Correction appended: July 8, 2013, 9:46 p.m. E.T.
Derivatives, those complex exploding financial securities that were at the heart of the 2008 Lehman Brothers collapse and global financial crisis, have been at the top of bank reformers’ agenda over the past five years. Figuring out a way to make them — and thus our financial system — safer has been one of the chief focuses of the Dodd-Frank financial-reform bill. But in the next week, a fight over some 20 words in that bill will come to a head, and if the battle goes the wrong way, it will put us right back to where we were in 2008 — with a system that is neither transparent, nor safe.
At issue is whether the new rules on derivatives will apply only in the U.S., or internationally — the latter meaning wherever U.S.-registered swaps dealers, which include all the major global banks like Citibank, JPMorgan, Deutsche, etc., trade. It’s a decision with enormous implications. Derivatives are part of a $300 trillion global market that developed from the 1980s onward and has been almost entirely unregulated since then. That is, it was unregulated, until Commodity Futures Trading Commission (CFTC) chairman Gary Gensler got on the case five years ago. Despite intense industry and political lobbying pressure, Gensler (a former Goldman Sachs partner about whom I wrote a long profile last year) has almost single-handedly led a global charge to clean up the derivatives market, increasing transparency and reporting standards, forcing through new rules about professional conduct and pushing for tougher capital requirements for traders.
Now, with his tenure set to expire by the end of the year (or whenever a successor is named and confirmed), he very much wants internationally binding rules to be the last feather on his reform cap. “American financial firms have between 2,000 and 3,000 legal entities spread around the globe, and banks are asking us to say that the rules we’ve set for them in the U.S. shouldn’t apply to those entities,” Gensler told me in an interview last week. “If we allow them to operate outside these common-sense reforms that Congress has mandated, we will not only have failed the public, but we’ll have repealed derivatives reform altogether.”
History shows he has a strong point. Many of the financial crises of the past decade involved derivatives, and some of the highest-profile events — things like the fall of the mega hedge fund Long-Term Capital Management (LTCM), the subprime crisis, the collapse of AIG and more recent events like JPMorgan’s London Whale trading scandal — involved trades that were booked overseas, rather than in the U.S. The financial industry, and derivatives trading in particular, is inherently global — indeed, a recent article in the International Financing Review noted that U.S. banks route about 50% of their derivatives trades overseas. And you can bet that number will shoot up if domestic rules for U.S. firms are suddenly much tougher than they are abroad.
“We have to protect the American people,” says Gensler, who was working as an Under Secretary in the Treasury Department of the Clinton Administration in 1998 when LTCM collapsed — and personally had to drive to the hedge fund’s Connecticut headquarters on a Sunday to sort through $1.2 trillion worth of totally opaque overseas derivatives bookings to try and figure out how the trades might ricochet back to the U.S. “We can’t say, ‘Oh sure, you can have a P.O. box in the Cayman Islands and trade from that, but the mother ship back home will guarantee those trades,’ even if reporting and regulatory standards around them are nonexistent,” he says. “This is ultimately about too big to fail.”
It seems like a no-brainer argument. But the banking lobby, five years on from the financial crisis and resulting Great Recession, remains intent on bucking reform efforts. In order to push the 20 words through in a format that would make Dodd-Frank derivatives rules truly internationally binding, Gensler needs to get agreement from four other CFTC commissioners, two of whom are Democrats (like Gensler), and two of whom are Republicans. All of them (along with any number of Congress members and government officials) are being lobbied heavily by U.S. banks, E.U. financial institutions and even E.U. regulators, all complaining that the overseas clauses would be “overreach” by a U.S. regulator. Indeed, the E.U. internal-markets commissioner Michel Barnier has gone so far as to call Gensler’s thinking “flawed,” and is petitioning U.S. officials like Treasury Secretary Jack Lew directly about the case.
(VIDEO: Q&A With CFTC Chairman Gary Gensler)
The good news is that despite bank pressure to have Gensler thrown under the bus like his predecessor, Brooksley Born — who lobbied unsuccessfully for derivatives reform before the financial crisis — there’s no way that he will be out of office before the overseas exemption for Dodd-Frank expires on July 12. In a sense, all Gensler has to do is wait around another week and the rules will be in place.
The bad news is that it’s quite possible that the CFTC commissioners won’t agree on tough and clear wording for those rules, and that will create a big loophole that banks and their lawyers can drive a truck through (many, like JPMorgan and Citi, are already studying all the legal possibilities that might be available to them). And a second bit of bad news is that whoever comes in after Gensler will almost certainly be less competent and less aggressive than he was. And that matters, because if the rules end up murky, as appears likely, then genuine compliance will depend on how aggressively the new commissioner fends off further efforts to weaken the rules or get around them.
Either outcome would be a pity, since pretty much everyone in the financial-reform camp — from Senator Elizabeth Warren to MIT finance professor Simon Johnson, to groups like the Consumer Federation of America and Americans for Financial Reform — believe that tough overseas derivatives rules that mirror those in the U.S. are essential for keeping the American financial system and economy safe. “So many people lost their jobs because of the 2008 crash,” says Gensler. “We can’t give this all up now.” It’s too bad that the politicians representing them, and the banks that should be serving them, don’t see it the same way.
MORE: The Money Cop
An earlier version of this article misstated the name of a publication. It is the International Financing Review, not Financial.
An earlier version of this article misidentified Elizabeth Warren as a Congresswoman. She is a Senator.