A Big Win For Wall Street Reform Advocates

By Sam Nadler

Sam Nadler is a senior at Vanderbilt University studying history.

The Commodity Futures Trading Commission (CFTC) scored a major courtroom victory on September 16th against some of the country's largest financial institutions, including some involved in the financial crisis. In a move with great ramifications for Wall Street and future financial regulations, Judge Paul Friedman, US District Court Judge for the District of Columbia, refused to vacate new cross-border swaps rules implemented by the CFTC.  

Regulating swaps, which are contracts that make it easier for derivatives traders to incur risk, is the focal point of the new CFTC rules. Simply put, derivatives are financial instruments that derive their value from an underlying asset. They are contracts between two parties that specifying the rules under which payments are made between the parties. They come in many different asset classes including commodities, bonds, stocks, and currencies, and are used to speculate or hedge market risk. Most of the trading in these financial instruments is known as Over the Counter (OTC), which simply means that it occurs as the result of a privately agreed upon contract between two parties and not through an exchange.

The impetus for the new rules is Title VII of the Dodd-Frank Act, aimed at reducing market risk and promoting transparency. The CFTC's mandate in the Dodd-Frank Act (2010) justifies the proposed extraterritorial regulation of OTC derivatives trading according to the ruling. Judge Friedman held that it is entirely appropriate that when "the conduit is located outside the United States, but is owned and controlled by a U.S. person ... to recognize the economic reality of the situation, the conduit's swaps should be attributed to the U.S. affiliate(s).” [1]  

The Dodd-Frank Act sought to correct many of the perceived abuses that led to the 2008 financial crisis. Because derivatives activity was previously grossly underregulated, Title VII of the act gave the CFTC jurisdiction over the derivative swaps market, whose global size is estimated at $700 trillion. The act extended the reach of the CFTC in this area beyond US borders, providing that any rules or regulations of the CFTC, including Title VII, "shall not apply to activities outside of the United States unless those activities... have a direct and significant connection with activities in, or effect on, commerce in the United States." [2] This extension of jurisdiction beyond US borders was essential for the swaps regulations to have any teeth because, as the plaintiffs in the suit recognized, "the swaps market is truly global: a single swap may be negotiated and executed between counterparties located in two different countries, book in a third country and risk-managed in a fourth country.” [3]

This type of financial activity came under the purview of federal regulators because of the role it played in the financial crisis, specifically the near-collapse of American Insurance Group (AIG). In the aftermath of the financial crisis, the government's Financial Crisis Inquiry Commission noted that AIG was pushed to the brink of failure because "its enormous sales of credit default swaps were made without putting up initial collateral, setting aside capital reserves, or hedging its exposure." The commission stated that, "AIG’s failure was possible because of the sweeping deregulation of over-the-counter derivatives, including credit default swaps, which effectively eliminated federal and state regulation of these products, including capital and margin requirements that would have lessened the likelihood of AIG’s failure." Especially notable in regards to the new cross-border swaps regulations proposed by the CFTC is that AIG set up much of this business in London, outside of the purview of federal regulators. Yet, the failure still had a significant impact on the American economy. Thus, in the aftermath of this failure, legislators sought to empower federal regulators to oversee derivatives activity even outside of American borders.

Under Title VII’s mandate, on July 26, 2013, the CFTC released a document entitled Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations. This policy statement was a finalization of the Proposed Guidance first published on July 12, 2012 and revised on December 21, 2012. This policy statement established a framework for regulating cross-border swaps but specified that it should be applied on a case-by-case basis. At the time the document was released, the CFTC had not yet made any substituted compliance determinations. The CFTC, therefore, issued an exemptive order providing, among other things, relief from the cross-border application of certain CFTC regulations through December 21, 2013.

Soon before this relief expired, the International Swaps and Derivatives Association (ISDA), the Securities Industry and Financial Markets Association (SIFMA), and the Institute of International Bankers (IIB) filed a lawsuit challenging the application of the cross-border rules. The lawsuit alleged that the CFTC unlawfully circumvented the requirements of the Administrative Procedure Act (1946) and the Commodity Exchange Act (1936) by portraying its regulations as “guidance.”  They alleged that the CFTC failed to conduct the necessary cost-benefit analysis required by law. The plaintiffs also argued that the rules’ “overreach could cause global fragmentation in markets,” which could reduce liquidity and significantly harm market participants and market-based financing. Additionally, the lawsuit alleged that by not conducting any cost-benefit analysis, the cross-border rules created "significant administrative, financial, and legal burdens that could negatively affect liquidity and the ability of end users to manage risk."

In his ruling, Judge Freidman struck down the plaintiff’s argument that the CFTC did not have the authority to apply the rules contained in the guidance. He explained that Congress had clearly indicated that the swaps oversight included in Dodd-Frank, including any rules or regulations prescribed by the CFTC, apply outside of the US’s borders. Friedman did question the CFTC for not thoroughly studying the costs and benefits of ten of the rules. However, he declined the industry call to vacate them. Throwing the regulations out “would be unnecessarily disruptive to the CFTC’s mission and the purposes of the Dodd-Frank Act,” the judge wrote.

Highly anticipated by Wall Street and financial regulators, Judge Freidman's ruling was a major victory for regulators looking to reign in the massive abuses that led to the 2008 financial crisis. “Proponents of financial reform secured a major victory,” said Representative Maxine Waters of California, the senior Democrat on the House Financial Services Committee. “It is in the best interests of American taxpayers that the U.S. District Court has expressed an understanding that these efforts to evade important U.S. regulations are contrary to Congressional intent, and only serve to harm consumers and our economy in the long run.”

This case is evidence of a major shift in the balance of power between Wall Street and the federal regulators charged with maintaining order in financial markets.  "This decision is a very big win for financial reform and for transparent derivatives markets," said Dennis Kelleher, who heads Better Markets, a group urging Wall Street reform.

The ruling also pleased the CFTC. “I am pleased the court upheld the Commission’s July 2013 policy statement on the cross-border application of Title VII swaps provisions, and rejected a sweeping injunction of the rules that are at the heart of Dodd-Frank’s overhaul of the swaps markets,” CFTC Chairman Tim Massad said in a statement. “I am committed to continuing our efforts to reform the swaps markets, including addressing Congress's concerns that risks undertaken abroad might threaten the health of the U.S. economy.”

While regulators and market participants will continue to tussle in the wake of the 2008 financial crisis, for the meantime, Judge Freidman's ruling is encouraging for financial regulators and proponents of financial reform.

[1] Securities Industry and Financial Markets Association et al. v. United States Commodities Futures Trading Commission, No. 13 Civ. 1916 (PLF), 2014 US Dist. (D.D.C. Sept. 16, 2014).
[2] 7 U.S.C. § 2(i)
[3] Securities Industry and Financial Markets Association et al. v. United States Commodities Futures Trading Commission, No. 13 Civ. 1916 (PLF), 2014 US Dist. (D.D.C. Sept. 16, 2014).
Photo credit: Flickr user Anthony Walker