Going Abroad With Dodd-Frank

AP Images/Harry Hamburg

One of the biggest catastrophes of the 2008 financial crisis came out of the AIG Financial Products division, whose disastrous trades eventually led to a $182 billion bailout of the insurance company. One of the largest financial market blowups since the crisis came from the Chief Investment Office of JPMorgan Chase, where similar trades backfired and cost the company at least $6.2 billion. The common thread? Both of these offices, despite being subsidiaries of American corporations, were based in London, and they enjoyed a degree of autonomy, both from their management teams and from federal regulators, who were unable to recognize the outsized risk until it was too late.

The Dodd-Frank financial reform law intended to end the practice of financial industry behemoths shifting away their riskiest practices from U.S. regulators’ prying eyes. But a rule that would subject the $630 trillion global derivatives market to the same regulations, no matter the location of the trades, is on life support, thanks to a combination of foreign regulators, bank allies at federal agencies and in Congress, and Treasury Secretary Jack Lew, who may have delivered the final blow last week. The complex battle over derivatives also reflects a battle for the soul of the Democratic Party, between populist reformers and Wall Street-friendly shoe polishers. And while the situation is fluid in advance of a Friday deadline, as it stands now, the shoe polishers are winning.

Derivatives are those massive bets on bets that are only tangentially related to real-world assets, like a rise in home prices or the reduction of the dollar. They accelerated the financial crisis when the housing bubble collapsed, and until recently, they were totally unregulated. But Dodd-Frank included substantial derivatives reform, forcing the trades to run through transparent clearinghouses, and forcing the dealers to carry sufficient capital to cover losses. Most important, under the “cross-border” provision, all affiliates that trade more than $8 billion in derivatives would be subject to the same regulation, regardless of where they are based. That’s crucial, because the five biggest U.S. banks control 95 percent of the derivatives market, and they have thousands of overseas affiliates where they often park their trading desks (at least half of their trading takes place overseas, according to International Financing Review). This allows them to spread risk in unregulated areas, only to plead for federal assistance when it all blows up. “Doing derivatives rules without cross-border is like blocking the front door and leaving the back door wide open,” said Marcus Stanley of Americans for Financial Reform.

Like most Dodd-Frank rules, interpretation was left to a financial regulator, in this case the Commodity Futures Trading Commission (CFTC), under the chairmanship of former Goldman Sachs partner Gary Gensler. Despite early concerns from reformers, Gensler has tirelessly fought Wall Street for the strongest rules possible. He sees cross-border as critical to regulating the derivatives markets, telling Time magazine, “If we allow (banks) to operate outside these common-sense reforms that Congress has mandated, we will not only have failed the public, but we’ll have repealed derivatives reform altogether.”
Gensler needs support from the two other Democrats on the five-member commission to finalize the cross-border rule (Republican Jill Sommers stepped down this week, but Gensler still needs 3 votes out of 4 to pass the rule). Commissioner Bart Chilton is on board, but in late June, Commissioner Mark Wetjen, a Democrat, gave a speech before an industry trade group—predictably, in London—arguing for an “interim final guidance” that “provides sufficient adjustment time for the marketplace.” Gensler recognized this as a call for delay. This is par for the course for Wetjen. I wrote in the Prospect in May about his bank-friendly tendencies that have already weakened derivatives rules. But delaying cross-border regulation would have a much bigger effect. Gensler is leaving the CFTC at the end of the year, and postponing the rules until his exit maintains the status quo, and will let Wall Street try their luck with a new Chairman to blow holes in the regulations.

Gensler has one piece of leverage. Right now, foreign affiliates are protected from the cross-border rules by an exemptive order that expires July 12. Extending it requires a vote, and Gensler controls the calendar. If he lets the exemptive order expire, the language of the Dodd-Frank statute would govern, and all derivatives trades with a “direct and significant connection” to the U.S. economy would fall under the rules. There would be some murkiness in the law without a final guidance, and banks could simply dare the CFTC to enforce the rule. But the uncertainty could also encourage bank lobbyists to pressure backers like Wetjen to get something done.

Gensler set a July 12 vote on the final cross-border rule, basically daring Wetjen to either cooperate on a solution or allow the exemptive order to expire. But forces outside the CFTC have used their power and influence to take away Gensler’s leverage and force him to soften the rules.

U.S. banks have cautioned about global competitiveness, though it’s unclear why the CFTC should care whether or not Goldman Sachs’ Hong Kong affiliate can compete with Deutsche Bank’s. Meanwhile, Democratic reformers and Wall Street allies alike have spoken out publicly, reflective of a split within the party. Jeff Merkley and eight Democratic Senators urged the CFTC to approve the rule without delay, and strengthen it, so that any foreign affiliate whose risk could flow back to the U.S. gets covered by the rules. But a competing letter from New York Senators Chuck Schumer and Kirsten Gillibrand among others, calls for delay until the Securities and Exchange Commission (SEC), which governs a tiny slice of the derivatives market, completes their rules.

There’s a massive irony here. Delaying cross-border gives Wall Street banks incentive to ship their derivatives trading desks overseas, away from oversight. This has a materially negative impact on New York City, which Schumer and Gillibrand represent. And there’s no greater critic of corporate outsourcing than Chuck Schumer. But Wall Street campaign contributions apparently trump parochial interests like the New York economy. (For what it’s worth, the New York Times editorial board bashed the Schumer/Gillibrand letter last week.)

Revealingly, Schumer and Gillibrand addressed their letter not to Gensler, but Treasury Secretary Jack Lew, essentially asking him to step in and get the rule delayed. And it appears he has done so.  After a “tense” meeting between Lew, Gensler, and SEC Commissioner Mary Jo White last week, Gensler has reportedly changed his tune, and will seek at least a partial delay of around six months. Gensler is technically an independent regulator, but the Obama Administration has ways of influencing his decisions. Many believe Gensler is being squeezed out of the CFTC, and he at least wants a say in his replacement. In the past couple weeks, former Senate staffer Amanda Renteria, seen as the heir apparent, withdrew her name from consideration. This leaves the seat open, and Gensler knows that, if he wants his rulemaking legacy to endure, he has to knuckle under certain White House demands.

Lew was acting not just on behalf of Wall Street and its Congressional backers, but foreign regulators, who have become incensed with Gensler usurping their authority to regulate derivatives in their countries. The Wall Street Journal reports that Lew and White will meet next week with EU Internal Market Commissioner Michel Barnier, the point person for foreign regulators, essentially going around Gensler.

It looks like a classic territorial dispute. “European regulators probably don’t care how strongly we regulate Goldman Sachs Hong Kong, but they don’t want the CFTC regulating their European banks,” said Americans for Financial Reform’s Marcus Stanley. And that’s a big problem, as foreign banks represent nearly half of all registered swap dealers. Foreign regulators, who have lagged in their rule-writing, want what they call “substituted compliance,” meaning that each country would recognize another’s derivatives rules as equivalent on a presumptive basis (this generally describes the SEC’s approach). Gensler initially rejected this in favor of a step-by-step process to judge compliance. That triggered the complaints by foreign regulators.

There’s also a status issue here. The CFTC has the smallest budget of any financial regulators, and is entirely dependent on Congress for their funds (the total annual funding for the CFTC is $200 million, about 5 percent of that of the IT budget for one global bank). European regulators sniffed at being pushed around by what they perceive as a backwater agency—they euphemistically call it a “lack of cooperation” by the CFTC.  And Jack Lew apparently sided with them over his own country’s CFTC chair. Now Gensler has floated a compromise that may spare foreign banks from many derivatives rules.

It’s perhaps not an accident that the smallest and most politically vulnerable financial regulator also governs the riskiest element of financial reform. It puts the CFTC in the position to be rolled, and without the steadfast advocacy of Gensler, it probably would have happened long ago. In fact, this resembles the odyssey of Brooksley Born, the Clinton-era CFTC Chairwoman who also tried to regulate derivatives markets, only to be stymied by Treasury Secretary Robert Rubin and his undersecretary Larry Summers. It’s hard for even qualified and effective regulators to withstand the power of Big Finance, said Marcus Stanley of Americans for Financial Reform. “You’re getting into the backroom wiring of international capital.”

Comments

It's clear that the commission is struggling to regulate an otherwise unregulated global market. It is also right for U.S. banks to raise concerns about incremental advantages accruing to foreign bank competitors. There are also competitiveness concerns with having to enforce External Business Conduct requirements in circumstances where foreign dealers do not have to comply.

Given the complexity of the regulation, and the aforementioned risks to U.S. banks, it makes sense that delays be implemented if warranted by the implementation risks. Ideally one set of rules for U.S. and foreign banks will emerge.

As noted in the PwC Viewpoint on Dodd-Frank Derivatives we all need to keep a close eye on the politics of upcoming CFTC regulatory releases in order to prepare and implement a competitive Swap program.

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