Offshore U.S. oversight of derivatives may bolster defenses against JPMorgan-type losses

May 29, 2012

By Nick Paraskeva

NEW YORK, May 29 (Thomson Reuters Accelus) – U.S. regulators are looking to use new their oversight authority over foreign derivatives trades to reduce the chances of new shocks such as JPMorgan Chase & Co’s trading loss of at least $2 billion.

Pointing out that JPMorgan’s money-losing trades on a credit default swap index were conducted in a London unit, similar to recent failures at AIG and Lehman Brothers, Commodity Futures Trading Commission Chairman Gary Gensler said implementation of Dodd-Frank regulatory reform rules would improve supervision of such activity in the future by expanding cross-border oversight.Gensler and Securities and Exchange Commission Chairman Mary Schapiro said their agencies would soon issue guidance on cross-border application of Dodd-Frank swaps rules, and Gensler urged lawmakers not to roll back Dodd-Frank derivatives requirements for affiliates of U.S. based companies.

“It’s critical that we do not retreat from reforms that will bring greater transparency and competition to the swaps market, lower costs for companies and their customers, and protect the public from the risks of these international markets,” Gensler told a Senate Banking Committee hearing last week.

The CDS indices involved in the JPMorgan trades are already encompassed under CFTC’s anti-fraud and anti-manipulation regime, and a clearing house clears trades in the CDS indices, Gensler said. However, JPMorgan is not yet registered as a swaps dealer, as those rules have not been finalized.

If Dodd Frank were already fully implemented, the swap positions would be centrally cleared, and would have been reported to swaps data repositories, thereby giving more transparency to regulators and the public. Gensler also confirmed that the CFTC’s Division of Enforcement has opened an investigation related to credit-derivative products traded by JPMorgan’s Chief Investment Office.

The Senate Banking Committee will hold a follow up hearing on June 7 with the banking regulators who had direct responsibility for JPMorgan. CEO Jamie Dimon will testify in a separate hearing.

“As these events have amply demonstrated – much to the dismay of those who endlessly seek to roll back this tough, new law – Wall Street continues to need better risk management, vigorous oversight and unyielding enforcement,” Banking Committee Chairman Tim Johnson said on Friday.

But Republican Sen. Richard Shelby looked to blame the regulators. He accused CFTC of lacking foresight — Gensler has acknowledged learning about JPMorgan’s loss from press reports — and said a CFTC had created widespread uncertainty on the regulation of OTC derivatives by implementing Dodd-Frank too slowly.

On the securities side, Securities and Exchange Commission Chairman Mary Schapiro told the hearing the agency is now focused on what JPMorgan has disclosed in its public filings and earnings releases, compared to when the information was first known internally. Disclosure is also required for changes in risk models that are used, such as Value at Risk (VaR).

Schapiro said the SEC is also considering whether the sort of trading involved in the JPMorgan losses would be encompassed by the Volcker rule banning risky trading by banks for their own accounts. The rule is part of Dodd-Frank but implementing regulations are not yet adopted and JPMorgan has led resistance to it. The legislation allows for portfolio hedging, which JPMorgan said was the goal of its trades, but a firm must meet strong criteria.

Hedging must be correlated to the risk, cannot give rise to new exposure, and be continually managed. A firm is also required to document the risk-mitigating purposes of a trade when the hedging is done outside the area where the risk was generated.

The CFTC has also scheduled on May 31st a roundtable with industry and the public to discuss their proposed regulations to implement the Volcker Rule. This will focus on the rule’s provisions for exempting hedging and market-making.

The SEC and CFTC both need more money to implement their reforms, the regulators and Johnson said.

“This trading loss has been a wakeup call for many opponents of Wall Street reform and the need to fully fund the agencies responsible for overseeing the swap trades that appear to be at the core of the firm’s hedging strategy,” Johnson said.

Guidance on Cross-Border Swaps

The CFTC and SEC chairmen outlined future guidance they will soon issue on cross-border application of Dodd-Frank to swaps. Gensler said this will require reforms to cover swaps activities which have a direct, significant effect on the U.S. As affiliates of U.S. firms are highly connected to their groups, contagion can quickly spread. The concern is that risk generated in London will come back to hit American taxpayers.

Gensler thus opposes a bill in the House that seeks to exempt affiliates of U.S. firms from the Dodd-Frank swaps rules. He claimed this bill, if enacted, would lower swaps transparency, and raise systemic risks in the U.S. It would also be likely to encourage U.S. firms to transact swaps with each other directly from their offshore units, which would allow them to avoid wider Dodd-Frank reforms.

The new regulatory guidance would require foreign firms transacting in more than de minimis US-facing swap dealing to register with the CFTC. A US-facing swap includes transactions done with a US person, their overseas branches, or their guaranteed affiliates. It will also cover trades with overseas affiliates that are operating as a conduit for a US entity’s swaps activity.

Some overseas swap dealer requirements will apply at an entity-level (to the firm as a whole), including capital adequacy and risk management records. Other rules will only apply at a transaction-level, such as clearing, margin, trade reporting, trade execution and sales conduct.

Some foreign swap dealers could also comply with entity rules via compliance with their local regulatory regime. Transaction-level rules apply to all US-facing trades, but will exempt some overseas transactions. Gensler gave the example of exempting trades between a foreign swap dealer and a foreign insurance firm not guaranteed by a US person.

Schapiro said the SEC’s cross-border approach is “being informed by our discussions with the CFTC” while not saying they would be identical. The agency’s proposed guidance will also be published prior to the finalization of other swap rules, such as the swap definition, so that the comments received can be taken into account in drafting those final rules.

SEC testimony.

CFTC testimony.


Nick Paraskeva is principal of Reg-Room LLC (, which provides regulatory information and consultancy. He covers various facets of the banking and securities industry and delivers exclusive analysis through Thomson Reuters.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=” ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)


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