The proposal was introduced by Senator Blanche Lincoln to the Senate’s financial reform bill, passed on May 20, and was a key point of contention in negotiations over the past few weeks to reconcile that bill with the equivalent legislation passed by the House of Representatives in December.

Lawmakers in Washington worked late into the night of Thursday June 24 hammering out a deal on the Lincoln proposals and other key disputed areas of the 2,000 page bill. By the end of the night it seemed clear that interest rate and foreign exchange swaps would be exempt from the spin-out requirement, which would apply to credit default swaps, commodities and dealings with speculative grade entities.

The FOA, like its US counterpart the Futures Industry Association, has lobbied regulators and politicans throughout the financial crisis to stave off what it sees as the risk of unintended damage to derivatives markets from overzealous regulation.

Atlantic split

Speaking on the morning of Friday June 25, Belchambers said: “There is clearly a strong difference between the EU and US positions. The EU has taken the view that universal banks are good things – they provide diversified services to international corporate clients that are themselves very diversified and very large.

“The second point that the EU’s position is strong about is that if we recapitalise risk and diversity so that if you do engage in these activities that are not core to narrow banking, they require higher capital – in effect an economic, not a physical restructuring – then you leave the industry to decide what kind of model it wants. If certain institutions don’t want to face higher capital requirements, they may decide to become narrow banks. I personally think that’s an infinitely better position than the kind of regulatory-enforced approach that is being pursued in the US.”

Belchambers said the US legislation was “not as empathetic to the way the world is at the moment”, particularly the diverse needs of large companies.

Recapitalising derivatives trading in separate affiliates would raise the costs for banks to engage in this business, he believes, even above the costs already imposed by higher capital requirements – partly because banks would no longer enjoy “that element of cross-subsidy” with their wider balance sheets. Separate entities would also require fresh compliance costs.

Why separate?

Belchambers went on to argue that the whole thrust of regulatory reform since 2008 had been to “substantially mitigate the risk of a crisis being caused by sudden defaults,” through higher capital requirements, much closer supervision of banks and measures to intervene earlier and manage failing firms proactively.

“Why, when you’ve done all that, would you want structural separation?” Belchambers asked. “What is the risk that’s been uncovered that you’re trying to address?”

He said banks were “significant providers of liquidity” to derivative markets, and that if their participation in those markets became less profitable, they might scale back on it. “Some of that lost liquidity might be made up by non-bank proprietary traders, but you are still going to have a question mark about whether there will be adequate financial order flow,” Belchambers said.

In his view “smaller and specialist markets” such as electricity and soft commodities could be particularly at risk because they rely heavily on financial order flow from banks.

Markets being squeezed

He also warned that it was important not to see the Lincoln proposals in isolation but in combination with other regulatory “compressions” to the market, such as “capital rules designed to disincentivise banks from proprietary trading” and the possibility of higher capital requirements even for non-bank proprietary traders under the Basle reforms.

In Europe Basle II was made to apply to all investment firms through the European Commission’s Capital Requirements Directives, Belchambers said.

As part of this mix he also cited pressure, in the consumer-sensitive commodity markets, from moves to introduce tighter position limits to protect against market manipulation and excessive speculation.

Another concern Belchambers raised was that the Lincoln clause could lead to competitive tensions between US and foreign banks. “If you were a narrow bank in the US” that had been forced to spin out its swaps desk “how comfortable would you be about foreign universal banks coming in and potentially doing this business more cheaply?”

He said the resentment could recall fairness arguments made by US banks in the last years before the repeal of the Glass-Steagall Act, which kept banks and securities firms separate from the 1930s until the 1990s – though by the last decade of its life the Act was so porous as to be almost meaningless.

Some consolation

However, Belchambers welcomed the news that FX and interest rates could be exempt from the spin-out rule. “It’s like reinventing the wheel,” he said. “If you have markets that work well and efficiently, like FX, why would you want to mess around with them? You might want to improve them, here and there, where it’s justifiable, but not change the basic structure.

“The same has got to be true of the interest rate market. There may be questions around transparency, or confirmations, but those can be dealt with. So if these markets are being exempted, I think that’s a healthy thing. It doesn’t mean they will be unregulated – the regulators will still be looking much more closely at these markets – and that’s a good thing.”

Jon Hay +44 207 779 8372 jhay@fow.com

Click here to read FOi’s editorial published on May 26, arguing in favour of the Lincoln proposals.