December 21, 2012
I support the Final Exemptive Order Regarding Compliance with Certain Swap Regulations and Further Proposed Guidance (Final Order). With this Commission action another important step has been taken to make swaps market reform a reality.
Starting at the end of this month, domestic and foreign swap dealers will register. Once registered, swap dealers will report their trades to both regulators and the public. Foreign swap dealers will report their trades with U.S. persons. With these steps, the bright lights of transparency will, for the first time, shine on the swaps market. Swap dealers also will be required to implement sales practice standards that prohibit fraud, treat customers fairly and improve transparency. The public and our economy will benefit.
The Final Order provides phased compliance for foreign swap dealers (including overseas affiliates of U.S. persons) and overseas branches of U.S. swap dealers with respect to certain requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
Since the enactment of the Dodd-Frank Act, the Commission has worked steadfastly toward a transition from an opaque unregulated marketplace to a transparent, regulated swaps marketplace and has phased in the timing for compliance to give market participants time to adjust to the new regulatory regime and smooth the transition.
Today’s Order is a continuation of the Commission’s commitment to this phasing of compliance – in this case for foreign market participants -- and is consistent with the phase-in order proposed in July 2012.
The Order will remain in effect until July, 2013, as proposed in the July 12 order, and is intended to complement other Commission and staff actions that facilitate an orderly transition.
During this transition period, a foreign swap dealer may phase in compliance with certain entity-level requirements. In addition, those entities (as well as foreign branches of U.S. swap dealers) are provided time-limited relief from specified transaction-level requirements when transacting with overseas affiliates guaranteed by U.S. entities (as well as with foreign branches of U.S. swap dealers).
The relief period provides time for the Commission to work with foreign regulators as they implement comparable requirements and as the Commission develops a substituted compliance program. Substituted compliance, where appropriate, would allow for foreign swap dealers to meet the reform requirements of the Dodd Frank Act by complying with comparable and comprehensive foreign regulatory requirements.
With respect to any transaction with a U.S. person, though, compliance will be required in accordance with previously issued rules and staff guidance.
The Order incorporates a definition of “U.S. person,” that benefits from helpful comments of market participants to our initial proposal and continuing discussions with the international regulatory community.
Under the Order, a foreign person will not be required to include in its calculation of swap dealing activities any swap with a non-U.S. person, as well as with foreign branches of U.S. swap dealers.
In addition, based upon comments received on the cross-border interpretive guidance proposed last July, the Final Order also provides time-limited relief from aggregation requirements with respect to the de-minimis calculation for swap dealer registration. Specifically, the Final Order provides time-limited relief from the requirement that a non-U.S. person include the swap dealing transactions of its U.S. affiliates under common control (or any of its foreign affiliates that are currently dealing) in its calculation for determining whether or not it has exceeded the de minimis threshold.
The Commission is seeking additional public comment on cross-border issues related to the term “U.S. person,” the aggregation requirements for foreign persons, as well as the definition of a “foreign branch”.
Today’s Commission action assists foreign swap dealers to comply with the Dodd-Frank Act in an orderly fashion.
Earlier this week in a separate action, the Commission issued an interim final rule allowing for more time to come into compliance on specific documentation requirements, providing swap dealers an additional four months with respect to sales practice documentation and six months with respect to relationship documentation.
The Commission recognizes the importance of international cooperation and coordination in the regulation of this highly interconnected global market. To this end, the Commission staff has actively engaged in substantive discussions with foreign counterparts in an effort to better understand and develop a more harmonized cross-border regulatory framework.
The Final Order also reflects comments from foreign market participants. For example, foreign banks requested a phase-in for the application of entity-level requirements. At the same time, foreign banks stated that the transaction-level requirements would apply to their transactions with U.S. persons.
This Final Order reflects this on-going consultation with foreign regulatory counterparts who provided comments on the proposed exemptive order issued in July 2012. During this period of phased compliance, the Commission will continue to engage with foreign counterparts. As set forth in a December 4 joint press statement of market regulators, the Commission will meet regularly with foreign regulators to consult on, among other topics, the basis for substituted compliance, timing and sequencing of rules, clearing determinations, and options to address potential conflicting, inconsistent, and duplicative rules.
As the Commission and the international regulatory community move forward, we all recognize that risk has no geographic boundary and money can move in and out of markets and jurisdictions in milliseconds. For the public to be protected, swaps market reform must cover transactions of overseas branches and overseas affiliates guaranteed by U.S. entities.
The 2008 financial crisis demonstrated this when financial aftershocks spread throughout the globe and swaps executed offshore by U.S. financial institutions sent risk straight back to our shores. As a result of the crisis, eight million Americans lost their jobs, millions of families lost their homes, and small businesses across the country folded.
Congress and the President responded with the Dodd-Frank Act, including the cross-border provisions of the law. Section 722(d) of the Dodd-Frank Act states that swaps reforms shall not apply to activities outside the United States unless those activities have “a direct and significant connection with activities in, or effect on, commerce of the United States.” Congress provided that reforms should account for risks that may come from abroad.
Failing to bring swaps market reform to transactions with overseas branches and overseas affiliates guaranteed by U.S. entities would mean American jobs and markets would likely move offshore, but, particularly in times of crisis, risk would come crashing back to our economy.
The nature of modern finance is that large financial institutions set up hundreds, if not thousands of “legal entities” around the globe.
They do so in an effort to respond to customer needs, funding opportunities, risk management and compliance with local laws. They do so as well, though, to lower their taxes, manage their reported accounting, and to minimize regulatory, capital and other requirements, so-called “regulatory arbitrage.” Many of these far-flung legal entities, however, are still directly connected back to their U.S. affiliates.
During a default or crisis, the risk that builds up offshore inevitably comes crashing back onto U.S. shores. When an affiliate of a large, international financial group has problems, the markets accept this will infect the rest of the group.
This was true with AIG. Its subsidiary, AIG Financial Products, brought down the company and nearly toppled the U.S. economy. It was run out of London as a branch of a French-registered bank, though technically was organized in the United States.
Lehman Brothers was another example. Among its complex web of affiliates was Lehman Brothers International (Europe) in London. When Lehman failed, the London affiliate had more than 130,000 outstanding swaps contracts, many of them guaranteed by Lehman Brothers Holdings back in the United States.
Yet another example was Citigroup, which set up numerous structured investment vehicles (SIVs) to move positions off its balance sheet for accounting purposes, as well as to lower its regulatory capital requirements. Yet, Citigroup had guaranteed the funding of these SIVs through a mechanism called a liquidity put. When the SIVs were about to fail, Citigroup in the United States assumed the huge debt, and taxpayers later bore the brunt with two multi-billion dollar infusions. The SIVs were launched out of London and incorporated in the Cayman Islands.
Bear Stearns is another case. Bear Stearns’ two sinking hedge funds it bailed out in 2007 were incorporated in the Cayman Islands. Yet again, the public assumed part of the burden when Bear Stearns itself collapsed nine months later.
A decade earlier, the same was true for Long-Term Capital Management. When the hedge fund failed in 1998, its swaps book totaled in excess of $1.2 trillion notional. The vast majority were booked in its affiliated partnership in the Cayman Islands.
This year’s events of JPMorgan Chase, where it executed swaps through its London branch, are a stark reminder of this reality of modern finance.
As there have been these and other financial institution failures in the past, in our free markets, we must be prepared for when other firms fail in the future. Dodd-Frank reform is about protecting the public from such failures in the future.
It’s my firm belief that if reforms were not to cover the branches and overseas affiliates of U.S. entities, either directly or through substituted compliance, the public will be left without the benefits and protections that Congress intended with Dodd-Frank.
Foreign governments and their taxpayers also will be concerned about the risks engendered by the cross-border activities of financial institutions.
The Final Order approved today benefitted from consultation with foreign regulatory counterparts. The Commission also received constructive comment from the public and Members of Congress.
I am grateful to the staff of the Commission for their tireless work on this Order and the Commission’s broader effort to implement swaps market reform. In accordance the directives of Congress and the Commission’s final rules, swaps market reform is taking shape. I look forward to working with my colleagues to complete this important task.
Last Updated: December 21, 2012