This week marks an important step forward in the implementation of financial reform. On Monday, the U.S. became the first country in the world to require mandatory clearing of many derivatives contracts, a crucial protection in these previously unregulated markets.
But even as this crucial protection takes effect, Wall Street is mobilizing to create a back door escape route. Its goal is to prevent U.S. regulation of derivatives transactions by U.S. companies that are conducted overseas.
This loophole could strike at the foundations of financial reform. Almost every major financial scandal involving derivatives – from the collapse of Long Term Capital Management's Cayman Island operations in the 1990s, to the bailout of AIG's London-based trades in 2008, to JP Morgan's recent "London Whale" trading losses – has involved derivatives transactions conducted through a foreign entity. Wall Street banks routinely transact more than half their derivatives through foreign subsidiaries. Through numerous avenues, including an important Congressional vote today, Wall Street is trying to create an “extraterritorial” loophole in derivatives regulation.
Derivatives are essentially bets on future financial moves. Prior to the crisis, the massive markets in derivatives (over $300 trillion in notional value in the U.S. alone) were essentially unregulated, and conducted as simple contracts between any two financial firms. There was almost no public transparency or regulatory oversight of firms' derivatives books, and no assurances that firms could deliver on the bets they made. This was a major contributor to the financial collapse.
The Dodd-Frank financial reform law of 2010 brought these markets under regulatory oversight for the first time. Although implementation of the rules has been greatly delayed by heavy industry opposition, we are finally beginning to see some progress. As of Monday, the Commodity Futures Trading Commission requires most U.S. derivatives transactions to be conducted through centralized clearinghouses. Clearinghouses specialize in risk management and guarantee performance of the contract. Future regulatory actions should bring close to 90 percent of the market under mandatory clearing.
Wall Street lobbyists are pushing hard to undermine this progress by exempting foreign transactions. If they succeed, entities nominally based in foreign countries but active in U.S. derivatives markets will not have to comply with U.S. derivatives rules. This could potentially include foreign subsidiaries of U.S. banks, the numerous U.S. hedge funds incorporated in places like the Cayman Islands and subsidiaries of major foreign banks that are major dealers in the U.S. markets. Because derivatives markets are global and conducted electronically, a click on a computer keyboard is all it takes for a major bank to route any transaction through a non-U.S. subsidiary. But the risk can still return to impact the U.S. economy.
Industry opponents claim that the rules of foreign countries will protect us in these cases. But no country in the world is as advanced as the U.S. in regulating its derivatives markets. While the U.S. is actively bringing derivatives regulations on line, key elements of oversight are still at least a year away in Europe and elsewhere. And permitting foreign regulation to govern U.S. derivatives transactions would be dangerous in any case. It would create an incentive for global banks to transact their business through whatever jurisdiction has the weakest regulations – a "regulatory haven" to match the tax havens that international corporations already use.
Multiple efforts are underway to undermine international derivatives rules. In Congress, the House will vote today on HR 1256, a bill that would sharply limit the jurisdiction of U.S. derivatives regulators over transactions conducted in foreign markets. This bill is likely to pass the House, having gained the support of a large majority of the Financial Services Committee – but it's still important for pro-reform forces to register opposition. There should be more resistance in the Senate, where six Senators led by Sen. Sherrod Brown, D-Ohio, recently sent a strong letter to regulators supporting effective international regulation of derivatives markets.
At the same time, both Wall Street and foreign regulators are pressing the Commodity Futures Trading Commission to step back from enforcing its rules overseas. The CFTC is scheduled to begin enforcement next month, on July 12, but industry is pushing for additional and perhaps indefinite further delays. While current CFTC chairman Gary Gensler is a strong supporter of effective regulation, other commissioners, led by Scott O'Malia, favor more delay.
Finally, industry and (astoundingly) some members of Congress are seeking to renegotiate U.S. financial regulations through secretive international trade negotiations, which could allow numerous new international exemptions to be added without any public accountability or oversight.
It's crucial that these efforts do not succeed. After years of work to implement basic safeguards in the massive shadow markets that crashed the global economy, we can't let Wall Street sidestep these protections simply by taking its business overseas.
Marcus Stanley is policy director of Americans for Financial Reform, a coalition of more than 250 civil rights, consumer, labor, business, investor and other groups working for a strong, stable and ethical financial system.