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The SEC Lures Off-Shore Subsidiaries

Newly proposed regulations are trying to bring off-shore derivatives subsidiaries back to the United States.

By John Thackray

In a major revamping of its regulatory machinery, the Securities and Exchange Commission has offered a succulent carrot to those Wall Street derivatives dealers who've set up offshore subsidiaries or domestic affiliates not registered with the agency.

Dealers typically set up these subs—a kind of regulatory arbitrage—to compete better with U.S. banks and other global rivals. The SEC released the blueprints of its highly complex architecture on the last day of last year, and they have been intensively studied by the best legal minds in the securities business.

Basically the analysts are enthusiastic. Tony Leitner, associate counsel at Goldman Sachs, calls the proposals nothing less than "revolutionary”—the most radical being that the proposed special-purpose over-the-counter derivatives subsidiaries would be exempt from many of the more onerous margin, capital and reporting requirements now imposed on regular broker-dealers.

The most important new freedom extended to these special-purpose subsidiaries is permission to use their own value-at-risk models as the basis for their capital adequacy computations. The SEC says that if this approach works with the experimental group, the methodology will be extended to all broker dealers. "It could be a harbinger of things to come, regarding changes in the regulatory structure, to embrace proprietary models as an overall part of the regulatory regime,” observes Paul Saltzman, general counsel of the Bond Market Association, which late in January hosted a discussion forum on the proposals. Saltzman emphasizes that this is an extremely complicated package. What's more, it is also rough. On some key points the SEC has been vague and has invited industry comments.

The proposed rule changes would remove many of the regulatory handicaps that broker-dealers face. According to Caite McGuire, associate director in the SEC's Division of Market Regulation, the agency acknowledges that the SEC's "regulatory system for derivatives in the United States is cumbersome,” and that in trying to protect ordinary investors with a single regulatory machinery for everyone there had been an unintended hostility to derivatives. A pity, since the agency thinks that these are good products when used properly.

New subs

In a nutshell, the SEC will allow the creation of a segregated pool of capital with a $100 million minimum, available to firms acting primarily as counterparties in privately negotiated derivatives transactions. Other permitted activities would be transactions for risk management purposes, for taking possession of or selling counterparty collateral, and for arbitrage and trading. These subsidiaries would also be tightly controlled as to their other activities. They would be allowed to issue securities, including warrants on securities, hybrid products and structured notes. But they would have their hands tied on selling activities, which must be handed off to the broker-dealer parent and are subject to the status quo rules.

Although this is a giant leap in regulatory liberalization, the SEC has to be careful that it does not penalize broker dealers who lack the qualifying requirements to create these subsidiaries. Also, the agency must ensure that the laxer margin and capital requirements for these entities don't tempt Wall Street firms to book business in stocks and bonds that should fall under the ordinary broker-dealer regulations and capital requirements. Ed Rosen, partner at Cleary, Gottlieb, Steen & Hamilton, says: "There is a significant concern at the SEC about the potential use of these vehicles as inventory dumps.”

In creating a code of acceptable transactions, the SEC seems fully aware of the ambiguities in managing derivatives risk. Says the report: "It is no longer possible, in many instances, to show the relationship between a hedging transaction and the instrument it is intended to hedge…[and] as a result, it may be difficult to demonstrate the relationship between trading done for risk management and the different OTC derivatives positions on a dealer's books.” The remedy it proposes is that firms develop their own compliance procedures by tagging and documenting the transactions that are clearly meant for risk management purposes. The agency would allow a safety net of 150 transactions a year that cannot be adequately justified or documented as pertaining to risk management objectives. Say, for example, a trader engages in a transaction that he or she thinks is within the firm's risk guidelines. If the risk manager decides the trade doesn't meet the guidelines, it can be added to the basket of 150 wildcards.

Unquestionably the main bait that the SEC is dangling in front of prospective offshore derivatives shops is the enormously relaxed capital and margin requirements, when compared with broker-dealer rules. Whether these inducements will prove to be sufficient will only be known in the fullness of time, as the main broker-dealers who are also big players in derivatives compare and contrast the pros and cons of their current regulatory framework with the probable life under the SEC proposals.

Now, for example, SEC Regulation T prohibits the extension of credit other than margin securities. Banks operating under Regulation U, however, can extend credit on collateral other than margin stock, including derivative instruments. Under the proposal these OTC derivatives dealers would be subject to Regulation U only.

But the juiciest part of the entire proposal is the relaxation of the present system of calculating net capital requirements, in which derivatives are considered unsecured receivables, and must be deducted from calculations of a firm's net worth in calculating its net capital. The present value of the next net interest payment on a swap, for example, is considered zero. Same with unrealized gains. In addition, present regulations do not give securities firms the same latitude for offsets as is available to others. The result, says the report, "Often requires broker-dealers to reserve more capital with respect to these transactions than banks or foreign broker-dealers have to reserve.”

The SEC proposes to permit the new OTC derivative dealers to treat unsecured receivables as capital, when they are with permissible counterparties. Second, it would allow VAR as a method of computing capital charges on proprietary positions, which will of course reduce market risk capital charges to the degree there are offsets. The SEC report says it has been considering the use of VAR models as the vehicle for setting regulatory capital. The OTC derivatives dealers would give the SEC a "valuable opportunity to gain experience with the use of these models by entitities within its jurisdiction.”

High hurdle

It is because this is something of an experiment that the SEC wants to liberalize the rules only for the big boys. So the eligible OTC derivatives subsidiaries would have to maintain a tentative net capital of $100 million that would never sink below $20 million. This should be enough, the SEC hopes, to ensure against excessive leverage and risks other than credit or market risk. As for the latter, these OTC derivatives shops would have to deduct from their net worth a capital charge for market risk that would be computed by the so-called full-VAR approach. The subsidiary would have to get preapproval from the SEC for this method, by describing its model, its logic and its qualitative and quantitative characteristics in writing. In addition, risk management controls would have to be detailed.

Unlike commercial bank regulators, however, the SEC does not claim expertise in the computational nuances of VAR. "It is our understanding that the SEC will approve the use of VAR models, but does not plan to look at the mechanics of the models,” says Cheryl M. Kallem, assistant controller and managing director at Bear Stearns. The agency, she explains, essentially wants to know that the VAR model is integrated into the firm's risk management apparatus and has been stress tested, reviewed by auditors and back tested.

The proposed machinery for credit risk is to deduct from net worth a capital charge computed on a counterparty-by-counterparty basis in three steps. Step one is an 8 percent haircut of the net replacement value in the account of the counterparty. Step two is another haircut depending on the counterparty's public ratings. Step three is yet another charge if any single counterparty's net replacement value should account for more than a quarter of the dealer's tentative net capital.

The entire package has had a lot of input from Wall Street firms, principally from members of the ad-hoc Derivatives Policy Group—which includes Goldman Sachs, Lehman, Merrill Lynch, Morgan Stanley and Salomon Smith Barney—who have long pressured the SEC for regulatory relief. So it would be surprising indeed if they do not 1) try to get an even better deal via comment letters, which have a March 30 deadline, and 2) eventually adopt this machinery. "The proposal might entice dealers to bring a portion of their business on shore,” observes Zachary Snow, managing director of Salomon Smith Barney.