SEC Extends Swaps Clampdown

U.S. banks' overseas swaps trades face new curbs under a U.S. Securities and Exchange Commission (SEC) plan adopted today, even as some members warned the regulation may not go far enough to rein in recent Wall Street efforts to escape the Dodd-Frank Act.

The SEC voted 5-0 to extend the agency's rules to transactions executed by foreign divisions of banks, including JPMorgan Chase & Co. and Goldman Sachs Group Inc., when the affiliate's trades are legally guaranteed by the parent company. The new rule comes as Wall Street has removed those guarantees to avoid Dodd-Frank Act regulations issued by another regulator, the Commodity Futures Trading Commission (CFTC).

“The recent financial crisis is replete with examples of firms rescuing their affiliates,” Commissioner Kara Stein said before the vote.“Firms do not jettison them off to fend for themselves in times of crisis; they bail them out.”

U.S. regulators have faced a backlash from European and Asian authorities for overreaching in their desire to apply Dodd-Frank rules overseas. Meanwhile, Wall Street lobbying organizations have sued the CFTC, which is the primary U.S. regulator of derivatives, to limit the international scope of the agency's power.

“The final rules and guidance have been substantially strengthened from our 2013 proposal to better protect the U.S. financial system from the risks that can be posed by security-based swap activity,” SEC Chair Mary Jo White said at a public meeting.

Cross-border application of U.S. derivatives rules is one of the most contentious features of Dodd-Frank, the regulatory expansion enacted after the 2008 credit crisis. The law gave the SEC authority over trading in equity and some credit-default swaps, about 5 percent of U.S. swaps, while the CFTC oversees the rest: swaps on interest rates, currencies, and credit indexes.

David Felsenthal, a New York-based partner at the Clifford Chance law firm, said the split oversight could cause problems for credit-default swaps.

“It will be very difficult if there is any inconsistency to try to mesh the two markets together,” Felsenthal said in a phone interview.

The SEC's final rules change its earlier approach to overseeing U.S. banks' overseas affiliates. Instead of exempting those entities from the rules, they will now come under the regulations when their overseas trades are guaranteed by a U.S. parent. A guarantee is “a legally enforceable right” that is “in whole or in part, oral or written, by contract or statute,” White said.

Rule Weakened

“To the extent that the new financial arrangements do not create a legally enforceable right of resource against a U.S. person, our rules may not bring these affiliates within our regulatory oversight,” White said.

The SEC also weakened the rules by not including a requirement to regulate swaps trades conducted in the U.S. by foreign banks and other overseas entities. The SEC said it would seek additional comment before adopting or rejecting the rule.

Critics of the SEC's approach faulted the agency last year for taking a different approach than the CFTC, which oversees about 95 percent of the U.S. swaps market. Others said the SEC's strategy would allow banks to escape regulation by moving more swaps deals offshore, which would raise the risk that an affiliate's collapse could harm the U.S. parent company.

Advocates of stricter regulation had urged the SEC to expand its authority over U.S. banks' swaps trading abroad. The agency should have broadened its definition of guaranteed trades to include those with the “implicit” backing of a U.S. parent company, according to groups such as Better Markets, a Washington-based non-profit that advocates for tougher financial regulation.

“They have seen how Wall Street has evaded the CFTC's rules since last July,” said Dennis Kelleher, president of Better Markets. “We have spent hours with the SEC staff discussing this and a straightforward solution: Directly prohibit de facto guarantees, Wall Street's latest tactic to avoid sensible and necessary rules.”

The Federal Deposit Insurance Corp., which regulates Wall Street banks, has said it is monitoring the move by banks to remove parent guarantees from affiliates or specific transactions so they can trade in the interdealer market free of many Dodd-Frank restrictions. The CFTC is reviewing the overseas changes and analyzing whether there is “evasive activity under way,” Commissioner Mark P. Wetjen said on May 14.

Market Fracturing

Under CFTC guidelines, overseas affiliates that lack a parent guarantee fall under fewer restrictions than do foreign branches or guaranteed affiliates of U.S. banks. As a result, the swaps market is fracturing, with trades in the U.S. falling under Dodd-Frank and trades elsewhere subject to local laws.

Trades with non-U.S. participants are occurring off of the new Dodd-Frank swap-execution facilities because they are being done by the non-guaranteed subsidiaries, John Nixon, an executive at London-based ICAP Plc, the world's largest interdealer broker, said at a CFTC advisory meeting on May 21.

The U.S. House voted 265-144 to approve legislation yesterday that would restrict the CFTC's ability to impose rules overseas, among other changes to the agency's authority over agriculture, energy, and financial markets.

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