Lawbitrage

It's the Comparability, Stupid: What Really Matters for Overseas Derivatives Regulation

As financial market regulators seek to coordinate their post-financial crisis reforms, a contentious question is to what extent one nation's regulations apply to companies in other countries. The general principle under the Dodd-Frank Act is that U.S. derivatives (swaps) regulation only applies to transactions that have a significant connection or effect on the U.S.

Much of the debate surrounding the Commodity Futures Trading Commission's (CFTC) regulation of cross-border swaps transactions has centered around which firms are subject to U.S. regulation either because they fall under the definition of a "U.S. person" or because they engage in transactions with U.S. firms. The key worries underlying these debates are subjecting foreign firms to onerous and duplicative U.S. regulation, and whether doing so will undermine the ability of U.S. firms to do business internationally.

But there's a good possibility that the content of U.S. regulation and concerns about who is ensnared by U.S. regulation will eventually become irrelevant to overseas firms.

This is because CFTC regulations do not apply to foreign firms if the CFTC determines that the foreign country's regulations are comparable to its own. On December 20, 2013, the CFTC determined that the swaps regulations of six non-U.S. jurisdictions (Australia, Canada, the European Union, Hong Kong, Japan, and Switzerland) were comparable. This means that firms in those six jurisdictions that would otherwise be subject to U.S. law because of their trades with U.S. firms are now exempt. 

The only thing preventing non-U.S. firms in those six jurisdictions from never having to worry about compliance with U.S. regulation is that the CFTC limited its comparability assessments to only a portion of its derivatives regime. As the law firm Sullivan and Cromwell observed, "[i]t is notable that the CFTC has not made any comparability determinations with respect to the CFTC’s mandatory clearing...trade-execution requirements...[and] margining for uncleared swaps."

The reason that the CFTC's failure to make comparability determinations in those areas is notable is because doing so would likely result in the vast majority of non-U.S. firms not being required to comply with the core requirements of U.S. derivatives regulation; namely, mandatory clearing and trade-execution for all swaps transactions, and lots of collateral for any exempted (uncleared) swaps. 

The possibility that the CFTC will ultimately make comparability assessments in the areas it has not done so is a good one. Right now, the CFTC's approach is piecemeal and fails to comport with the approach widely agreed upon by international financial regulators, including the Securities and Exchange Commission.

Over time, market participants will likely convince regulators to remove duplicative regulations among otherwise equivalent regulatory regimes. When that happens, the more important issue will be what derivatives regimes are considered comparable to those that are already recognized as a comparable to one another, and not the specific rules of any regime or the risk of being subject to a foreign jurisdiction's regulations.

Report by Americans for Financial Reform and the Roosevelt Institute Disappoints on Derivatives

A new report released yesterday by Americans for Financial Reform and the Roosevelt Institute offers a wide ranging analysis of the status of financial regulatory reform.

Without having read the entire report, it seems like a good overview of persistent issues in financial reform such as capital regulation and regulatory enforcement. As the title of the report--An Unfinished Mission: Making Wall Street Work For Us--suggests, the authors view much work still to be done in making financial markets safe and fair.

Over-the-counter (OTC) derivatives (or swaps) are the focus of the report's first chapter, by MIT financial economist John Parsons. Unfortunately, Parsons makes two fundamental mistakes that undermine his entire analysis.

Overgeneralizing

Parsons paints with too broad of a brush when he generalizes from the disastrous use of a specific kind of derivative by American International Group (AIG) to the derivatives market generally. According to Parsons, AIG's collapse "[m]ore than any other single event...provides...clarity behind the need to regulate the [entire] derivatives market."

But the collapse of AIG shows no such thing. AIG collapsed because it took on too much risk with credit default swaps (CDSs) written on mortgage-related securities. When the market value of those securities fell, AIG was unable to meet the ensuing collateral calls. But even at their peak, mortgage-related CDSs at most accounted for 20% of the CDS market, and a tiny fraction of the unregulated swaps market overall. This is important because CDSs and other unregulated swaps not tied to the mortgage market--including CDSs referencing bonds and interest rate swaps--performed well during the financial crisis and were not a source of instability.

So while a lack of regulation may have enabled AIG's derivatives disaster, it certainly did not cause it. To the contrary, the derivatives that helped bring down the system were part of broader governance failures throughout credit risk transfer markets.

Regulatory Reform Isn't a Straight Path

Much of Parsons' chapter reviews the widely accepted goals of derivatives reform and laments the lack of progress in meeting them. These goals consist of universal oversight, transparency, and central clearing. To reformers like Parsons, the hardest part of reform is implementation, not design.

But it's hardly clear what a properly regulated derivatives market looks like. For example, it's not obvious that swaps should be generally cleared by central counterparties. Moving swaps to clearinghouses creates a new class of "too big to fail" entities that may take on excessive risk due to implicit government subsidies or poor regulation. It is also unclear to what extent centralized clearing is a better form of risk management. Central clearing may, among other negative consequences, reduce the efficiency of netting out risk exposures.

Even when it comes to the broad goal of reducing systemic risk, it's remarkably easy to take one step forward and two steps back. Proponents of reform should be more sensitive to that.

 

When Market Discipline Strikes Back

Prior to the financial crisis, banking institutions exercised tight discipline over hedge funds. Prime brokers to hedge funds, while certainly interested in attracting hedge fund clients by offering credit on terms better than their competitors, nevertheless were exacting in their lending and other exposures to the funds. As noted by the Government Accountability Office in 2008:

To control their risk exposures, creditors and counterparties to generally large hedge funds told us that, unlike in the late 1990s, they now conduct more extensive due diligence and ongoing monitoring of a hedge fund client....Creditors and counterparties of large hedge funds use their own internal rating and credit or counterparty risk management process and may require additional collateral from hedge funds as a buffer against increased risk exposure....

Creditors and counterparties told us they currently establish credit terms partly based on the scope and depth of information that hedge funds are willing to provide, the willingness of the fund managers to answer questions during on-site visits, and the assessment of the hedge fund’s risk exposure and capacity to manage risk. If approved, the hedge fund receives a credit rating and a line of credit. Several prime brokers told us that losses from hedge fund clients were extremely rare due to the asset-based lending they provided such funds. Also, one prime broker noted that during the course of its monitoring the risk profile of a hedge fund client, it noticed that the hedge fund manager was taking what the broker considered to be excessive risk, and requested additional information on the fund’s activity. The client did not comply with the prime broker’s request for additional information, and the prime broker terminated the relationship with the client.

As a result, hedge fund leverage from prime brokers before the financial crisis was not particularly high; and it is even lower now. Over-the-counter derivatives dealers also kept hedge fund counterparties on a short leash by requiring the funds to post so much collateral that their derivatives exposures were more than fully collateralized.

But now, and since the financial crisis, it is hedge funds that are exercising discipline over banks. FT Alplhaville's Lisa Pollack notes

[t]hat hedge fund clients get itchy feet far easier these days, and that some of them look at the credit default swap spreads of their counterparties when deciding whether to stick with them or get out of dodge.

And from an earlier post with Tracy Alloway:

Bankers at relatively healthy financial institutions describe how clients have been seeking to turn over their prime broker relations to stronger lenders. If they’ve been unable to do so – because they may have a myriad of assets and services linking them to their prime broker – these funds have found other ways to limit their counterparty risk.

But the phenomenon is broader than just hedge funds imposing discipline back on the banks that extend them credit. Financial institutions are also being more stringently monitored by their own short-term creditors, a development that Gillian Tett recently noted was fatal to MF Global:

The chain of events that sparked the broker’s demise appears to have started when it published its last set of quarterly accounts. As financial players perused that statement, using their flashy new monitoring systems, they spotted the brokers’ sovereign exposure – and started to worry about counterparty and liquidity risk.

Market discipline should be a two-way street when risks are reciprocal. Improving counterparty risk has taken on a new urgency since the financial crisis, and it is good to see some of that urgency being translated into practice.

 

Dodd-Frank Unlikely to Reach Foreign Shores

The Dodd-Frank Act does not apply extraterritorially, to activities outside the United States, unless those activities meet a threshold level of significance to the U.S. Under Section 722(d), for example, swaps regulation does not apply outside the U.S. except to activities that "have a direct and significant connection with activities in, or effect on, commerce of the United States."

Depending on how broadly regulators or courts interpret "direct and significant," a wide range of overseas transactions could be subject to Dodd-Frank. That could include, for example, requiring a European swaps dealer to abide by Dodd-Frank reporting, capital, margin, and business conduct standards if it enters into a swap with a U.S. institution. The problems with such an approach include subjecting non-U.S. institutions to duplicative or inconsistent regulation, and that doing so may make non-U.S. dealers reluctant to transact with U.S.-regulated institutions in the first place.

U.S. lawmakers recently took a significant step away from such a broad approach, however, by seeking to clarify and limit the extraterritoriality of Dodd-Frank swaps provisions in a bill, the Swap Jurisdiction Certainty Act.

With respect to extraterritoriality, the proposed bill would permit non-U.S. swaps dealers registered with the Commodities Futures Trading Commission (CFTC) to only comply with Dodd-Frank requirements with respect to their swaps with U.S. institutions, hence exempting them from complying with U.S. rules for their swaps with non-U.S. institutions. And even with respect to their swaps entered into with U.S. institutions, the bill would exempt registered non-U.S. swaps dealers from Dodd-Frank's capital requirements so long as their home country's regulations are comparable and the country is a Basel signatory.

Although the bill is in its early stages, it seems to reflect a growing acceptance of limiting Dodd-Frank's extraterritoriality as seen, for example, in recent remarks by CFTC Chairman Gary Gensler and in a number of comment letters on behalf of financial institutions to regulators. Importantly, the "mutual recognition" approach adopted by the bill (which allows complying with comparable non-U.S. regulation to substitute for complying with Dodd-Frank) will likely promote healthy regulatory competition.

Lawbitrage Links (11/9/11)

ISDA, swaps, and transnational private governance (SSRN).

The conflicts that undermine institutional investor stewardship (Simon Wong).

Volcker Rule too complicated (Paul Volcker).

Volcker Rule may limit non-investment grade bridge loans in the context of committed financings for acquisitions (Paul Hastings).

Consumer Financial Protection Bureau has a new model disclosure form for mortgage closings (CFPB).

House passes bill to increase Regulation A limit on  private capital raising from $5 million to $50 million (James Hamilton).