My colleague Doug Terry and I have been discussion Footnote 513 to the Policy Statement appearing in the Federal Register for July 26, 2013. The large bank swap dealers have been interpreting Footnote 513 as a loophole to exempt a large proportion of their derivatives businesses from exchange requirements. As part of the Dodd-Frank law, there has been an ongoing effort to force more and more bank business onto exchanges where they can be tracked and monitored.
Banks are resisting because the standardization of exchange activity removes some of the profitability of the business – there is more profit potential in bespoke and OTC arrangements where contracts and business deals are not easily comparable. There are also reserve and capital issues at play, but profitability is by far the largest concern.
To show how far they are willing to go, these dealers have gotten positively Clintonian in their interpretation of 513. As written, the Footnote pertains to bank “branches”:
“Consistent with the foregoing rationale, the Commission takes the view that a U.S. branch of a non-U.S. swap dealer or MSP would be subject to Transaction-Level requirements, without substituted compliance available. As discussed above, a branch does not have a separate legal identity apart from its principal entity. Therefore, the Commission considers a U.S. branch of a non-U.S. swap dealer or non-U.S. MSP to be a non-U.S. person (just as the Commission considers a foreign branch of a U.S. person to be a U.S. person).”
What the banks are arguing, and I have to agree, is that the word “branch” is not the same as affiliate. Foreign affiliates, as separate companies, are thus not “branches”, and therefore Footnote 513’s language is too narrow. Under this interpretation, dealers are initiating trades with their US brokers, but booking or executing them through foreign-based affiliated subsidiaries to skirt the rule. Even though this “loophole” only applies to trades with foreign clients, the intent, as expressed by the CFTC, is to cover any trade that has any “US person” as a counterparty, including the example I just cited.
I think this demonstrates a couple of problems with regulations moving forward. First and primarily, they are far too complex, leading to this type of situation where a single word has an enormous impact. No doubt that is due to the nature of the business itself, but regulations should first be able to understand and handle such complexity before moving to codify and enforce in real world settings.
Second, banks will always resist these types of activities, but here they are given a cheap “victory” because complexity happens to fall in their favor. Like the 1990’s, US banks will always complain about regulatory asymmetry, where US rules are much more restrictive than foreign. Nowhere is that more evident than London/eurodollars. They will act and spend massive resources to make sure that any move toward regulatory symmetry ends up harmonizing in the foreign/less restrictive direction. If Deutsche Bank can do it, why can’t Goldman Sachs?
This is where regulation should at least attempt a firm stance. As long as regulation exists, it should either move entirely in one direction or the other – remove all regulations and let banks do whatever they want whenever they want, and only require full and honest transparency (however that might work), or drop the charade and regulate the hell out of them. The goal of regulation has to be a sound banking system, full stop, not this patchwork of various agencies all with their own agendas. Protecting banks is the priority, despite the lip service to the “public good.”
If foreign banks want to blow themselves up being utterly irresponsible, then let them. Make no mistake, that is the intention of every single large bank – to grow and expand as fast as possible, which requires inordinate levels of recklessness. Regulations should not aid them by providing cover; current regulations, like the Basel Rules, center around making risky behavior appear less risky. I cannot overstate that point or emphasize it enough. Again, either regulate them fully, or require full transparency.
If US banks had been prohibited from engaging in dubious activities, especially proprietary trading, when their foreign counterparts were on the verge of failure in 2008 they might have been in position to take full advantage rather than totter on the edge, lobbying for TBTF safeguards and bailouts. Sure, they would have whined about Credit Suisse during the housing bubble, but not when Credit Suisse was being carved up for the taking in 2008 were they in any shape to be the vulture.
The economy requires sound banking; the current rules do nothing toward that goal. Further, Wall Street banks resist because they want to play both sides – be risky and use regulations as a cover for that risk. Despite the heraldry surrounding Dodd-Frank, there has been no advancement toward rectifying this banking imbalance. Such is Footnote 513.
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