Wall Street finds a foreign detour around U.S. derivatives rules

SINGAPORE (Reuters) - Wall Street banks are looking to help offshore clients sidestep new U.S. rules designed to safeguard the world’s $640 trillion over-the-counter derivatives market, taking advantage of an exemption that risks undermining U.S. regulators’ efforts.

U.S. banks such as Morgan Stanley MS.N and Goldman Sachs GS.N have been explaining to their foreign customers that they can for now avoid the new rules, due to take effect next month, by routing trades via the banks' overseas units, according to industry sources and presentation materials obtained by Reuters.

The rules, a result of Washington’s Dodd-Frank reforms, aim to prevent financial catastrophes in the over-the-counter (OTC) market - a huge, opaque market which is partly blamed for felling Lehman Bros in 2008 and fuelling a global financial crisis.

They 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, execute their trades on electronic platforms and report them to U.S. authorities - requirements that worry the banks’ offshore clients and threaten to drive business away from Wall Street.

OTC brokers say liquidity has already begun to suffer.

In response, Wall Street has launched a last-minute effort to show foreign counterparties how they can keep doing business together and still keep trades out of the U.S. regulatory net.

The banks’ solution is to route trades via their non-U.S. affiliates - subsidiaries with their own separate balance sheets, often 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.

“What we are seeing now is a gamesmanship dance in which firms do whatever they can to avoid regulation, which is an age-old phenomenon,” said Thomas Cooley, a professor of economics at New York University’s Stern School of Business.

Financial industry concerns over U.S. regulation of the OTC market focus mainly on trades in swaps, among the most common and flexible financial instruments, used to hedge all kinds of financial risks from interest rates to currency movements.

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) as “swap dealers”, a designation that brings with it capital and margin requirements that could drive up costs.

But the precise definition of a “U.S. person” is unclear.

A presentation given on November 16 by Morgan Stanley to its Asian commodity clients explained how they 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.

Morgan Stanley spokesman Mark Lake said the presentation “was an update to clients on Dodd-Frank regulation and clearly states that it was not intended as advice or a specific recommendation from Morgan Stanley”.

“While we note that one option for certain non-U.S. clients trading swaps with a U.S. swap dealer may be to switch to a non-U.S. swap dealer, we also point out that all G-20 jurisdictions are expected to adopt similar requirements to the U.S.”

Goldman Sachs, too, is sending a similar message. Its bankers are meeting counterparts from regional Asian banks, assuring them they can trade with Goldman’s London entity, Goldman Sachs International, and not be subject to the new rules, according to sources familiar with the matter.

Goldman declined to comment on the matter.

“What banks are looking at is: can they put their business with non-U.S. counterparties through a London entity, and will the regulators in the UK accept all the business coming through those entities?” said Mark Austen, chief executive of the Asia Securities Industry & Financial Markets Association.

Lawyers say the answer may be yes, for now - at least until foreign regulators, also mindful of avoiding another financial crisis, catch up with Washington and impose similar rules.

Gareth Old, a lawyer at Clifford Chance in New York, said the CFTC had made it clear that any swaps traded with the foreign affiliate of a U.S. bank would not count toward the $8 billion “de minimis” threshold for identifying a swap dealer.

“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,” Old said.

However, lawyers say U.S. commercial banks like JPMorgan JPM.N and Citigroup C.N may find it harder to detour their clients around Dodd-Frank, noting that these banks tend to operate overseas through branches, not stand-alone affiliates.

Overseas branches of U.S. banks are expected to still be classed as a “U.S. person” under the new regulation.

It is not clear what JPMorgan and Citigroup are doing, if anything, to address the impact on their offshore clients.

Citigroup spokesman in Hong Kong, Godwin Chellam, declined to comment on the issue. JPMorgan also declined to comment.


U.S. regulators want their derivative rules to apply to offshore trades by Wall Street banks as well as domestic ones, given 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,” said CFTC chairman Gary Gensler in June. “It was true with the London and Cayman Islands affiliates of AIG, Lehman Brothers, Citigroup and Bear Stearns.”

However, Wall Street faces fierce resistance to the reforms from foreign counterparties, especially those trading around the $8 billion threshold which are seen as most likely to take the “affiliate” detour offered by U.S. banks.

Several mid-sized foreign banks, including Singapore's DBS DBSM.SI, 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, brokers said.

In contrast, major foreign banks such as Germany's Deutsche Bank DBKGn.DE, whose OTC trade would dwarf the threshold, are simply too big to escape the U.S. regulatory net entirely.

The CFTC is still working on cross-border guidance on the reach of the rules, raising doubts over whether it will close the affiliate exemption or not, but it clearly hopes foreign regulators will adopt most of the Dodd-Frank reforms anyway.

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.

Morgan Stanley’s November 16 presentation in Asia was aimed at clients trading commodity swaps, but the rules will also apply to products such as interest rate swaps and cross-currency options. Foreign exchange forwards and swaps will be exempt, largely because the U.S. Treasury felt this market had been operating well for decades with its own risk-management systems.

Reporting by Rachel Armstrong; Additional reporting by Douwe Miedema in Washington and David Henry and Lauren Tara LaCapra in New York; Editing by Jonathan Leff, Michael Flaherty and Mark Bendeich