If you're a U.S.-based hedge fund operating out of a post office box in the Cayman Islands, U.S. Commodity Futures Trading Commission Chairman Gary Gensler has a message: get ready for more oversight.
A divided CFTC today approved final guidance covering cross-border swap transactions, a crucial element of financial reform. But questions remain about exemptions, enforcement and whether the agency may have violated the Administrative Procedure Act in rolling out the guidance.
Gensler said the guidance "appropriately balances the international harmonization efforts... but most importantly the protection of the American public in bringing transparency to these markets and the reality of modern finance that global financial institutions guaranteed in any jurisdiction can bring risk back to that jurisdiction."
It's not hard to find examples of overseas risk with devastating domestic consequences. Take Lehman Brothers, whose London affiliate had more than 130,000 outstanding swaps contracts when it collapsed. Or Citigroup, which had structured investment vehicles launched in London and incorporated in the Cayman Islands. When the investments failed in 2007, Citi assumed $58 billion in debt before being bailed out by taxpayers. More recently, JPMorgan Chase lost billions when a trader based in London made a bad bet on credit default swaps.
As part of the Dodd-Frank Act, the CFTC was tasked with coming up with guidance to reform the cross-border swaps market. Commissioner Bart Chilton, who voted in favor of the guidance, called it "the most complicated thing we've done" since the law was passed.
A central tenet of the guidance, said Commissioner Mark Wetjen, who also voted in favor, is that "the foreign branches of U.S. banks operating overseas, and other foreign entities benefiting from the credit support of a U.S. firm, will be required to register if they are active dealers in the swap markets.”
"With registration, of course, the public is assured that such entities implement risk-management programs, report their swap activities, abide by capital standards, and manage credit risk in compliance with margin and clearing requirements," Wetjen said.
Republican Commissioner Scott O'Malia opposed the guidance, which he called "statutorily weak," and raised numerous concerns at the meeting at CFTC headquarters this morning.
O’Malia focused some of his objections on four no-action letters released by the CFTC yesterday that provided relief in connection to certain swaps regulation issues. Two letters were to European-based clearing organizations, another applied to registered swap dealers and major swap participants in the United States or European Union.
He called such letters "an abused process that is creating—that is frankly creating regulation and undermining the commission decisions... If you say the rule is X and then say except for Y and you make that indefinite, that turns into reversing commission action. That is a rulemaking in my mind."
Gensler responded that over the last 20 years, the CFTC has issued about 700 no action letters, and that they are "a tool of regulatory agencies like ours." As for the most recent letters, he said that "this circumstance was one where the European Commission wanted us at least at the staff level to do something sooner than could possibly be done" by the CFTC's four politically appointed commissioners.
O'Malia also said the agency should have spent more time attempting to harmonize its rules with its counterparts overseas. He did, however, praise what he termed a "last minute" joint understanding announced yesterday between the CFTC and the European Commission on regulating cross-border derivatives that he said averted "a regulatory train wreck."
O'Malia also questioned the unusual process for adopting the exemptive order on compliance. Rather than soliciting public comments before the order was final, as is standard agency practice, the CFTC is accepting comments for 30 days afterwards.
He noted that under the Administrative Procedure Act, agencies are supposed to "give interested parties an opportunity to participate in a rulemaking through a submission of written data views or arguments ... Now we've gone to execute the order and have a simultaneous comment period which does not seem to meet...notice required by this section."
General Counsel Jonathan Marcus said it's actually an "interim final order," not a final order, so comments can still be accepted, and that such a move is allowed under the Administrative Procedure Act.
"We believe in the circumstances here it was justified...in light of the rapidly evolving nature of the legal regime, the novelty of that regime, the global reach of the swaps market," Marcus said.
O'Malia noted the document is not titled "interim," and asked for case law supporting the issuance of interim final orders.
He also asked what enforcement and legal authority is provided by the guidance. Marcus said the "guidance itself is not binding strictly. We couldn't go into court and...list the violation of the guidance as an actionable claim. But the guidance does tell market participants what the commission's current views are about how to -- how [section] 2(i) applies in the cross-border context and the statute gives us that enforcement authority."
Commissioner Chilton added, "During this interim period of phased in compliance, I cannot envision nor would I support the agency taking any action against an entity engaging in good faith compliance, nor can I envision an action in the future taken retroactively for non-compliance in this interim period. We’ve all got to use a common sense, reasonable man standard here."