Substituted compliance, equivalence and the importance of preventing market fragmentation

16 January 2015

In the wake of the global financial crisis triggered by the Lehman meltdown, a frantic regulatory effort ensued. The idea was to come up with rules applicable to every step and every aspect of derivatives trading, so as to curb systemic risk, promote greater market transparency and prevent market abuse.

There came the 2009 G20 Pittsburgh summit and Dodd-Frank and EMIR were born in the US and in the EU, respectively. A number of other countries, such as Canada, Switzerland, Australia, Singapore and Japan also passed regulation comparable in scope and objectives.

The approach under Dodd-Frank’s Title VII is, in a nutshell, to keep a close watch on those entities entering into derivatives transactions in a dealing capacity over a certain threshold, by mandating that such entities register as swap dealers with the Commodity Futures Trading Commission (“CFTC”). In the future, registration as security-based swap dealers with the Securities Exchange Commission (“SEC”) will also be required for entities dealing in derivatives classed as security-based swaps over a certain threshold. Those entities registered as swap dealer must comply with a range of business conduct rules, both at entity level, as well as at the transactional level.

A pillar of those business conduct rules is the obligation to clear certain kinds of swaps on clearinghouses and trade the same on trading facilities with all types of counterparty, as long as they are not end users. As a general rule, parties other than financial entities may be classified as end users (though some financial entities may also qualify), to the extent that their trades are entered into for purposes of hedging commercial risk. The same party may act as an end user in connection to certain trades, whilst also entering into swaps for purposes other than hedging of commercial risk. If so, the end user exemption from clearing will apply only in relation to those swaps entered into for hedging purposes.

Meanwhile in Europe, EMIR does not require entities to register. All market participants resident in the EU are obliged to comply with the regulation and there is no concept of end user. EMIR provides three categories under which an entity may fall: Financial Counterparty (“FC”), Non-Financial Counterparty + (“NFC+”), or Non-Financial Counterparty – (“NFC-”). Each party must self-classify, by letting its counterparty know whether it is an FC, NFC+ or NFC-.

The difference between an NFC+ and an NFC- is that the former has entered into non-hedging derivatives over a certain threshold, over a certain period of time.

Just as in Dodd-Frank, mandatory clearing is a pillar under EMIR and is to be obligatory for certain kinds of transactions where each party is either an FC or an NFC+.

Both Dodd-Frank and EMIR impose an array of other obligations, such as real time reporting, timely confirmation, portfolio reconciliation, dispute resolution rules, pre-trade transparency and others, each of which apply slightly differently. Also, each of the US and the European regulation (as well as the Canadian one, and likely others) have extraterritorial effects. This means that national regulators encroach to some extent on the competencies of other jurisdictions’ regulators, creating regulatory overlaps and, in some instances, incompatibilities.

A great number of entities that do business in, or with counterparties from, one or more foreign jurisdictions embarked on post-Lehman regulatory endeavours, are caught in a political tussle between national regulators. Those entities do not know exactly what lies ahead but have the certainty that they will have to comply with it. Cross-border regulatory harmonization and legal certainty is a must if market fragmentation and disruption is to be avoided.

Focusing on the US and the EU being the two largest markets, Dodd-Frank provides for a mechanism called substituted compliance, which EMIR calls equivalence. In its purest form, substituted compliance/equivalence means that a foreign entity that complies with its own domestic regulation is deemed to be in compliance with the corresponding foreign rules.

Whether a European rule is comparable to a US one requires that the CFTC so determines. Conversely, only the European Commission may decide whether a US rule is equivalent to an EU one. “Both ways” equivalence will only exist once both regulators have determined it to the same extent.

To date, the CFTC has made substituted compliance determinations in two instances only:


  1. In no-action letter 13-45 the CFTC determined that, when one of the parties is a US person and the other is European and one of the parties is a swap dealer or major swap participant, the parties may agree whether to comply with the rules regarding swap confirmations, portfolio reconciliations, portfolio compression, swap trading relationship documentation, either under the CFTC Part 23, or under EMIR’s risk mitigation techniques, so long as Part 23 is complied with whenever the EMIR rules are less onerous.
  1. In the second instance, the CFTC issued a comparability determination (78 FR 78923) at the end of 2013 between certain CFTC entity-level business conduct rules and the corresponding articles in the European Markets in Financial Markets Infrastructure Directive (“MiFID”), applicable to European swap dealers. There, the CFTC found that a European swap dealer will be in compliance of the CFTC rules in connection with the requirements for the compliance report and the risk management report if it meets the requirements under MiFID provided that, where the CFTC’s requirements are more onerous, the MiFID reports must be “topped-up” to meet the CFTC’s requirements.


The top-up is the catch and the telltale that there is no co-ordination between national regulators to sensibly co-regulate markets that are international by their own very nature. As has been mentioned at the beginning of this article, the US and the European regulatory architectures differ materially. Just because of that, topping-up will almost always be required, negating the benefit of any substituted compliance.

The MiFID compliance report is so much broader in scope than the CFTC report, that very few European swap dealers would be willing to volunteer to the CFTC, a foreign regulator, a wealth of information that goes well beyond the CFTC’s remit. Trimming the report for the CFTC’s perusal effectively means that there will not be substituted compliance.

Likewise, the risk management report under MiFID has a yearly frequency and, again, a much broader scope than those matters under the CFTC’s oversight. The CFTC rules require that a risk management report be filed quarterly, and meet certain parameters. Again, topping-up the risk management report to meet the CFTC’s requirements (i.e., trimming it down and preparing quarterly reports ad-hoc for the CFTC) makes substituted compliance illusory.

Substituted compliance plus top-up stills requires duplicative compliance efforts, practically to the same extent as would be required if no substituted compliance existed, and requires non-US swap dealers to keep their ear to the ground for any changes in those US rules in respect of which substituted compliance has been granted, as they will need to supplement compliance to the extent there are any differences. It represents little or no upside in terms of compliance effort or cost.

To date, the European Commission has not issued any equivalence determination in respect of US regulation. It is unknown whether, once equivalence determinations are made, Europe will require topping-up to meet its own requirements as the US does. Yet we know there are a number of major matters where there does not seem to be compatibility, as the regulators on both sides of the Atlantic have admitted. Such is the case of clearing. Clearing mechanics have been conceived in the US and in Europe in radically different ways. Unless the authorities in the US and the EU come to an agreement in time, market disruption (and fragmentation) might ensue. This is mitigated to some extent by the fact that certain clearinghouses have been recognized in both the US and the EU.

The same concern applies with clearing in any other jurisdiction where it is required: if the same transaction must be cleared under two applicable, overlapping regulations but the two incumbent regulators have not previously reached a mutual recognition agreement on the matter, then clearing the transaction in the clearinghouses of one jurisdiction would imply breaching one of the party’s clearing obligation in the other.

In the meantime, the rule of thumb is that, where there are two overlapping sets of applicable rules and each resolves the same situation differently, the most onerous requirement must be met.

But meeting the highest regulatory onus in case of overlap represents a competitive handicap, which leads some to believe that overlapping regulatory incompatibilities represent, whether fortuitously or by design, a protectionist barrier that contribute to make foreign entities less competitive. European swap dealers are a case in point: when dealing with US clients (typically end users), European banks are having a hard time explaining that, apart from Dodd-Frank, they must also comply with EMIR, which has a number of requirements of its own.

If a US client refuses to make representations under EMIR (which is understandable, as they might not know what they entail and might well be unwilling to hire European counsel unless strictly necessary for their own interests), a European bank might have to let that client go. In turn, that US client is likely to trade with US banks only, as they will not have to apply any regulation other than US rules, with which its client is familiar. In turn, the flipside of the same example would show competitive disadvantages that US banks face vis-à-vis clients in Europe.

To compound the situation, a number of Canadian provinces (with more expected to follow)[1] have each adopted rules that require that any entity (Canadian or not) entering into derivatives or securities transactions with counterparties resident in their respective provinces must report such transactions to the relevant Canadian provincial regulator, with the obligation to register as a dealer in each relevant province and, supposedly, compliance with a number of business conduct rules, expected to follow. There is talk of substituted compliance being on the cards, although the requirements and conditions in each case have not yet been outlined, which further contributes to the general legal uncertainty on the matter.

Entities without an establishment in Canada are faced with the option to submit to open-ended obligations and fly blind (retaining counsel on a permanent basis to be warned of new rules as they arise), or leave the market.

Here is where market fragmentation starts to appear as a real possibility: as a market, Canada’s specific weight is rather small when compared to the US or Europe; those entities with clients in Canada representing revenues not sufficient to outweigh compliance costs might well decide to pull out, and leave the market to those whose business volume is such that the cost of complying with yet another set of rules does not tip the balance.

And, given that each country is free to regulate its financial markets as it deems appropriate, a patchwork of complex, differing and overlapping national regulations is likely to emerge.

Such market fragmentation might take place unless international regulators agree on a common policy applicable across the board. If it does take place, a number of entities doing business across two or more regulated jurisdictions might find it disproportionately onerous to comply with all the disparate applicable national rules, to the extent that the compliance cost and effort becomes uneconomical. Come that point, some entities would presumably decide to drop out from those markets in which compliance has become too burdensome in comparison to the revenues produced, to fall back on a smaller, less onerous geographical footprint.

And yet, as national regulators keep ticking regulatory milestones off their lists, there is little sign that international harmonization is on the horizon for financial regulation.

The competing laws currently implemented and taking shape appear to be erecting national regulatory barriers that may result in reduced market liquidity and increased risk concentration, which would exacerbate the market share of too big to fail entities. At the same time, disparate regulations would create the right conditions for regulatory arbitration. All those results are very much at odds with the goals stated in the Pittsburgh G20 meeting where it all started.

If your entity is domiciled in any of these jurisdictions, or your counterparty is American or European, you need to be aware of how the financial regulation applicable to your entity and to your counterparty will impact your deals.

Contact us for a confidential, no-obligation discussion.

[1] So far, Ontario, Quebec, Manitoba and New Brunswick have passed such regulation.