Why Derivatives Regulation Must be Global
I recently posted a piece about legislation pending in Congress that would restrict the extraterritorial jurisdiction of the Commodity Futures Trading Commission over the derivatives market. Chapter two of that story is the struggle of the CFTC Commissioners to provide formal guidance establishing the scope of its own jurisdiction under Dodd-Frank Act over activities taking place beyond the U.S. borders. The outcome is critically important. If banks can simply move their activities offshore, the regulation of derivatives directly affecting U.S. banks will most likely be widely avoided. This means that an important systemic threat to the economy will persist.
Extraterritorial jurisdiction is a difficult subject for two reasons. First, it seems perfectly sensible that activities outside of the U.S. would be the concern of local regulators, not a U.S. agency.
The second reason is that the first is absolutely nonsensical and poses a grave risk. There is nothing in all of finance that is less rooted to a physical location than the derivatives market. A derivative does not represent ownership of anything physical, not a company, not a home mortgage, not a barrel of oil. It is a contract between two parties requiring an exchange of cash on a future date in an amount that merely references the market price of an asset or an index. This business can be transacted wherever a computer can be connected to a communications system. To a bank, the only differences between one of its traders transacting in New York or in London involve matters such as taxes and regulations. Regardless of the location, that trader has the power to inflict enormous damage on the bank and the U.S. markets by engaging in risky behavior. (Dare I reference Jamie Dimon’s phrase, a “terrible, egregious mistake?”)
Which brings us to the subject of the London Whale, Bruno Iskil, and his colleagues in London. The Chief Investment Office of JP Morgan Chase, responsible for the debacle that lost $2-5 billion at last count, operates in New York, London and a few other locations. This group was designed to manage firm-wide risks and cash (referred to by the bank as “excess deposits”), but the trading activities were spread across the planet for reasons that have yet to be explained. The most obvious explanation is that it allowed JP Morgan Chase to arbitrage regulatory regimes. In any event, this strange organizational chart resulted in a London operation that pursued its risk-taking approach to managing risk over the objections of the larger New York Chief Investment Office and senior risk officers. It is true that the loss will not bring down the giant bank, but it is very significant both in its size and the larger message that risk controls at banks still do not work, almost four years after the onset of the financial crisis.
The CFTC Commissioners need to resist the financial services lobbyists who regularly present their view that what happens in London, Frankfurt. Tokyo and Hong Kong should be exempt from US regulation. If the CFTC fails to assert jurisdiction over the branches and affiliates of U.S. banks in these trading centers, the government will simply surrender the power to protect the public from threats to the U.S. financial system, at least as it relates to the dangerous $70 trillion per-year derivatives marketplace. Trading activities will migrate to the jurisdiction with the weakest regulatory regime. But there is no doubt that the damage from the next “terrible, egregious mistake” will wash up on our shores.
So London (or another financial center) will get the jobs and we will bear the risk. That’s a lousy trade if I ever saw one.
The regulators must not be deceived by legalistic sophistry on this point. Opponents of broad jurisdiction, and perhaps even well-meaning attorneys who generally support strong rules, may assert that any foreign operation must be either a division of a US bank or explicitly guaranteed by one if it is to be covered by US regulation. I have neither the expertise nor the inclination to engage in a hermeneutic inquiry into the need for a legally enforceable liability of the parent bank. This much is clear: a major international financial institution inevitably will be dragged into the insolvency of an affiliated organization. The Bear Sterns episode and similar situations make it clear that informal connections between the operations of a bank and its affiliates are just as dangerous as formal ones.
This is not an abstract concern. The major banks literally have thousands of operating subsidiaries, and they have developed complex and effective mechanisms for transferring the rewards and the related risks up the organizational chain. The statutory scope of jurisdiction encompasses activities that have “a direct and significant connection with activities in, or effect on, commerce of the United States.” This language is broad, but must not be narrowed because of intimidation and fear of legal challenge by the financial industry.
That challenge will come regardless of the CFTC’s interpretation. The banks will not be appeased by a narrow approach to jurisdiction.