Waiting for Uniform Derivatives Rules Is a Losing Proposition

Anybody who thinks the Commodity Futures Trading Commission has been dragging its feet in the Dodd-Frank rule writing process should look at how much commissioners' and staff members' time is taken up meeting with visitors.

From the beginning of this year until early June, CFTC commissioners and senior staff had 30 such meetings just on the topic of Dodd-Frank's cross-border implications, with a third of the meetings in the last 30 days. Thanks to the CFTC's transparency policy, the public can learn who comes to visit the CFTC.

Other than the advocacy group Better Markets, all the other CFTC visitors who have come to meet about cross-border issues have been financial institutions (including buy and sell side institutions as well as CME Group and LCH), financial lobbies or law firms such as Cleary Gottlieb, which visited twice in four business days. The CFTC has also held court for numerous foreign banks and lobbies such as Barclays, CIBC, and the Institute of International Bankers.

Given the meetings, congressional testimonies, presentations and reading of comment letters, it is impressive that the CFTC has completed 90% of the transparency and oversight rules for the swaps market. Yet, much of what the regulator has accomplished – in spite of outside lobbying and limited resources – could be significantly set back this summer as the debate heats up on Dodd-Frank's cross-border implications.

Besides the ongoing battle to increase capital and leverage requirements for large banks, reforming the $233 trillion over-the-counter derivatives markets is probably the most important and contentious component of the Dodd-Frank Act. The number of recent visitors to CFTC offices and comment letters show that a significant amount of money is at stake with the cross-border implications of Dodd-Frank's Title VII.

In June of last year, the CFTC issued for public comment a proposed interpretive guidance regarding the cross-border application of the swaps provisions of Dodd-Frank's Title VII. The CFTC also proposed a one-year transition period phasing in requirements for foreign swap dealers and foreign branches of U.S. swap dealers. In December, the CFTC finalized this transition period, which ends July 12 – a deadline that's fast approaching.

Dodd-Frank requires that all foreign or U.S. firms transacting with U.S. persons comply with derivatives market reform. This has been the case since the end of last year, when swap dealers began registering. Of particular interest to big financial firms, not just the banks, CFTC Chairman Gary Gensler has proposed that the definition of "U.S. person" in the final guidance must include offshore hedge funds and collective investment vehicles that are majority-owned by U.S. persons or that have their principal place of business in the United States.

Pressure from financial lobbies has intensified. On June 6, six financial domestic and international lobbying groups sent a letter to Chairman Gensler asking for an extension of the deadline until Jan. 12, 2014.

The lobbyists argue that until other countries all have uniform derivatives rules, the U.S. should not unilaterally impose derivatives clearing requirements on U.S. companies' branches offshore or foreign financial institutions here in the states. A few weeks ago the European Commission chastised the CFTC, essentially for moving quicker than other regulators on attempting to reform the global derivatives market. But if we have learned anything from the Basel Accord discussions which began in the early 1970s, countries' differing cultural traditions, legal frameworks, and points in the economic cycle make it impossible for everyone to craft, implement, and supervise a uniform regulatory framework simultaneously.

Another essential point Gensler has made is that financial institutions often book derivatives in multiple legal entities in the U.S. but also abroad. Bank of America, for example has more than 2,000 subsidiaries, with 38% of them in foreign jurisdictions. Bank of America books its derivatives not only in the U.S. but also in the U.K. and Ireland, among other foreign jurisdictions.

Importantly, due to banks' opacity, especially when it comes to derivatives, it is often difficult to discover parent guarantees for different subsidiaries. AIG, Citibank, and Lehman are recent examples of institutions where the U.S. parent was hurt by those firms' problems abroad. Lehman had 3,300 subsidiaries at the time that it declared bankruptcy; its London subsidiary had more than 130,000 outstanding swaps contracts, many of them guaranteed by Lehman Brothers Holdings, headquartered in the U.S.

Gensler wants Dodd-Frank requirements to cover swaps between non-U.S. swaps dealers and guaranteed affiliates of U.S. persons, as well as swaps between two guaranteed affiliates that are not swap dealers. The banks argue compliance with transaction requirements for these trades could come under comparable and comprehensive rules abroad, where they exist – what the CFTC calls "substituted compliance."

This means that if the CFTC believes a foreign regulator's derivatives rules are similar to U.S. rules, the U.S. would accept that regulator's supervision. I argued recently in a CME Group Education publication that, since other regulators may not have written their derivatives rules yet – and importantly, they may not all be conducting a risk-based supervision approach – "substituted compliance" may mean no compliance at all. JP Morgan's whale scandal, Citibank, AIG, Lehman, Bear Stearns, and Long Term Capital Management should have taught us by now that just because trades are booked offshore does not mean the risk stays offshore.

Unless we can find a way for foreign taxpayers to substitute our pocketbook if a derivatives implosion abroad comes back to haunt us, the CFTC and U.S. bank regulators must carry out their respective responsibilities to monitor derivatives activities and capital levels of U.S. branches abroad and foreign branches here.

"At some point in the future," Gensler warned in a recent speech, "someone will be calling the U.S. Treasury Secretary with bad news: a U.S. financial institution is failing under the weight of its overseas swaps business. And what else might he or she say? The public was on the losing end of the deal, in part, because the CFTC back in 2013 knowingly left offshore operations out of common-sense reform."

With any luck, Gensler will not suffer the same fate as his 1990s predecessor Brooksley Born, who repeatedly warned legislators and regulators that derivatives markets were interconnected globally and people could not understand them because of increasing volumes, complexity and lack of transparency. Her plea that the CFTC should regulate the growing OTC derivatives market was ignored, and we all know the devastating consequences.

Mayra Rodríguez Valladares is Managing Principal at MRV Associates, a New York based capital markets and financial regulatory consulting and training firm. She is also a faculty member at the New York Institute of Finance.