Earlier this year, the US Supreme Court overturned the Chevron deference (also referred to as the “Chevron Doctrine”), which stated that if laws were ambiguous, the courts should defer the interpretation of laws to federal regulatory agencies charged with enforcing such laws, and presume that their interpretations are correct. With this deference overturned, many in the financial services markets are questioning what this means to regulators and participants of financial markets.
In a recent DerivSource podcast – Living the Trade Lifecycle, Ed Ivey, partner, Haynes Boone discussed what this change means for the CFTC’s regulation of the derivatives markets. He explained how the overturning of the Chevron deference might affect the CFTC’s current methods and how market participants may respond to regulatory uncertainties.
Q: What is the Chevron Deference and why does its removal matter for US regulations?
A: Chevron deference was a court doctrine providing that, if a law was ambiguous, the US courts would defer to how a federal regulator or agency interprets the ambiguity. A federal agency will often interpret language in a way which applies old laws to new facts, technologies and otherwise expand their own reach and power from the scope of the original laws. However, this is a very simplified and somewhat cynical view of the Chevron deference since it focuses on one consequence of applying laws written years ago to new facts and situations today. Chevron deference also allows our laws to more quickly evolve and be dynamic, in markets which are also quickly evolving and are dynamic.
For example, derivatives in the US are regulated under the Commodity Exchange Act of 1936 and the Securities Act of 1933. These have been amended many times, with one of the more significant and recent amendments being the passage of the Dodd-Frank Act after the 2008 global financial crisis. The laws in the Dodd-Frank Act were written by Congress and are, in many cases, not very detailed. As a consequence, regulated markets often rely on the expertise of federal agencies to craft meaningful regulations which implement and interpret these laws. These interpretations generally advise the market “how” to comply with Congress’ laws. For this reason, compliance with relevant laws often just focuses on complying with regulations, which are more detailed and provide more clarity on how to interpret and apply the law.
With this background, it is easy to understand why it could be helpful to defer to the regulator, since they are entrusted with the job of advising the market on how to comply with applicable laws. The Chevron deference helped facilitate this without too much concern about market participants taking a regulator to court to challenge how a regulator interpreted the law, then leaving it to the courts to be something of a tie breaker.
Q: What does overturning Chevron mean for the US derivatives market and its regulations?
A: On the surface, not very much that will be noticeable. The Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have often been challenged by the markets and the US courts, and in many cases, they have lost. One could say that the courts already felt empowered to challenge and rule against these regulators, with or without giving Chevron deference. Also, it is true that neither of these regulators generally rely heavily on or draft laws with the expectation that Chevron deference would help support their interpretations of the law.
However, it is incorrect to say it will have no impact. The removal of Chevron deference may embolden more market participants to seek to challenge laws in the US courts, and it could potentially embolden judges that already tend to take a narrow view on what laws do, and do not, say and further embolden them to rule against the federal agency.
“The removal of Chevron deference may embolden more market participants to seek to challenge laws in the US courts, and it could potentially embolden judges that already tend to take a narrow view on what laws do, and do not, say and further embolden them to rule against the federal agency.”
This impact will not be easy to quantify. The CFTC and SEC have both lost court cases in the past, so just because we see a loss here or there, it will not necessarily have anything to do with the overturning of Chevron deference. However, the regulators will be cognisant of the new reality that controversial regulatory actions will be challenged. This could lead to less aggressive rulemaking, or the same rulemaking but with significantly more time and energy spent by lawyers at those agencies writing support for their interpretations.
“Regulators will be cognisant of the new reality that controversial regulatory actions will be challenged. This could lead to less aggressive rulemaking, or the same rulemaking but with significantly more time and energy spent by lawyers at those agencies writing support for their interpretations.”
Q: What current regulatory items could be impacted by this development?
A: It will be interesting to see how this impacts the CFTC’s recent focus on expanding the reach of its regulations that require an entity to register as a swap execution facility (SEF). In 90 percent of cases, it is fairly obvious when someone sets up an exchange where buyers and sellers can competitively bid, price and execute swaps. However, in the other 10 percent of cases, there can be uncertainty. There is particular ambiguity around prime brokers and Commodity Trading Advisors (CTAs).
Over the last few years, the CFTC appears to have changed its view on whether prime brokers are or are not a SEF. For example, in cases where two customers of a prime broker agree to terms of a potential trade to be intermediated by a prime broker, and then ask the prime broker to intermediate such trade, this dynamic where arranging, negotiating and proposed execution of a trade between buyer and seller, is only subsequently intermediated by a prime broker, seems a bit removed from the exception from SEF registration based on platforms with a single counterparty. As the prime broker model has grown with more and more market participants seeking swap execution via prime brokers, new technologies have also been introduced to better facilitate swaps execution. With the evolution of the prime broker business, the CFTC’s views also evolved. In recent years, CFTC has become concerned over how the customers of the prime broker were able to interact and arrange the trade, and whether the prime broker was facilitating this via electronic chat rooms or other customer-to-customer communications. Today, any prime broker may be the single liquidity provider on their platform, but as their prime broker products and services evolve, the prime broke must also analyse the SEF-registration risk associated with its platform.
In another context, there are Commodity Trading Advisors, or CTAs. Buy-side parties will often engage CTAs as hedge advisors. CTAs help their clients achieve best execution, often by bidding out proposed swaps among multiple potential counterparties to see who offers the lowest cost to their client. This process is not new, but the CFTC has identified these activities as potentially requiring SEF registration. This seems unusual, particularly since the CTA is already registered and subject to legal requirements regarding how it operates in the derivatives markets. One of the most common, if not fundamental tasks of a CTA, is to help its clients achieve the best price and execution through a mix of their expertise, connections to liquidity providers and ability to better achieve competitive pricing than a corporate entity with less familiarity and expertise in the derivatives markets.
Today, that bidding process, to some at the CFTC, makes CTAs look more like an exchange in the eyes of the regulator. The CTAs counter that they are simply acting as an agent of the customer, and in that context, a customer would be allowed to set up their own bidding process and execute at the best price without being considered a SEF. This leads to simple question from the CTA: So why is it different for the CTA, the agent, to do it?
Q: How will removing the Chevron deference affect these situations?
A: Post Chevron, everyone’s calculus changes slightly. The CFTC has been aggressive in using advisory letters or enforcement actions to apply SEF registration requirements to the market in a manner it was unable to achieve through formal rulemaking. This activity is now ripe for challenge by market participants and industry groups. The resources required to respond to such challenges may make the CFTC less cavalier about using letters or enforcement actions to expand regulatory scope. I would note, these letters and enforcement actions can also be very helpful to the market, particularly letters, so there is potential for negative consequences to the market if we see fewer letters.
From the view of market participants, the new reality may change how market participants thinking about responding to CFTC enquiries which, in the view of the market participant, represent questionable regulatory expansion. Some may be more willing to take the CFTC to court, if success in that activity now seems more likely. However, before or after Chevron, this decision will often boil down to which is the least expensive option.
Challenging the CFTC in court is not inexpensive. Some may consider paying a fine and making changes to their business operations a better option than either going to court or going through the process of registering as a SEF. Registering as a SEF requires significant investments in personnel and IT infrastructure, as well as ongoing legal and compliance costs.
On the other side, some market participants may realize that having a registered SEF may give them a business advantage in the long run or otherwise present a long-term benefit that justifies the immediate costs. Ultimately, each firm needs to decide for itself what makes the most sense.
