Responding to warnings from U.S. regulators that banks are finding ways around new curbs on financial risks, Wall Street is mobilizing to defend its latest tactic to keep overseas derivatives beyond the reach of U.S. rules.
The industry’s main lobbying group is prepping a strategy to explain why the new practice—removing guarantees from U.S. banks’ overseas trading—is a lawful response to the 2010 Dodd-Frank Act and not an effort to take advantage of a loophole, according to a two-page memo obtained by Bloomberg News.
The move “allows non-U.S. affiliates to compete on a level playing field with their foreign counterparts,” the Securities Industry and Financial Markets Association (Sifma) said in the unsigned memo. The association—which represents JPMorgan Chase & Co., Morgan Stanley, and other large U.S. swap-dealers—said the change is similar to “other steps that banks regularly take” in response to new regulations.
The memo, which hasn’t been released publicly, was drafted as a list of talking points for industry lobbyists to defend the practice in discussions with congressional lawmakers and regulators.
The industry campaign comes as regulators at the Commodity Futures Trading Commission (CFTC), Federal Deposit Insurance Corp. (FDIC), and Securities and Exchange Commission (SEC), as well as the top Democrat on the House Financial Services Committee, have expressed concerns that lifting guarantees might sidestep rules designed to limit risk in the financial system. Under Dodd-Frank, non-guaranteed affiliates must comply with fewer regulations than foreign branches and guaranteed affiliates of banks.
Sifma spokeswoman Carol Danko declined to comment on the memo. CFTC spokesman Steven Adamske also declined to comment.
U.S. regulators argue that losses suffered in overseas units could affect the stability of U.S. parent companies and the entire financial system.
Swaps, a type of derivative previously traded directly between banks and other firms, were largely unregulated prior to the 2008 financial crisis and were blamed for exacerbating it. Critics warn that without curbs on swaps trading overseas, U.S. taxpayers could face a repeat of 2008, when they had to rescue American International Group Inc. from billions of dollars in losses attributed to a London unit.
Dodd-Frank regulations are designed reduce risk by having most interest-rate, credit-default, and other swaps guaranteed at central clearinghouses that accept collateral from buyers and sellers. The rules also seek to increase price competition and transparency by having the transactions occur on new swap-execution facilities (Sefs) that must be open to all money managers and dealers.
U.S. regulators have faced a backlash from European and Asian authorities for extending their authority to trading done overseas. Wall Street lobbying organizations have sued the CFTC, the primary U.S. regulator of derivatives, to limit the international scope of the agency’s power.
Several U.S. agencies are examining the situation. The CFTC is reviewing the practice of de-guaranteeing to see if it violates anti-evasion provisions of Dodd-Frank, and the FDIC is monitoring the trades. At a meeting last week, three of five SEC commissioners expressed concerns about the tactic, with Democrat member Kara M. Stein saying it provides “an easy way to evade our rules.”
“Firms do not jettison them off to fend for themselves in times of crisis; they bail them out,” Stein said at the June 25 meeting, referring to overseas affiliates. “And that’s what we’re trying to deal with here—those risks flowing back to the United States.”
The Sifma memo seeks to dispute the notion that banks remain exposed to risks from the non-guaranteed trades. For example, banks have not replaced the guarantees with other support arrangements, according to the memo. Overseas units are separately capitalized and subject to supervision by local authorities, the memo said.
Removing guarantees “relieves U.S. parent entities from liability on obligations incurred by their non-U.S. affiliates and fully complies with the CFTC’s approach,” Randy Snook, Sifma’s executive vice president of business policies, said yesterday in an e-mailed statement.
The Sifma memo says that CFTC guidance on cross-border trading issued last year indicates that the test of a guarantee is whether a U.S. firm incurs risks on specific new trades, and “not whether the non-U.S. affiliate might have had U.S. guarantees in the past.”
“We had been warning for years about this loophole in the CFTC’s cross-border guidance,” Marcus Stanley, policy director for Americans for Financial Reform, a coalition including the AFL-CIO labor federation, said yesterday in a phone interview. “Now CFTC seems to be letting it become an exit-ramp from Dodd- Frank.”
In the Sifma memo, industry representatives say the de-guaranteeing “does not undermine the price transparency goals of Dodd-Frank” because the requirements are meant to provide bank clients with better pre-trade transparency.
“This rationale for mandatory Sef trading is not applicable to swaps between dealers, as dealers already have a high degree of pre-trade price transparency,” according to the memo.
As a result of the change in business, trades with non-U.S. participants are occurring off of the new Dodd-Frank swap-execution facilities because they are being done by the non-guaranteed subsidiaries, John Nixon, an executive at London-based ICAP Plc, the world’s largest inter-dealer broker, said at an advisory meeting of the CFTC on May 21.
(Bloomberg LP, parent of Bloomberg News, operates a swap-trading platform and swap data repository.)