An odd couple, yet an obvious match: Foreign broker dealers and the US balance of payments deficit
Thank you to Rebecca and Apostolos for inspiration and a sense of direction. Thank you to Perry and Stefan for comments and invaluable conversation. All errors are mine.
When investment banks based and licensed outside the US participate in securities offerings with a distribution in and outside the US, they need to ensure that they are either registered as a broker dealer in the US, act through one of their US registered broker dealer affiliates or are exempted from the US registration requirement for broker dealers.
A close look at the history of the registration requirement exemptions applicable to foreign broker dealers reveals that they were granted in the context of a gradual re-globalization of capital markets after World War II, which was also driven by global (im)balances of payments. It is therefore fair to say that the SEC’s rulemaking on the exemptions was also (not only!) driven by how policy makers managed the US balance of payments deficit. This is an interesting detail often omitted from the narrative of the history of the exemptions, which is usually exclusively spun around the SEC’s desire to enhance the efficiency of capital markets and to allow for their internationalization. Needless to say, that the US policy goal of managing the US balance of payments deficit runs deep and seamlessly connects to the management of the global dollar system and to this day has significant implications for geopolitics.
Section 15(a) of the Securities Exchange Act of 1934 requires all brokers or dealers effecting securities transactions by means of interstate commerce to registered with the Securities and Exchange Commission (the “SEC”). Section 3(17) of the Securities Exchange Act of 1934 defines interstate commerce to include “trade, commerce, transportation or communication among the several States, or between any foreign country and any State.” Because of this definition the jurisdictional reach of Section 15(a) of the Securities Exchange Act of 1934 is potentially quite broad. A literal reading of this provision would include within the scope of the registration requirement any broker dealer (regardless of its jurisdiction of incorporation or its principal place of business) selling securities issued by a US issuer in the US or outside the US as well as any broker dealer (regardless of its jurisdiction of incorporation or its principal place of business) selling securities issued by a non-US issuer in the US. A London based investment bank would therefore have to register with the SEC before it sold any securities issued by a Texan issuer on the continent or before it sold any securities issued by a European issuer to a New York based fund or would otherwise risk an SEC investigation and a penalty.
In 1964, the SEC issued an interpretive guidance (Release 34-7366, the “1964 Release”) that clarified that under certain circumstances a foreign broker dealer would not have to register in the US.
“[…] if a foreign broker-dealer, participating as an underwriter in a distribution of American securities being made abroad, or being made both abroad and in the United States, limits his activities to (1) taking down securities which he sells outside the jurisdiction of the United States to persons other than American nationals, and (2) participating solely through his membership in the underwriting syndicate in activities of the syndicate in the United States such as sales to selling group members, stabilizing, over-allotment, and group sales, which activities are carried out for the syndicate by a managing underwriter or underwriters who are registered with the Commission, then the Commission will generally raise no objection if the foreign broker-dealer performs these limited functions without registration as a broker-dealer under section 15 of the Act.”
The 1964 Release exempted foreign broker dealers that distribute securities issued by an American issuer outside the US to persons other than American nationals. Also, if securities issued by an American issuer are distributed both in the US and outside the US, the foreign broker dealer will be exempted from the registration as long as it sells the securities outside the US to persons other than American nationals and lets the distribution in the US be carried out by the syndicate members that are registered US broker dealers.
Given that the exemptions granted under the 1964 Release were only available to foreign broker dealers and not to US broker dealers, one of the implications of the release was that foreign broker dealers received more favorable treatment than US broker dealers when it came to the distribution of US securities outside the US. Another implication of the 1964 Release was that American issuers that wanted to exclusively issue securities to non-US investors outside the US could do so by using the services of non-registered foreign broker dealers and not giving any business to US broker dealers. The SEC had good reasons to grant these generous privileges to foreign broker dealers and in doing so acted in the US interest.
In 1964, when the Bretton Woods system was still in place and the global financial system operated with fixed exchange rates, the US balance of payments deficit was large and of growing concern to US policy makers who wanted “to reduce the US balance of payments deficit and protect US gold reserves” (quoting from the 1964 Release). Since the second half of the 1950s the US had seen a surge in net capital outflows from the US, i.e. a surge in US private direct investment abroad, which resulted in non-US creditors holding dollars in New York deposit accounts. The nightmare of US policy makers at the time was that these international creditors would stage a run on the US and ask for gold in exchange for the dollars they held in the deposit accounts of New York banks (a good summary of the issue provides the BIS Annual Report 1972, 3-33). What was needed in the minds of US policy makers was a reversal of the capital outflows, i.e. international investors buying US assets and in doing so swapping their dollars that were at the time redeemable in gold for securities that were not redeemable in gold and hence reducing the risk of drain of the US gold reserves. To achieve this, a Presidential Task Force on Promoting Increased Foreign Investment in the United States Corporate Securities and Increased Foreign Financing for United States Corporations Operating Abroad was appointed. This task force recommended that the SEC facilitate foreign broker dealers’ participation in distributing US debt outside the US to non-US individuals by clarifying that a SEC registration was not necessary to make such distributions. Against this background the SEC published the 1964 Release in the hope that foreign broker dealers’ distribution of US securities outside the US would pick up significantly and create a capital inflow for the US given that they would no longer run the risk of violating US securities laws if they distributed US securities without SEC registration.
The 1964 Release was one of several measures the US took in the 1960s to separate the US market from the offshore market and to prevent capital outflows (Stigum 2007, 221 also lists the Interest Equalization Tax of 1964, the Foreign Credit Restraint Program of 1965 and the Foreign Investment Program of 1968). Together the measures led to a sharp increase of US securities issues abroad and a sharp decrease of foreign issues in the US. The issuances of US companies in foreign capital markets sharply increased from zero in 1963 and 1964 to a total of 174 US issuances in foreign capital markets in 1968 (BIS Annual Report 1967, 48; BIS Annual Report 1969, 48). Similarly, the international bond issues of US issuers, i.e. those placed on several markets simultaneously, recorded a sharp rise from zero in 1963 to 2059 in 1968 (BIS Annual Report 1967, 48; BIS Annual Report 1969, 48).
Despite the sharp increase of US foreign and international bond issuances, the basic US balance of payments (i.e. the balance of current andlong-termcapital transactions) showed a persistent and large deficit, which pivoted upon a substantial decline in the US trade surplus (BIS Annual Report 1972, 4). From the BIS Annual Report 1972, 10:
“In considering movements on capital account during this period [the 1960s], it should be remembered that the authorities’ main efforts to contain the overall deficit, which are discussed later, were directed at capital outflows. In general, such measures achieved some success up to the end of the decade. The net outflow of private long-term capital fell back from around $4.5 milliard in 1964 and 1965 to an average of $1.2 milliard over the next five years—even giving way to an inflow in 1968. A large part of this change was attributable to a surge of foreign investment in US long-term securities; the inflows were very heavy in 1968 and 1969, far in excess of the already substantial outflow of US capital into foreign securities. The net outflow of direct private investment reached $3.6 milliard in 1966; this abated somewhat, as a result of official measures, to $2.4 milliard by 1969, only to surge back to $3.5 milliard in 1970. The underlying character of this particular deficit did itself hint at a growing overvaluation of the dollar.”
Fast-forward to 1989. 25 years after the publication of the 1964 Release, the SEC specified in its then issued Release No. 34-27017 on the Registration Requirements for Foreign Broker-Dealers (“Rule 15a-6”) that foreign broker dealers that limit their US activities to those permitted under Rule 15a-6 will be exempt from registration under Section 15(a) of the Securities Exchange Act. A few, non-exhaustive examples of US activities by foreign broker dealers that are exempted under Rule 15a-6 are: (i) a foreign broker dealer effecting transactions in securities with or for US persons that have not been solicited by the foreign broker dealer; (ii) a foreign broker dealer furnishing research reports to major US institutional investors and effecting transactions in the securities discussed in the research reports with or for those major US institutional investors (provided compliance with certain other requirements); or (iii) a foreign broker dealer inducing the purchase or sale of any security by a US institutional investor provided that the foreign broker dealer effects any resulting transaction through a registered broker dealer in the manner set out in Rule 15a-6.
Rule 15a-6 provides very limited conditional exemptions from the general registration requirement in Section 15(a) of the Securities Exchange Act. Like in the 1964 Release foreign broker dealers receive more favorable treatment under Rule 15a-6 than US broker dealers given that the exemptions granted in Rule 15a-6 are only available to foreign broker dealers and not to US broker dealers. Once again in 1989 the SEC had good reason to grant privileges to foreign broker dealers and in doing so acted in the US interest.
The world had changed quite drastically between 1964 and 1989 and the SEC’s rules had to catch up with these changes. Here is how the SEC described the evolution of capital markets in its original proposal of Rule 15a-6 in 1988:
“The world’s securities markets rapidly are becoming international in scope. Multinational offerings have become commonplace, linkages are developing between trading markets, and many US and foreign broker-dealers are developing an international business, establishing offices throughout the world. Investor interest in trading in world financial markets has become widespread. Institutional investors such as investment companies, pension funds and major commercial banks, in particular are active on an international basis. As U.S. institutions increasingly invest in securities whose primary market is outside the US, the ability of these institutions to obtain ready access to foreign markets has grown in importance. Foreign broker-dealers may offer valuable services to these U.S. investors. Foreign broker dealers often provide opportunities to execute trades quickly in a wide range of foreign securities markets. Foreign broker dealers also make available research reports concerning foreign companies, industries, and market environments that are major sources of information for US institutions investors. In addition, they act as a source of market quotations on securities trading in foreign markets.”
When the SEC wrote about the internationalization of capital markets, it referred to the steady increase in the number and volume of international and cross-border securities offerings (see below table on US portfolio transactions). What the SEC left unmentioned in the proposal was that US investment in foreign securities persistently lagged behind the large volumes of foreign investment in US securities, consequently creating significant net capital inflows into the US (see below table on capital movements in thirteen industrial countries). These capital inflows supported the high valuation of the dollar boosting imports and suppressing exports, thus reinforcing the US current account deficit, which had only increased since 1964. Given that US capital inflows were and are inherent to the US current account deficit and the dollar’s role as the world’s unofficial reserve currency, US policy makers’ hope was to counterbalance the large capital inflows with an increased volume of capital outflows, which would stabilize the global financial system and decrease pressure on the dollar. Unlike in 1964, capital outflows per se were no longer a risk for the US given that the convertibility of the dollar into gold had been suspended in 1971. The policy question of the hour was, how to facilitate US investment in foreign financial assets?
Source: Philip Turner, Capital Flows in the 1980s: A Survey of Major Trends, BIS Economic Papers, No 30, April 1991.
Source: BIS Annual Report 1990, 82.
Facilitating access to the services and research of foreign broker dealers, Rule 15a-6 (together with Regulation S and Rule 144A) was part of a package of measures aiming to facilitate US investors’ access to foreign financial assets and thus to enhance US capital outflows. Since the 1970s the SEC had at times exempted foreign broker dealers engaging with specified US institutional investors from the registration requirement by way of no-action letters. In 1989, building on these past interpretive, no-action and exemptive positions, the SEC wanted to eliminate uncertainty around which conduct by foreign broker dealers was exempted from the registration requirement in the hope that foreign broker dealers’ US activities would consequently pick up and prove conducive to increasing the volume of US investments in foreign financial assets.
As a result of the US policies, including Rule 15a-6, cross-border transactions in bonds and equities as a percentage of US GDP as well as US ownership of foreign (corporate) bonds sharply increased (see table and graph below).
Source: BIS Annual Report 1996, 98.
Source: Brad Setser, Mapping Capital Flows Into the US over the last Thirty Years, Council on Foreign Relations, Follow the Money Blog, February 16, 2018.
Recalling Kindleberger (“History can serve as a [great] laboratory […]” (Kindleberger 1984, 1)), the history of the exemptions illustrates three general points policy makers need to consider during the post-pandemic reconstruction: (i) “Money will not manage itself” (Bagehot 1873, 11 about the London money market). The history of the registration requirement exemptions provides an example of how the US rose to manage the global dollar system and the challenges it has encountered along the way. Any central bank, treasury or regulator will have to rethink how it will manage the money flows crossing its jurisdiction in the aftermath of the global pandemic. (ii) The law can help a great deal in building markets and directing and managing capital flows. Both in 1964 and in 1989 the SEC eliminated uncertainty around the legality of existing market practices and in both cases market participants responded with an increased number and volume of transactions. (iii) Anyone building new markets needs to study the underlying capital flows and pressures before designing the rules that shall govern such new market. It may be possible to create new (offshore) markets. Yet creating a new market may not automatically be a fix to the problem one may have set out to solve.
Maria C. Schweinberger