I’m excited that a bunch of our best minds will dedicate their life’s work to finding ways to structure ordinary derivatives transactions in order to be routed through the foreign exchange markets to qualify for a loophole. I wonder if the unnecessary routing of derivatives through an international market will increase global instability?
The New York Times’ editorial page writes about Mr. Geithner’s Loophole (my bold):
Until recently, the big threats to the Dodd-Frank financial reform law came from Republican lawmakers, who have vowed to derail it, and from banks and their lobbyists, who are determined to retain the status quo that enriched them so well in the years before, and since, the financial crisis. Now, the Obama Treasury Department has joined their ranks.
In an announcement on Friday afternoon — the time slot favored by officials eager to avoid scrutiny — the Treasury Department said it intends to exempt certain foreign exchange derivatives from key new regulations under the Dodd-Frank law. These derivatives represent a $4 trillion-a-day market, one that is very lucrative for the big banks that trade them.
A loophole in the law — which the bankers and their friends, including the administration, fought for — allows the Treasury secretary to exempt the instruments. The arguments in favor of exemption, beyond a desire to please the banks, were always unconvincing. They still are. The Treasury Department has asserted that the exempted market is not as risky as other derivatives markets, and therefore does not need full regulation.
Zach Carter has more on this at Huffington Post.
I’m glad the New York Times noted that the administration fought for exempting – a fight that actually goes back to 2009 and the original House language. A fight between Treasury who wanted exemptions and the CFTC which didn’t. The former Director of Trading and Markets at the Commodity Futures Trading Commission (CFTC) under Brooksley Born, Michael Greenberger, discussed this battle in his Make Markets Be Markets financial reform chapter on derivatives:
The Treasury’s OTC Derivatives Legislative Proposal
However, on August 11, 2009, the Treasury Department, on behalf of the Administration, submitted to Congress a specific legislative proposal (the “Proposed OTC Act”) in furtherance of its prior narrative recommendations. The Proposed OTC Act created new and significant loopholes that would undermine the Obama Administration’s stated goals for OTC derivative reform, namely, that the new regulatory structure “would cover the entire marketplace without exception.”
On August 17, 2009, CFTC Chairman Gary Gensler, in a letter to Congress, critiqued the following exclusions suggested by Secretary Geithner, but not previously found in the Obama Administration’s narrative OTC reform proposals.
1. Foreign Exchange Swaps Exclusion. Chairman Gensler correctly explained: “The Proposed OTC Act would exclude foreign exchange swaps and foreign exchange forwards from the definition of a ‘swap’ regulated by the CFTC. The concern is that these broad exclusions could enable swap dealers and participants to structure swap transactions to come within these foreign exchange exclusions and thereby avoid regulation. . . .In short, these exceptions could swallow up the regulation that the Proposed OTC Act otherwise provides for currency and interest rate swaps.”
Chairmen Frank and Peterson, leaders of the two committees of jurisdiction on this legislation in the House of Representatives, challenged the wisdom of this exclusion, claiming that it would eliminate from the exchange trading and clearing requirements over $50 trillion in swaps.
This kind of exclusion has proven highly problematical. Recently, we have discovered that Greece and Portugal, and possibly Italy and Japan (if not many others), have used, inter alia, foreign currency swaps sold by U.S. swaps dealers as a vehicle for masking short term sovereign debt in order to, inter alia, gain entrance to the European Union in exchange of the case of Greece for paying swaps dealers hundreds of billions of dollars in Greek revenue streams extending to the year 2019. As one leading derivatives expert has noted, in these kinds of transactions, “the participant receives a payment today that is repaid by the higher-than-market payments in the future. . . Such arrangements provide funding for the sovereign borrower at significantly higher cost than traditional debt. The true cost to the borrower and profit to the [swaps dealer] is also not known, because of the absence of any requirement for detailed disclosure.”
If you want Gensler’s (Gensler! Gensler, who Bernie Sanders tried to block as being too Wall Street friendly) full argument about why Geithner and Treasury’s plan is too friendly to Wall Street and introduces unnecessary regulatory arbitrage risks here’s the original letter:
1. FX Swaps and Forwards The Proposed OTC Act would exclude foreign exchange swaps and foreign exchange forwards from the definition of a “swap” regulated by the CFTC. The concern is that these broad exclusions could enable swap dealers and participants to structure swap transactions to come within these foreign exchange exclusions and thereby avoid regulation.
In particular, currency and interest rate swaps could be broken down into their component parts and then restructured to resemble a series of foreign exchange forwards or a foreign exchange swap to come within the scope of these foreign exchange exclusions and thereby avoid regulation. For example, these foreign exchange exclusions might be used to exclude each individual leg of a currency swap, and/or the final currency exchange at maturity (which is often a significant portion of the economic value of a currency swap), from the new regulatory regime for swaps. In short, these exceptions could swallow up the regulation that the Proposed OTC Act otherwise provides for currency and interest rate swaps.
There is also a risk that these exclusions may have the unintended consequence of undermining the CFTC’s enforcement authority over retail foreign currency fraud enacted by Congress as part of last year’s Farm Bill. Furthermore, although the Proposed OTC Act includes “anti-evasion” provisions authorizing the CFTC and SEC to prescribe rules defining a “swap” and “security-based swap” to include transactions that have been structured to evade regulation, those provisions are not specifically tied to the exclusions for foreign exchange swaps and forwards.
As an alternative to these exclusions:1) the foreign exchange swap exclusion should be stricken so that all swaps are covered by the Proposed OTC Act; and 2) an appropriately tailored exclusion for foreign exchange forwards should be adopted.This narrower exclusion for foreign exchange forwards should: 1) not apply to transactions involving retail customers; 2) be explicitly tied to the anti-evasion rulemaking authority provided to the CFTC and SEC; and 3) require compliance with the transparency and business conduct provisions of the Proposed OTC Act.
David Grad, Perry Mehrling and Daniel H. Neilson have written a paper, The evolution of last-resort operations in the global credit crisis, which argues that the foreign exchange swaps market is how the Federal Reserve became the de facto lender-of-last-resort to the shadow banking market of the entire world. Through these mechanisms they were able to provide liquidity to European SIVs when the regular channels dried up:
Swap counterparties were demanding increasing compensation to accept the risk, and the one-sided order flow (from euros into dollars) prevented the CIP arbitrage from working. European SIVs found it increasingly difficult to obtain dollar funding and consequently to remain solvent. The gradual increase of the euro swap implied rate from the US LIBOR rate and the resulting size of the deviation from CIP is displayed in Figure 16.
In response to this US dollar shortage, the Federal Reserve announced the establishment of foreign-exchange swap lines with the ECB on December 12, 2007. In this program, the Fed provided US dollars to the ECB in the form of foreign exchange swaps, providing the ECB with dollar reserves. The ECB then lent out these dollar funds through a program similar to the Fed’s Term Auction Facility. Use of the swap lines was approximately $50 billion through the first two stages of the crisis, and rose to over $200 billion after Lehman’s collapse. In this way the euro-denominated backstop of the ECB was transformed into a dollar-denominated backstop so that European SIVs could continue to fund their US dollar assets.
Maybe it’s a good idea for the Federal Reserve to be lender-of-last-resort to SIVs in the European shadow banking system or maybe it’s not, but if it is foreign-exchange derivatives should be folded under the regulatory umbrella and if it’s not the Federal Reserve should explain what will be different next time. This push against new regulations in the foreign swap markets masks the dramatic changes in what the Fed does and postpones the necessary debate over new international financial architecture and Federal Reserve reform.