LONDON — Like many closed societies, the financial industry thrives on jargon and obscure acronyms. Back in 2009, TARP and “Too-Big-To-Fail” (TBTF to insiders) became household concepts, mostly because it was households — the American taxpayer — who had to foot the bailout bill.
Now, thanks to massive $2 billion in losses racked up by JP Morgan’s London-based chief investment branch, another piece of financial sector jargon has taken center stage: regulatory arbitrage.
This sounds devilishly complicated, but stay with me. It’s really quite simple.
Imagine, for instance, that you’re a 66-year-old living in New Jersey and you’re retiring next year on a pension. You find out that New Jersey – in spite of what Gov. Chris Christie may claim – is going classify your pension as income and tax the bejesus out of it. All of a sudden, the $1500 a month you thought you had coming to you drops to $1100, and those nights at the casino in Atlantic City, along with that new yellow and white Cadillac had your eye on, are out the window.
What do you do? Like many people in NJ over the past two decades, you apply regulatory arbitrage: move to Pennsylvania, where virtually all pensions are tax free. This is not illegal – in fact, it may be a necessity in the case outlined above. After all, what’s a 66-year-old in Jersey without a Cadillac?
But now, imagine you are an investment bank. Based in New York, you trade in billions regularly, much of it in “Over-the-Counter” (OTC) derivatives.
For decades, OTC trades had been handled over the phone, and later via email, with the brokers involved noting the amounts and reporting them to their supervisors at the end of the day. The banks loved this system. Given that the prices were opaque, they were able to make a mint on derivatives trades without their clients knowing the difference. Also, this informal system was light on red tape
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But it came with its own, sometimes massive problems. It let traders hide huge loses (at least for a while), usually involving even bigger bets placed in a desperate effort to recoup and hide the original loss. Such an attempt at multi-billion dollar ass-covering by a single young trader took down Barings, the world’s oldest investment bank, in 1995.
This opaque trading also meant that outside regulators, and even risk managers inside these banks, had no sure way to know how many such trades were out there, or how huge a hole they might create if they went bad. Indeed, in 2008, when Lehman collapsed, just figuring out who was involved in these trades proved impossible.
Cue the alarm bells: After the “light touch” deregulatory approach that reigned from about 1997-2008 led to global disaster, the G20 nations agreed at their 2009 summit to create transparent exchanges for “over-the-counter” derivatives, to ensure that trades like those that brought Lehman Brothers to its knees could be seen beforehand.
That sounds good in principle. But, in fact, US regulators still cannot get a straight answer from Congress on whether they have the right to force overseas branches of banks like JP Morgan or Citicorp to adopt these reforms.
Why should we care?
Enter JP Morgan: Just like about seven other American banks, and about two dozen globally, JP Morgan is so big that its collapse would threaten to take the US and global economies down with it. So, years after the worst of the crisis, the US taxpayer is officially on bailout duty, regardless of where in the world the US bank makes its bets.
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Dodd-Frank makes it quite clear that bets made in the US must be made on exchanges. The British version of the Securities and Exchange Commission (SEC), known as the Financial Services Authority (FSA), has also moved to ensure the same. But neither regulator seems to agree on who should be watching the branch offices of overseas banks.
In recent testimony to Congress, JP Morgan’s CEO, Jamie Dimon, has said his bank has not tried to dodge the rules by sitting its chief investment office — which handles hundreds of billions in complex trades – in London. London’s own tightening regulations suggest this is probably true, though the bank certainly is aware of the limbo that overseas offices exist in for the moment.
Down the road, however, Dimon shows he understands the future perfectly well, noting that once London and New York finally get their act together, "[w]e will lose a lot of business. They will not move to London, but I assure they will be in Singapore, in other parts of the world."
And Singapore helpfully chimed in earlier this month, too. As the G20 nations with major exchanges — Australia, Germany, the US, Britain, Japan, and yes, India and China, too — have moved to comply with this G20 rule. The compliance is uneven, but it is moving in the right direction.
But over the past month, Singapore and Hong Kong, said basically, “Hell no, we won’t go.” As a Financial Times journalist put it at a Singapore conference earlier this week, “That, to many in London, was seen as pure regulatory arbitrage, to say 'come on, guys — you don't have to trade all these derivatives on exchanges in London or New York, you can come to Singapore.’”
In that case, moving to Pennsylvania ain’t gonna cut it.