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The Ongoing Congressional Assault On International Derivatives Regulation

Gary Gensler, Chairman of the US Commodity Futures Trading CommissionThe massive and lavishly funded opposition to reasonable financial reform still wages a multi-front war to preserve the risk-oriented business model that produced the financial crisis of 2008. The debacle at JP Morgan Chase involving billions of dollars of trading losses from a trading strategy that was billed as “risk reducing hedging” tells us that nothing has changed in the banks’ approach to the markets and the consequent perils to the public’s welfare.

A central tactic of the banking lobby is to procure amendments to the Dodd-Frank Act that bear innocuous titles, but in reality gut reform, allowing business as usual to continue. These amendments originate in the Republican-dominated House in which a majority for passage is assured. The lobby then leans on individual Democratic Representatives and Senators, often through constituent business interests, taking advantage of election year pressures. The Administration, through Treasury Secretary Geithner, has resisted these proposals, but the risk that some become law because of targeted Democratic support is real.

Two bills are particularly insidious. Under the Dodd-Frank Act, the Commodity Futures Trading Commission has broad extraterritorial jurisdiction to regulate derivatives trading. The CFTC is permitted to regulate offshore activities that “have direct and significant connection with activities in, or effect on, the commerce of the United States.” The SEC has a different, and perhaps narrower, jurisdiction, but the vast majority of derivatives are under the purview of the CFTC. Through this provision, the CFTC has the power to oversee the derivatives trading of, for example, the London operations of US banks. Having experienced the nightmarish windup of the 2,854 Lehman subsidiaries and witnessed the effects on JP Morgan Chase from its London operation, the consequences of foreign derivatives trading on domestic too-big-to-fail banks is indisputable.

Nevertheless, the House has passed a bill titled the Swap Jurisdiction Certainty Act (HR 3283) that would exempt derivatives transacted by offshore operations from regulation so long as the trades are recorded at swap data repositories after the fact. As a practical matter, oversight would be impossible because the regulators would be limited to divining the implications of impossibly complex strategies implemented under rules of foreign jurisdictions. Just consider the “London Whale’s” so-called “hedging” operation that is still bleeding JP Morgan Chase of billions of dollars because it cannot be unwound.

The companion bill is HR 2779 that would exempt inter-affiliate derivatives from regulation. The bills together would allow a bank to set up a foreign derivatives trading affiliate in a jurisdiction with lax regulation and enter into inter-affiliate swaps that transfer the risks and rewards of the affiliate’s transactions back to the US parent. The entire arrangement would escape US regulation. A bank could shop for the least onerous regulation and substantively transact at the US parent level using an inter-affiliate swap. All regulation would be based on the least common denominator, encouraging jurisdictions to impose weak rules to accommodate regulatory evasion.

This is in no way an abstract concern. Lehman routinely swept cash from subsidiaries on a daily basis, relocating profits and losses back to the parent. By doing so, transmission of a problem in one affiliate throughout the organization was guaranteed, as funds were trapped in individual corporate entities that become insolvent. There is little doubt that this is a common practice among banks today.

These bills would eviscerate the financial reform initiatives in the US and in other jurisdictions. CFTC Chairman Gary Gensler has warned of the dire consequences of enacting them into law, pointing out that the legislation “would lead to vast parts of the swaps market not coming under reform.  It would substantially reduce transparency and increase risk to our financial system and the economy.” The bills may seem innocuous to members of Congress based on a superficial understanding, and a vote in favor may please some whose support may aid in an election, but the increased risk of a calamitous financial crisis is real.

The regulatory agencies must be allowed to complete implementation of Dodd-Frank. The CFTC can work with its international colleagues to establish a system that properly regulates the $60 trillion global derivatives market. But if the agency does not have jurisdiction over foreign operations (even jurisdiction that the agency forebears from exerting in exchange for robust local regulation), negotiation to establish a system free of regulatory arbitrage opportunities will be impossible. These proposals, along with several that threaten other important reforms, must be stopped.