The main U.S. swaps regulator may determine how much of a bank’s foreign trading activity will be subject to regulation under the Dodd-Frank Act based on whether the firm conducts the trades from branches or affiliates, according to people familiar with the discussions.
Gary Gensler, chairman of the Commodity Futures Trading Commission, may recommend to his fellow commissioners that regulators use the legal distinction between a branch and an affiliate as the basis for applying new derivatives rules to U.S. banks’ overseas trades with foreign customers, said the people, who asked not to be named because the discussions are private.
Branches would face more restrictions because they are legally part of the U.S. banking entity, the people said. Affiliates are often separately capitalized and could be overseen by overseas regulators if the agency considers the foreign country’s regulatory regime comparable, they said.
The debate over the reach of the U.S. financial-overhaul law is one of the most contentious aspects of the effort to bolster oversight of the derivatives market. The commission is seeking to prevent a repeat of the takeover of American International Group Inc. (AIG:US), which was seized by the U.S. government in 2008 after its London-based unit sold credit- default swaps on mortgage-backed securities with little U.S. oversight.
U.S. banks have said that Dodd-Frank rules will hurt their ability to compete with foreign-based rivals if the rules are applied to overseas offices. Banking lobbyists have argued that foreign supervision of their overseas arms and Federal Reserve oversight of the U.S. holding companies is sufficient to protect against risk to the financial system.
“These are international markets so the reach of Dodd Frank will have a very big impact on how the banks and their customers fare under these regulations,” said Craig Pirrong, a finance professor at the University of Houston. European and Asian regulatory decisions will be important to the final shape of the rules, Pirrong added.
Steve Adamske, a CFTC spokesman, declined to comment. The CFTC will release its decision as proposed interpretive guidance, which will go through a public-comment period before a final vote is required to pass the measures, the people said. Gensler has been working with CFTC staff on the proposal and is close to sharing it with the four other commissioners, one of the people said.
The five largest U.S. financial firms organize their overseas operations differently. JPMorgan Chase & Co. (JPM:US), Citigroup Inc. (C:US) and Bank of America Corp. (BAC:US) conduct foreign swaps trading through branches, according to bank representatives. Morgan Stanley operates most of its overseas trading through affiliates, according to a person familiar with the situation. Michael DuVally, a Goldman Sachs Group Inc. (GS:US) spokesman, refused to say how the bank conducts its overseas swaps business.
Those five banking holding companies account for 95 percent of the $304 trillion in notional amount in the American market, according to the Office of the Comptroller of the Currency. Globally, the notional amount of over-the-counter derivatives is estimated at $708 trillion, according to the Bank for International Settlements in Basel, Switzerland.
Citigroup’s “foreign activity is conducted through a combination of branches and affiliates,” Scott Helfman, a spokesman, said in an e-mailed statement. He declined to comment on the CFTC debate. Justin Perras, a JPMorgan spokesman, DuVally of Goldman Sachs, John Yiannacopoulos, a Bank of America spokesman, and Morgan Stanley (MS:US)’s Mary Claire Delaney declined to comment.
Branches versus Affiliates
Pirrong said the distinction between branches and affiliates could be a challenge to implement.
“There’s a continuum of relationships between affiliates and parent,” Pirrong said, referring to parent companies. “Drawing bright lines between them is difficult.”
Global regulators have been meeting to reach consensus on new standards for clearing, capital and margin for derivatives in an effort to prevent banks from exploiting regulatory differences. Gensler said May 2 that the CFTC may institute a system of so-called substituted compliance, in which U.S. regulators would determine if overseas rules are sufficient to comply with Dodd-Frank. If an overseas jurisdiction doesn’t have comparable regulation, the CFTC wouldn’t allow the substituted compliance, Gensler said at the International Swaps and Derivatives Association Inc.’s annual meeting.
‘Skirting’ the Law
“If your question is, ‘Can two U.S. parties go to some jurisdiction that doesn’t have an execution requirement to skirt around the law,’ then the answer would be no -- until you find good lawyers to skirt around it,” he said.
A related question to how U.S. bank affiliates would fare under Dodd Frank involves what parts of the law to apply to their activity, the people said. Gensler is considering two options, they said.
The first option would be to apply the rules meant for bank-holding companies, such as capital that must be set aside against the size of the swaps-trading portfolio, the people said. The second option would be to apply transaction rules, including requirements that most swaps must be processed with clearinghouses which require margin to back the trades and be traded on exchanges or similar electronic systems, they said.
In March, the House Financial Services Committee approved a bill that would limit the CFTC’s ability to apply its rules to foreign-based arms of U.S. banks when trading with overseas clients. The House has yet to schedule a vote, and the Senate hasn’t considered similar legislation.
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