Derivatives WMD: some progress on financial regulation. But not enough

Recently we wrote about forthcoming rules in the United States relating to the Wild-West, $600+ trillion global derivatives markets, and joined an international letter urging U.S. lawmakers to hold firm in enforcing 'extraterritorial' (or cross-border) regulation of derivatives activity, to avert the possibility that derivatives trades could simply be shunted to the laxest jurisdiction to escape regulation. It turns out that our joint letter had a demonstrable impact.

As our letter stated:

"Effective regulation of fundamentally international and global financial markets requires that national regulators be able to enforce strong oversight rules for all transactions that seriously impact their economy and their markets, wherever these transactions are nominally located.

A failure to embrace this principle will leave the entire global financial system vulnerable to weak regulations in a single host jurisdiction. Financial institutions located in the under regulated jurisdiction will be able to conduct transactions that affect markets across the globe, and other nations will face incentives to reduce their regulatory oversight as well."

Americans for Financial Reform (AFR) in the U.S., who have been pushing hard to support efforts to close the offshore derivatives loophole, issued a press briefing recently under a headline that summarises the issue nicely:

"Cross-Border Exemption = Backdoor Repeal"

See also the New York Times editorial on this, for more background. Last Friday was the deadline for a decision on this crucial issue related to offshore arbitrage and 'financial weapons of mass destruction (WMD)', and the result has been . . . a mixed bag. We are pleased to see that the Commodity Futures Trade Commission (CFTC), the lead U.S. regulator in this area, referenced our letter four times in guidance notice on Friday (search for "Tax Justice Network", or scroll to pp192-3.) It seems clear that our letter gave the CFTC grounds to support stronger cross-border derivatives rules, and we think we achieved our goals helping provide a civil society voice in the process.

The outcome could certainly have been a whole lot worse, and it is to the credit of CFTC Chair Gary Gensler in particular for fighting so hard against the massed armies of financial lobbyists pushing to open the offshore loophole.

In a statement issued on Friday, AFR summarised the positives:

"We are pleased that the CFTC released a final guidance on the extra-territorial application of CFTC derivatives rules. This finalized guidance implements a principle vital to financial reform: transactions by nominally foreign subsidiaries supported by a U.S. parent, and by foreign entities that are major dealers in U.S. markets, can pose significant risks to the U.S. economy and must fall under U.S. financial regulations. In today’s global financial markets, risk is not bounded by geographic borders but instead flows to whatever entity is ultimately liable for a transaction.
. . .
The finalized guidance leaves no doubt that the Commission intends to exercise its clear Dodd-Frank jurisdiction over many cross-border transactions. Indeed, in a few areas, such as the treatment of foreign-registered U.S. hedge funds and the cross-border application of clearing requirements, the finalized agreement appears stronger than previous proposals. The Commission has succeeded in finalizing this guidance against strong industry pressure."

But there are many negatives, too. There is too much reliance on 'substituted compliance' under which the baton of regulatory oversight is handed to a foreign jurisdiction once its regulation is judged to be good enough. This is an acceptable principle if the foreign jurisdiction's regulation is good enough - but this does not appear to be the case, and leaving too much leeway for substituted compliance risks turning into a rubber-stamping exercise leading to a renewed race to the bottom on financial regulation and another global free-for-all. As AFR summarises:

"The heavy reliance on substituted compliance means that the entire U.S. derivatives framework could be unraveled if the Commission eventually permits inadequate foreign regulations to substitute for U.S. regulation."

Note, too, that the application of cross-border rules has been delayed until December for six major foreign jurisdictions: Australia, Canada, the European Union, Hong Kong, Japan, and Switzerland - some of whose members with a track record for making race-to-the-bottom regulation part of the business model. As AFR describes it:

Several of these jurisdictions are not near completion of their rules and could not possibly be ‘comparable’ to U.S. rules by December.

So there will be much to play for.

One important message has emerged from this, from our perspective. Those in Europe engaged on fighting for financial reform are too few - yet it is possible to make a difference.  We hope that many others can engage on these crucial, if complex, issues.