Signup for our free newsletter:

SEC Unmasks Bank Swaps

Written By Briton Ryle

Posted June 26, 2014

If you have ever had to assemble a large screen TV, home theatre sound system, cable channel box and video game console all plugged-in together, you know you’re going to need a whole lot of manuals, a whole lot of time, and a whole lot of patience.

Government regulators in charge of plugging in an extensive array of new laws and regulatory devices designed to prevent a repeat of the 2008-09 financial crisis would gladly swap chores with you. They have already spent four years implementing changes put forth in the Dodd-Frank Wall Street Reform and Consumer Protection Act which was signed into law by President Obama in July of 2010.

Yesterday one more regulatory device was officially plugged into the system and switched on for the first time.

Now we wait and see how well it works.

The new rule affects foreign banks that enter into over-the-counter derivatives trades with U.S. banks, which includes the trading of the bad-boy of all derivatives… swaps.

Foreign banks trading certain instruments with U.S. banks are now required to register with U.S. regulators as “security-based swap dealers”, allowing the Securities and Exchange Commission to look into the particulars of these swaps trades to ensure there’s nothing fishy going on.

Opponents lost no time voting on a bill that would unplug this new regulatory device on Tuesday – the day before the new rule even came into effect. It’s like two roommates fighting over their entertainment system, with one guy plugging things in and the other guy trying to block him from doing so.

Dysfunction? Yes, to some extent. But there’s more too it than that – like self-interest, for instance. Let’s see what all the arguing is about this time.

Ensuring Transparency and Accountability in Derivatives

The Dodd-Frank Act covers a wide array of financial regulations designed to “create a sound economic foundation to grow jobs, protect consumers, rein in Wall Street and big bonuses, end bailouts and too-big-to-fail, and prevent another financial crisis,” the Senate Committee on Banking summarized.

One portion of the Dodd-Frank Act focuses on “bringing transparency and accountability to the derivatives market” – where banks trade products whose value is based on other products, such as options and swaps. This section of the Act “closes regulatory gaps and provides the SEC (Securities and Exchange Commission) and CFTC (Commodity Futures Trading Commission) with authority to regulate over-the-counter derivatives so that irresponsible practices and excessive risk-taking can no longer escape regulatory oversight”.

To accomplish this, it Act imposes “data collection and publication through clearing houses or swap repositories to improve market transparency and provide regulators important tools for monitoring and responding to risks”. In other words, the Dodd-Frank Act requires trades which were previously shrouded in secrecy to be published for all to see what is being traded and by whom.

The Act further imposes a requirement for foreign banks to register with the SEC as a “security-based swaps dealer” when certain trades with U.S. banks are entered into. ‘If you want to trade with us,’ the Act effectively says, ‘you have to identify yourself and sign up’.

This last requirement is what came into effect yesterday, outlining which specific types of trades will trigger this requirement for foreign banks to register.

As Reuters outlines it, “Any bank deemed a dealer must register with U.S. regulators and comply with potentially costly rules such as mandatory clearing to reduce default risk, and routing swaps onto regulated platforms to promote price transparency.”

Obviously, the requirement to take off your mask, take off your cloak and step into the light is something many parties are none too thrilled about. They grew pretty fond of those back-alley deals transacted under the cover of darkness.

But it’s just that sort of clandestine wheeling and dealing that contributed to the financial collapse of hundreds of banks, stock markets and real estate markets the world over in 2008. It may seem kind of ironic, but those opposed to these new rules of transparency include many of the banks themselves.

It’s kind of like a drug gang having their warehouse vandalized. They want the authorities to catch the perpetrators. But at the same time, they don’t want the cops to come inside and take a look around.

We’ll Just Go Trade Over There, Then

To avoid having the SEC and CFTC peer into their activities, some U.S. banks and trading firms have been registering with less strict foreign regulators, instead of having their foreign trading partners register with the U.S. In essence, if your friend can’t come over to your house to smoke pot, you’ll simply go to his house and smoke there, since his parents are not as strict.

Not so fast, says the Dodd-Frank Act. If U.S. banks and trading firms think they can keep their activities cloaked by trading under foreign regulations, the new regulation enacted yesterday will require them to register with U.S. authorities all such activities conducted in those foreign trading houses.

“The SEC rule also defines the scope of the SEC’s anti-fraud powers and spells out the process [U.S.] banks and others must follow if they wish to comply with the rules of a foreign regulator, rather than U.S. regulators,” Reuters explains the closing of the loophole.

The closing of this loophole that once allowed U.S. banks to trade under foreign rules, together with the more stringent requirements for foreign banks to register with U.S. authorities, are intended to “quarantine” U.S. banks and investors from toxic cross-border trades that were once able to enter the U.S. economy across an open border. Yesterday’s enactment of the new measures effectively puts a long line of guards on that border.

Opposition Already Mounting

But there is always someone who doesn’t like a new rule, and it is usually those who are going to be making less money because of it.

On Tuesday – the day before the new transparency rule came into effect – “the House of Representatives voted… to water down key parts of the 2010 Dodd-Frank Act, weakening the Commodity Futures Trading Commission’s power to regulate derivatives,” Reuters informs.

Who would be opposed to a new rule that sheds more light onto a previously darkened corner of the back-alley? “The [House] bill helps big banks and the Koch brothers,” Reuters answers.

The Huffington Post adds that the new transparency rule would limit the activities and profits of some of the largest banks on Wall Street, as well as “the billionaire Koch brothers, who have large financial and energy derivatives operations”.

Of course, those against any new regulation always make the same claim to support their opposition – it stifles business growth, of course.

“The purpose of this bill [the opposition bill voted for on Tuesday] is to remove barriers to business growth that have been imposed by over-reaching and burdensome regulations [the new Dodd-Frank transparency rule],” New York Republican Representative Michael Grimm explained.

Get Real

I say come off it. We all know the real business growth that would be stifled by such new transparency regulations… their own.

“Swaps markets allow borrowers with different kinds of loans to exchange those loans with each other,” the Financial Times explains the banks’ addiction to derivatives. “The borrowers are looking for an advantage they did not receive from their original loans, such as a particular currency.”

That’s the real reason for their opposition… the banks are “looking for an advantage they did not receive from their original loans”. In today’s low interest rate environment, banks barely make any money from lending to their clients. So they need these swaps and derivatives to amplify their profits, using leverage to multiply their returns several times over.

Unfortunately, new rules limit the amount of leverage banks are allowed to use, which must be disclosed to regulators and investors alike. That is why clandestine swaps were so popular… no one really knew who was trading what or how much except for the two parties involved in the trade. As such, no one would ever know just how much leverage and risk a bank was taking on.

This is why the 2008-09 crisis resulted in so many collapses across the nation and around the world. No one really knew just which banks owned which instruments, making it virtually impossible to hold anyone accountable.

Tightening regulations are never comfortable. But to those who have nothing to hide they are manageable. It’s only the shady characters who have a problem with them. Pay attention to who are opposed to this new rule.

These are the shady ones to keep an eye on.

Joseph Cafariello