Derivatives Jurisdiction: Victory or Defeat?

This morning, several media outlets rushed to report that Commodity Futures Trading Commission Chairman Gary Gensler had lost his battle to secure robust rules governing the international exercise of the Commission’s jurisdiction to govern derivatives. The story went that the final Guidance and Exemptive Order, adopted this morning, constituted a major loss for the Chairman and advocates of reform. These journalists did not wait for the actual meeting to occur, much less take the time to review the actual text.

These reports were simply wrong (and Dewey did not defeat Truman). First of all, they misinterpreted the substantive Guidance itself. In fact, there was no way they could have gotten it right. The Guidance and Exemptive Order appear to be filled with language that gives political cover to multiple interested parties, but do not have the grave consequences that the media reports assumed. Further, the details of the Guidance and Exemptive Order, hundreds of pages of dense bureaucratic text, cannot be fully understood without seeing the text, which will be released next week.

But even worse, the measure of Gensler’s success could not be determined by counting up the changes that went into the final document compared to the proposed Guidance. His strategy was far more nuanced for that.

Today was the expiration day for an interim Exemptive Order delaying the effectiveness of the CFTC’s regulation of extra-territorial derivatives transactions. Derivatives are by far the largest and riskiest sector of the financial market and they can be transacted throughout the world. The scope of US jurisdiction is a vitally important issue. Gensler recently told a roomful of bankers lobbying him on the rule: “Guys, I am one of you. But you’re asking us to repeal Dodd-Frank. We’re not going to do this.”

To hear some tell it, this deadline loomed as a regulatory “cliff” since, by its terms, the Dodd-Frank Act derivatives provisions cover all activity that affects US commerce, with no concern for borders. No doubt, many derivatives involving a trader sitting in London and one sitting in Frankfurt would be within the scope of the Dodd-Frank language.

This was no drafting error. AIG, the London Whale and many other financial foibles illustrate that it no longer matters if the perpetrators of misdeeds and mistakes sit at desks in the City of London and light their cigars with hundred Euro notes when the losses are destined to come home to the USA. Congress was wise to leave it to the likes of Mr. Gensler to negotiate a seamless international regulatory regime with foreign regulators or, failing that, make sure that US rules apply everywhere.

Gensler had a choice: he could have allowed a further delay, during which the powerful bank lobby would have further undermine the strength of draft rules. In this political fight, time was on the side of the banks who had allied with the international regulators, primarily the Europeans. They are substantially behind the pace of the CFTC in finalizing rules, leaving them at a disadvantage in negotiations with the Americans.

Instead, Gensler called the bluff of the international banking community and the Eurocrats by being willing to let the existing Exemptive Order expire. If this happened, every rule adopted by the CFTC so far will apply to every derivative in the world that affects US commerce. And in the global financial market, this is means many derivatives would have been immediately covered.

Gensler decided that the way to get the best deal possible was to use that leverage to precipitate a final action. He negotiated hard, giving concessions to the Europeans and fellow Commissioners to get an agreement. It appears that the result was not perfect for reform advocates, but it was the best that could be achieved now. And that was what Gensler’s strategy was all about.

In fact, it just may be that when the final text is released next week, the concessions prove to be more form than substance. At a minimum, it establishes the principle that the thousands of US bank affiliates and branches around the globe are subject to CFTC jurisdiction and that hedge funds and banks cannot simply form a company in a place like the Cayman Islands to evade regulation.  

Gensler’s term expires in December and he has been so effective at regulating the derivatives markets that he could never be confirmed by the Senate if he were reappointed. Gensler will certainly leave the chairmanship soon. Was this brinksmanship the irrational act of a petulant man who feels unappreciated? Recently departed Commissioner Jill Sommers, a Republican appointee, said “no one has ever accused Gary Gensler of being reasonable.”

I beg to differ. The Chairman acted with steely determination and searing rationality. Chairman Gensler may be crazy, but his craziness is of the fox variety.