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Did The CFTC Do The Right Thing With EC Swaps Deal?

This article is more than 10 years old.

Gary Gensler (Getty Images via @daylife)

Is the CFTC’s recent deal with the European Commission on swaps regulation a bad deal? Recent press coverage maintained that outgoing CFTC Chairman Gary Gensler caved to the wishes of Europeans and big swap dealer banks. It’s not that bad. The CFTC got swaps with U.S. counterparties and hedge funds covered, and the European exemptive order will expire in December.

Some background is in order.

The premise of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is flawed. The premise was that derivatives could be made safe for the world by regulating them and clearing them.

The problem is that some derivatives are inherently unsafe and should be flat out banned. Naked credit default swaps should be banned. And as the Europeans are about to discover, a clearinghouse is just another undercapitalized, too-big-to-fail financial intermediary.

But Congress was convinced that derivatives are used for hedging. Most swaps aren’t used for hedging, which is exempt from regulation. Most swaps are bets made between systemically dangerous. banks and other big players.

It’s as though a bunch of investment bankers sat down at a sports bar and made million-dollar bets on the point spread in a Jets game. And then the taxpayer had to pick up the tab for the losing side.

That’s essentially what happened in the 2008 AIG bailout. Taxpayers paid 100 cents on the dollar to make good on bets that Goldman Sachs, Societe Generale and Deutsche Bank made with AIG’s London swaps desk.

Why are bailed-out zombie banks still allowed to deal derivatives? Because the Fed and the Treasury thought that they could use the considerable profits from this activity to grow their way out of the black holes on their balance sheets.

Grow their way out? Gee, doesn’t that sound the teensiest bit like Japan in 1992? The U.S. banking system is Japan in the 1990s with more capital and better marking. The European banking system is Japan in the 1990s, full stop.

The 19 largest U.S. banks make a lot of derivative bets with each other. These bets are, of course, speculation. The bailout would have been cheaper had the government nullified the bets the 19 had with each other, and changed the law to treat them as unenforceable gambling debts. Not only did the government not do that, but Dodd-Frank prohibits the application of state gambling laws.

Four of the five largest derivatives dealers doing business in the United States are American: JP Morgan (the largest by a wide margin), Goldman Sachs, Citigroup, and Bank of America Merrill Lynch. The fifth is Deutsche Bank, which is in the process of shrinking its balance sheet to comply with Basel III.

Derivatives dealers don’t want to have expose their pricing to customers, and customers don’t want to have to put up margins. The CFTC is investigating price-fixing for interest rate swaps. The European Commission is pursuing the big dealers for fixing the prices of credit default swaps. But European squealing has let the same banks minimize U.S. regulation for a while.

These big dealers do their swaps business out of London. Over-the-counter swaps are frequently collateralized, and London has been the preferred location for the swap dealing operations of U.S. banks because rehypothecation of collateral is unlimited. Five years after the meltdown began, British regulators are still talking about whether to limit rehypothecation.

All the monkey business blowing back to the United States came out of London, and still does—nearly $700 trillion in notional amount of swaps is outstanding (trillion is not a misprint). Then the CFTC should regulate the incoming mischief from London branches of U.S. banks. But the CFTC’s recent exemptive order to reduce regulation was a big concession to European regulators.

“If the CFTC doesn't get this right and do the right thing, future financial crises are much more likely and future bailouts funded by U.S. taxpayers are much more likely as well.” Better Markets argued, noting that the U.S. government bailed out the world in 2008, while foreign regulators failed to protect their taxpayers and treasuries.

The CFTC deal with the Europeans on London branches of U.S. banks is better than it could have been.

“The nature of modern finance is that financial institutions commonly set up hundreds, if not thousands of legal entities around the globe. In fact the U.S.'s largest banks each have somewhere between 2-and-3,000 legal entities around the globe. Some of them have hundreds of them just in the Cayman Islands alone,” Gensler said at the July 12 public meeting to approve the exemptive order for Europe.

JP Morgan uses a branch in London. Goldman and Bank of America Merrill Lynch use separately incorporated subsidiaries. Legally, a branch is part of its parent. A subsidiary has a separate legal personality. Financially, there is no difference. The U.S. bank—and implicitly the U.S. taxpayer—is on the hook.

If a branch is legally and functionally part of the parent bank, shouldn’t it be subject to regulation applicable to the parent? Branches are part of their parent banks only for purposes of CFTC swap dealer registration.

The banks did not achieve the carte blanche for their London operations that they wanted. Although branches would be eligible for local regulation for some transactional rules, the CFTC would retain jurisdiction on other important aspects of regulation.

The deal made with the Europeans is called “substituted compliance,” which rests CFTC approval of European regulation as equivalent. For areas in which there is no rule or the CFTC judges the rule to be insufficient, substituted compliance says that the relevant CFTC rule applies. Thus American rules act as a backstop.

It should be acknowledged that underlying the complaints about the substituted compliance is the view that Europeans would not do as good a job regulating derivatives as the re-energized CFTC. But substituted compliance is not presumed. It does require a CFTC analysis of the other country’s rules. It will not be a line-by-line analysis, but rather a category analysis.

Moreover, the European exemptive order expires December 21, during which period the CFTC will have to analyze European rules. It’s not clear that the six-month exemptive period is enough time to analyze foreign rules that may themselves not be fully developed. There will be political pressure to find equivalence. After expiration, however, the CFTC may have to assert oversight over swaps on some large European derivatives markets.

The exemptive order and accompanying no-action letters mean that London branches of U.S. banks are temporarily excused from transactional requirements only when dealing with purely foreign counterparties. U.S.-managed hedge funds resident in the Caymans would be considered U.S. persons for this purpose, so swaps with them would be CFTC regulated.

London branches of U.S. banks dealing with foreign counterparties are not excused from clearing, recordkeeping and trade execution requirements. A CFTC no-action letter, which can be retracted, lets them clear and execute swaps on 16 foreign boards of trade.

To be eligible for substituted compliance, European branches of U.S. banks must be the bona fide obligors on swap contracts. Turns out that the bona fide inquiry is a fig leaf that asks whether overpaid bankers in London negotiated the contract rather than overpaid bankers in New York.

Under the CFTC interpretive guidance that accompanied the exemptive order, any derivatives with a U.S. counterparty are subject to CFTC transactional requirements. U.S.–managed hedge funds will be considered U.S. persons for this purpose. The CFTC interpretive guidance is a blueprint for future regulations.

Trouble is that the risk can come back to the United States even when the parties to a swap are arguably foreign and foreign-regulated. Under the CFTC exemptive order, London branches of U.S. banks are allowed to have local regulation of swaps with other London branches of U.S. banks and with purely foreign counterparties, even though the risk of those contracts is clearly borne by their parent U.S. dealer banks.

“Foreign subsidiaries of U.S. entities will still be permitted to escape Dodd-Frank jurisdiction altogether for an inappropriately broad range of transactions,” said Americans for Financial Reform.

Some big U.S. swap dealers operate through London subsidiaries. Such a subsidiary could not function without a parent guarantee. But the exemptive order’s treatment of these dangerous instrumentalities is indulgent.

If one of these guaranteed affiliates of a U.S. bank entered a swap with a U.S. counterparty, it would be eligible for substitute compliance--despite the risk residing in the U.S. parent. And if it entered a swap with a purely foreign counterparty, it would only be subject to local regulation—not even substituted compliance.

The CFTC will regulate swaps issued by U.S. branches of big foreign banks like Deutsche and Barclays.

U.S. branches of foreign banks are treated as part of their parents for registration and transactional requirements. Although they would not be treated as separate U.S. persons, they would be regulated by the CFTC. This result is not obvious from the interpretive guidance.

It may have been better for foreign relations for the CFTC not to advertise its plans to regulate U.S. branches of big European swap dealers. But it’s there in footnote 513 of the interpretive guidance. Substituted compliance would not be available for U.S. activity of these branches. So if a U.S. branch of a foreign bank entered into a swap with a U.S. counterparty, it would be subject to CFTC regulation.

Advocates of letting the Europeans handle everything coming out of Europe whined that the CFTC gave with one hand and took back with the other. That reaction indicates that the CFTC must be doing something right. It retained the power to act should London swaps activity get out of hand again.