SEC Extends U.S. Swaps Clampdown to Guaranteed Affiliates

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

The five-member SEC voted unanimously to extend the agency’s rules to transactions executed by foreign divisions of banks including JPMorgan Chase & Co. and Goldman Sachs Group Inc. when a unit’s trades are guaranteed by the parent company. The new rule comes as Wall Street has removed those guarantees to avoid Dodd-Frank regulations issued by another agency, the Commodity Futures Trading Commission.

“The recent financial crisis is replete with examples of firms rescuing their affiliates,” said Commissioner Kara M. Stein, who warned the rule may create a new loophole. “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 extending their authority to trading done overseas. Wall Street lobbying organizations have sued the CFTC, the primary U.S. regulator of derivatives, to limit the international scope of the agency’s power. U.S. regulators have argued that losses suffered in overseas units could affect the stability of the parent company.

Cross-Border Rules

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 about five percent of the U.S. swaps market, while the CFTC oversees the rest, including swaps on interest rates, currencies, and credit indexes.

The rules adopted today change the SEC’s initial approach to overseeing U.S. banks’ overseas activity. Instead of exempting the affiliates from the rules entirely, the SEC will apply its rules when the overseas trades are guaranteed by a U.S. parent.

The change is intended to prevent banks from avoiding new rules for swaps, a type of derivative which was largely unregulated before the crisis, by pushing most of their swaps trading to overseas units. Critics warn that otherwise, U.S. taxpayers could face a repeat of the 2008 crisis, when they had to rescue American International Group Inc. from billions of dollars in losses attributed to a London unit.

‘Substantially Strengthened’

“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.

At the same time, the change may not make much difference to the way swaps are traded now, since banks have already removed legal guarantees so that their transactions may take place beyond the authority of the SEC and CFTC.

White said that Dodd-Frank does not permit the agency to extend its jurisdiction further.

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

Stein said the agency should have considered how its rules could apply when a guarantee is implicit -- understood to exist but not outlined legally.

“Today the SEC is pretending we don’t have some of these tools so that we can justify adopting this particular rule in this particular form,” she said.

Implicit Guarantees

SEC General Counsel Anne Small said Dodd-Frank didn’t give the agency the legal authority to regulate overseas trades that have implicit guarantees. Stein, a former Senate aide who worked on the law, said she disagreed.

“Leaving de facto guaranteed foreign affiliates outside of US regulation invites Wall Street to game the rules and puts US taxpayers at risk of future bailouts when their foreign derivatives deals blow up, as they have done repeatedly in the past,” said Dennis Kelleher, president of Better Markets, a group that advocates stricter regulation of Wall Street.

While the rules announced today outline who will fall under the SEC’s framework, the agency didn’t adopt specific rules such as capital and margin requirements for swaps dealers. White said the SEC would next adopt rules affecting how swaps trades are reported to facilities that record the trades.

The SEC also postponed a separate provision of the overseas policy that was criticized by the financial industry. In its proposal last year, the agency said it would apply Dodd-Frank rules to trades conducted within the U.S. even if they are held by foreign banks or overseas entities. The SEC said today that it will seek additional comment from the public on the question.

(Bloomberg LP, parent of Bloomberg News, operates a swap-trading platform and swap data repository.)


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