Wednesday, August 03, 2011

Chairman Bachus Cautions that Dodd-Frank Derivatives Regulations Could Engender Regulatory Arbitrage

In a letter to Treasury Secretary Tim Geithner, House Financial Services Committee Chair Spencer Bachus (R-Ala) said that there is no indication that the international community is following the US lead on regulatory reform of the derivatives markets. Specifically, there is no concrete evidence that international regulators will, in fact, adopt the more controversial provisions in Title VII of Dodd-Frank, such as the Section 716 swap push-out rule requiring banks to divest risky derivatives activities. Since non-US regulators are moving at a slower pace in implementing derivatives reforms, capital and liquidity will flow out of the US to more hospitable regulatory environment. This is heightened by the fact that some US regulators intend to advocate for what Chairman Bachus called an ``extremely broad’’ extraterritorial application of the US derivatives regulations.

He noted that Dodd-Frank prohibits the extraterritorial application of US derivatives regulations unless an offshore activity has a direct and significant connection with or effect on US commerce or when extraterritorial application is necessary or appropriate to prevent the evasion of Dodd-Frank. According to Chairman Bachus, the statutory language indicates that Title VII is to be applied outside the US in only limited circumstances. He is concerned by US regulator comments that regulations implementing Title VII may apply to an offshore entity solely because it is a subsidiary or affiliate of a US company. The prudential regulators seemingly took this approach in their recent margin proposal that expressly exempts foreign dealers from margin requirements if they conduct swaps with other foreign counterparties, but does not allow the off-shore subsidiaries of US companies to partake of this exemption.

Chairman Bachus emphasized that the mere fact that a non-US entity is an affiliate or subsidiary of a US company does not create a direct and significant impact on the US and should therefore not be determinative on whether such an entity should be subject to Title VII. Subjecting a non-US entity to Dodd-Frank regulations solely because of its affiliation would be creating an unequal competitive environment for US and non-US institutions. Similarly, providing exceptions from regulations solely for non-US entities not controlled by US companies will disadvantage US companies and their non-US operations. The US should not extend its regulations to cover activities or entities subject to comprehensive regulation by a comparable non-US regulator.

The Chair asked Treasury to respond to a number of specific questions by August 15, 2011, including what is being done to coordinate the implementation of derivatives reforms with non-US regulators and how to ensure that no implementation gaps will contribute to competitive disparities. Also, the Chair wants to know if the extraterritorial application of margin rules is necessary if other countries plan to harmonize their rules in coordination with the US.

If Treasury believes that the mere fact that a non-US entity is an affiliate or subsidiary of a US company is sufficient for the extraterritorial application of Title VII, said the Chair, then Treasury should explain how every transaction between a non-US subsidiary with a US parent and a foreign counterparty affects US commerce in a direct and significant manner or, alternatively, is designed to evade US regulations.

Chairman Bachus specifically asks the Treasury Secretary, in his capacity as Chair of the Financial Stability Oversight Council, if he believes that Section 716 of Dodd-Frank is necessary to ensure the safety and soundness of the US financial system. Also, since non-US jurisdictions will not be enacting a provision similar to Section 716, Chairman Bachus would like to know what the Secretary is doing as FSOC Chair to ensure that the SEC and CFTC will implement the rule so as to mitigate its impact on the ability of US institutions to compete against their foreign counterparts.

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