U.S. regulators are under immense pressure from foreign officials to rework the Volcker rule trading ban so that it does not restrict trading in their foreign debt, but that's easier said than done.
Finance officials from the Group of 20 economic powers expressed confidence over the weekend that the United States would rejig the proprietary trading ban so that it does not exempt just U.S. Treasurys.
But to expand that exemption, the law requires regulators to conclude that broadening the exemption would protect the financial stability of the United States and the safety and soundness of banks.
That will not be an easy standard to meet, according to analysts and lawyers, regardless of how sympathetic U.S. officials are to the pleas of their foreign counterparts.
U.S. regulators also risk criticism that they are watering down regulations, and it could open the floodgates for other market players to beg for their own exemption to the Volcker rule.
A lawyer who has worked closely with banks on the Volcker rule said regulators have let it be known they do not think there is an obvious way to broaden the exemption.
"They basically say 'not an easy bar,'" said the lawyer, who asked not to be identified in order to describe the private discussions.
The 2010 Dodd-Frank financial oversight law sought to keep a tight lid on any exemptions regulators could make to the prohibition on banks trading for profit with their own funds. The regulation is known as the Volcker rule, after former Federal Reserve Chairman Paul Volcker, who championed the policy.
The overall trading restrictions would mostly impact the largest banks, such as Goldman Sachs Group Inc and Morgan Stanley.
The law specifically exempted trades in U.S. debt from the restriction but not securities issued by other countries, which has drawn howls of protest from abroad.
Foreign regulators — including those from Europe, Asia and Canada — are lobbying U.S. officials to expand the definition.
They warn say the proposal, issued in October, would cause the cost of borrowing for some countries to rise because the market for their debt would be limited if the role of large U.S. banks shrinks.
Michel Barnier, EU commissioner in charge of financial regulation, put the issue at the top of his agenda when visiting Washington's top policymakers last week.
A U.K. Treasury official attending the G20 meetings in Mexico City this past weekend said that "very constructive" talks were under way with U.S. officials and that the British government was "very confident" they would resolve matters successfully.
However, Darrell Duffie, a finance professor at Stanford University, said it would be "difficult" for U.S. regulators to meet the standard necessary to broaden the exemption.
Duffie has been sympathetic to the argument that the Volcker rule could damage the liquidity of various trading markets and increase borrowing costs.
But he said it would be a stretch to say a less-liquid market for some foreign debt would lead to U.S. financial instability or major problems for the health of large U.S. banks.
The public pressure being applied by foreign officials is unusually intense and some analysts and lawyers said they believe it will lead U.S. regulators to find a way to address at least some of the concerns — even if it is only with regard to debt issued by a limited number of countries.
Providing more leeway for trades in foreign debt would likely draw stiff criticism from supporters of the Volcker rule who are wary of any loosening of the restrictions.
Democratic Senators Carl Levin and Jeff Merkley, who authored the Volcker language in Dodd-Frank, wrote regulators earlier this month warning that expanding the exemption could create more risk for U.S. banks.
They cited the recent demise of the brokerage MF Global, which filed for bankruptcy on Oct. 31 after its $6.3 billion bet on European sovereign debt spooked investors and customers.
"When the law was being developed, it was already clear, as it is now, that foreign sovereign debt instruments can be risky instruments," the senators wrote in a Feb. 13 letter.
If regulators do widen the sovereign debt exemption, it could spark increased pressure from all types of market participants who want the October proposal loosened to accommodate securities important to their businesses.
"If you can use that exemption in this instance, why can't you use it in another instance? How do you put a fence around it?," said Donald Lamson, a lawyer with Shearman & Sterling. "That's the more difficult problem."
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