USA - NATIONWIDE: An Introduction to Derivatives

Entering US Derivatives Markets: Legal Considerations for Offshore Counterparties

US law generally permits US swap dealers to engage in swap transactions with foreign entities, provided that regulatory conditions are met. While the absence of direct registration or licensing obligations on the foreign entity may suggest a permissive regime, the practical realities of accessing the US derivatives market are more intricate. Foreign-domiciled entities entering into over-the-counter (OTC) derivatives with US-regulated entities will encounter a regulatory framework that demands careful navigation. Transaction-level obligations, eligibility thresholds and counterparty-imposed requirements collectively create a compliance environment that is legally dense and operationally consequential, necessitating thoughtful structuring and documentation. In addition, the US Commodity Futures Trading Commission (CFTC) and US prudential banking regulators have promulgated complex definitions of who is a “US person”, which can affect the regulatory requirements that apply to a US swap dealer (and its non-US affiliates and branches) if its foreign-domiciled counterparty nonetheless happens to fall within a “US person” definition because of a particular US-related aspect of its business.

The International Swaps and Derivatives Association (ISDA) Master Agreement and its supporting documentation serve as the contractual backbone of most cross-border OTC derivative relationships. However, standardized terms are no longer sufficient for regulatory compliance. ISDA has created a number of different protocols that allow US swap dealers to address their regulatory obligations. Among other considerations, protocol documentation may address margin segregation and custodial arrangements, trade reconciliation, dispute resolution and recognition of US resolution authority. Understanding which terms are truly market standard, which are discretionary, and which carry downstream operational consequences is critical to efficient negotiation and long-term compliance.

This article outlines certain considerations for general counsels, COOs and finance professionals at non-US entities transacting swaps with US swap dealers. It uses the ISDA Dodd-Frank Protocols (published in August 2012 and March 2013 and available on the ISDA website) to illustrate regulatory complexities and is not intended as a comprehensive guide.

Case study: swap dealers external business conduct and documentation rules in a cross-border swap

A Cayman-domiciled hedge fund (Fund B), managed from London, seeks to enter into non-deliverable currency swaps with a US bank’s New York trading desk. The fund has no US investors, meets “Eligible Contract Participant” (ECP) requirements and does not trade through any US branches. Despite being outside the US regulatory perimeter, Fund B is informed that it cannot proceed without providing the swap dealer with certain information, representations and warranties, and covenants that will allow the swap dealer to comply with rules promulgated under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Fund B is informed that it can comply with these requirements by adhering to ISDA’s DF Protocols. These protocols enable US swap dealers to satisfy their obligations under the CFTC’s external business conduct rules, including obtaining counterparty representations and suitability-related documentation. Adherence requires Fund B to:

• submit a protocol adherence letter to ISDA; and
• complete a detailed counterparty questionnaire and submit it to the swap dealer bilaterally or on ISDA Amend through S&P Global Market Intelligence’s Counterparty Manager service.

Fund B initially objects, citing equivalent standards under its own regulatory regime. However, US law does not recognize substituted compliance in this context, so the bank requires completion of the DF Protocols. With counsel, Fund B tailors its protocol responses to reflect its governance structure, ultimately enabling the transaction to proceed. This case illustrates how US regulatory obligations are operationalized by the swap dealer obtaining the required comfort from its foreign counterparts through the DF Protocols. We discuss below some of the prerequisites that are addressed in the DF Protocols.

ECP status as a market access requirement

Under US law, only “Eligible Contract Participants” (ECP) may enter into OTC derivative transactions. The specific guidelines for ECP status are spelled out in the Commodity Exchange Act. A threshold of at least USD10 million in total assets is applied for investors, such as hedge funds, though thresholds are lower if an entity’s main activity is hedging.

ECP status is not merely a legal formality; it is a gating condition. US counterparties require affirmative documentation of ECP qualification as a condition of trading. In unclear cases, structuring advice may be necessary to satisfy the ECP requirements.

Does the counterparty understand the risks?

A US swap dealer acts as counterparty on trades and is entitled to do so, if (i) it notifies the counterparty that it isnot undertaking to assess the suitability of a swap entered into with the counterparty, (ii) it obtains representations from its counterparty that the counterparty, or its agent (a Designated Evaluation Agent) has the required knowledge to independently evaluate the risks involved in the swap, and (iii) the counterparty or its agent represents in writing that it is exercising independent judgment in evaluating the recommendations of the swap dealer, if any. This notification from the swap dealer and representations by the counterparty are included in the DF Protocol. If the counterparty is acting through an agent, the agent will be required to make the necessary representations and execute the protocol.

Will the relationship be subject to mandatory clearing?

The CFTC requires certain derivatives transactions to be centrally cleared, unless an exemption applies. The end-user exception permits eligible commercial entities to opt out of the clearing requirement if they are not Financial Entities, are using derivatives to hedge or mitigate commercial risk, and submit required information as to how they intend to meet their obligations. “Financial Entity” is defined in the Commodity Exchange Act and includes such entities as dealers, private funds, and commodity pools. These entities cannot avail themselves of the exemption.

Is the necessary documentation in place for the relationship?

Compliance with US derivatives rules requires a written agreement between the swap dealer and its counterparty. This is typically in the form of the ISDA Master Agreement or if the parties do not have an ISDA in place they can agree in the DF Protocol to have their trades subject to a deemed ISDA. The deemed ISDA, especially in the case of one-off trades, allows parties to circumvent the, sometimes protracted, ISDA negotiations.

US derivatives market

US derivatives regulation does not formally extend to most foreign entities. However, effective participation in this market requires more than regulatory awareness; it requires fluency.

The extraterritorial reach of US derivatives regulation is such that foreign market participants, even those whose sole nexus to the US is the US swap dealer they are trading with, must understand the regulations and be prepared to comply. As new regulations emerge, foreign entities should expect US documentation practices to remain in flux.

Engaging in swap transactions with US-regulated entities is less a matter of obtaining a regulatory exemption and more a matter of ensuring continuous alignment with US rules as they apply to the transaction, such as:

• periodic review of ECP status;
• provision of information for Designated Evaluation Agent and updates, as and when one is replaced; and
• contemporaneous updates to protocol representations to ensure swap dealer compliance with regulatory requirements.

General counsels and senior operations leads should treat US derivatives compliance not as a one-time onboarding exercise but as a continuous, layered legal framework embedded in each transaction.