Big U.S. Banks Make Swaps a Foreign Affair

By Katy Burne 

As regulators tighten rules on the U.S. swaps market, large American banks are maneuvering to take some of the business overseas.

Banks including Bank of America Corp., Citigroup Inc., Goldman Sachs Group Inc., J.P. Morgan Chase & Co. and Morgan Stanley are changing the terms of some swap agreements made by their offshore units so they don't get caught by U.S. regulations, according to people with knowledge of the situation.

The changes have generally focused on new trades between the London affiliates of U.S. banks, or between those units and non-U.S. banks, which combined constitute a large portion of swaps trading, the people said.

The moves mean the U.S. parent bank is no longer the guarantor of some swaps issued by its foreign affiliate. Instead, any liability for those swaps lies solely with the offshore operation.

Without that tie to the U.S. parent, those contracts won't fall under U.S. jurisdiction and so won't be subject to new, stricter rules that include reporting and a requirement that the historically telephone-traded contracts be traded on U.S. electronic platforms.

Having swaps come under European oversight is more attractive because derivatives trading rules on the Continent aren't likely to be implemented until 2016 at the earliest, allowing the swaps mostly sold in London to be conducted in relative secrecy. Even then, some bankers anticipate the European rules won't be as strict.

While a seemingly arcane shift, the unusual step of removing the parent guarantees could shift more of the $700 trillion swaps market to London, Europe's financial hub.

U.S. regulators are aware that banks are making these changes and so far haven't raised objections, according to the people. The moves are legal, and some officials have argued that the severing of guarantees could even help reduce the risk to the U.S. parent bank should a counterparty to an offshore contract renege on their agreement, some people said.

The CFTC would become concerned if banks moved a substantial portion of their swaps business offshore, a more blatant attempt the skirt the rules, one official said.

Still, detractors say that the U.S. parent bank may still ultimately choose to bear responsibility for any losses, as some did during the financial crisis.

The changes could "come back to haunt the American taxpayer," said Dennis Kelleher, president of Better Markets, which describes itself as an advocate for public interest in financial markets. Mr. Kelleher said he and others had warned lawmakers that banks may stop guaranteeing swaps sold by their offshore affiliates.

Banks stepped up plans to cut ties with non-U.S. units earlier this year when the Commodity Futures Trading Commission implemented U.S. trading rules for swaps. Now, some of the banks are nearly through the process of working with trading partners to strike the guarantees of the U.S. parent.

The agreements between large banks are credit-default swaps, which are used to wager on a borrower's likelihood of repaying its debts, and interest-rate swaps, often used to hedge against big swings in borrowing costs.

For U.S. regulators, the new rules aim to bring swaps trading into the open and protect the U.S. financial system from firms amassing huge derivatives positions in non-U.S. markets.

The CFTC drafted rules after the 2010 Dodd-Frank law passed to rein in risky derivatives trading, in part in response to the massive collection of swaps at American International Group Inc.'s European unit that led to a $182 billion rescue of the insurer in 2008.

Some warn that the regulators' muted response to the banks' latest moves may ultimately result in bigger problems.

"Taking away the guarantee removes the legal obligation for a U.S. entity to bail out trades by a foreign affiliate," said Jack Chen, principal at derivatives consultancy Pronetik. "But the regulators are acting on a set of assumptions. There is always the question of whether or not a bank may be compelled to bail out [an affiliate] for reputational risks."

Representatives for the Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. said there was no requirement for the banks to seek their advance approval or notify the regulators regarding the removal of guarantees of overseas affiliates.

Marcus Stanley, policy director for Americans for Financial Reform, a public-interest coalition, warned that if U.S. banks trade swaps out of unguaranteed affiliates abroad, on platforms that aren't overseen by the CFTC, they could "avoid Dodd-Frank rules completely...while trading with other unguaranteed affiliates of U.S. entities."

Some lawmakers anticipated that banks would seek to shift their business away from the U.S.

A group of U.S. senators last July warned that the CFTC rules would "encourage foreign firms to do business with non-guaranteed foreign affiliates of U.S. firms in return for more favorable pricing and lighter regulatory scrutiny."

In some cases, it has been hard for banks to persuade their trading partners to give up the benefits of the guarantees, some said. In other instances, consents have been easier to obtain because many swaps are now being processed through central clearinghouses that guarantee the trades.

"Regulators are demonstrating that they've learned very little from 2008, when we saw time and again how the biggest banks hadn't really gotten rid of risk but simply transferred it," said Sen. Jeff Merkley (D., Ore.).

Andrew Ackerman contributed to this article.

Write to Katy Burne at [e-mail]

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