On Tuesday, 7 June, among a huddle of reporters in an Atlanta briefing hall, a private banker ambushed a central banker with a passive aggressive rant about regulation for all the world to see.
The private banker was JP Morgan’s Jamie Dimon. The central banker was the Federal Reserve’s Ben Bernanke. And the regulation, we are led to believe, was the Dodd Frank Wall Street Reform and Consumer Protection Act, or Dodd Frank.
Dimon’s meandering remonstration, which you can find on YouTube, was during the International Monetary Conference. In it he reads through a laundry list of the financial regulation that has been imposed and that is to be imposed in response to the credit crunch.
It can be summarised as so: You’ve done enough. Stop. Dodd Frank, the single largest reform legislation in the history of the US, is bad for US banks and therefore the US recovery and therefore US jobs.
Dimon’s headline-grabbing act was an extension of something that has been going on around Washington for two years now.
Open letters, closed minds
If you are a lobbyist, lawyer, public relations expert or consultant, it’s likely the past 24 months have been fruitful. All of the dark arts of policy maker persuasion have been employed to declaw Dodd Frank.
JP Morgan’s rival Goldman Sachs recently topped a poll of investment banks that had had the most consultations with the CFTC, the group responsible for the regulation of the $300 trillion swap market.
And as of 17 June the Financial Services Roundtable – you know it’s a lobbying group when the title of the organisation is so ominously ambiguous – had submitted 103 comment letters on Dodd Frank. FSR’s CEO, Steve Bartlett, expressed his exasperation at the scope of the bill to Colin Barr at Fortune magazine: “The fast pace of rulemaking will certainly continue as 109 rules are due to be adopted in the third-quarter of 2011 alone, and we are not even at the halfway mark for the rules called for under Dodd-Frank."
And these are just drops – albeit very large drops – in the ocean. Opensecrets, the Center for Responsive Politics, reports that at the peak 815 companies and other groups were lobbying on the Dodd Frank regulation.
Well, the FSR, Goldman, JP and the other 812 agents of obfuscation can rest easy. The 16 July deadline for drawing the Title VII rules – more on these later – has been put on ice. In an Exemptive Order the SEC and CFTC issued “temporary relief” to rules that otherwise would have gone into effect on July 16. This is so that the Commissions can clear up some key definitions – more on this later too – by no later than 31 December.
Thomson Reuters global head of market structure Robert Hegarty is relieved at the delay: “The deadline has been pushed off and that’s a good thing. With 300 pages of legislation, there are rules, overlap gaps and confusions that need to be cleared up.
“The debt ceiling is the number one concern of Congress right now. Shortly thereafter we anticipate a Congressional recess.”
Result. The banking industry has bought itself more time to lean on the CFTC and SEC. But why are they so worked up? What’s at stake here?
Don’t touch my swaps
Dodd Frank really started to generate headlines in March last year.
It was at this time that Jamie Dimon’s JP Morgan published a trio of reports on the Dodd Frank bill. There were two main bones of contention: Section 619 and 716.
Section 619, the so-called Volcker rule, would clip US investment bank proprietary trading relative to their European counterparts. The US bank described this as a “very significant part” of the Derivatives business of the big US banks.
However, while this debate held the interest of the financial community, it is Section 716 that really caught the public’s interest, gracing the pages of mainstream papers and the Huffington Post.
This is the Title VII issue drafted by Senators Dodd and Lincoln. It’s on the Prohibition Against Federal Bailouts of Swaps Entities.
The idea is that there will be a ban on any federal assistance to swap dealing entities. It’s woolly, but that assistance will especially be prohibited in instances where the entity cannot fulfill obligations in swap transactions.
That means no Federal Reserve credit facility, no discount window, no loan or debt guarantees by the FDIC and no debt swaps. Goldman Sachs, Morgan Stanley, JP Morgan, Citigroup and BofA would be required to isolate their swap desks from the bank structure. Swap entities and bank entities would not be part of the same bank holding company. That is, unless the bank holding company was willing to forgo federal assistance in the case of a systemic market crash.
Which, of course, they would not.
Former Chief Economist to the World Bank Joe Stiglitz was overjoyed by the proposal. In an open letter (another one) addressed to the Senate, the Nobel prize winning economist spoke in emotionally charged terms: “By quarantining highly risky swaps trading from banking altogether, federally insured deposits (and our basic payments mechanism) will not be put at risk by toxic swaps transactions.
“Moreover, banks will be forced to behave like banks, focusing on extending credit in a manner that builds economic strength as opposed to fostering worldwide economic instability.”
It was at this point, where Stiglitz re-re-defines what a bank is, or ought to be, that he and the other supporters of Section 716 were hoisted by their own petard.
Definition “swap dealer”: missing
Stiglitz spoke of revisiting banking definitions. He probably wasn’t expecting his enemies in this fight to be taking his advice. Of the hundreds of meetings held with the CFTC, the highest proportion were over definitions.
One particularly contentious definition is that of a swap dealer.
What is a swap dealer? It’s a matter of debate. First, I spoke with Anthony R. G. Nolan from K&L Gates, the law firm representing CalPers, Peabody Energy and PIMCO among others:
“[Dodd-Frank] defines “swap dealer” and “security-based swap dealer” in a functional manner by focusing on how a person holds itself out in the market, the nature of the person’s conduct, and the market’s perception of the person’s activities.”
“That is to say swap dealers generally dealing, making a market, entering into swaps with counterparties in the regular course of business for its own account or “engaging in activity that causes it to be commonly known in the trade as a “dealer” or “market maker” in swaps or security-based swaps. “
If you weren’t already confused, Newedge introduce nuance into already complex definitions.
To follow up on yet another open letter to the CFTC I spoke with John Nicholas USA acting head of compliance:
Q. You appealed to the CFTC to consider FCMs and broker dealers not as swap dealers. Why?
“The answer is simple. Historically, the swap position we take is that of a broker. We are not taking market risk. We are taking credit risk. We put on a swap with one counterparty and offset it immediately with another swap or with a liquidity provider or another market participant.
Historically, we have never seen ourselves as a dealer.
Q. So, what are you then?
“We see ourselves as a facilitator, or broker. The OTC activity we engage in is part and parcel of our normal broking activity except that that it involves an off exchange product.
“We would ask the CFTC, what is it to take market risk? It gets difficult because what is it to be deemed to take market risk? We probably take interim market risk because we take one leg of the trade before we take the next leg.
On one side we're long the swap and on the other side we've hedged the position. There’s no directional exposure. I think regulators have to look at the purpose of that transaction, they have to look at the timeframe of the transaction, the timeframe that the facilitation is open. Maybe, on balance they'll fall on our side and come up with standards that for one type of transaction is deemed dealing and for another its considered just broking.
Q. So, what or who is a swap dealer then?
“Anyone who takes a pure directional punt. It is no surprise that the regulators are struggling. The devil is in the detail and it’s not easy to delineate between facilitation that is dealing and that which is not.
“But if ultimately, even if you hedge, you take some risk – you may be a swap dealer. But, historically, that is not us.”
Thomson Reuters’ Robert Hegarty reminds us that “Swap Dealer” is not the only definition that institutions have to concern themselves with. “What is a standardised derivative? That’s the question I hear discussed most often.”
Sarbanes Oxley all over again
That man again, Jamie Dimon, suggested to an audience at the Council of Institutional Investors that the more draconian the Dodd Frank bill, the more it would play into the hands of their foreign rivals: “Singapore licking its chops”, he said.
Why the fear? As is well-known, the OTC market is considerably larger than the exchange traded market. It’s also a well know fact that London is the global capital. The BIS estimates that 43% of the overall market is based in London versus 24% in the US.
Why is London large and in charge?
“This is a dynamic shift that started some 15 years ago, though the gap has narrowed since then. London is a bit more flexible with respect to OTC markets. Its regulations are such that wholesale market incur far fewer regulations” says Robert Hegarty.
“Learn from our regulatory mistakes” is the cry from the US. It’s apt. After all, the OTC trade is not the only market that America’s well-intentioned Senators have caused to slip through American fingers.
The two words I hear from most US based respondents for interview are Sarbanes and Oxley. The Sarbanes Oxley Act of 2002 set new standards for US listed equities. Unfortunately, it also drove an increasing amount of business towards London. A published 2008 academic paper titled: "Regulation and Bonding: Sarbanes Oxley Act and the Flow of International Listings" found that indeed companies were choosing London for their IPOs.
Unintended consequences
At the least it has led to trenchant communications between the EU and the US,” says Anthony Belchambers, the Futures and Options Association chief executive. “The issues are manifold. We have to consider the application of exporting rules based on passporting, exemptions, home-state rules, etc. Position limits are a case in point...”
Though, one supposes the good news from all this is that [the delay] gives time for EMIR / Dodd Frank issues to be reconciled?
“In truth, the July 16 timetable never looked likely. There was simply too much to get through. The re-training of IT, staff, informing customers. This all needs to be factored in and it cannot start until we are all clear on the rules and definitions that will be implemented.
“It seems that the regulators underestimated this.”
That, and the determination of the US lobbyists.
Going forward it’s very difficult to say what comes next. There is the issue of regulatory arbitrage – the force that, as described by Sandeep Vishnu of Capco describes it “identifying and positioning a firm under the most beneficial regulatory regime.” And the perfect nesting bed for regulatory arbitrage to form is inconsistency.
With the special interest groups pushing regulators in many different directions, strained relations with regulatory bodies in Europe and the confusing, overlapping nature of Dodd Frank itself, we have the blueprint for a regulatory arbitrageur’s dream. The antidote to this is heavy-handed extra-territoriality the type of which the AMF and Anthony Belchambers’ FOA are trying to supress.
Some describe it as Dodd Franc, i.e. of great benefit to Swiss banks. Many a sell-side paper has speculated on the uptick in proprietary trading activity that UBS and Credit Suisse in particular would encounter if Dodd Frank was rushed through as is.
“For the time being the US banks running derivatives business out of the US banks such as BoA, Citi and HSBC are facing a real risk of lower competitiveness, in our view,” says JP’s Kian Abouhossein in a comprehensive white paper on Dodd Frank.
Its team says in the theoretical implementation of this element of Dodd Frank (which is now subject to edits) the Swiss banks fair best as they have a heavy concentration of private bank revenue. That would tacitly suggest, with the risk of extra-territoriality, that there will be no winners.
The international reach of Dodd Frank would prevent RBS or BNP Paribas stealing flow and customers as much as it would stymie the progress of the big US players. The only winners are those least dependent on the income of standardized derivatives – the Swiss.
This is because equity derivatives, credit derivatives and part of commodity derivatives would be in the scope of exchange traded derivatives subject to Dodd Frank oversight.
In a sign of the times, more parties are concerned that the volume will travel in the other direction – the emerging east.
The players to watch are Gary Gensler of the CFTC and Jean-Pierre Jouyet of the Autorité des Marchés Financiers who warns that if Dodd Frank works to exclude foreign firms, Europe will reciprocate. However, these matters of US registration for US client facing European and Asian funds and private equity firms is of limited concern to derivatives players.
The definitions rulemaking comment period is still open, until July 22.
Gensler would like to see definitions finalised this year but Anthony R G Nolan sees that as unlikely: “Given the numerous issues related thereto, and the fact that that particular rulemaking must be done jointly with the SEC (which has to deal with several big issues other than derivatives), I think that it will be difficult to finalize the definitions by year-end.
You can see that the bill’s ambition and scope are ultimately what are undermining it. Expect plenty more rhetoric to fly around, for more senior bankers to crash policy maker press conferences and – of course – plenty more open letters directed at the CFTC.