Reuters published an excellent piece in August on US derivatives dealers moving trades away from the US to overseas affiliates, largely in Europe. The story had all the pieces we like: regulation, liquidity and asset manager acceptance all featured heavily. In a media comment, ISDA said “It’s a tale of vanishing trades, shadow banking and international intrigue.” All true, sort of. Here’s what’s going on and what it means for counterparty risk management.
At the heart of the matter is that somehow (we’re not entirely sure where), European rules are more lenient than US rules on OTC derivatives. According to the Reuters story, the issue lies in a CFTC amendment to Dodd-Frank:
“Gensler and his staff tucked a 17-word insert into a 228-page amendment to the Dodd-Frank bill. The addition seemed to assure banks that the new derivatives rules wouldn’t apply to their overseas trading operations…. If those activities “have a direct and significant connection with activities in, or effect on, commerce of the United States,” then the rules would apply, Gensler’s addition read. One year later, at a late 2010 meeting of the CFTC’s board, one of Gensler’s legal aides declared that the passage in fact gave the regulator worldwide reach over U.S. banks’ trading operations.”
By 2012, Goldman Sachs had found that if they removed all guarantees from their OTC derivatives contracts then they could move any trade to a non-US affiliate and avoid the CFTC’s regulation. Trades moved overseas then came under the now-local regulator. Banks were able to make the loophole effective by having clients sign off on an ISDA agreement that allowed the move and that took away bank guarantees on the trade. Reuters says that in 2013, “U.S. banks seized on the gap in the new CFTC policy, according to lawyers and investors. They pressed clients to strip guarantees from hundreds of thousands of swaps contracts. Most went along, say lawyers and investors familiar with the effort.”
ISDA issued a media comment yesterday noting that “The article claims US banks are shifting derivatives trades overseas in order to benefit from “weaker” regulation in Europe and elsewhere…. The crux of the issue, then, is those trades conducted by US banks with non-US counterparties…. Many banks have therefore organized their operations in order to serve those clients. As a result, some trades with non-US clients are being conducted through non-guaranteed, non-US affiliates. (The obligations of a non-guaranteed affiliate are not guaranteed by the parent company.)” The solution to the problem, according to ISDA, is harmonization of OTC derivatives rules across regulatory jurisdictions.
In effect, Reuters says this is a regulatory dodge while ISDA says it is business in the service of the client. Both answers are likely correct, depending on the time and place and who is making the decision. But whichever answer is correct, in our view, is less interesting than the consequence: guarantees have been stripped from these transactions.
The move by banks to trade with any counterparty then move the trade to a non-guaranteed affiliate, or not issue the guarantee to begin with, takes away a key tenet in counterparty risk management. It is amazing to us that investors would accept this condition, except if they simply recognized that they would be shut out of the OTC derivatives market in the face of collective action by every major bank trading partner. Our research consistently finds the expectation of a counterparty guarantee, regardless of whether it exists or not, is a primary rationale for an asset manager or hedge fund to engage in a trade. Without this guarantee, the risk of the counterparty goes up substantially. Arguably the risk of a major US bank going belly up is low these days, but a loss of the guarantee means that counterparty risk management tools may need a rethink. We have not seen any evidence of major buy-side firms considering guarantees vs. non-guarantees in deciding on a trade or a trading partner. On a good day, as with any collateralized transaction, this arguably doesn’t matter. It’s the bad days that investors should be worried about. The message to counterparty risk managers is if your trading partner has changed to an overseas affiliate, and/or selected partners no longer offer guarantees on your OTC derivatives transactions, it may be worth looking for better alternatives.