Thursday, January 05, 2012

Japanese Securities and Banking Regulators Fear that Volcker Rule Proposed Regulations Would Hurt Government Bond Trading

The proposed regulations implementing Dodd-Frank’s Volcker Rule provisions would have an adverse impact on the trading of Japanese government bonds, in the view of the Financial Services Agency and the Bank of Japan. In a letter to the SEC, the Japan’s financial regulators said that the Volcker proposals would raise the operational and transactional costs of trading in Japanese government bonds and could lead to the exit from Tokyo of Japanese subsidiaries of US banks.

In addition, some Japanese banks might be forced to cease or dramatically reduce their US operations. In turn, these reactions could further adversely affect liquidity and pricing of the government bonds. Even more, sovereign bond markets worldwide might be affected at this critical juncture. Thus, the FSA and Bank of Japan urged the SEC and the banking agencies to expand the range of exempted securities to include Japanese government bonds.

The Japanese regulators posit that the extraterritorial application of the Volcker Rule restrictions on proprietary trading and relationships with hedge funds and private equity funds to foreign entities owned by foreign financial groups could adversely affect the liquidity of the financial markets globally. It could also have a negative impact on US financial stability, which the Dodd-Frank Act aims to achieve as a primary objective. As long as the groups are subject to appropriate group-wide supervision by foreign supervisors, noted the letter, such foreign entities should be exempted from the requirements.

According to the proposed restrictions, US banking groups and foreign banking groups with a branch or a subsidiary in the US would be subject to restrictions on their current positions of government bonds, except US treasuries. While market making and other less-risky trading are exempted, noted Japan’s financial regulators, the restrictions would impose a significant burden and higher costs on foreign banks, including major Japanese firms, and make sovereign bond trading less attractive and profitable.

It is also possible that the smooth functioning of the Bank of Japan's money market operations would be adversely affected by the proposed restrictions. This might, in turn, exert extremely negative pressures on sovereign bond markets worldwide through reduced liquidity and a rise in volatility, which would be particularly worrisome under current financial market condition.

Short-term foreign exchange swaps would also be subject to the proposed restrictions. In many jurisdictions, short-term foreign exchange swaps are used uniquely for the purpose of US-dollar funding by major foreign banking entities, observed the regulators, including the Japanese Banking Groups, rather than as tools for proprietary trading. If foreign exchange swaps are restricted by the new Volcker regulations, cautioned Japan’s financial regulators, branches and subsidiaries of US banks would not be able to provide USD liquidity to foreign counterparts through short-term swaps.

This could squeeze USD funding significantly outside the US and accelerate the deleveraging of European banks by liquidating foreign assets. In addition, it does not seem consistent to restrict short-term swaps while FX spot trading and long-term swaps, through which more risks could be assumed, are exempted. Therefore, the FSA and central bank strongly request that short-term foreign exchange swaps be exempted from the Volcker restrictions.

Non-US asset management funds would also be subject to the restrictions, said the regulators, except those which do not have US investors or those which would need to register under the Investment Company Act. In practice, it would be almost impossible for an investor to judge whether a fund is exempted or not, and the proposed restrictions could create an uncertain investment climate for non-US funds, resulting in significantly reduced investments in those funds and reduced investment opportunities for US investors. The FSA and central bank said it would be more appropriate to dialogue with foreign regulators to find a clear objective definition of the funds in question.

Finally, and more broadly, Japan’s regulators urged the SEC and the banking agencies to take due account of the cross-border impact of financial regulations and the need to collaborate with affected countries. When it comes to the extraterritorial application of financial regulations, emphasized the FSA and Bank of Japan, the home authorities bear the primary regulatory responsibilities.

Considering the potentially serious negative impact on the Japanese markets and associated significant rise in the cost of related transactions for Japanese banks, the regulators urged the SEC and banking agencies to refrain from extraterritorial application of the Volcker restrictions, or to amend the definition of “control” and “affiliate” in the final regulations so as not to include foreign joint ventures and foreign subsidiaries which are controlled by foreign banking groups.