I wrote this originally on the Tax Justice Network blog.
This important blog is fairly long, so we preface it with a short summary.
The Wild-West $600 trillion unregulated global market in financial derivatives, implicated in numerous financial disasters before, during and since the hottest phase of the global financial crisis in 2008/9, now potentially faces some welcome (if very belated) new regulation in the U.S., Europe and elsewhere. Last week, for instance, the U.S. became the first country in the world to require mandatory clearing of many derivatives contracts, a crucial protection for citizens.
The U.S. Dodd-Frank financial reform bill of 2010, currently the leader in this particular area, envisages that if a derivatives trade has a “direct and significant connection” to the U.S. economy — in other words, if risky derivatives trading activity could turn around and bite U.S. taxpayers — then the U.S. should be able to regulate it whether it is nominally located in the U.S., in the City of London or in the Cayman Islands. We at TJN fully support that as a generally useful principle, for all regulators worldwide.
But financial lobbyists and others are now battling to stop this, so that transactions by U.S. companies that are conducted overseas are exempted from the rules. They argue that it is ‘burdensome’ for global banks in one jurisdiction to have to comply with regulation emanating from another jurisdiction, and they want to get all foreign transactions exempted from regulation. If they succeed, this would constitute a basic and gigantic offshore escape route which would kill effective regulation of this industry, lead to yet another race to the bottom on financial regulation, and strike at the very foundations of global financial reform. The stakes are high.
Worryingly, Michel Barnier, the European Commissioner for Internal Market and Services, and several European and other finance ministers, appear to have sided with the financial lobbyists, and want financial regulation to stop at national borders.
The core question to consider here is: whose priorities are most important here? Should one put the interests of financial stability and the general public first? Or is it more important to make life more convenient for global banks?
We urge any groups and people interested in financial stability issues to take an interest in these crucial issues.
From the Washington Post on Saturday:
“Pop quiz: What do the following financial crises — AIG, Lehman Brothers, Citigroup off-balance sheet SIVs, Bear Stearns, Long-Term Capital Management, and the “London Whale” of JP Morgan — all have in common?”
One thing they have in common, of course, is that these are names for some of the worst financial disasters that have hit the world in recent years. But there’s something else they have in common too. The article cites Gary Gensler of the U.S. Commodity Futures Trading Commission (CFTC), one of few U.S. regulators to have tenaciously tried to rein in many Wall Street abuses:
“According to a speech given by Gensler earlier this month, they all involved exposures to derivatives across countries.
And, in more detail:
“AIG Financial products was run out of London as a branch of a French-registered bank. The U.S. Lehman Brothers Holdings guaranteed 130,000 outstanding swaps contracts from their London affiliate. Citigroup’s off-balance sheet financial instruments were launched from London and incorporated in the Cayman Islands. The two Bear Stearns hedge funds that collapsed, precipitating the firm’s failure and the taxpayer rescue, were incorporated in the Cayman Islands [TJN: and let's not forget the role of Wild West offshore Ireland in that particular debacle]. Long Term Capital Management’s swaps were booked in a Cayman Islands affiliate (that according to Gensler, who was with Treasury at the time of their 1990s collapse, was basically a P.O. Box). And, as the name stipulates, the London Whale trades of JPMorgan Chase were in London.”
Our emphasis added. We have written about this before.
Some time before the crisis, derivatives were accurately described by Warren Buffett as ‘financial weapons of mass destruction (WMDs)’ – and so it turned out. Key to the mess was Wall Street’s ability to escape regulation it didn’t like by going elsewhere to conduct the trades in jurisdictions (such as London) with laxer regulation.
Our emphasis added, again: those two words ‘escape’ and ‘elsewhere’ are close to being definitional for us at TJN. This is quintessentially offshore business.
This gigantic business is currently putting Europe and the rest of the world at grave financial risk – as if there wasn’t enough to worry about. The Washington Post continues:
“As Marcus Stanley, of Americans for Financial Reform [AFR], notes to Erika Eichelberger of Mother Jones, “Wall Street banks routinely transact more than half their derivatives through foreign subsidiaries. [TJN: Bloomberg analysis last year discovered that 62 percent of Goldman Sachs' and 77 percent of Morgan Stanley's derivatives operations were foreign.]
How big is this issue? Well, according to a recent letter by [tax justice hero] Carl Levin, Elizabeth Warren, Sherrod Brown and three other U.S. senators, the four largest U.S. commercial bank derivatives dealers alone, accounting for 93 percent of the $223 trillion notional value of the U.S. bank derivatives market (note: that is trillion, not billion), had over 3,300 foreign subsidiaries.
Now the U.S. 2010 Dodd-Frank financial reform bill has an excellent and potent ‘extraterritorial’ aspect: a principle that is one of the most powerful generic tools available in global financial regulation. Put simply, Congress granted authority to the CFTC (which regulates around 90 percent of U.S. derivatives markets) to oversee all derivatives transactions if they have a ‘direct and significant connection’ to the U.S. economy — whether those transactions are nominally located in the U.S. or in Cayman or in London. This stands to reason: if derivatives cowboys in London are putting U.S. taxpayers at risk, or vice versa, then the home country should be able to regulate that business, wherever it is.
And of course this is not purely a U.S. matter. Far from it.
For one thing, Wall Street is the biggest part of global markets in financial derivatives, and the financial crisis has shows us that in our interconnected world, one big country’s problems soon become everyone else’s problems. More importantly, there is an essential principle at stake here: that when risky trading activities happen, any country that is seriously at risk from these financial WMDs should not be rendered powerless to regulate to make them safer. The possibility of cross-border regulation is an essential, foundational principle that is worth defending to the last. And, perhaps still more importantly: giving individual countries free rein to regulate as they see fit, without concern for the impacts on other jurisdictions, is a tried and tested recipe for a race to the bottom: where the laxest jurisdictions get the most business, and others then face incentives and pressures to relax their regulation just to keep up in this dangerous race. At TJN we have seen this deadly dynamic again and again and again: on tax, on secrecy, on financial regulation, and otherwise.
So for Dodd-Frank to succeed, this potential for “extraterritorial” reach is absolutely essential: a foundation stone of the whole exercise.
And now comes the problem.
The ‘extraterritorial’ aspect of Dodd-Frank is now under serious threat, from two main quarters. First, Wall Street and assorted hangers-on in the United States are powerfully attacking the principle. As Marcus Stanley of AFR writes in U.S. News:
“On Monday, the U.S. became the first country in the world to require mandatory clearing of many derivatives contracts, a crucial protection in these previously unregulated markets.
But even as this crucial protection takes effect, Wall Street is mobilizing to create a back door escape route. Its goal is to prevent U.S. regulation of derivatives transactions by U.S. companies that are conducted overseas. This loophole could strike at the foundations of financial reform.
. . .
It would create an incentive for global banks to transact their business through whatever jurisdiction has the weakest regulations – a “regulatory haven” to match the tax havens that international corporations already use.
. . .
If they succeed, entities nominally based in foreign countries but active in U.S. derivatives markets will not have to comply with U.S. derivatives rules. This could potentially include foreign subsidiaries of U.S. banks, the numerous U.S. hedge funds incorporated in places like the Cayman Islands and subsidiaries of major foreign banks that are major dealers in the U.S. markets”
But, worryingly and more surprisingly, it’s not just U.S. lobbyists who are trying to undermine this crucial aspect of Dodd-Frank.
We have now seen an unholy alliance formed between Michel Barnier, European Commissioner for internal market and services, and George Osborne, UK Chancellor; Switzerland’s Eveline Widmer-Schlumpf; and several other finance ministers. They, too, want to stop Dodd-Frank at the U.S. borders. In a letter sent to U.S. Treasury Secretary Jacob Lew on April 18th, they stated that:
“we hold the view that as a principle, local regulations should not be extended beyond national borders.”
This is the classic recipe for a race to the bottom. Can we trust Switzerland, one of history’s top racers-to-the-bottom, to ensure that their derivatives regulations do not create enough of loopholes to lure lots of derivatives business? Of course not. London’s history in this respect makes it equally untrustworthy.
While Barnier may have made some useful moves on financial regulation in other areas, this letter goes in exactly, precisely the wrong direction. The justifications that the signatories of the letter for wanting regulation to stop at national borders include:
- If this happens, derivatives markets will recede into localised and “less efficient” structures.
- The simultaneous application of multiple rules to cross-border activity will result in conflicting, inconsistent or duplicative requirements on market participants, constituting “burdensome regulatory conditions.”
- (subtext: who do these Americans think they are?)
Now those complaints will carry a lot of weight especially among those who worry a lot about ‘burdensome’ regulations being applied to this market. For sure, extraterritorial regulation has the potential to make specific regulatory compliance issues more complex. But against this, weigh some other considerations.
First, this is not a story about the United States bullying other jurisdictions, although on the surface it could look that way. This is a case of weary, embattled, outgunned financial regulators facing up to enormously powerful financial interests, under heavy fire, to try and protect their citizens as best they can.
Second, if one is worried about efficiency and complexity, one should consider the complexity and inefficiency (not to mention injustice and disruption) that would result from more gigantic bailouts.
The right approach, of course, is to put financial stability and the fate of ordinary taxpayers around the world at the first order of priority, and the convenience of global banks in complying with regulation after that.
Given this big picture, some important details now need to be taken into account.
Dodd-Frank guidance does envision a role for what is known as ‘substituted compliance’, which would exempt foreign activity from falling under a home country’s rules — just so long as the home country (in this case the U.S.) deems the foreign rules to be good enough and equivalent to its own. In other words, instead of having regulators reaching into other jurisdictions to regulate risky activities, you effectively have regulators handing out certificates of good conduct to other jurisdictions and trusting them to regulate properly.
All this sounds like a good idea in theory – and indeed ‘substituted compliance’ may be a principle worth taking on board, as a co-operative end goal.
But if carried out too early, and in the wrong way, it could be a total disaster.
It is essential that this ‘substituted compliance’ only happens once both the requirements and the enforcement of the foreign regime’s derivatives protections are genuinely equivalent and good enough to be able to hand over to that foreign regulator. This approach, among other things, gives foreign regulators powerful incentives to shape up and put genuinely strong regulation in place, so as to get their hard-earned certificate of good conduct. This is a race-to-the-top incentive. This ‘strong version’ of substituted compliance puts the interests of taxpayers and societies first, and the interests of global banks second.
But a weak version of ‘substituted compliance’ would put the interests of global banks first and protect them from ‘burdensome’ financial regulation, where jurisdictions generally trust each other to regulate at home, as they see fit, and perhaps a few of the most egregious recalcitrants get slapped on the wrist or even have their certificates of trustworthiness temporarily withdrawn. This would be an appalling, race-to-the-bottom outcome.
So what is the approach reflecteded in the April 18th letter sent to U.S. Treasury Secretary Lew by Barnier and the finance ministers?
The letter does accept ‘substituted compliance’ as a general principle, which on the face of it is not necessarily in conflict with Dodd-Frank.
But the question now is: are the ministers angling for a weak version of ‘substituted compliance’, or a strong version? Well, the letter states, in part:
“as a principle, local regulations should not be extended beyond national borders. We expect any deviations from this principle to be narrow, and to exist only where there is a clear and specific justification.”
This looks exactly like the weak version, or something perhaps just as bad: a recipe for waiting until all jurisdictions are up to scratch before anyone does anything at all. That could be a recipe for waiting interminably, while the financial derivatives orgy continues unabated. (And there are other things, highlighted in the FT, that are worrying about the letter.)
We urge all organisations in Europe that have an interest in global financial stability to get up to speed on these crucial issues. A good place to start is here.