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*Banner image taken September 2008. 

On March 9, IATP submitted its first regulatory letter of the year to the Commodity Futures Trading Commission (CFTC). Some of our letters have and will concern agricultural price risk management and prevention of market manipulation. But other letters, including the March 9 letter, concern rules about systemic financial risk that affect all asset classes regulated by the CFTC, including agricultural contracts. Rules, well implemented and enforced by adequately resourced staff, can make the difference between a financial system that absorbs shocks, such as the coronavirus and global increase in oil production that have triggered the current collapse in oil prices and equity share values, and a system that amplifies the price responses to the shocks. Before summarizing the content of the IATP letter and its context, a little history may help us better understand the recent impact of an unregulated or underregulated financial services industry.

Some of the causes of the 2007-2008 Wall Street bankruptcies, which resulted in at least $20 trillion in damages to the U.S. economy, were homegrown and entirely self-inflicted. For example, in April 2004, the Securities and Exchange Commission granted the request of Hank Paulson, then CEO of Goldman Sachs (and the Secretary of the Treasury during the crash) and other big bank CEOs, to remove limits on the amount of debt and risk that their banks could accumulate. When the value of their assets cratered, they did not have enough capital reserves to cover their losses. The Federal Reserve Bank rescued them with $29 trillion in ultra-low interest rate loans, $10 trillion of which went to foreign central banks to rescue their “national champion” financial institutions, most with U.S. subsidiaries.

But other causes included unregulated financial products that were arranged and marketed in the U.S. but traded by thousands of foreign subsidiaries and affiliates of U.S. financial firms on exchanges outside the U.S. This practice continues today, mostly a normal commercial practice. But unregulated or badly regulated cross-border trading can have very bad outcomes, as summarized by a former official at the London subsidiary of Bank of America Merrill Lynch commenting on the 2018-2019 theft of $60 billion in taxes derived from the European trading of equity products by British subsidiaries of U.S. bank holding companies: “There was this culture in London, and it really came from New York,” he said. “These guys were either from New York or trained in London at New York banks, and they looked at Europe as their playground. People at the highest levels were collaborating to rip off countries.”

The Dodd Frank Wall Street Reform and Consumer Financial Protection Act of 2010 (Dodd Frank Act) authorized U.S. financial regulators to issue rules and negotiate with foreign regulators to enable the cross-border trading of financial products while preventing regulatory evasion and financial misconduct. By 2013, the CFTC had finalized guidance to the financial industry on how it would regulate the cross-border trading of a previously unregulated class of financial product, swaps (more formally, Over the Counter derivative contracts). (IATP wrote in support of the draft guidance.) Following a Wall Street lawsuit against the guidance won by the CFTC, in the waning days of the Obama administration, the CFTC proposed a rule on cross-border swaps trading that IATP supported, with a few caveats.

One of the most important features of the 2016 proposed rule is the Foreign Consolidated Subsidiary (FCS) definition and accounting framework that connects the FCS to the U.S. “parent entities,” i.e., bank holding companies. The proposed FCS designation enables the CFTC to access and analyze the swaps trading data of foreign subsidiaries and affiliates of U.S. bank holding companies to determine if the trading losses and/or contract risks pose a danger to the U.S. parent and to U.S. commerce. FCS authorized auditing should help prevent a scale of losses and risks that could trigger a cascade of one or more parent company’s defaults on other contracts, necessitating a bankruptcy filing or a taxpayer funded bailout. In normal market conditions, use of the FCS likely would be rare. But when conditions become abnormal, it’s necessary to have a hammer to break the emergency glass.

Donald Trump campaigned against Wall Street. But President Donald Trump, enabled by Wall Street lobbyists and Republican majorities in financial regulatory agencies, has carried out his promise to “do a big number” on Dodd Frank. The cross-border rule, if finalized as proposed, will be another promise kept.

The 2020 proposed cross-border rule withdraws the proposed 2016 rule and with it the FCS tool, “due to market and regulatory developments in the swap markets and in the interest of international comity.” The “market developments” were explained as nothing more than confidential market participant discussions with CFTC staff and Commissioners about “mitigating market distortions and inefficiencies and avoiding [market and liquidity] fragmentation.” IATP reminded the CFTC that confidential discussions with market participants do not provide the administrative record required to withdraw a proposed rule.

The “regulatory developments” rationale referred to just one source, the 2019 report of the Financial Stability Board on progress reported by FSB members (central banks and financial regulators) in regulating swaps markets. However, the FSB Secretary General noted in 2019 that while there has been progress, there are still many signs of vulnerability and risks to the system given the incomplete implementation of reforms. We noted the CFTC’s own notorious underfunding as the scale of markets and diversity of financial products it oversees increases.

“International comity” refers to the legal framework governments use to defer to the laws, rules and administrative procedures of other governments. In the CFTC, the principle of regulatory deference to foreign regulators takes the form of grants of “substitute compliance” for foreign regulatory regimes that are comparable to and as comprehensive as the CFTC regime. The 2020 proposed cross border rule removes the comprehensiveness criterion and introduces so much flexibility in the comparability determination as to make likely legal inconsistency among grants of substitute compliance to different governments.

Among IATP’s proposed recommendations to the CFTC were to:

  • Restore the comprehensiveness requirement for substitute compliance;
  • Restore the FCS designation to enable the CFTC to determine whether foreign subsidiary trading losses and contract risks could trigger U.S. bank insolvency and another round of taxpayer funded bailouts;
  • Ensure that the grants of substitute compliance verify and remain updated about foreign regulator capacity;
  • Re-propose the 2020 rule based on the 2016 proposed rule and the 2013 guidance.

IATP has worked on the cross-border rule because it will affect a lot of money and people affected by that money. U.S. corporate debt is approaching a record $10 trillion, with 36% of that debt marked in 2019 at the “lowest investment grade rating” (i.e., junk bond rating) according to the FSB Secretary General. If trading even part of that debt in cross-border swaps is not subject to stringent regulation and oversight, 2018’s low default rate in Collateralized Loan Obligations could increase to the point where the swaps market is a financial shock amplifier, rather than an absorber. A March 12 New York Times article reports that cash-strapped major market makers are not able or willing to buy assets at falling prices, resulting in unusual price co-movements, a flashback to the 2008 market collapse. It perhaps goes without saying that global financial markets are already experiencing more than enough major shocks to the system.

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