Derivatives Reform: A Day in the Life of the CFTC
By Mayra Rodriguez Valladares, MRV Associates
Originally published on TABB Forum
Reforming the global OTC derivatives market is one of the most critical aspects of reducing risk in the financial system, but harmonizing cross-border rules is proving a major challenge. As a key derivatives reform deadline approaches in the US, the pressure on the CFTC to delay and soften requirements on foreign entities has been intense.
“At some point in the future, someone will be calling the U.S. Treasury Secretary with bad news: A U.S. financial institution is failing under the weight of its overseas swaps business. And what else might he or she say? The public was on the losing end of the deal, in part, because the CFTC back in 2013 knowingly left offshore operations out of common-sense reform.”
–Chairman Gary Gensler’s Keynote Address on the Cross-border Application of Swaps Market Reform at Sandler O’Neill Conference, June 6, 2013
Reforming the $633 trillion global over-the-counter financial derivatives market is one of the most critical tools to end ‘Too Big to Fail.’ As a key July 12 derivatives reform deadline fast approaches in the US, the number of visitors and the amount of comment letters to the Commodity Futures Trading Commission from domestic and foreign financial institutions, lobbies, law firms, and corporations have risen dramatically.
Given that the monetary stakes are very high due to the cross-border implications of The Wall Street Reform and Consumer Protection Act’s (Dodd-Frank) Title VII, it is no surprise that CFTC Chairman Gary Gensler is having to compromise in light of strong opposition not only from banks, some US politicians, and European regulators, but also from most of his own commissioners. It is very likely that either the July 12 deadline will be extended at least six more months, or that foreign banks here in the US and US companies’ subsidiaries abroad may get lighter treatment in their OTC derivatives’ clearing and reporting requirements.
The US Derivatives Market
In the US alone, the $232 trillion notional OTC derivatives market represents billions in revenue for insured banks and savings and loans associations, especially disproportionately for the top four largest Significant Financial Institutions (SIFIs). Banks’ exchange traded derivatives represent only about 5% of their derivatives portfolios, with the overwhelming remainder being over-the-counter bilateral trades; 80% of OTC trades are interest rate swaps or options, which is why the CFTC focuses so much on trying to regulate these instruments.
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Note: $ millions
Source: OCC’s Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2013
An essential point that needs to be understood is that financial institutions may manage their derivatives portfolios in one location but often book their derivatives in multiple legal entities in the US and abroad. Bank of America, for example, has more than 2,000 subsidiaries, with 38% of them in foreign jurisdictions, especially the UK. Due to banks’ opacity, especially when it comes to financial derivatives, it is often very difficult to discover what type of parent guarantees exist for different subsidiaries. AIG, Citibank, and Lehman are recent examples of financial institutions where the US-headquartered parent was negatively impacted by those firms’ problems abroad. Lehman had 3,300 subsidiaries at the time that it declared bankruptcy, and its London subsidiary had more than 130,000 outstanding swaps contracts, many of them guaranteed by US-headquartered Lehman Brothers Holdings.
A US Person
In June 2012, the CFTC approved for public comment proposed interpretive guidance regarding the cross-border application of the swaps provisions of Dodd- Frank Title VII. The CFTC also proposed a one-year transition period phasing in requirements for foreign swap dealers and foreign branches of U.S. swap dealers; the transition ends this July 12.
Dodd-Frank requires that all foreign or U.S. firms transacting with U.S. persons are to comply with derivatives market reform. Chairman Gensler has proposed that the definition of “U.S. person” in the final guidance must include offshore hedge funds and collective investment vehicles that are majority-owned by U.S. persons or that have their principal place of business in the United States. Gensler has argued that Dodd-Frank requirements must cover swaps between non-U.S. swaps dealers and guaranteed affiliates of U.S. persons, as well as swaps between two guaranteed affiliates that are not swap dealers.
If you are not a fan of numerous meetings at work, then being a professional at the CFTC would be very challenging. In the first half of this year there have been hundreds of meetings with external visitors on various Dodd-Frank derivatives topics, of which the vast majoring have been about the cross-border implications of derivatives reform. Almost 90 different domestic and financial institutions, corporations, lobbies, and legal firms have paid about 125 visits to the CFTC to speak about cross-border issues, with a third of the visits occurring in June alone. It is important to remember that the visits to the CFTC are in addition to those paid to US congressional and state legislators, the bank agencies (the Federal Reserve, OCC, FDIC, and state bank regulators) and the SEC on this subject. Numerous other Dodd-Frank meetings under the heading ‘general’ have also taken place.
Given the meetings, presentations and reading of comments, it is actually impressive that the CFTC has completed 90% of the transparency and oversight rules for the swaps market. Yet much of what the CFTC has accomplished in spite of lobbying and working with limited financial resources will be significantly set back if, as looks likely, the July 12 deadline continues to be extended.
Other than financial sector reform groups, Better Markets and Americans for Financial Reform, all the other CFTC visitors who have come to meet about cross-border issues have been financial institutions (both buy- and sell-side institutions, as well as exchanges such as CME Group and LCH), financial lobbies, corporations (energy, automotive, industrial) or law firms. Most firms have come once or twice, but some have been very frequent visitors, such as the International Institute of Banks, which has visited the CFTC five times, and international law firm Clearly Gottlieb, which is by far the most frequent visitor, sometimes visiting twice in a day. How much is at stake is clear not only from the number and wide array of visitors, but also from the number of countries that they represent in addition to the United States, including Canada, France, Germany, Japan, Spain, Switzerland and the UK.
For the banks to transition from OTC to clearable derivatives is requiring a massive change in risk management culture, not to mention business strategy, and a significant overhaul of how data are collected, verified, and reported to comply with Dodd-Frank. Bank management have been very worried about the financial impact that transitioning derivatives portfolios will have on their profits, since they will have to learn to make money on volumes and not on the spread the way they do in the tailored OTC market.
Also, having derivatives go through a clearinghouse will mean that banks have to be able to post high-quality collateral at a time that multiple regulatory frameworks may make it challenging for banks to always have high-quality collateral at hand. This is particularly challenging for European banks and companies given the Eurozone’s fiscal woes. One need only look at the percent that UK, French, and German banks represent in their countries’ GDP to understand their incredible influence in the financial regulatory, and especially the derivatives, reform debate. This in part explains why European Commissioner for Internal Markets and Services Michael Barnier has intensified his critiques of the CFTC for essentially moving quicker than other regulators on attempting to reform the global derivatives market. In April, Barnier asked US Treasury Secretary Jack Lew for more implementation uniformity in derivatives rules between the US and Europe. In mid-June, Barnier took his message to a broad audience of business news readers.
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Source: Record of Meeting of the Federal Advisory Council and the Board of Governors May 17, 2013
Pressure from domestic and financial lobbies has intensified even more since the beginning of June, with numerous financial institutions and companies asking for an extension from July 12 until January 12, 2014. Their argument is that until other countries all have uniform derivatives rules, the US should not unilaterally impose derivatives clearing requirements on US company branches offshore or foreign financial institutions here in the US. They also argue that compliance with transaction requirements for swaps could come under comparable and comprehensive rules abroad, where they exist – or what is known as “substituted compliance.” Substituted compliance means that if the CFTC believes that a foreign regulator’s derivatives rules are similar to the US’s, then the US would accept that regulator’s supervision. Under the proposed guidance, foreign branches – like JPMorgan’s U.K. branch – may comply with Dodd-Frank through substituted compliance. The final guidance, however, must ensure that the definition of a foreign branch is bona fide and that the swap is actually entered into by that branch. This is to ensure financial institutions do not attempt to sidestep full compliance with reform through substituted compliance, which may not be identical to Dodd-Frank.
Given that other regulators may not have written all their derivatives rules yet, and importantly, they may not all be conducting a risk-based supervision approach, ‘substituted compliance’ may mean no compliance at all. Unless we can find a way for foreign taxpayers to be substituted for us if a derivatives implosion comes back to haunt us, the CFTC and US bank regulators must monitor US branches abroad and foreign branches here. JP Morgan’s whale scandal, Citibank, AIG, Lehman, Bear Stearns, and Long Term Capital Management should have taught us by now that just because trades are booked offshore does not mean that the risk stays offshore.