Four years ago, with the passage of the Dodd-Frank financial reform law, Congress established basic standards of safety and transparency for the massive and previously unregulated derivatives markets that played a central role in crashing the world economy. Now nineteen current and former legislators involved in drafting that legislation, led by former Representative Barney Frank, are speaking out to oppose Wall Street’s efforts to do an end-run around the law.
The question at issue is whether U.S. derivatives rules will govern transactions conducted through nominally overseas entities, like foreign subsidiaries of U.S. banks, or foreign banks who are key players in the U.S. derivatives markets. This is a critical question because the largest global banks can shift derivatives risks and funding between thousands of international subsidiaries at the touch of a computer keyboard. Nominally, a transaction may be booked in a foreign subsidiary, incorporated in the Cayman Islands or Hong Kong, but the risk and economic impact remain with the U.S. economy. It’s impossible to effectively regulate derivatives markets without applying rules to transactions conducted through foreign subsidiaries.
In fact, if you’ve read about a major scandal involving derivatives, chances are foreign subsidiary transactions were at the center of the affair. In the 1990s, Long Term Capital Management almost brought down Wall Street with trillions in derivatives traded through Cayman Islands subsidiaries, and in Britain the 230 year-old Barings Bank failed thanks to the actions of a single rogue derivatives trader. During the financial crisis, AIG’s London subsidiary, AIG Financial Products, experienced massive derivatives losses that resulted in a U.S. taxpayer bailout. And even more recently, the London Whale created billions of dollars in losses for JP Morgan through London derivatives trades.
No one understands all this better than the major Wall Street banks, who routinely conduct over half of their derivatives transactions through foreign subsidiaries. That’s why as the Commodity Futures Trading Commission (CFTC) finally begins to implement Dodd-Frank derivatives rules, the major Wall Street derivatives dealers are trying a last minute end run around derivatives enforcement. Their vehicle is a major lawsuit that seeks to stop the derivatives regulation in its tracks by banning any cross-border enforcement of any Dodd-Frank derivatives oversight. Arguing that the CFTC has failed to comply with technical procedural requirements for economic analysis, a few global mega-banks are asking the court to forbid the agency from enforcing any of the Dodd-Frank derivatives and commodity market reforms at foreign subsidiaries of U.S. banks, or foreign banks operating in the U.S. If they get everything they’re asking for, dozens of rules that took years to complete will be rendered almost impossible to enforce, until elaborate new rulemaking procedures are completed for each and every rule. That would add fresh years of delay to the three and a half years we’ve already waited for real derivatives oversight.
But there’s at least one major problem with their argument: Congress also understood the danger of cross-border evasion of derivatives rules, and ensured that the CFTC has clear jurisdiction to address it. Specifically, Section 722(d) of the Dodd-Frank Act states clearly and unambiguously that any CFTC derivatives rule governs not just transactions conducted on U.S. soil, but also any nominally foreign transaction that has a ‘direct and significant’ connection with U.S. commerce.
Now Congress is speaking up against Wall Street’s attempt to use procedural technicalities to dodge this clear statutory rule. Today, nineteen current and former Representatives and Senators, led by former representative Barney Frank, a lead drafter of the Dodd-Frank Act, filed an amicus brief opposing the big banks’ case. Their brief makes a conclusive case for Congress’ intent to properly regulate all derivatives that impact the U.S. economy – even those that take an end run through a foreign country. Let’s hope that this strong statement by Congress leads the court to push back the bank’s attempt to get out of the rules.