Swap Loophole Leaves U.S. Taxpayers on Hook for Trades

(Bloomberg) -- Loopholes that let the largest U.S. derivatives dealers skirt Dodd-Frank regulations haven’t been fixed, threatening to leave taxpayers on the hook to bail out U.S. banks if another financial crisis hits, according to a report published by a left-leaning think tank.

Citigroup Inc., JPMorgan Chase & Co., Goldman Sachs Group Inc. and Bank of America Corp. handle about 90 percent of U.S. swaps trading, and have been able to shift swaps contracts traded in the U.S. to foreign subsidiaries, according to a working paper by Michael Greenberger, a law professor at the University of Maryland. That’s effectively shielded those transactions from key elements of the 2010 Dodd-Frank financial reform law, including requirements for posting collateral on certain kinds of trades, the report said.

A 2016 proposal by the U.S. Commodity Futures Trading Commission to close the loophole was never finalized and "almostly certainly" won’t be under the Trump administration, the paper said, effectively letting banks keep unregulated swaps on their balance sheets indefinitely. The swaps market was by one measure $120.49 trillion at the end of December, according to data compiled by the U.S. Office of the Comptroller of the Currency. That figure, the notional size of the market, refers to the amount of securities referenced by the derivatives and not the actual cash flows that banks are on the hook for in most cases.

Representatives for Bank of America, Goldman Sachs and JPMorgan declined to comment. A representative for the CFTC didn’t immediately respond.

Danielle Romero-Apsilos, a spokeswoman for Citigroup, said the bank conducts swaps activity in Europe through entities that are registered with the CFTC as swaps dealers and that meet applicable CFTC and European Union derivatives rules when transacting with EU counterparties. The entities it trades in have external credit ratings and are highly capitalized, she said.

Banking and derivatives trade groups said global rules for swaps are well crafted to keep markets safe. Kenneth Bentsen, chief executive officer of the Securities Industry and Financial Markets Association, said in a statement that all CFTC-regulated swaps, amounting to over 95 percent of the over-the-counter derivatives market, are reported to trade repositories if a U.S. entity or non-U.S. affiliate are part of the trade. Swap dealers are subject to robust regulation in other jurisdictions including the EU and Japan, he said.

The International Swaps and Derivatives Association said in a statement that there is no loophole, and that some European parties prefer for their financial transactions to be governed by EU rules, which are similar to those in the U.S. Kevin Fromer, CEO of the Financial Services Forum, said global regulators have made important changes to improve the safety of derivatives markets.

Debt Cascade

The current system could ultimately hurt taxpayers, the report said. Rising defaults in auto loans, student debt and credit card obligations mirror conditions seen before last decade’s mortgage crisis. A cascade of bad debt could lead to another financial meltdown, the paper said, putting taxpayers "in the position of once again being the lender of last resort to these huge U.S. institutions."

The CFTC has had some success in plugging swaps loopholes in the past. It approved a rule in May 2016 that broadened the circumstances in which banks’ foreign units must adhere to U.S. collateral requirements. But that change only applied to margin requirements on one type of contract Dodd-Frank regulates. The later proposal would have eliminated the loophole for all regulated swaps, according to the working paper published by the left-leaning Institute for New Economic Thinking.

State-level attorneys general or regulators can bring Dodd-Frank violations to federal courts, making them "likely to be the last bastion of defense" against problems stemming from a minimally-regulated swaps market, wrote Greenberger, who was a director of the division of trading and markets at the CFTC during Bill Clinton’s administration.

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