(Refiled with correct dateline.)
By Charles Levinson
NEW YORK Aug 21 This spring, traders and
analysts working deep in the global swaps markets began picking
up peculiar readings: Hundreds of billions of dollars of trades
by U.S. banks had seemingly vanished.
"We saw strange things in the data," said Chris Barnes, a
former swaps trader now with ClarusFT, a London-based data firm.
The vanishing of the trades was little noted outside a
circle of specialists. But the implications were big.
The missing transactions reflected an effort by some of the
largest U.S. banks - including Goldman Sachs, JP Morgan Chase,
Citigroup, Bank of America, and Morgan Stanley - to get around
new regulations on derivatives enacted in the wake of the
financial crisis, say current and former financial regulators.
The trades hadn't really disappeared. Instead, the major
banks had tweaked a few key words in swaps contracts and shifted
some other trades to affiliates in London, where regulations
are far more lenient. Those affiliates remain largely outside
the jurisdiction of U.S. regulators, thanks to a loophole in
swaps rules that banks successfully won from the Commodity
Futures Trading Commission in 2013.
The products affected by that loophole include some of the
most widely traded financial derivatives in the world - such as
interest rate swaps, where a bank takes a fee for exchanging a
variable-rate interest payment for a fixed rate with a client,
and credit default swaps, a sort of insurance where one party,
often a bank, agrees to pay another party in the event of a bond
For large investors, the products are an important tool to
hedge risk. But in times of crisis, they can turn toxic. In
2008, some of these instruments helped topple major financial
institutions, crashing the U.S. economy and leading to
After the crisis, Congress and regulators sought to rein in
this risk, and the banks fought back. From 2010 to 2013, when
the CFTC was drafting new rules, representatives of the five
largest U.S. banks met with the regulator more than 300 times,
according to CFTC records. Goldman Sachs attended at least 160
of those meetings.
"Consistent rules around the world are better for investors
and markets," said Andrew Williams, a spokesman for Goldman
Sachs. "That is what we advocated for then and continue to do so
Many of the CFTC employees who were lobbied in these
meetings went on to work for banks. Between 2010 and 2013, there
were 50 CFTC staffers who met with the top five U.S. banks 10 or
more times. Of those 50 staffers, at least 25 now work for the
big five or other top swaps-dealing banks, or for law firms and
lobbyists representing these banks.
The lobbying blitz helped win a ruling from the CFTC that
left U.S. banks' overseas operations largely outside the
jurisdiction of U.S. regulators. After that rule passed, U.S.
banks simply shipped more trades overseas. By December of 2014,
certain U.S. swaps markets had seen 95 percent of their trading
volume disappear in less than two years.
"THE SHADOWS THAT DO YOU IN"
While many swaps trades are now booked abroad, some people
in the markets believe the risk remains firmly on U.S. shores.
They say the big American banks are still on the hook for swaps
they're parking offshore with subsidiaries.
This worries some regulators, who fear that Washington, in
turn, will be on the hook for another bailout if these "too big
to fail" banks are hit by a fresh shock - such as a rash of
defaults in a recession.
"These are the shadows that do you in during a crisis, when
there is almost always that link back to the core money center
banks at home," said Simon Johnson, an adviser to the Federal
Deposit Insurance Corporation, which regulates government
insured banks, and a former chief economist at the IMF.
To be sure, some post-crisis regulations have reduced
certain kinds of risk-taking by major institutions, regulators
and lawmakers say. Certain CFTC rules still apply to U.S. banks'
operations abroad, such as requirements that swaps trades be
reported to a central data center. Other regulators, such as the
Federal Reserve, have jurisdiction over U.S. banks' global
Still, the banks' victory on the swaps loophole leaves a
concentrated knot of risk at the heart of the financial system.
The U.S. derivatives market has shrunk but remains large, with
outstanding contracts worth $220 trillion at face value. And the
top five top banks account for 92 percent of that.
A NEW ORDER
In late 2010, the CFTC began drafting new rules regulating
derivatives markets as mandated by Congress in the landmark
Dodd-Frank Wall Street Reform Act. Lawmakers were doing an
about-face: In 2000, Congress had passed a law barring the
regulation of derivatives. But times had changed.
The notional value of derivatives holdings on banks' balance
sheets had ballooned from $88 trillion globally in 1999 to $672
trillion in 2008, when the financial crisis hit. Those barely
regulated products, including certain types of swaps, brought
many giant financial institutions to their knees.
The Dodd-Frank Act required better reporting and record
keeping to keep tabs on risk, and it implemented trading rules
aimed at minimizing the chance that a collapsing bank would
bring down others. The most commonly used swaps were required to
be traded on an electronic exchange open to all buyers and
sellers, much like the stock market is today.
The rules would make it easier for new competitors to enter
the swaps-dealing market, worth an estimated $40 billion to $60
billion a year to the 16 large global banks that dominate the
market. Fees would fall - and most important to regulators
worried about another meltdown, risk would be dispersed among
In 2009, President Barack Obama tapped Gary Gensler, then 51
years old, to chair the CFTC. Liberals grumbled about Gensler's
résumé. The son of a cigarette and pinball-machine salesman in
working class Baltimore, Gensler, at 30, had become the youngest
banker ever to make partner at Goldman Sachs.
Among other jobs, he oversaw the bank's derivatives trading
in Asia. Later, as an undersecretary of the Treasury, Gensler
helped push through the 2000 law that had banned regulation of
But he had an insider's knowledge. At Goldman, he had seen
how U.S. banks took advantage of differences in regulations in
different countries. London, for example, increased its appeal
as a global finance hub, in part, by touting its "light touch"
regulation to woo banks.
That practice - known as regulatory arbitrage - had a
history of landing the economy in trouble.
AIG, a Connecticut-based insurance giant, buckled in 2008
under trades made by its office in London. U.S. taxpayers footed
the bill with a $182 billion bailout. Gensler often told people
how, at the Treasury, he was stuck with the task of briefing
then-Secretary Robert Rubin about Long-Term Capital Management
in 1998. The Connecticut hedge fund collapsed under $1.2
trillion in swaps booked to a post office box in the Cayman
In 2009, soon after Gensler took the job, Congress was
hashing out the Dodd-Frank bill. A powerful Republican
congressman, Rep. Spencer Bachus of Alabama, put forth an
amendment that would keep banks' overseas operations outside the
new rules. Alarmed, the Democratic co-sponsor of the bill, Rep.
Barney Frank, asked Gensler to craft a counter-proposal.
Gensler and his staff tucked a 17-word insert into a
228-page amendment to the Dodd-Frank bill. The addition seemed
to assure banks that the new derivatives rules wouldn't apply to
their overseas trading operations. Bachus backed off. But the
insert was craftily worded to leave wiggle room. If those
activities "have a direct and significant connection with
activities in, or effect on, commerce of the United States,"
then the rules would apply, Gensler's addition read.
One year later, at a late 2010 meeting of the CFTC's board,
one of Gensler's legal aides declared that the passage in fact
gave the regulator worldwide reach over U.S. banks' trading
A coalition of 13 global banks banded together to fight the
clause. They hired Edward J. Rosen, a derivatives lawyer with
Cleary Gottlieb Steen & Hamilton, to lead the effort.
The debate that ensued became one of the most contentious
chapters of the post-crisis regulatory battle. "The industry ran
to the ramparts once it became clear how the CFTC would apply
this provision," said Dennis Kelleher, president of Better
Markets, a Washington D.C.-based advocacy group for tighter
By the end of Gensler's term at the CFTC, Rosen's firm had
reaped nearly $6 million in lobbying fees from various banks,
according to U.S. Senate lobbying records provided to the Center
for Responsive Politics. (Rosen told Reuters that about $3.6
million of that was related to CFTC lobbying.)
On weekly conference calls, Rosen and the banks hashed out
strategy to shape the new rules. In scores of letters and
hundreds of meetings with regulators and politicians, they
warned that the CFTC's proposal would cripple banks' ability to
The proposal was "unworkable and would give rise to a number
of significant problems," warned Rosen in an August 2012 letter
to the CFTC.
Kenneth Raisler, a former Enron lobbyist representing JP
Morgan, Citigroup, and Bank of America, argued in a letter that
the CFTC should allow U.S. banks to do things overseas "even if
those activities were not permissible for a U.S. bank
Goldman Sachs Managing Director R. Martin Chavez put it more
bluntly in an August 2012 letter to the Commission. The CFTC had
"failed without justification," he wrote.
In late 2011, banks caught a break. Michael Dunn, the third
Democrat on the five-person commission, stepped down. Dunn's
vote had ensured that Gensler was able to carry the day on
controversial rules, outgunning the two Republicans, who tended
to vote for bank-friendly regulations.
In his place, Obama nominated a long time aide to Democratic
Senator Harry Reid, Mark Wetjen. Gensler and other pro-reform
allies assumed that the veteran Democrat would vote with the
Democrats on the commission.
Wetjen, a derivatives newcomer, was not a conventional
liberal. He came with an endorsement from the U.S. Chamber of
Commerce, an opponent of the Dodd-Frank Act. As his policy
adviser, Wetjen hired Scott Reinhart, former in-house counsel at
the structured credit products division at Lehman Brothers - the
bank whose collapse in 2008 set off the financial crisis.
Rosen, the banks' lead lawyer, discussed Wetjen often on
calls with his bank clients. The newcomer, Rosen told them, was
key to swinging the commission in the banks' favor.
Banks got dramatically more face time with commissioners
after Wetjen's appointment. In 2010, Gensler had met with the
top five U.S. banks 13 times, and in 2011, 10 times. That was
still more than any other staffer or commissioner at the CFTC.
In the year after Wetjen's appointment, Wetjen aide Reinhart
met with the top five banks 36 times, more than anyone else at
the CFTC. Wetjen himself met with the top banks second-most
often, 34 times. Gensler met them less than half as frequently,
as did nearly every other commissioner and staffer, according to
In June, Reinhart left the CFTC to join Rosen's practice at
SEEKING A LOOPHOLE
One former CFTC official close to Wetjen told Reuters that
the commissioner and his aides were simply newcomers studying up
on the complex issues facing the CFTC. Bankers say Wetjen gave
them a fairer hearing than Gensler.
"Given Gensler's view of the world, a lot of firms,
ourselves included, stopped meeting with him," said one bank
executive. "He was confrontational and not terribly open minded,
unlike our experience with Mark, who wanted to be educated about
Gensler had little patience for the bank-friendly Wetjen,
former CFTC officials say. As their disagreements sharpened,
Wetjen's pro-bank views seemed to harden, these people said.
"Mark was struggling a little with the substance," one
former CFTC official said. "Gary treated Mark like he was a
moron, and then Mark refused to budge."
Wetjen joined the CFTC just as the regulator was starting to
draft a preliminary version of an important statement that would
determine the CFTC's global reach. The banks were seeking a
loophole to trump Gensler's 17-word insert.
They turned to a footnote in an early draft of the policy
dealing with cross-border regulation. The footnote referred to
banks' overseas "branches" but not to their "affiliates." The
banks argued that there was a legal distinction between a branch
and an affiliate. Therefore, the rules should apply only to
overseas branches, and not to overseas affiliates. Gensler shot
that argument down.
ONE WORD: "GUARANTEE"
The banks then zeroed in on wording in that first policy
draft giving U.S. regulators jurisdiction over banks' overseas
operations that were backed by a parent-company credit
At the time, virtually all swaps contracts were backed by
guarantees that a bank's parent company in New York would make
good on a contract if an overseas affiliate ran into trouble.
And so the passage seemed to Gensler a good way of capturing all
global swaps trading carried out by U.S. banks.
On a call with bank officials in 2012, Rosen, the lobbyist,
wondered aloud to his clients: "What happens if you just stop
guaranteeing these transactions?" recalled a former bank
official who participated in some of the calls. Rosen told
Reuters that the idea of de-guaranteeing only came up after the
CFTC issued its final policy guidance.
Picking up on that idea, banks fought for a narrower
definition of the word "guarantee." The banks seized on a
footnote in the final draft, say people familiar with the
debate. That passage declared that only "explicit" promises of
financial support would count as a guarantee. So, the banks
reasoned that if they stripped out the word "guarantee" and
equivalent terms, they could avoid the CFTC rules.
"The fight over this provision was one of the biggest policy
fights in all of Dodd Frank," said Kelleher, of the think tank
Better Markets. "Once the banks got that loophole, then a lot of
that predatory behavior migrated overseas to wherever there was
Goldman had already started moving to restructure its
trading operations to get around Dodd-Frank. In March 2012, it
sent out a four-page letter to its derivatives clients with an
unusual demand. Goldman wanted clients to sign off on giving the
bank standing permission to move a client's swaps trades to
different affiliates around the world, whenever and wherever the
bank saw fit.
Goldman called the letter the "Multi-entity ISDA Master
Agreement." It meant that a client might strike a derivatives
deal with Goldman in New York in the morning, and that
afternoon, with no disclosure, a Goldman office in London or
Singapore or Hong Kong could take over the deal. With each
shift, the trade could fall under different regulators.
That was a big change. Swaps contracts often run for years,
with each party committed to paying the other regularly,
according to fluctuations in interest rates or some other
benchmark. To a swap buyer, such as a pension fund, or a city
issuing bonds, it's vital to know that the other party will be
around to pay up.
"It was a bold request," said Kevin McPartland, head of
market structure and technology at Greenwich Associates, a
financial research firm. "As an investor you want to know where
your money is and who is responsible to pay you when it's time
to pay you."
An industry executive familiar with Goldman's thinking said
the agreement was meant to help clients by giving them
flexibility to move trades outside U.S. jurisdiction if they
wished. "It was an option for those who wanted that
flexibility," this person said.
Gensler stepped down from the CFTC at the end of 2013. This
April, he was named an economic adviser to Hillary Clinton's
2016 presidential campaign.
Soon after Gensler left, other U.S. banks seized on the gap
in the new CFTC policy, according to lawyers and investors. They
pressed clients to strip guarantees from hundreds of thousands
of swaps contracts. Most went along, say lawyers and investors
familiar with the effort.
"Banks that de-guaranteed acted in a manner consistent with
applicable law and stated agency policy," said Rosen, the bank
By August 2014, U.S. bank participation in certain swaps
markets had plummeted.
The global inter-dealer market for interest rate swaps in
Euros is one of the largest derivatives markets in the world.
U.S. banks' monthly share of the market had plunged nearly 90
percent since January 2013, from over $1 trillion to $125
billion, according to ISDA.
The data were misleading. U.S. banks were still trading as
vigorously as ever. But their trades, booked through London
affiliates, without any credit guarantees linking them back to
the U.S., were now showing up in the data as the work of
Executives from several large U.S. banks said they removed
guarantees from their contracts because European exchanges,
seeking to avoid CFTC jurisdiction, were refusing to let U.S.
banks trade. That would cause U.S. banks to lose access to much
of the global swaps market, these bank officials said.
International clients also threatened to take their business
to non-U.S. banks in order to avoid the new American rules, the
U.S. bank executives said.
"We were worried about our major competitors taking away our
access to those markets and clients," a lawyer for a large U.S.
Some investors balked at signing the new contracts. "I don't
want to face a non-guaranteed subsidiary," said one hedge fund
lawyer. "I want to face the highest-credit counterparty
possible. And if I'm not, then I want to be compensated for the
But premiums paid by clients were largely unaffected, say
investors asked to sign the revised contracts.
JP Morgan told one hedge-fund client to sign the new
contract or find another bank to buy swaps from, according to
the client's lawyer. This fund agreed to sign rather than
jeopardize its relationship. "My client was looking at a fait
accompli," the lawyer said. "The message was: 'You need to sign
this if you want to continue trading.'"
A PLEDGE TO INVESTIGATE
By mid-2014, the five biggest U.S. banks had changed
"hundreds of thousands" of such contracts, according to
estimates by Michael Beaton, a European derivatives lawyer who
works with many international banks.
In mid 2014, the Securities Industry and Financial Markets
Association, a banking lobby in Washington, circulated a private
memo to its members. The memo consisted of talking points banks
could use to justify the de-guaranteed contracts and shifting of
trades if questioned by regulators and lawmakers.
"This practice (of removing guarantees) reduces the
perceived transmission of risk to the US financial system,"
SIFMA said in the memo. "Based on regulators' guidance, the
termination of U.S. guarantees should be encouraged - not
labeled as evasion" of the new derivatives rules.
That November, Bank of America notified its clients that, as
of November 25, 2014, all swaps conducted in Euros and British
sterling would be booked out of the bank's London affiliate,
Merrill Lynch International, according to bank clients who
received the notice.
A spokesman for Bank of America, William P. Halldin, said
the bank didn't force customers to move trading to the bank's
London affiliates, but did so if clients desired.
In early 2014, the CFTC began fielding reports that banks
were using the guarantee loophole to move trades abroad.
Gensler's successor, Timothy Massad, a former corporate lawyer
and Treasury official with expertise in derivatives, pledged to
This June, Massad announced a proposal that would force U.S.
banks' overseas operations to comply with one slice of American
swaps rules - setting aside collateral when trading in a
category of swaps.
But the guarantee loophole remains, as does the uncertainty
that comes with it.
(Edited by Michael Williams and John Blanton)