While the U.S. Commodity Futures Trading Commission continues to work through a slate of swaps market reforms mandated by the Dodd-Frank Act, CFTC Chairman Gary Gensler sees an overseas threat that could undermine that process.
During a keynote address on Thursday at the Sandler O'Neill Global Exchange & Brokerage Conference in New York, an annual meeting of financial industry executives, Gensler said the CFTC has completed 33 of its required reforms and fewer than 20 are still pending. How these reforms are applied across borders is an area that, “if not handled appropriately could significantly undercut Dodd-Frank swaps market reforms.”
“Recent events at JPMorgan Chase are a stark reminder of how swaps traded overseas can quickly reverberate with losses coming back into the United States,” he said. “We've seen this movie before. Financial institutions set up hundreds, if not thousands of legal entities around the globe. During a default or crisis, risk inevitably comes crashing back onto our shores.”
AIG's subsidiary, AIG Financial Products, brought down the company and “nearly toppled the U.S. economy,” Gensler said. It was run out of London as a branch of a French-registered bank, though technically was organized in the United States.
Among Lehman Brothers' web of affiliates was Lehman Brothers International (Europe) in London.
“When Lehman failed, this London affiliate, with more than 130,000 outstanding swaps contracts, failed as well,” Gensler said. “Who stood behind these swaps contracts? The U.S. mother ship, Lehman Brothers Holdings, had guaranteed many of them.”
Citigroup set up numerous structured investment vehicles (SIVs) to move positions off their balance sheet for accounting purposes, as well as to lower their regulatory capital requirements. When the SIVs were about to fail, Citigroup in the U.S. assumed the debt, and “taxpayers later bore the brunt with two multi-billion dollar infusions,” he said. These SIVs were launched out of London and incorporated in the Cayman Islands.
Bear Stearns and Long-Term Capital Management both had failed hedge funds based in the Cayman Islands and, “yet again, the public assumed part of the burden.”
“There are many in the industry who want us to ignore these experiences,” Gensler said. “They might tell you that swap trades booked in London branches shouldn't be brought under Dodd-Frank reform. They might tell you that their affiliates guaranteed by their mother ship shouldn't come under [it]. They might tell you that their affiliates acting as conduits for swaps activity back here shouldn't be brought under Dodd-Frank reform. If we follow their comments, the result would be that American jobs and markets would move offshore but the risk would still be very much part of the activities of these U.S. financial institutions. Particularly in times of crisis, the risks would come back to affect our economy.”
Swaps market reform “should cover transactions not only with persons or entities operating in the U.S., but also with their overseas branches,” he said, adding that, “in the midst of a default or a crisis, there is no satisfactory way to really separate the risk of a bank and its branches.”
Commissioners are currently reviewing staff recommendations on the cross-border application of swaps market reforms.
On other regulatory fronts, Gensler highlighted a “crucial” need for public market transparency, which “helps shift information and access from dealers to the broader market.”
Transparency lowers the risk of the swaps market, “by allowing the public and users of swaps to see the pricing and volume of transactions, as well as many bids and offers, in real time,” Gensler said. Giving dealers and end users the ability to look to markets to value positions, allows for better supervision of and accounting for risk. Providing greater liquidity, “is particularly important when positions need to be unwound, either by a clearinghouse or a dealer facing a loss or default.”
Among the transparency reforms the CFTC has completed are those related to swap data repositories (SDRs), real-time reporting and designated contract markets (DCMs). SDRs will receive data on all swaps transactions. Four entities have thus far applied to become SDRs.
Swaps transaction data will be reported in real time to the public and to regulators starting this summer. It will begin with interest rate and credit default swaps (CDS) followed by similar reporting on other swaps later this year, Gensler said. The CFTC is hoping to complete rules for the block rule and swap execution facilities (SEFs) later this summer.
Central clearing exists in the swaps market, but on a voluntary, dealer-to-dealer basis. With reform, clearing will expand to include transactions between dealers and financial entities, Gensler said.
The CFTC has completed rules establishing derivatives clearing organization risk management requirements, the bulk of which went into effect last month. The remainder will become effective in November, including customer protection enhancements requiring clearinghouses to collect margin on a gross basis and the so-called “LSOC rule” (legal segregation with operational comingling) for swaps.
CFTC staff is currently preparing recommendations for public comment on clearing requirement determinations. The first determinations will be put out for public comment this summer and, according to plan, be completed this fall. They are likely to begin with standard interest rate swaps, as well as a number of CDS indices, Gensler said. His staff may propose a requirement for fixed-to-floating interest rate swaps, basis swaps, forward rate agreements, and overnight index swaps in four currencies: U.S. dollars, Euros, British pounds and Japanese yen.