The biggest Wall Street banks are pushing the U.S. Treasury Department to exclude foreign exchange derivatives from new regulations, a move that would leave a $42 trillion market largely outside of federal oversight.
A coalition of 20 firms, including Deutsche Bank AG, Bank of New York Mellon Corp. and UBS AG, contends that foreign exchange is less complex than other derivatives and had no role in the financial crisis, unlike credit-default swaps that led to the near-collapse of American International Group Inc.
The Dodd-Frank regulatory overhaul signed by President Barack Obama in July said that foreign exchange “shall be considered” the same as other swaps, unless the Treasury secretary makes a written determination that they are different. Last week, the banks filed comments asking for the exclusion.
The decision may put Treasury Secretary Timothy F. Geithner in a politically difficult spot between the banks, regulators and Congress. During the legislative debate, his department sought unsuccessfully to exclude foreign exchange from regulation over the objections of Commodity Futures Trading Commission Chairman Gary Gensler and several lawmakers who negotiated the final shape of the bill.
“I urge Treasury not to create a potentially dangerous loophole,” Senator Maria Cantwell, a Washington Democrat who was a leader in the derivatives debate, told Bloomberg News in a statement. “The security of our economy depends on foreign exchange derivatives coming under the same transparency and oversight provisions as the rest of the vast derivatives market.”
The Dodd-Frank law requires most swaps to be traded on an exchange or on a similar system and then guaranteed by a clearinghouse, where the parties would be required to post collateral. Proponents say the system will be more transparent and help guarantee that the trades can be settled, thus reducing the risk that excessive speculation or bad deals can threaten the broader economy.
The banks say that imposing clearing and trading rules on over-the-counter foreign-exchange swaps could disrupt currency markets and impede the government’s ability to set monetary policy.
Derivatives are financial instruments whose value is based on an underlying security or benchmark, such as a stock option. Currency swaps are over-the-counter contracts that let investors lock in future exchange rates or convert funds denominated in one currency into another. They are used by corporations to hedge risks and are also traded by investors like hedge funds.
Foreign exchange contracts were the largest source of trading revenue for banks’ derivatives and cash positions in the second quarter of 2010, according to the U.S. Office of the Comptroller of the Currency. U.S. commercial banks recorded $4.3 billion in revenue on trading of foreign-exchange derivatives.
The ‘Treasury Amendment’
When Congress set up the CFTC in 1974, it specifically cut foreign-exchange swaps out of the agency’s jurisdiction. The exclusion was known as the “Treasury Amendment” since it was proposed by the department to protect what it said were efficient markets.
“This is the ultimate unregulated market,” said Bill Brown, a professor at Duke University School of Law and a former global co-head of listed derivatives at Morgan Stanley.
The Treasury late last month asked for public comments on the matter to be filed by Nov. 29, and noted that Geithner hasn’t decided whether the exclusion is warranted.
The decision will affect a market for foreign-exchange swaps and forwards that reached $42 trillion in the second half of this year, according to a Bank for International Settlements global derivatives survey published Nov. 15.
Ford Motor Co. used swaps, forwards and option contracts to hedge against shifts in exchange rates that could have affected the value of F-Series trucks manufactured in the U.S. and sold in Mexico and Canada, company Treasurer Neil Schloss told lawmakers in congressional testimony on Nov. 18, 2009.
While 85 percent of foreign exchange transactions involve the U.S. dollar, the bulk of the market is overseas. The U.K. has the biggest share at 37 percent; 18 percent of foreign exchange transactions are handled in the U.S.
In the Nov. 15 letter sent to Treasury, the 20-bank coalition said making currency derivative traders post margin in the U.S. -- a requirement for mandatory clearing -- would drive the remaining domestic market offshore. The letter was filed by three associations on behalf of 20 banks they termed the “Global FX Division.”
The companies also noted that almost 90 percent of inter- dealer foreign exchange trades are already handled by a settlement bank. Under Dodd-Frank, price and other information about foreign exchange swaps and forwards would be reported to new central databases, even if Treasury decides to exclude the market from clearing and trading rules.
“Central banks, particularly the Federal Reserve, actively oversee the FX market, supervising compliance of industry ‘best practices’ through safety and soundness reviews and regulation of banks,” the firms wrote in their letter.
Investor advocates and labor unions have countered the banks’ arguments, pointing to comments from Gensler after Treasury excluded foreign exchange in its first proposal on regulating derivatives in 2009. Within days, the CFTC chairman fired off a letter to lawmakers arguing that the exemption threatened to “swallow up the regulation.”
He also said the exclusion could allow dealers to make an end-run around regulation by creating transactions that appear as foreign-exchange swaps when they are actually other derivatives.
“This is on our radar screen and has been on our radar screen since Chairman Gensler raised questions about it in August of 2009,” said Heather Slavkin, senior legal and policy adviser at the AFL-CIO labor federation.
“We have been trying to get an explanation as to why you would want to exempt foreign exchange swaps but haven’t heard anything we find convincing.”
Gensler declined to comment further on the matter.
The Treasury won’t say when Geithner will make his decision and the law doesn’t set any required timeline. The law directs him to consider a number of factors, including whether mandatory clearing of the derivatives would create systemic risk, lower transparency or threaten the financial stability of the U.S.
Congress also asked Geithner to review whether foreign- exchange swaps are already subject to “materially comparable” oversight, whether bank regulators provide adequate market supervision and if the exclusion could be used to evade U.S. rules.
The legal hurdles Geithner needs to clear, coupled with the potential political traps, have some outside observers predicting that the Treasury chief will try to find a middle ground. One option would be to exempt short-term swaps, such as those with maturities of under six months, and put longer-term swaps under the CFTC’s jurisdiction.
“You’d better believe if you leave the currency markets totally unwatched they will probably be one of the places that blow up next,” said Brown, the Duke law professor who says both the banks and those seeking more oversight have arguments in their favor.
“The goal here is to find a way of providing the right amount of regulation of the institutions, and leaving the currency markets to trade so the markets don’t run offshore,” Brown said.
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