It has been half a decade since the U.S. housing bubble burst, triggering one of the worst economic crises the modern world has seen. The financial sector, which bore the brunt of the consequences, is feeling the squeeze of new and more watertight regulations.
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It has been half a decade since the U.S. housing bubble burst, triggering one of the worst economic crises the modern world has seen. The financial sector, which bore the brunt of the consequences, is feeling the squeeze of new and more watertight regulations.Vigilance against white-collar crime and insider trading—a growing problem in Asia—is on the rise. Basel III is forcing banks to cut their risks and strengthen their capital. And the Dodd-Frank Financial Regulatory Reform Bill is clamping down on the trade of complex financial instruments, particularly derivatives. Many of the big banks, however, seem determined to find ways around the new regulations for their clients.
DODD-FRANK – OTC DERIVATIVES
As part of the Dodd-Frank Act in the U.S., new rules have been put in place for the world’s $640 trillion over-the-counter (OTC) derivatives market – a large, indistinct sector that has been partly blamed for felling Lehman Brothers in 2008 and fuelling a global financial crisis.
The reforms call for U.S. banks dealing in OTC instruments, such as interest-rate swaps and cross-currency options, to effectively set aside capital against the risk of trades turning sour, to execute their trades on electronic platforms and to report them to U.S. authorities. These requirements are worrying the banks’ offshore clients, and could drive business away from Wall Street. Some OTC brokers have complained that liquidity in the derivative market has already begun to suffer.
Wall Street’s banks have responded by helping their offshore clients to sidestep the rules by routing OTC trades via their non-U.S. affiliates – subsidiaries with their own separate balance sheets, often located in London – rather than the parent banks. It is a detour that could eventually be shut down by foreign regulators, but for now offers shelter from the U.S. regulatory storm.
Under the new rules, any entity that trades more than $8 billion a year of swaps with a “U.S. person” is required to register with the Commodity Futures Trading Commission (CFTC) of the U.S. as a swap dealer, a designation that brings with it capital and margin requirements that could drive up costs.
However, the precise definition of a “U.S. person” is unclear. In a presentation given in November 2012 to its Asian commodity clients, Morgan Stanley, a U.S. investment bank, explained how it might want to consider “cutting over trading to a non-U.S. swap dealer”. One slide named Morgan Stanley & Co International Plc, a London-based subsidiary, as an example of a non-U.S. swap dealer.
The question is: Will the regulators in the UK accept all the business coming through those entities? Lawyers say the answer may be “yes, at least for now” – until foreign regulators, mindful of avoiding another financial crisis, catch up with Washington and impose similar rules.
The CFTC has made it clear that any swaps traded with the foreign affiliate of a U.S. bank would not count towards the $8 billion de minimis threshold for identifying a swap dealer, Gareth Old, partner at Clifford Chance in New York, tells Reuters. “This is a very, very important exclusion. It means that non-U.S. financial institutions can continue to trade with at least a unit of a U.S. bank...without running the risk of being a U.S. person,” says Old.
However, lawyers say U.S. commercial banks like JPMorgan and Citigroup may find it harder to find a way around Dodd-Frank, noting that these banks tend to operate overseas through branches, not stand-alone affiliates.
Furthermore, U.S. regulators want their derivative rules to apply to offshore trades by Wall Street banks as well as domestic ones. They state that bad trades outside their borders can still rebound on the parent banks, weaken their balance sheets and add to risks that may be building up across the U.S. banking system. “Swaps executed offshore by U.S. financial institutions can send risk straight back to our shores,” CFTC chairman, Gary Gensler, said last June. “It was true with the London and Cayman Islands affiliates of AIG, Lehman Brothers, Citigroup and Bear Stearns.”
However, the reforms are facing staunch resistance from foreign counterparties, especially those trading around the $8 billion threshold, and these are seen as most likely to take the “affiliate” detour offered by U.S. banks. Several mid-sized foreign banks, including Singapore’s DBS, have said they do not intend to register with U.S. regulators as swap dealers. Some banks have even stopped trading with U.S. counterparts, say some brokers.
In contrast, major foreign banks such as Germany's Deutsche Bank, whose OTC trade would dwarf the threshold, are simply too big to escape the U.S. regulatory net entirely.
That the CFTC is still working on cross border guidance on the reach of the rules casts doubts over whether it will close the affiliate exemption or not. Morgan Stanley itself notes that the detour strategy may be short-lived in the UK and other G-20 jurisdictions, saying that they are expected to eventually adopt similar rules.
Legal uncertainty
But while regulators are trying to coordinate and collaborate, legal systems are proving to be a little more rigid. “Law is very much still on borders, at least in Asia-Pacific,” said Yvonne Siew, partner at Allen & Overy, at Thomson Reuters’ third annual Pan-Asian Regulatory Summit in November. “In the U.S. you have one homogenised U.S. law, and in Europe you have the European Union, so there is a certain amount of commonality. But in Asia there is still no statute of Asian law. That adds a lot of complexity when looking at how the legislation and reforms work.”
At the summit, Siew advised financial institutions to consider whether they need to register as swap dealers with the CFTC, adding that it was important to know whether or not they were engaged in swap dealing, whether they had crossed a threshold, and how to work through the process. “These are things that may seem really straightforward, but when you work through it, there is a lot of legal uncertainty,” she added.
BASEL III
Tighter regulation for banks has also come in the form of Basel III, the third instalment of the Basel Accords that has been developed to strengthen the resilience of the global banking system to future financial risks. Under the proposed rules, which are to be phased in from 2013 to 2018, banks would have to hold about three times more basic capital to protect against potential losses. The biggest banks would have to hold even more.
Large investment banks in the West have recently made bold statements about reorganising to adjust to the stricter regulations. But Asian banks do not seem to feel the same pressure to transform their business models, at least in the short term, according to Stephen Long, Asia managing director at Moody’s. “In Asia, the immediate impact is relatively benign because the banks here are well capitalised,” he said at the Thomson Reuters summit. However, this will have to change further down the road. “That this is a fast-growth region means that over the long run, capital requirements will be quite high. If you’re raising the bar in terms of capital requirements, then Asian banks in the long run will need to raise more capital than their counterparts elsewhere,” added Long.
As part of Basel III, international regulators ushered in the new year by relaxing rules on minimum holdings of easily sellable assets. Welcomed by the financial industry, the rules are set to be introduced in January 2015, and will be fully in effect four years after that. Updating a draft version unveiled two years ago, the latest regulations give banks more time to comply and widen the assets that banks can put in the buffer to include certain shares, corporate bonds and retail mortgage-backed securities.
INSIDER TRADING
Another focus for heightened scrutiny is the problem of insider trading. The recent high-profile prosecution and conviction of Galleon Group founder, Raj Rajaratnam, and the ex-McKinsey & Company managing director, Rajat Gupta, shows that regulators in the West need to be alert.
So do watchdogs in the East. For example, in China, a regulatory focus on insider trading in recent years has yielded good results, including the criminal prosecution of several top provincial officials, according to Tong Daochi, director general of international affairs in the China Securities Regulatory Commission (CSRC). Speaking at the Thomson Reuters summit, he noted that from 2008 to October 2012, the CSRC had investigated 586 cases of insider trading, accounting for more than 50 percent of its entire caseload. Of these, some 10 percent were passed on to the government for criminal prosecution. “We consider insider trading very damaging to market integrity, so we have adopted a zero tolerance approach to insider trading problems,” he added.
The CSRC has also enlisted the help of the country’s courts and asked the judiciary to focus on securities crimes such as insider trading. Tong noted that there have been several important cases where the courts have punished senior officials, such as the mayor of Zhongshan in Guangdong province.
The Chinese watchdog agency is ramping up cross -border cooperation with other regulators on enforcement – a trend that is likely to increase, given the growing internationalisation of China’s financial markets. Cooperation with Hong Kong’s Securities and Futures Commission (SFC) has been especially strong in recent years, as many cases involved mainland Chinese companies listed on the Stock Exchange of Hong Kong. For example, in the infamous case of Hontex International Holdings, a Chinese textiles manufacturer listed in Hong Kong, the SFC suspended its shares just three months after the company went public on the grounds that it had overstated its financial position in its prospectus. The SFC said that the CSRC had helped to investigate Hontex's claims.
Greater cross border collaboration on enforcement can be expected in the future. “With global regulatory enforcement, financial institutions are going to be facing global reputation risks, so major incidents of financial crime and regulatory misconduct are now not going to be confined to jurisdiction incidents, but are going to be more global and have more impact. I thought we were going to be facing U.S. and UK-dominated rules and enforcement [in the years ahead], but perhaps we will be seeing China join the world of cross -border enforcement as well,” said Simon Clarke, partner at Allen & Overy in Hong Kong, at the summit.
To complement its crackdown on insider trading, the CSRC has also made efforts to boost public education on the issue. “Prevention and education are important, and we have initiated a series of programmes to try to prevent this happening. People sometimes don't even know that they are engaging in insider trading. For example, they could be talking to their friends on the golf course and don't realise until later that they have talked about insider information,” said Tong.
It is clear that regulators are doing as much as they can, and as fast as possible, to implement measures to safeguard the global financial community from future potential pitfalls. While several regulations have been rolled out in the West, authorities in Asia too are preparing to comply, while clamping down on enforcement. Banks and other financial institutions will need to carefully review their documents, procedures and business models to ensure that they are prepared for this fast-changing regulatory environment.
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