What country are you in? Where is your business situated? In what country did your trade take place?
Those were once questions whose answers were so obvious that no one asked them. Now they are questions that can drive financial regulators and tax collectors to distraction. Lawyers can get rich proving that under one definition or another, the person, company or transaction was somewhere with more convenient rules.
Earlier this year, we learned about Apple’s disappearing subsidiary, an extremely profitable one that had no employees and — for tax purposes — was located nowhere. Under U.S. tax law, it was based in Ireland. Under Irish law, it was based in the United States. So it paid taxes to no one. Presumably, if Congress ever overhauls the tax code, that will be dealt with.
Now we learn of the vanishing swaps market.
During the deregulation era — broadly 1980 through 2008 — swaps were more or less unregulated and grew exponentially. Then after the financial crisis, Congress regulated swaps for the first time in 2010, under the Dodd-Frank financial overhaul law, which many banks fought. A market that had operated undercover — and that played an important role in causing the financial crisis — would be brought into the open. Trades would be reported for everyone to see. They would go through clearinghouses. Participants would put up margin and have to put up more if the value of their position declined.
And some overseas trading would be covered. Congress was quite aware that the American International Group had hidden huge bets in the credit-default swap market in an unregulated British subsidiary — and that those bets had almost brought down the company.
The new U.S. rules have started to take effect, and it turns out that some of the banks found a way around the guidance issued in July by the Commodity Futures Trading Commission, which regulates most of the U.S. swaps market. Somehow, a lot of swaps that were being traded in New York were not being reported as U.S. trades. That had a big advantage, from the point of view of the banks doing the trading: less transparency and no requirements for customer margin.
At first, that offended other banks, who deemed it unfair that they had to play by the rules while others did not. Then those banks began to set up their own foreign affiliates to keep the trades away from U.S. rules.
To Gary Gensler, the commission’s chairman, it was obvious that the commission’s intent had been misunderstood or simply distorted. He had the commission’s staff issue an “advisory” Nov. 14, saying that if a swap trader was doing business in New York, he or she was actually in the United States.
If Gensler really thought that was routine, he was quickly disabused of the idea. The banks, which had thought the commission understood and accepted their tactic, were outraged. They complained to politicians and found immediate support.
First out of the box was Rep. Jeb Hensarling of Texas, chairman of the House Financial Services Committee. To him, this was not an issue of how to interpret or fix some poorly written guidance, let alone a squabble over a transparent effort to avoid the Dodd-Frank law. It was a total outrage, one that threatened the U.S. economy and was likely to force grandmothers to pay more to fly.
“At a time millions of Americans still can’t find a job, this surprise decision made late Thursday afternoon by unelected and unaccountable bureaucrats at the CFTC will do nothing but inject more uncertainty into our weak economy,” he said. “The CFTC staff — not the commissioners, but the staff — decided late Thursday afternoon that swaps transactions that had been permissible Thursday afternoon would not be permissible on Friday morning.”
Whether they were permissible Thursday is not so clear to the commission, but there is no question that some banks had decided that they could interpret the guidance in a way that left people in New York but not subject to U.S. law.
Hensarling said: “How is this sudden and unexpected change fair to the small-business owners, the farmers and the manufacturers who rely on these transactions to stay in business? How is it fair to the grandmother who is planning to fly to visit her grandkids for Thanksgiving that the cost of her plane ticket will go up since airlines use these transactions to keep the cost of fuel down? This is yet another example of out-of-touch Washington bureaucrats making rules in a vacuum and acting with absolutely no regard for the impact their arbitrary and capricious actions have on our economy.”
That argument is based on the idea that forcing these transactions out into the open, and forcing those who trade in them to put up margin, will raise the costs for those who use the derivatives. It is at least possible that the opposite will turn out to be true: that as transparency drives down the spreads between the prices at which people are willing to buy and sell derivatives, it will damage the profits of the swap dealers — generally the big banks — but benefit the customers. Certainly that is what has happened when other markets, such as those for corporate and municipal bonds, were opened up to sunlight.
This week, the complaints from the Republican side brought a response from the other side of the aisle.
“The CFTC is underfunded and understaffed, but it had the backbone to slam shut the latest loophole some swap dealers have concocted to circumvent U.S. rules requiring swaps to be traded in a transparent and fiscally responsible manner,” said Sen. Carl Levin, a Michigan Democrat.
“The CFTC has it exactly right,” he added, “since exempting offshore swap dealers operating in the U.S. from U.S. swap safeguards has no legal basis, would gut U.S. swaps laws and would expose the U.S. financial system to unacceptable risks.”
In theory, the commission is committed to something called “substituted compliance,” in which a foreign company can abide by its own country’s laws as long as they are more or less as effective as U.S. rules. But Europe is behind in passing those laws.
By now some may be wondering what a “swap” is. The answer is that it is a lot of things. There are interest rate swaps, in which one side essentially bets that interest rates will not go up. There are commodity swaps, which amount to bets on the price of oil or some other commodity. There are credit-default swaps, which are bets that a company will or will not go broke. The industry would prefer to remove the word “bet” and say that companies are “hedging” their possible exposure to an adverse move in prices. That is certainly true sometimes.
That fight over the commission’s latest guidance is probably not over. Banks think the agency should have put the new advisory out for comment and then had the commissioners vote on it. They think it should have been treated as a formal rule, with a cost-benefit analysis. There is a good chance that someone will sue over it.
If so, it will eventually end up at the U.S. Court of Appeals for the District of Columbia Circuit, which is controlled by a conservative majority that has shown intense opposition to many regulations. Senate Republicans have blocked President Barack Obama’s nominations to that court, contending that it does not need new judges. Democrats say the Republicans really want to ensure that the court, which has three vacancies, keeps its current political complexion.
This may be one of many skirmishes over bank regulation in which banks will contend that forcing them to comply with stricter rules than foreign competitors will cost jobs and drive business overseas. To them, finding ways to claim that people are where they aren’t is simply a way to remain competitive.