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Wall Street Faces New U.S. Scrutiny of Derivatives Tactic

By Silla Brush, Bloomberg

Wall Street banks face heightened scrutiny from the Commodity Futures Trading Commission over their latest tactic to escape U.S. trading rules for overseas derivatives.

The regulator sent letters today to JPMorgan Chase & Co. (JPM), Goldman Sachs Group Inc. (GS), Bank of America Corp., Citigroup Inc. (C), and Morgan Stanley (MS) seeking further information about the practice of removing parent-company guarantees from overseas trades. An agency official who asked not to be named because the letters aren’t public confirmed that they were sent to the banks.

U.S. banks have been relying on the de-guaranteeing process to trade derivatives with other dealers in a way that avoids curbs imposed by the Dodd-Frank Act on the $700 trillion global market. The restrictions were designed to increase transparency and prevent losses booked in overseas units from threatening the stability of a U.S. bank.

Defusing Derivatives

The letters were signed by Gary Barnett, director of the CFTC’s division of swap dealer oversight, the official said.

The five banks receiving the letters control 95 percent of cash and derivatives trading for U.S. bank holding companies as of March 31, according to the Office of the Comptroller of the Currency.

Latest Step

Zia Ahmed, a Bank of America spokesman, Mark Lake, a Morgan Stanley spokesman, and Andrew Williams, a Goldman Sachs spokesman, declined to comment. Spokesmen for the other two banks didn’t immediately respond to e-mail requests for comment that were sent outside of normal business hours.

The CFTC letter is the latest step regulators have taken to review the practice, which has also attracted scrutiny by officials at the Federal Deposit Insurance Corp. and Securities and Exchange Commission. Representative Maxine Waters of California, the top Democrat on the House Financial Services Committee, has called for a CFTC investigation to ensure banks aren’t increasing risk to the U.S. financial system.

Swaps, a type of derivative previously traded directly between banks and other firms, were largely unregulated prior to the 2008 financial crisis and were blamed for exacerbating it. Critics warn that without curbs on swaps trading overseas, U.S. taxpayers could face a repeat of 2008, when they had to rescue American International Group Inc. (AIG) from billions of dollars in losses attributed to a London unit.

Dodd-Frank Rules

The wrinkle arises from the rules that Dodd-Frank applies to trades in overseas affiliates that operate with the financial guarantee of their parent. Non-guaranteed affiliates are subject to less scrutiny than overseas branches or guaranteed affiliates, the agency said in July guidance.

Wall Street has sought repeatedly during the last four years to curb the reach of CFTC rules overseas. Three of the industry’s largest lobbying organizations sued the agency, seeking to overturn the CFTC’s policy for cross-border trading. A federal court in Washington heard arguments in the case today.

The Securities Industry and Financial Markets Association, the banking industry’s main lobbying group in Washington, is defending the banks’ recent steps. In private talking points drafted by the association and obtained by Bloomberg News this month, the industry says the de-guaranteeing practice is lawful and allows U.S. banks to compete on a level playing field with their foreign-based counterparts.

Price Transparency

In the Sifma memo, industry representatives say the process “does not undermine the price transparency goals of Dodd-Frank.” Requirements including the use of new swap-execution facilities are meant to provide bank clients with better pre-trade transparency, the group said.

“This rationale for mandatory Sef trading is not applicable to swaps between dealers, as dealers already have a high degree of pre-trade price transparency,” according to the memo.

As a result of the change in business, trades with non-U.S. participants are occurring off the new Dodd-Frank swap-execution facilities because they are being done by the non-guaranteed subsidiaries, John Nixon, an executive at London-based ICAP Plc (IAP), the world’s largest inter-dealer broker, said at an advisory meeting of the CFTC on May 21.

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