Converting an Obscure Agency Footnote into an “At Will” Nullification of Dodd-Frank’s Regulation of the Multi-Trillion Dollar Financial Swaps Market
The multi-trillion dollar market for what was at that time wholly unregulated, over-the counter derivatives (“swaps”) is widely viewed as a principal cause of the 2008 worldwide financial meltdown. The Dodd-Frank Act, signed into law on July 21, 2010, was expressly considered by Congress as a remedy for the deregulatory problems in that market that led to the crash. The legislation required the swaps market subject to U.S. regulation to comply with a host of business conduct and anti-competitive protections, including that the swaps market be fully transparent to U.S. financial regulators, collateralized, and capitalized. The statute also expressly provides that it would cover foreign subsidiaries of big U.S. financial institutions if their swaps trading could adversely impact the U.S. economy or represented an attempt to “evade” Dodd-Frank.
In July 2013, the CFTC promulgated an 80 page, triple columned and single-spaced “guidance,” implementing Dodd-Frank’s extraterritorial reach, i.e., that manner in which Dodd-Frank would apply to swaps transactions executed outside the United States. The key point of that guidance was that “guaranteed” foreign subsidiaries of U.S. bank holding company swaps dealers were subject to all of Dodd-Frank’s swaps regulations wherever in the world those subsidiaries’ swaps were executed. At that time, the standardized industry swaps agreement contemplated that, inter alia, U.S. swaps dealers foreign subsidiaries would be “guaranteed” by their corporate parent as was true since 1992.
In August 2013, without notifying the CFTC, the principal swaps dealer trade association privately circulated to its members standard contractual language that would for the first time “deguarantee” foreign subsidiaries. By relying only on the obscure footnote 563 of the CFTC guidance’s 662 footnotes, the trade association assured its swaps dealer members that the newly deguaranteed foreign subsidiaries could (if they so chose) no longer be subject to Dodd-Frank.
As a result, it has been reported (and also has been understood by many experts within the swaps industry), that a substantial portion of the U.S. swaps market has shifted from the large U.S. bank holding companies swaps dealers and their U.S. affiliates to their newly deguaranteed “foreign” subsidiaries. The CFTC also soon discovered that these huge U.S. bank holding company swaps dealers, through their foreign subsidiaries, were “arranging, negotiating, and executing” these swaps in the United States with U.S. bank personnel and, only after execution in the U.S., after which these swaps were formally “assigned” to the U.S. banks’ newly “deguaranteed” foreign subsidiaries with the accompanying claim that these swaps, too (even though executed in the U.S.), were not covered by Dodd-Frank.
In October 2016, the CFTC proposed a rule that would have closed these loopholes completely. However, the proposed rule was not finalized prior to the inauguration of President Trump. All indications are that it will never be finalized during a Trump Administration.
Thus, as the tenth anniversary of the Lehman failure approaches, there is an understanding among many market regulators and swaps trading experts that large portions of the swaps market have moved from U.S. bank holding company swaps dealers to their newly deguaranteed foreign affiliates. But, what has not moved abroad is the very real obligation of the lender of last resort to rescue these U.S. swaps dealer bank holding companies if they fail because of poorly regulated swaps in their deguaranteed foreign subsidiaries, i.e., the U.S. taxpayer.
With relief is unlikely to be forthcoming from either the Trump Administration or a Republican-controlled Congress, some other means will have to be found to avert another multitrillion dollar bank bailout and/or financial calamity caused by poorly regulated swaps on the books of big U.S. banks. This paper notes that the relevant statutory framework affords state attorneys general and state financial regulators the right to bring so-called “parens patriae” actions in federal district court to enforce, inter alia, Dodd-Frank on behalf of a state’s citizens. That kind of litigation to enforce the statute’s extraterritorial provisions is now badly needed.
