Republicans in Congress have been pressuring regulators for years to exempt derivatives that U.S. companies sell overseas from the new rules set by the 2010 Dodd-Frank financial reform law. For much of 2013, the deregulatory drive enjoyed bipartisan support in the House, with lawmakers casting their efforts as an attempt to harmonize U.S. law with international regulations. But financial reform advocates have attacked the initiative for padding Wall Street profits at the expense of important public protections, and Democratic support has eroded.
In June, the House passed a bill that would completely exempt from U.S. oversight derivatives sold through the nine most popular foreign derivatives jurisdictions. The legislation is occasionally derided as the "London Whale Loophole Act" on Capitol Hill -- a reference to the overseas trades that cost JPMorgan Chase more than $6 billion in 2012. London was the epicenter of much of the derivatives trading by U.S. financial firms leading up the 2008 crash, including AIG's infamous Financial Products division. If banks can simply route trades through loosely regulated overseas affiliates, financial reform advocates warn, the most critical aspects of Dodd-Frank will be effectively nullified.
The "London Whale Loophole Act" faces opposition from Senate Democrats and President Barack Obama, so it's unlikely to be signed into law. But June's House Agriculture Committee funding bill has much stronger prospects for passage, since it's tied to approximately $19 billion in other spending. That bill would require the Commodities Futures Trading Commission -- the agency with responsibility for more than 90 percent of the derivatives market -- to negotiate its regulations with the Securities and Exchange Commission, which oversees the remainder of the derivatives business.
Big banks have railed against the CFTC guidelines for taking a broad view of what constitutes an American firm. The SEC's proposed rule, by contrast, would bar American regulators from overseeing many offshore partnerships run by U.S. firms, and many trades between U.S. firms and overseas companies. Forcing the CFTC to negotiate with the SEC would almost certainly introduce loopholes into the CFTC's rules, and may shut down the rulemaking process altogether.
"The House bill is nothing more than a backdoor way of killing derivatives reform," said Dennis Kelleher, president and CEO of the financial reform advocacy group Better Markets. "It's Christmas in July for Wall Street."
Prior to Dodd-Frank, derivatives trades were essentially secret deals between two companies, with no market or regulatory scrutiny. The 2010 law required companies to trade through a third party that guaranteed each side’s ability to make good on its bets. To buttress the guarantee, each side of the trade was required to post margin -– a small upfront deposit just in case the trade went bad. An offshoring loophole would allow firms to evade these requirements, provided they meet the technical definitions of the loophole.
While Wall Street has pursued multiple avenues to derail the CFTC’s rule, some Senate Democrats cautioned that even the more aggressive regulatory interpretation may ultimately undermine the essence of Dodd-Frank.
Eight Democratic senators, organized by Sens. Jeff Merkley (D-Ore.) and Carl Levin (D-Mich.), on Wednesday signed a letter to CFTC Chairman Gary Gensler and SEC Chairman Mary Jo White stating that both the CFTC and the SEC have failed to deal with shadowy financial entities “sponsored” by U.S. banks without any explicit legal guarantee for their obligations.
This type of arrangement was common in the years leading up to the 2008 crash. Citigroup held nearly $50 billion in complex derivatives off its official balance sheet in so-called structured investment vehicles, and Bear Stearns operated risky hedge funds that it officially had no financial obligations to. The financial crisis began in August 2007 when two such Bear Stearns funds failed, and the company decided to pay off its investors rather than take the damage to its reputation from leaving clients out to dry. By the fall of 2008, Citi had decided to suck up its losses on structured investment vehicles, rather than signal to the market it was incapable of doing so.
"A U.S.-based firm should not be able to escape U.S.-mandated swaps oversight simply because its swaps trading is conducted through an offshore affiliate or branch," the letter from the Democratic senators reads. "It is likely that, if your agencies’ current proposals were adopted, foreign firms doing business with the foreign affiliate of a U.S.-based derivatives dealer would opt to forego an explicit guarantee from the U.S.-based entity in return for: (1) more favorable pricing, and (2) the ability to avoid U.S. trading regulations and any attendant costs."
Both the CFTC and SEC standards would allow an offshore fund organized by a U.S. bank that formally rejected any responsibility for the fund’s solvency to evade American oversight. Reform watchdogs said they worry that U.S. firms will simply route much of their derivatives business through these nebulous entities, leaving the financial system to operate much as it did in the years before the crash.
Read the full letter, signed by Sens. Merkley, Levin, Elizabeth Warren (D-Mass.), Tom Harkin (D-Iowa), Jeanne Shaheen (D-N.H.), Barbara Boxer (D-Calif.), Richard Blumenthal (D-Conn.) and Dianne Feinstein (D-Calif.) here.