Too Big to Fail U.S. Banks’ Regulatory Alchemy: Converting an Obscure Agency Footnote into an “At Will” Nul- lification of Dodd-Frank’s Regulation of the Multi-Trillion Dol- lar Financial Swaps Market Michael Greenberger1 Working Paper No. 74 June 2018 ABSTRACT The multi-trillion dollar market for, what was at that time wholly unregulated, over-the- counter derivatives (“swaps”) is widely viewed as a principal cause of the 2008 worldwide finan- cial meltdown. The Dodd-Frank Act, signed into law on July 21, 2010, was expressly considered by Congress as a remedy for the deregulatory problems, in that market, that led to the crash. The legislation required the swaps market, subject to U.S. regulation, to comply with a host of business conduct and anti-competitive protections, including that the swaps market be fully transparent to U.S. financial regulators, collateralized, and capitalized. The statute also ex- pressly provides that it would cover foreign subsidiaries of big U.S. financial institutions if their swaps trading could adversely impact the U.S. economy or represent an attempt to “evade” Dodd-Frank. 1 Law School Professor, University of Maryland Carey School of Law, and Founder and Director, University of Maryland Center for Health and Homeland Security, former Director, Division of Trading and Markets, Commodity Futures Trading Commission. This arti- cle draws from these previous publications: Michael Greenberger, Closing Wall Street’s Commodity and Swaps Betting Parlors: Legal Remedies to Combat Needlessly Gambling up the Price of Crude Oil Beyond what Market Fundamentals Dictate, 81 GEO. WASH. L. REV. 707 (2013); Michael Greenberger, Diversifying Clearinghouse Ownership in Order to Safeguard Free and Open Access to the De- rivatives Clearing Market, 18 FORDHAM J. CORP. & FIN. L. 245 (2013); Michael Greenberger, The Extraterritorial Provisions of the Dodd-Frank Act Protects U.S. Taxpayers from Worldwide Bailouts, 80 UMKC L. REV. 965 (2012); Michael Greenberger, Out of the Black Hole: Regulatory Reform of the Over-the-Counter Derivatives Market, in MAKE MARKETS BE MARKETS 99 (Robert Johnson & Erica Payne eds., 2010); The Role of Derivatives in the Financial Crisis: Hearing before the Financial Crisis Inquiry Commission, 111th Cong. (June 30, 2010), https://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0630-Greenberger.pdf. This paper was under- taken with the financial support of the Institute of New Economic Thinking. 1 In July 2013, the CFTC promulgated an 80 page, triple columned, and single-spaced “guidance” implementing Dodd-Frank’s extraterritorial reach, i.e., that manner in which Dodd- Frank would apply to swaps transactions executed outside the United States. The key point of that guidance was that “guaranteed” foreign subsidiaries of U.S. bank holding company swaps dealers were subject to all of Dodd-Frank’s swaps regulations wherever in the world those sub- sidiaries’ swaps were executed. At that time, the standardized industry swaps agreement con- templated that, inter alia, U.S. swaps dealers foreign subsidiaries would be “guaranteed” by their corporate parent, as was true since 1992. In August 2013, without notifying the CFTC, the principal swaps dealer trade association privately circulated to its member’s standard contractual language that would, for the first time, “deguarantee” foreign subsidiaries. By relying only on the obscure footnote 563 of the CFTC guidance’s 662 footnotes, the trade association assured its swaps dealer members that the newly deguaranteed foreign subsidiaries could (if they so choose) no longer be subject to Dodd-Frank. As a result, it has been reported (and also has been understood by many experts within the swaps industry) that a substantial portion of the U.S. swaps market has shifted from the large U.S. bank holding companies swaps dealers and their U.S. affiliates to their newly de- guaranteed “foreign” subsidiaries. The CFTC also soon discovered that these huge U.S. bank holding company swaps dealers, through their foreign subsidiaries, were “arranging, negotiat- ing, and executing” these swaps in the United States with U.S. bank personnel and, only af- ter execution in the U.S., were these swaps formally “assigned” to the U.S. banks’ newly “de- guaranteed” foreign subsidiaries with the accompanying claim that these swaps, even though executed in the U.S., were not covered by Dodd-Frank. In October 2016, the CFTC proposed a rule that would have closed these loopholes com- pletely. However, the proposed rule was not finalized prior to the inauguration of President Trump. All indications are that it will never be finalized during a Trump Administration. Thus, as the tenth anniversary of the Lehman failure approaches, there is an under- standing among many market regulators and swaps trading experts that large portions of the swaps market have moved from U.S. bank holding company swaps dealers to their newly de- guaranteed foreign affiliates. However, what has not moved abroad is the very real obligation of the lender of last resort to rescue these U.S. swaps dealer bank holding companies if they fail because of poorly regulated swaps in their deguaranteed foreign subsidiaries, i.e., the U.S. tax- payer. While relief is unlikely to be forthcoming from either the Trump Administration or a Re- publican-controlled Congress, some other means will have to be found to avert another multi- trillion dollar bank bailout and/or financial calamity caused by poorly regulated swaps on the books of big U.S. banks. This paper notes that the relevant statutory framework affords state attorneys general and state financial regulators the right to bring so-called “parens patriae” ac- tions in federal district court to enforce, inter alia, Dodd-Frank on behalf of a state’s citi- zens. That kind of litigation to enforce the statute’s extraterritorial provisions is now badly needed. JEL Codes: E5, G01, G21, G28, K22 Keywords: Derivatives, Commodity Futures Trading Commission, finance, banks, Dodd-Frank, cross border, regulation 2 Table of Contents I. Summary and Introduction. ................................................................................................................................ 5 II. The Troubled History of the Swaps Market and its Poor Regulation ................................................................ 16 A. The Origins and Purposes of the Commodity Exchange Act’s Regulation of Derivatives ........................... 17 B. The Nature of Futures Contracts ................................................................................................................... 18 C. The Contours of the CEA’s Exchange Trading Requirement........................................................................ 19 D. The Development and Characteristics of Swaps ........................................................................................... 20 E. Swaps and the CEA’s Exchange Trading Requirement ................................................................................ 23 F. The Standardization of Swaps through the ISDA Master Agreement ........................................................... 25 G. The CFTC’s May 1998 Concept Release Suggesting the Regulation of Swaps ............................................ 26 H. The Serious Pre-May 1998 Swaps Market Dysfunctions .............................................................................. 28 I. Opposition to the CFTC’s Suggestion That Swaps Regulation Was Needed ................................................ 29 J. The Long Term Capital Management Crisis ................................................................................................. 30 K. The President’s Working Group’s (“PWG”) April 1999 Report on LTCM Suggesting Some Regulation of Swaps 31 L. The November 1999 PWG Report Recommending the Deregulation of Swaps ........................................... 32 M. The Commodity Futures Modernization Act of 2000’s Complete Deregulation of Swaps ........................... 33 III. The 2008 Economic Meltdown as a Product of Unregulated Swaps ................................................................ 36 A. CDSs and “Naked” CDSs Foremost Role in the Meltdown .......................................................................... 36 B. Counterparty Interconnectedness: The Systemic Risk Derived from All Types of Swaps ............................ 42 1. The Lehman Bankruptcy Evinces the Complete Financial Interconnectedness through Swaps of The World’s Large Financial Institutions ................................................................................................................. 43 2. Bear Stearns Collapse Shows Financial Institution Swaps Interconnectedness ............................... 44 3. AIG’s Threatened Collapse and Systemic Interconnectedness ........................................................ 45 C. Other Prominent Twenty-First Century Financial Calamities Caused by Unregulated Swaps ..................... 46 1. The Greek Financial Crisis ............................................................................................................... 46 2. The City of Detroit Bankruptcy ........................................................................................................ 49 3. Jefferson County, Alabama (Birmingham) Bankruptcy ................................................................... 51 4. Other Problems with Unregulated Interest Rate Swaps Faced by Local Governments and University Systems 54 5. The London Whale