for reputational or other business reasons can clearly lead to nominally foreign risk returning directly to the U.S. parent entity. This in fact occurred on multiple occasions during the financial crisis of 2008, with a significant impact on U.S. financial stability.

As AFR has warned in multiple comments to the CFTC and SEC over the past several years, this omission could leave the door open for global banks to avoid U.S. derivatives oversight. According to multiple press reports, such evasion is already occurring, as U.S. banks seek to ‘de-guarantee’ derivatives transactions conducted through foreign subsidiaries. AFR continues to favor a solution that would create a rebuttable presumption that any significant foreign subsidiary of a U.S. bank is effectively guaranteed by the U.S. parent, unless the presumption is rebutted by clear evidence that the subsidiary is not supported by the parent.

The above is a central and very serious concern. That said, the final rule does include some positive elements. The SEC has followed the CFTC in extending a higher level of oversight to ‘conduit affiliates’ of U.S. banks, nominally foreign entities that regularly transfer risk back to the U.S. The rule also follows a recommendation in the AFR comment letter in strengthening the SEC’s rules for designation of derivatives dealers by counting transactions with foreign branches of U.S. banks against the minimum required for dealer designation. Also following an AFR recommendation, the final rule expands the provisions for public notice and comment on requests for U.S. regulators to accept foreign rules as equivalent to U.S. rules. Finally, the detailed discussion of what counts as a ‘recourse guarantee’ triggering U.S. oversight is also useful, especially since it makes clear that a range of circumstantial evidence may be relevant to determining whether such a guarantee exists.

The SEC has chosen to leave some critical elements of its cross-border determinations for future rulemakings. This includes a more detailed definition of ‘conduct within the U.S.’, which is crucial for determining whether U.S. rules apply to derivatives transactions. Combined with the loophole related to guarantees discussed above, a loose definition of ‘conduct within the U.S.’ could lead to many derivatives transactions actually being negotiated and executed in New York City by U.S. banks, but avoiding U.S. oversight. Other important determinations that are still to come include rules on exactly which requirements will be applied to non-U.S. persons regarding reporting, clearing, margin, and various other regulatory areas. These remaining elements of the cross-border rules are critical to the overall cross-border regime. In some cases they offer opportunities to address weaknesses in this rule, for example by specifying that certain important regulatory requirements continue to apply to foreign subsidiaries of U.S. banks even if such a subsidiary does not meet the overly narrow definition of ‘guaranteed’ in this rule.