On May 28, 2020, commissioners of the U.S. Commodity Futures Trading Commission (CFTC) unanimously voted to approve:

(1) an interim final rule (IFR) that would defer the next phase of the compliance schedule for the initial margin (IM) requirements for uncleared swaps in response to operational challenges certain entities are facing due to the COVID-19 (coronavirus) pandemic; and

(2) a proposed rule (Proposed Rule) which, if finalized, would amend the CFTC Regulation 3.10 exemption from registration as a commodity pool operator (CPO) for certain foreign persons.

This post provides an overview of these two items.

Interim Final Rule on Uncleared Margin Requirements

The IFR both revises the compliance schedule for the posting and collection of IM under the CFTC’s 2016 uncleared margin rules (UMR) and invites comments on any aspect of the changes made by this IFR. The IFR will be effective upon publication in the Federal Register and comments are due 60 days after the date of publication.

The UMR set a staggered compliance schedule for its IM requirements based on the sizes of the trading entities. Phase 1 of the IM requirements applied to the largest entities (i.e., any entity that had an average aggregate notional amount (AANA) of $3 trillion or more) on September 1, 2016 and Phases 2, 3, and 4 applied to entities with decreasing trading portfolios in September 2017, 2018, and 2019, respectively. Entities with an AANA between $8 billion and $750 billion were subject to the Phase 5 compliance deadline on September 1, 2020. However, as we covered in a prior post, market participants raised increasing concerns regarding preparation for the Phase 5 compliance date, which was anticipated to impact far more market participants than Phases 1 through 4. The CFTC ultimately adopted amendments to the UMR on April 9, 2020, along with certain conforming technical changes, to create an extended Phase 5 compliance date that would apply to entities with AANA between $8 billion and $50 billion beginning on September 1, 2021.

Once effective, the IFR will amend the compliance schedule once more by deferring the September 1, 2020 Phase 5 compliance deadline for one year to September 1, 2021. The adopting release explains, “compliance with the existing requirements could exacerbate COVID-19’s adverse impact on operations by causing entities to divert scarce resources from more pressing operational needs, which could hinder business continuity efforts and adequate management of volatility, liquidity, and other risks brought about by the pandemic.”

The IFR is partly consistent with actions recently taken by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO), which announced a one-year deferral of the final two IM compliance deadlines. The IFR explains that the CFTC will address the later compliance date through the notice of proposed rulemaking and public comment process.

Proposed Rule on CPO Exemption for Non-U.S. CPOs

CFTC Regulation 3.10(c)(3) provides an exemption from CPO registration for non-U.S. CPOs engaging in CPO activity on behalf of offshore commodity pools only. Regulation 3.10(c)(3) also provides that CPOs relying on this exemption are confined to acting on behalf of offshore commodity pools.

If finalized, the Proposed Rule would amend existing CFTC Regulation 3.10 to: (1) permit qualifying non-U.S. CPOs to rely on the exemption on a pool-by-pool basis; (2) add a safe harbor for non-U.S. CPOs of offshore commodity pools meeting certain enumerated factors; and (3) permit certain U.S. affiliates of a non-U.S. CPOs to contribute capital to such CPO’s offshore pools as part of the initial capitalization without rendering the non-U.S. CPO ineligible for the exemption. The Proposed Rule has a 60-day comment period following publication in the Federal Register.

Further, if finalized, the Proposed Rule would amend CFTC Regulation 3.10 to specify that the availability of the exemption would be determined by whether all of the participants in a particular offshore pool are located outside the U.S. Accordingly, non-U.S. CPOs would be able to rely on the exemption on a pool-by-pool basis and also rely on multiple exemptions or exceptions from CPO registration requirements for its pool activities.

The Proposed Rule also contemplates relief for non-U.S. CPOs who cannot represent with absolute certainty that all of its pool participants are offshore for purposes of the exemption. For example, the Proposed Rule explains that “non-U.S. CPOs of offshore pools that are traded in offshore secondary markets cannot be assured that only persons located outside the U.S. would be accepted as participants because the participation units are not purchased directly from the offshore pool.” Additionally, non-U.S. CPOs may be structured in a way that prevents the CPO from having “complete visibility into the ultimate beneficial owners of its offshore pool’s participation units, even in the absence of secondary market trading.” Accordingly, the Proposed Rule proposes a safe harbor by which such non-U.S. CPOs may rely on CFTC Regulation 3.10, provided that the following conditions are met:

  1. The offshore pool’s offering materials and any underwriting or distribution agreements include clear, written prohibitions on the offshore pool’s offering to participants located in the U.S. and on U.S. ownership of the offshore pool’s participation units;
  2. The offshore pool’s constitutional documents and offering materials: (a) are reasonably designed to preclude persons located in the U.S. from participating therein, and (b) include mechanisms reasonably designed to enable the CPO to exclude any persons located in the U.S. who attempt to participate in the offshore pool notwithstanding those prohibitions;
  3. The non-U.S. CPO exclusively uses non-U.S. intermediaries for the distribution of participations in the offshore pool;
  4. The non-U.S. CPO uses reasonable investor due diligence methods at the time of sale to preclude persons located in the U.S. from participating in the offshore pool; and
  5. The offshore pool’s participation units are directed and distributed to participants outside the U.S., including by means of listing and trading such units on secondary markets organized and operated outside of the U.S., and in which the non-U.S. CPO has reasonably determined participation by persons located in the U.S. is unlikely.

Finally, the Proposed Rule seeks to add a provision to CFTC Regulation 3.10 which would, in effect, permit a U.S-based controlling affiliate of a non-U.S. CPO to contribute capital to an offshore pool operated by the non-U.S. CPO affiliate without disqualifying the CPO from relying on Regulation 3.10. In support of the addition, the Proposed Rule stated, “the Commission preliminarily believes that due to the fundamentally different features of the relationship between a controlling affiliate and a non-U.S. CPO as compared to an outside investor and a CPO, a U.S. controlling affiliate’s participation, through an initial investment, in its affiliated non-U.S. CPO’s offshore pool does not raise the same customer protection concerns as similar investments in the same pool by unaffiliated persons located in the United States.

You can view the voting drafts for both rules and of CFTC Chairman Heath P. Tarbert and Commissioners Brian Quintenz, Rostin Behnam, Dawn Stump and Dan Berkovitz regarding the rules here.

Good day. Good to see these longstanding issues being addressed in a reasonable way. DR2.