WASHINGTON (CN) - Commodity Futures Trading Commission Chair Gary Gensler urged a room full of stockbrokers and traders at a major financial conference to accept regulation of their foreign subsidiaries under the Dodd-Frank Wall Street Reform and Consumer Protection Act, to help prevent losses that begin abroad from coming home.
During his keynote address last week to the Sandler O'Neil Global Exchange and Brokerage Conference, Gensler reminded the audience that the collapse of the financial markets in 2008 was made much worse by heavy losses in the foreign offices of AIG, Lehman Brothers, Citigroup, and Bear Stearns.
Gensler didn't have to back to 2008 to make his point, noting that the $2 billion loss announced by JPMorgan Chase last month came from trades initiated at its London office.
Reiterating points he made during congressional hearings in May, Gensler said that given the way financial firms set up "hundreds if not thousands" of off-shore entities whose activities are ultimately backed by their U.S. based parents, it was inevitable that during a default or financial crisis that their risks come "crashing back onto our shores."
As evidence he pointed to Lehman Brothers, whose international unit in London had more than 130,000 outstanding swaps contracts when the firm was allowed to collapse, most of them guaranteed by the U.S. parent Lehman Brothers Holding.
In addition, he said, Citigroup used structured investment vehicles created in its London offices and incorporated in the Cayman Islands to clean up its domestic balance sheet, thus lowering its domestic capital reserve requirement.
When investors panicked during the meltdown and cashed out the offshore investments, Gensler noted that, "Citigroup in the US assumed the huge debt, and taxpayers later bore the brunt with two multi-billion dollar infusions."
Gensler also cited the collapse of Bear Stearns in 2008 and Long-Term Capital Management in 1998, both of which had huge swaps booked in the Cayman Islands, as evidence that foreign affiliates should be covered under Dodd-Frank because of the risk to U.S. parent companies, and taxpayers.
"There are many in the industry who want us to ignore these experiences. They might tell you that swap trades booked in London branches shouldn't be brought under Dodd-Frank reform. They might tell you that their affiliates guaranteed by their mother ship shouldn't come under Dodd-Frank reform. They might tell you that their affiliates acting as conduits for swaps activity back here shouldn't be brought under Dodd-Frank reform. If we follow their comments, the result would be that American jobs and markets would move offshore but the risk would still be very much part of the activities of these U.S. financial institutions. Particularly in times of crisis, the risks would come back to affect our economy," Gensler said.
Section 722 of Dodd-Frank mandates that its swap reforms apply to activities outside the United States if those activities have "a direct and significant connection activities in, or effect on, commerce" of the United States.
The financial industry has aggressively lobbied congress to exempt foreign affiliates from complying with Dodd-Frank either for swaps and trades between affiliates of the same company or with third parties saying such regulation would be a competitive disadvantage.
A bill to exempt foreign affiliates from much of Dodd-Frank was introduced by US Rep. James Himes of Connecticut last year but has not yet come up for a vote before the full House.
Gensler opposes the bill saying in his keynote address that "swaps market reform should cover transactions not only with persons or entities operating in the U.S., but also with their overseas branches. In the midst of a default or a crisis, there is no satisfactory way to really separate the risk of a bank and its branches."
He would also extend coverage to "transactions with overseas affiliates that are guaranteed by a U.S. entity, as well as the overseas affiliates operating as conduits for a U.S. entity's swaps activity."
The CFTC and the Securities and Exchange Commission are expected to release guidance on cross-border application of Dodd-Frank to swaps soon.
In testimony before the US Senate Committee on Banking, Housing and Urban Affairs last month, Gensler said that application of Dodd-Frank to cross-border swaps would likely be tiered so that some of the market reforms such as requirements for capital, risk management and recordkeeping would apply to the firms themselves while others, such as clearing, margin and real time public reporting would apply at the transaction level.
In his closing remarks to room full of Wall Streeters, Gensler said recent efforts to cut the commission's budget "put the interests of Wall Street ahead of those of the American public by significantly underfunding the agency Congress tasked to oversee derivatives - the same complex financial instruments that helped contribute to the most significant economic downturn since the Great Depression."
Gensler noted that with just 10 percent more staff than it had in the 1990's the CFTC is being asked to oversee the swaps market which he said is eight times larger than the futures market the commission has traditionally overseen.