In enacting financial reform, Congress recognized the basic lessons of modern finance and the 2008 crisis. During a default or crisis, risk knows no geographic border. Risk from our housing and financial crisis contributed to economic downturns around the globe. Further, if a run starts on one part of a modern financial institution, almost regardless of where it is around the globe, it invariably means a funding and liquidity crisis rapidly spreads and infects the entire consolidated financial entity.
This phenomenon was true with the overseas affiliates and operations of AIG, Lehman Brothers, Citigroup, and Bear Stearns.
AIG Financial Products, for instance, was a Connecticut subsidiary of New York insurance giant that used a French bank license to basically run its swaps operations out of Mayfair in London. Its collapse nearly brought down the U.S. economy.
Last year’s events of JPMorgan Chase, where it executed swaps through its London branch, are a stark reminder of this reality of modern finance. Though many of these transactions were entered into by an offshore office, the bank here in the United States absorbed the losses. Yet again, this was a reminder that in modern finance, trades booked offshore by U.S. financial institutions should not be confused with keeping that risk offshore.
Failing to incorporate these basic lessons of modern finance into the CFTC’s oversight of the swaps market would fall short of the goals of Dodd-Frank reform. It would leave the public at risk.
More specifically, I believe that Dodd-Frank reform applies to transactions entered into by overseas branches of U.S. entities with non-U.S. persons, as well as between overseas affiliates guaranteed by U.S. entities. Failing to do so would mean American jobs and markets may move offshore, but, particularly in times of crisis, risk would come crashing back to our economy.
Similar lessons of modern finance were evident, as well, with the collapse of the hedge fund Long-Term Capital Management in 1998. It was run out of Connecticut, but its $1.2 trillion swaps were booked in its Cayman Islands affiliate. The risk from those activities, as the events of the time highlighted, had a direct and significant effect here in the United States.
The same was true when Bear Stearns in 2007 bailed out two of its sinking hedge fund affiliates, which had significant investments in subprime mortgages. They both were organized offshore. This was just the beginning of the end, as within months, the Federal Reserve provided extraordinary support for the failing Bear Stearns.
We must thus ensure that collective investment vehicles, including hedge funds, that either have their principle place of business in the United States or are directly or indirectly majority owned by U.S. persons are not able to avoid the clearing requirement – or any other Dodd-Frank requirement – simply due to how they might be organized.
We are hearing, though, that some swap dealers may be promoting to hedge funds an idea to avoid required clearing, at least during an interim period from March until July. I would be concerned if, in an effort to avoid clearing, swap dealers route to their foreign affiliates trades with hedge funds organized offshore, even though such hedge funds’ principle place of business was in the United States or they are majority owned by U.S. persons. The CFTC is working to ensure that this idea does not prevail and develop into a practice that leaves the American public at risk. If we don’t address this, the P.O boxes may be offshore, but the risk will flow back here.
Congress understood these issues and addressed this reality of modern finance in Section 722(d) of the Dodd-Frank Act, which states that swaps reforms shall not apply to activities outside the United States unless those activities have “a direct and significant connection with activities in, or effect on, commerce of the United States.” Congress provided this provision solely for swaps under the CFTC’s oversight and provided a different standard for securities-based swaps under the SEC’s oversight.
To give financial institutions and market participants guidance on 722(d), the CFTC last June sought public consultation on its interpretation of this provision. The proposed guidance is a balanced, measured approach, consistent with the cross-border provisions in Dodd-Frank and Congress’ recognition that risk easily crosses borders.
Pursuant to Commission guidance, foreign firms that do more than a de minimis amount of swap-dealing activity with U.S. persons would be required to register with the CFTC within about two months after crossing the de minimis threshold. A number of international financial institutions are among the 71 swap dealers that are provisionally registered with the CFTC.
Where appropriate, we are committed to permitting, foreign firms and, in certain circumstances, overseas branches and guaranteed affiliates of U.S. swap dealers, to comply with Dodd-Frank through complying with comparable and comprehensive foreign regulatory requirements. We call this substituted compliance.
For foreign swap dealers, we would allow such substituted compliance for requirements that apply across a swap dealer’s entity, as well as for certain transaction-level requirements when facing overseas branches of U.S. entities and overseas affiliates guaranteed by U.S. entities. Entity-level requirements include capital, chief compliance officer and swap data recordkeeping. Transaction-level requirements include clearing, margin, real-time public reporting, trade execution, trading documentation and sales practices.
When foreign swaps dealers transact with a U.S. person, though, compliance with Dodd-Frank is required.
To assist foreign swap dealers with Dodd-Frank compliance, the CFTC recently finalized an exemptive order that applies until mid-July 2013. This Final Order for foreign swap dealers incorporates many suggestions from the ongoing consultation on cross-border issues with foreign regulatory counterparts and market participants. For instance, the definition of “U.S. person” in the Order benefited from the comments in response to the July 2012 proposal.
Under this Final Order, foreign swap dealers may phase in compliance with certain entity-level requirements. In addition, the Order provides time-limited relief for foreign dealers from specified transaction-level requirements when they transact with overseas affiliates guaranteed by U.S. entities, as well as with foreign branches of U.S. swap dealers.
The Final Order provides time for the Commission to continue working with foreign regulators as they implement comparable swaps reforms and as the Commission considers substituted compliance determinations for the various foreign jurisdictions with entities that have registered as swap dealers under Dodd-Frank.
The CFTC will continue engaging with our international counterparts through bilateral and multilateral discussions on reform and cross-border swaps activity. Just last week, SEC Chairman Walter and I had a productive meeting with international market regulators in Brussels.
Given our different cultures, political systems and legislative mandates some differences are unavoidable, but we’ve made great progress internationally on an aligned approach to reform. The CFTC is committed to working through any instances where we are made aware of a conflict between U.S. law and that of another jurisdiction.