June 25, 2014
By WILLIAM ALDEN
The Securities and Exchange Commission adopted a rule on Wednesday to rein in derivatives trading by foreign branches of United States banks, moving to strengthen oversight of a risky business that helped cause the financial crisis.
The rule, unanimously supported in a vote by the agency’s five commissioners, clarifies which foreign subsidiaries need to register with the S.E.C. and become subject to tougher standards for reporting trades and for maintaining a cushion against losses. The new rule stems from the Dodd-Frank financial overhaul law that was passed nearly four years ago.
The S.E.C. is trying to prevent a repeat of a financial crisis like the one in 2008, which showed vividly the potential for risky trading in derivatives — contracts that derive their value from an underlying asset, like a corporate bond or a mortgage security — to come crashing back to United States shores. Derivatives trades by a London unit of the American International Group crippled the insurance giant and worsened a crisis that nearly toppled the United States economy, requiring a huge taxpayer bailout.
But the rule adopted on Wednesday contains a potential loophole that banks could use to avoid registering foreign subsidiaries, two of the commissioners said. While the rule expands the agency’s oversight to subsidiaries that are legally guaranteed by their parents, it does not require the registration of subsidiaries that are not explicitly guaranteed.
That could lead to a situation where banks route their overseas trades through a nonguaranteed subsidiary with the implicit understanding that they will rescue those subsidiaries if need be, according to two of the commissioners, Kara M. Stein and Luis A. Aguilar. Already, some banks have removed legal guarantees for subsidiaries in response to similar rules by another agency, the Commodity Futures Trading Commission.
“This rule before us today ignores this reality of corporate finance by assuming that a United States parent is linked to the foreign affiliate only when an explicit recourse guarantee is provided,” Ms. Stein said. “This, to me, is the epitome of form over substance and may be an easy way to avoid our rules.”
Even the chairwoman of the S.E.C., Mary Jo White, noted in her opening remarks that the rule might “not capture all of the risks of the vast cross-border derivatives market that may flow back to the United States.”
But the agency, which has faced lobbying from Wall Street and criticism from consumer advocates for its delay in adopting the rule, ultimately put these concerns aside in the interest of getting the job done.
Completing the registration rule was only the first part of the S.E.C.’s task to strengthen its regulation of the vast market for derivatives trading overseas. While the majority of derivatives trading is overseen by the futures trading commission, the S.E.C. regulates derivatives that are based on securities, including bonds and stocks — a crucial market on Wall Street.
The vote on Wednesday covered narrower territory than a proposal released last year. For example, after aggressive resistance from Wall Street, the S.E.C. chose to delay a rule that would govern trades conducted in the United States between two foreign firms. The agency said that the issue was complex and that it would solicit additional feedback from Wall Street before completing a rule.
“Over all, the S.E.C. took a small step forward but two steps backward today,” said Dennis M. Kelleher, the head of the consumer advocacy group Better Markets, referring to the delay in the rule, as well as the potential loophole in the registration requirement.
The opening in the registration rule, he added, is “an invitation to Wall Street to exploit the gaps and evade the rules and expose U.S. taxpayers to pretty serious risks of U.S. bailouts.”
The S.E.C.’s general counsel, Anne K. Small, maintained that the agency did not have the legal authority to regulate subsidiaries that lacked explicit legal guarantees. “We have considered the questions of authority carefully,” Ms. Small said during the meeting on Wednesday.
Whenever it writes a rule that affects Wall Street, the S.E.C. has to consider the threat of litigation. The C.F.T.C., after adopting its own derivatives rules last year, was sued by three industry groups that contended the agency had failed to evaluate the effect of the rules on Wall Street. The S.E.C. is keeping a close eye on that lawsuit, which has yet to be resolved.
Ms. White said the derivatives rule had been “substantially strengthened” from the original proposal. Among the changes, banks now need to register their guaranteed subsidiaries even if the subsidiaries are doing only foreign trades. In addition, the rule said that a “guarantee” included any legally enforceable right of recourse, whether written or oral.
“The approach we take in these final rules addresses the potential risks posed by those operations to the extent feasible under our statutory authority,” Ms. White said.
Even Mr. Aguilar and Ms. Stein, who expressed the most forceful criticisms among the S.E.C.’s five commissioners, ultimately chose to support the rule, calling it a “step forward.”
“We have spent hundreds of hours poring over alternatives,” Ms. Stein said. “While I’m disappointed the final product does not address my key concerns, I also think we need to get this one done and move on to the next rule.”
