Decade After Crisis, a $600 Trillion Market Remains Murky to Regulators

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Decade After Crisis, a $600 Trillion Market Remains Murky to
Regulators
By Emily Flitter, July 22, 2018, NY Times

In the maze of subsidiaries that make up Goldman Sachs Group, two in
London have nearly identical names: Goldman Sachs International and
Goldman Sachs International Bank.

Both trade financial instruments known as derivatives with hedge
funds, insurers, governments and other clients.

United States regulators, however, get detailed information only about
the derivatives traded by Goldman Sachs International. Thanks to a
loophole in laws enacted in response to the financial crisis, trades
by Goldman Sachs International Bank don’t have to be reported.

A decade after a financial crisis fueled in part by a tangled web of
derivatives, regulators still have an incomplete picture of who holds
what in this $600 trillion market.

“It’s a global market, so you really have to have a global set of
data,” said Werner Bijkerk, the former head of research at the
International Organization of Securities Commissions, an umbrella
group for regulators around the world overseeing derivatives markets.
“You can start running ‘stress tests’ and see where the weaknesses
are. With this kind of patchwork, you will never be able to see that.”

Derivatives are instruments whose values are derived from the prices
of other things, like a stock or a barrel of oil or a bundle of
mortgages. Originally designed to protect their holders against future
risks, they evolved into vehicles that traders used for financial
speculation. Unlike stocks, they often aren’t traded over public
exchanges, which means the market — and who is exposed to what — is
opaque.

The 2010 Dodd-Frank law was supposed to improve regulators’ ability to
monitor derivatives. American banks had to start reporting specifics
about their trades, including whom they traded with, to the Commodity
Futures Trading Commission.

The goal was to prevent a recurrence of the financial crisis, when
fatal problems at Lehman Brothers caused a tidal wave of troubles at
other banks that were connected through derivatives. In part because
nobody could map out those connections, nobody knew where problems
lurked, and fearful banks stopped lending to one another.

But the Dodd-Frank Act contained a big gap: Banks don’t have to
disclose to American regulators their holdings of derivatives housed
in certain offshore entities. The critical variable is whether the
American parent company is legally on the hook to bail out its foreign
subsidiary if it gets into trouble. As long as the answer is no, the
foreign entity isn’t subject to the Dodd-Frank requirements.

The size and severity of this blind spot are hard to measure. One
consequence is that United States regulators are unable to grasp the
full exposure of American banks to their foreign rivals. Germany’s
troubled Deutsche Bank, for example, is one of the largest players in
the derivatives market, and much of its derivatives trading occurs in
foreign markets that are outside the purview of American regulators.
That means they have limited visibility into United States banks’
connections to Deutsche Bank.

Other countries’ regulators can seek information about those holdings,
but they generally do not collect the same data that is reported to
American regulators.

The Dodd-Frank law “didn’t really give a mandate to coordinate on the
things that naturally would benefit most from coordination, one of
which is the flow of information,” said Guy Dempsey, a derivatives
lawyer.

Goldman, for example, reports its total exposure to the derivatives
market as a single number: The bank had $45 billion in
over-the-counter derivatives alone on its balance sheet at the end of
2017. Because of the trading in its Goldman Sachs International Bank
unit and other foreign subsidiaries, a certain amount of those trades
are invisible to American regulators.

A Goldman spokesman said less than 1 percent of the bank’s global
derivatives activity wasn’t visible to the Commodity Futures Trading
Commission, but he declined to comment further.

For JPMorgan Chase, trades not reported to the commission account for
less than 10 percent of all the bank’s derivatives, a spokesman said.
(The firm reported $56.5 billion in outstanding derivatives for 2017.)

A Citigroup spokeswoman said the bank’s European derivatives trades
were made “predominantly” through subsidiaries that reported their
trades to the Commodity Futures Trading Commission.

The portion of Bank of America’s derivatives portfolio that isn’t
reported to regulators is not discernible in its public filings. A
bank spokesman would say only that the percentage is small. A Morgan
Stanley spokesman said “virtually all” of its trades were reported to
American regulators.

The banks say that they aren’t trying to hide anything and that in
some cases they are responding to demands from overseas clients who
don’t want the United States government looking at their transactions.
Even foreign bank regulators argue there’s no reason American law
should apply to financial instruments held outside the United States.

“This problem, I think, is really driven more by regulators each
wanting their own silo,” said Sheila Bair, a former chairwoman of the
Federal Deposit Insurance Corporation. “I think the industry would be
fine with some type of consolidated reporting.”

Mr. Dempsey, the lawyer, said, “What you have is a picture that has
more clarity to it than what the regulators had in 2008, but you still
don’t have maximum clarity.”

Regulators can still monitor risk for individual institutions. The
Federal Reserve, for example, can ask for specific information about
derivatives trades as it sees fit. But because the trades aren’t
automatically reported, the regulator would have to decide which
trades to ask about beforehand. Theoretically, the Fed could ask for
banks to report every single trade, but the central bank hasn’t done
that.

In October 2016, the Commodity Futures Trading Commission proposed a
rule that would have closed the reporting loophole by requiring all
American bank subsidiaries to report their derivatives exposure. It
also would have subjected the subsidiaries to financial regulations
that would have made derivatives trading less profitable.

The banking industry opposed the rule. After President Trump took
office, it was never authorized.

Officials at the Commodity Futures Trading Commission acknowledge that
there is a problem. The agency noted in an April paper that the
current reporting “cannot provide regulators with a complete and
accurate picture” of risks in the market.

Even so, Amir Zaidi, the director of the commission’s market oversight
division, said more data was available to regulators now than before
the financial crisis, enough to enable “effective oversight.”

In a recent paper, a University of Maryland law professor, Michael
Greenberger, argued that banks were exploiting the disclosure loophole
and creating a major vulnerability for the financial system.

The largest banks “have engineered a way to evade Dodd-Frank’s
regulations at will,” Mr. Greenberger wrote. He warned that in a
period of financial stress, derivatives cause cascading losses.
Because the ownership and connections of those derivatives remain
murky, he wrote, “the economic chaos and harm of the 2008 financial
meltdown may very well be repeated.”

Mr. Greenberger’s warnings — published last month by the Institute for
New Economic Thinking, a progressive think tank — have been endorsed
by the former Federal Reserve chairman Paul Volcker and Thomas M.
Hoenig, who stepped down as vice chairman of the Federal Deposit
Insurance Corporation in April.

Mr. Hoenig noted that the universe of derivatives was already very
complicated, “and so when you make it even more opaque in a foreign
subsidiary, I think the ability to control outcomes is very
different.”

He recalled earlier efforts to bring transparency to the derivatives
markets. Such proposals were derailed by senior officials in the
Clinton administration, and Mr. Hoenig warned against repeating that
mistake.

https://www.nytimes.com/2018/07/22/business/derivatives-banks-regulation-dodd-frank.html