27 Apr 2012, Joe Rennison, Risk magazine
On the face of it, regulators and politicians worldwide are in complete agreement. Standardised over-the-counter derivatives should be cleared through central counterparties; higher capital requirements are necessary, as are strict liquidity standards; and no bank should ever be too big to fail. A variety of global bodies are pushing the requisite changes through, including the Group of 20 (G-20), the Financial Stability Board and the Basel Committee on Banking Supervision. In theory, then, what should emerge is a set of standards that everyone agrees with, implemented consistently in every jurisdiction.
That was never going to happen – national regulators have always been sensitive to the peculiarities of their own markets, and have looked to fine-tune global standards to suit their local banking systems. But what is now emerging from national supervisors goes well beyond that, to the extent the various regulations are actually inconsistent in certain areas, bankers claim. Some of the rules also appear to have an extraterritorial reach, which could mean global banks have to meet certain requirements that are at odds with their domestic rules.
The Volcker rule is a case in point, bankers say. Part of the Dodd-Frank Act, the rule is designed to prevent banks from engaging in proprietary trading, as well as owning, sponsoring or investing in hedge funds or private equity funds. Crucially, the rule applies to the non-US operations of US banks and to foreign banks that have a US branch, unless they can prove they meet certain exemption criteria.
“In an ideal world, we would have preferred to have seen more convergence and co-ordination on global regulations,” says Eraj Shirvani, co-head of global credit products at Credit Suisse, and a former chairman of the International Swaps and Derivatives Association. “The extraterritoriality of some US regulations and the many divergences on timetable and details show how, for example, there’s room for greater co-operation between different jurisdictions.”
The Volcker rule contains several exemptions to the prop trading ban, including trading in certain US government securities, underwriting, market-making and risk-mitigating hedging. According to a detailed rule published by four US regulators last year, certain foreign banking entities would also be exempt, so long as any prop trading activity takes place outside the country. However, the foreign bank must prove to US regulators that any banking entity that engages in prop trading is not organised under the laws of the US, no US residents are party to the transactions, none of the prop traders are located in the US, and the trades are executed wholly outside the US. Just proving they meet the exemption would require foreign banks to undergo a huge compliance process – a requirement essentially set by an overseas regulator (Risk November 2011, page 6).
The exemption for US government securities has also prompted criticism, both from bankers and foreign regulators. Not only are US banks and their overseas operations important liquidity providers in foreign government bond markets, but foreign banking entities would need to meet the exemption criteria – meaning they couldn’t offload any proprietary government bond positions to US investors. The end-result will be reduced liquidity in non-US government bond markets, some claim.
Even some US regulators are nervous about these extraterritorial implications. “Major issues with the Volcker rule arise because one country is trying to do what it thinks is right for its market, but must then grapple with the international and extraterritorial features of the policy and try to reconcile that as best it can without actually converging with regulation in other countries,” says John Walsh, who was acting head of the Office of the Comptroller of the Currency (OCC) in Washington, DC until early April.
This isn’t the only example of extraterritoriality in Dodd-Frank. Section 716 – otherwise known as the swap push-out clause – also has some potentially troubling implications for foreign banks. This clause prohibits federal assistance to any swaps entity, including access to the Federal Reserve discount window and guarantees from the Federal Deposit Insurance Corporation (FDIC) – essentially forcing banks to shift their swaps businesses into separate entities in order to continue to access these facilities.
Again, there are some exemptions – insured depository institutions are allowed to use derivatives to hedge and can also conduct traditional banking activities, as described in US federal law. This has been interpreted to mean banks can act as market-makers on interest rate and foreign exchange derivatives, gold and silver swaps, and cleared credit default swaps (CDSs). Other businesses – equity derivatives, commodity derivatives and non-cleared CDSs, for instance – would have to be moved into separate affiliates.
This could pose significant problems for foreign banks, however. Most US branches of foreign banks do not take deposits and are not covered by FDIC insurance, but do access the Fed discount window. This means none of the exemptions would apply to foreign banks as the legislation currently stands, requiring them to carve out their entire US derivatives businesses into separate entities if they want to continue to access the discount window.
Even worse, because the US branch is part of the same legal entity as the parent bank overseas, it is possible the rules could end up applying to the entire group. Many lawyers doubt US regulators will go as far as to expect foreign banks to carve out their global swaps operations, but they warn the legislation as it stands could be interpreted so that it applies to the foreign branches of US banks, giving it a strong extraterritorial application. This ties in with another area of uncertainty – the swap dealer registration rules.
Most foreign banks tend to solicit derivatives business with US clients through their US branches, but book the trades through an overseas banking entity. This could mean these foreign banks have to register as swap dealers, requiring them to meet US regulatory disclosure rules and be subject to oversight by the Commodity Futures Trading Commission (CFTC) – potentially creating friction with home regulations.
The legislation could also apply to the non-US operations of US banks, even when conducting business with non-US entities. In other words, a client in Hong Kong, for example, might have an incentive not to trade with a Hong Kong branch of a US bank, as it may be subject to Dodd-Frank rules – a standardised derivatives trade would then need to be cleared through a CFTC-registered derivatives clearing organisation, and an uncleared trade would be subject to stringent margin requirements proposed by US prudential regulators in April 2011 (Risk June 2011, pages 24–27).
These kinds of implications – particularly those that would put US banks at a competitive disadvantage – have started to garner the attention of US politicians, and several bills are working their way through Congress that would water down certain aspects of the rules. For instance, HR 1838 would modify the swap push-out clause, ensuring both foreign and domestic banks are treated equally, and narrowing the scope so only swaps referenced to asset-backed securities need to be transferred to separate entities. It also clarifies that the rule would not apply to swaps activity conducted outside the US by a non-US swaps entity with a non-US counterparty. In other words, a foreign branch of a US bank trading with a non-US firm would not be subject to section 716 if the bill is passed.
Meanwhile, HR 3283 is meant to limit the extraterritorial reach of Dodd-Frank by clarifying the definition of a US person and non-US person. Specifically, the bill states that trades conducted between US swap dealers, or swap dealers with a US parent, and non-US entities that aren’t registered as swap dealers – which includes any agency or branch of a US entity located outside the US – would not be subject to Dodd-Frank. Any trade between the swap dealer and a US or non-US subsidiary, branch or affiliate of that dealer would also not be covered. In addition, it stipulates that a non-US entity that registers as a swap dealer will only need to comply with Dodd-Frank if it trades with a US entity (unless that entity is a US subsidiary, branch or affiliate of the non-US swap dealer).
However, there is no guarantee these bills will make it through Congress. At the time of going to press, both bills had been passed by the House Committee on Financial Services, but still need to be considered by the House of Representatives, as well as the Senate, in order to become law.
But while US legislators are looking to ditch some of the more contentious – and unique – elements of Dodd-Frank, global regulators appear to be moving towards the US position in other areas. Margin requirements on uncleared swaps are one example. US prudential regulators were on their own when they proposed these rules in April 2011, and US banks complained their extraterritorial reach would put them at a severe competitive disadvantage overseas. Now, a group comprising the Basel Committee on Banking Supervision, the International Organization of Securities Commissions, the Committee on Payment and Settlement Systems and the Committee on the Global Financial System are working to develop a global set of standards, potentially creating a more level playing field (Risk May 2012, pages 16–20).
“There is a degree of convergence. The similarities between different regulatory proposals are greater than the differences. Certainly, for the major markets, there is a broad consensus,” says Richard Metcalfe, head of global policy and a senior regulatory adviser at Isda in London.
Perhaps surprisingly, that might include the Volcker rule. While no directly comparable standard has been proposed elsewhere, there are signs other regulators are looking to do something similar. This includes the Independent Commission on Banking (ICB) – a group set up by UK chancellor of the exchequer George Osborne to propose ways of improving the stability of the UK banking system, and chaired by John Vickers (Risk October 2011, pages 70–72). In its final report, published in September 2011, the ICB recommended the ring-fencing of retail banking operations to ensure certain crucial banking functions, such as payments services, retail deposits and lending to small and medium-sized enterprises, are carved out from the rest of the group and placed in separate legal entities with their own capital requirement. Some argue this has similar intentions to the Volcker rule.
“Both are aimed at achieving the same thing: making sure the costs of bank resolution at the point of non-viability are minimised. But they are coming at it in different ways. Vickers is saying a bank can engage in this riskier activity, but only outside the ring fence; Volker is saying you can’t do it at all,” says Simon Hills, executive director for prudential capital, risk and regulatory relationships at the British Bankers’ Association in London (see box, Banks working on recovery and resolution).
Others agree. “Vickers addresses some of the same considerations that are in Volcker – of too big to fail, moral risk and conflicts of interest. Those issues can be addressed in different ways. Volcker is really one way of looking at it; Vickers is another,” says Eric Litvack, chief operating officer of global equity flow at Société Générale Corporate and Investment Banking, and an Isda board member.
Something similar could be under way in the European Union (EU), too. The European Commission has set up a group led by Erkki Liikanen, governor of the Bank of Finland, to consider whether structural reforms of EU banks are necessary to strengthen financial stability and improve consumer protection. The group should finish its work in the third quarter of this year, and many participants expect it to suggest something akin to the ICB. “What the Liikanen group will come up with will probably be yet another way of looking at the issue addressed by Vickers and Volcker,” says Litvack.
These measures are unlikely to slot together neatly – but they do signal a realisation by national regulators that they need to consider the bigger picture, say bankers. “If someone comes out with regulations that are too far away from the spirit of the G-20 commitments, it will appear as possibly facilitating regulatory arbitrage,” says Nitin Gulabani, global head of foreign exchange rates and credit at Standard Chartered, and an Isda board member.
Time is short, however. Much of the Dodd-Frank Act is supposed to be implemented this year, but some of the key rule-makings have yet to be finalised by US regulators (see table A). Meanwhile, the European Market Infrastructure Regulation (Emir) is meant to come into effect from 2013 – even though the final text was only agreed in February and approved by the European Parliament at the end of March. The European Securities and Markets Authority now has to draw up a number of technical standards required by Emir by September (see table B for a summary of the key technical standards). That doesn’t leave a huge amount of time to ensure a smooth, globally consistent framework, say bankers.
The timeline for the Volcker rule looks to be a little longer, though. Several US regulators now concede the July 21 deadline is unlikely to be met. “We’re working away and we’ll get it finished as fast as we can, but we’re unlikely to get it finished by the deadline,” says Walsh at the OCC.
Dealers welcome the fact that US regulators are willing to take longer to finalise this particular rule, but argue this recognition should have come at a much earlier point. “It gives all market participants a lot of comfort that regulators are listening to each other and to market participants. Many senior officials have now openly stated that the Volcker rule needs to be reworked, which shows how this dialogue is having an impact. In an ideal world, this would have happened at an earlier stage in the process and without triggering a market reaction,” says Shirvani at Credit Suisse.