Wall Street, trying to preserve profits from swap trading in the face of tougher scrutiny from Washington, has found a new way to keep some of its overseas deals private. It’s called Footnote 513.
Banking lawyers have seized on the wording of the footnote, contained in an 84-page policy statement issued in July by the main U.S. regulator of derivatives. The largest banks told swap brokers in late September that the language means certain swaps still don’t fall under the agency’s new trading rules, according to three people briefed on the discussions.
London-based ICAP Plc, one of the largest swap brokers, told the banks it didn’t agree with their interpretation, said the people, who spoke on condition of anonymity because the discussions weren’t public. Other brokers accepted the banks’ position and have been trading billions of dollars in contracts outside the new regulatory system, the people said.
The deals in question include swaps for foreign clients that are arranged by U.S.-based traders or brokers and then booked through a U.S. bank’s overseas affiliate. Bank lawyers say that if the trade goes through an affiliate it can stay private and doesn’t need to be handled on one of the public electronic trading platforms approved by the Commodity Futures Trading Commission (CFTC), two people said.
Of the dozens of derivative rules being completed by the CFTC, the most contentious have involved how to oversee swaps traded across borders. The biggest banks sometimes trade half their swaps with overseas clients.
CFTC Chairman Gary Gensler has sought to extend U.S. authority to those transactions, arguing that the global nature of the 2008 credit crisis proved that American taxpayers could be at risk when banks book them in foreign units.
ICAP asked the CFTC to issue formal guidance on the debate over the footnote, three people briefed said. The CFTC hasn’t yet responded, in part because of the 16-day government shutdown over the budget.
Bart Chilton, one of the CFTC commissioners, said he favored having the agency publish new guidelines.
“I want to ensure everyone is playing according to the same rules, and regret the lack of clarity,” Chilton said in an interview.
Spokesmen for JPMorgan Chase & Co. and Goldman Sachs Group Inc., two of the biggest swap traders, declined to comment. Industry executives and attorneys who spoke on condition of anonymity said the banks aren’t using the footnote as a loophole to skirt the law. Rather, they are striving to interpret often-murky guidelines, and ICAP is the only major firm to push back on their position, they said.
In an interview, Gensler said he was aware of the controversy. While he declined to discuss the footnote, he said swap dealers must be careful how they interpret regulations. He said trades made in the U.S. are meant to fall under CFTC rules.
“If they’re taking on transactions in New York, or Chicago or Connecticut, then that’s activity related to U.S. commerce” that should be on a registered platform, Gensler said.
The electronic platforms, known as Swap Execution Facilities, or Sefs, were created by the 2010 Dodd-Frank law to make prices more public and reduce risk in the system. They started trading on Oct. 2. ICAP and more than a dozen other firms have registered Sefs with the CFTC, including GFI Group Inc., Tradeweb Markets LLC, MarketAxess Holdings Inc., and Bloomberg LP, parent of Bloomberg News.
Sef trading is off to a slow start as firms test the waters before the new rules become mandatory, according to a Goldman Sachs research report released yesterday. The bank’s analysts estimated that for interest-rate swaps, the biggest part of the overall market, only about one-sixth of the volume has been traded on Sefs.
Under the CFTC’s rules, most U.S. swaps will be required by early 2014 to trade on the platforms. The latest dust-up over Footnote 513 involves how a swap is determined to be a U.S.-related product.
The four-sentence footnote appears at the bottom of page 60 of the guidance the agency published in July to explain how the CFTC’s rules affect U.S.-based banks doing business overseas and foreign banks doing business in the U.S. Although the passage doesn’t deal directly with trading rules, the banks are using it to justify their trading methods.
The banks’ assertion is focused on what the footnote doesn’t say, rather than on what it does say. It mentions bank “branches"—which generally are part of the parent company—and not “affiliates,” which are considered legally separate.
The banking lawyers are taking the omission to mean that deals that are set up in the U.S. and are booked in their foreign affiliates can escape many CFTC rules, according to the people briefed on the conversations.
For example, under that interpretation traders at a New York-based bank could enter into a swap with a Japanese bank, using brokers also based in New York to set it up. As long as the deal is executed in the Wall Street bank’s London affiliate, it wouldn’t need to be traded on a Sef or fall under CFTC trading regulations.
ICAP’s position has been costing it business as banks take their swaps to brokers who agree with their interpretation of the footnote, the people briefed said. ICAP also is being cautious about CFTC rules after paying $65 million in September to settle an enforcement case with the agency over some of its brokers’ attempts to manipulate the Libor interest-rate benchmark, two people said.
Guy Taylor, a spokesman for ICAP, declined to comment.
The debate highlights a long-running dispute over the parity of swaps regulation in the U.S., Europe and Asia. Comparable trading rules haven’t been completed in European or Asian jurisdictions. The CFTC and foreign regulators also have been fighting over how much they will defer to each other’s requirements for trades that stretch across borders.
The overseas reach of the CFTC’s rules has been one of Gensler’s most common themes since he became chairman of the agency in 2009. In a June 6 speech, he reiterated that domestic or foreign swap dealers dealing with “U.S. persons” had to comply with Dodd-Frank rules to ensure that risk accumulated somewhere else doesn’t land back in the U.S.
“It was financial institutions operating complicated swaps businesses in offshore entities that nearly toppled the U.S. economy” in 2008, Gensler said.