/

Financial engineers restarting the risk generator

by Kevin P. Gallagher

The U.S. economy continues to have a hard time recovering from the biggest financial crisis since the Great Depression. So the last thing one would expect the U.S. government to do is to engage in policies that open the floodgates to severe risks in financial markets once again. Yet, that is precisely what’s going on.

For all the attention that is paid to the Federal Reserve’s “tapering,” what Washington has in its crosshairs is something quite different. It is putting massive pressure on the Commodity Futures Trading Commission (CFTC) and the Security and Exchange Commission (SEC). Unless concerned policymakers and the public at large act quickly to counter that pressure, the disastrous past — a financial industry running amok — may well be in the future of not just the United States but also the world.

How is this even possible?

Even though the U.S. Congress passed the Dodd-Frank financial reform law a few years ago as a bulwark against recurring financial crises, the legislation actually left most of the key decisions — the actual detailed rule-making to rein in the financial industry — for later.

At the center of this issue is Gary Gensler, a former Goldman Sachs partner who is now the Commodity Futures Trading Commission Chairman. Gensler is one of the few officials who can credibly say that, having worked in the lion’s den for many years, he is committed to rectifying what he knows is truly troublesome in the boiler rooms of the U.S. financial industry.

Yet the deck is stacked against him. The fundamental imbalance at the heart of this issue is not just irritating but also profoundly undemocratic. Just look at the numbers. The Sunlight Foundation found in a study released last year that Wall Street has met 1,298 times with government officials to influence the new rules. By sharp contrast, public interest groups have only been able to get 242 such meetings. They have been outgunned 5 to 1.

This unsettling imbalance in the U.S. political process has consequences way beyond U.S. borders as the U.S. financial industry is still in a dominant position globally, setting many of the standards and practices for “what goes.” The Group of 20 and the Financial Stability Board have pledged that powerful nations like the U.S. will ensure that the global impact of their rule-making will be taken into account.

Now the U.S. may blow a hole in the Dodd-Frank law by allowing many of the key global operations of U.S. banks to be exempted from regulation. The first blow came quietly late last year while Congress was on its Thanksgiving holiday. The Treasury Department exempted foreign exchange (FX) swaps and forwards from the regulations. Why should Americans and the global public care about this?

When U.S. banks operating offshore, and in places like South Korea, sell FX derivatives to exporters, they can hedge against foreign exchange risk. That sounds innocuous enough. But when the last financial crisis hit, there was such a flight of capital out of emerging markets and back to the U.S. that many of those positions were rapidly unwound — to the great detriment of those economies. Such are the massive — and global — transmission effects of today’s tightly integrated financial markets.

Never relenting, these same FX derivatives market operators got very busy again right in the wake of the global financial crisis. Hedge funds and big banks engaged in the carry trade; they borrowed in dollars at low interest rates then invested in foreign currencies in a broad range of countries — from South Korea, Brazil, Chile, Colombia, Mexico, South Africa, Indonesia, to Thailand.

They then built FX derivatives that shorted the dollar and went long on those currencies. This fueled exchange rate appreciation and asset bubbles that are part of the reason for the slowdown in emerging markets. Now that the Federal Reserve is looking to wind down its easing policies, capital is fleeing emerging markets, causing exchange rates to depreciate and debt burdens to rise.

By now it’s a familiar story. Financial engineers, largely at American-owned firms, generate serious blowback in the real economy, and get hurt themselves. Citigroup, a too-big-to-fail bank, may lose $7 billion in FX derivatives markets if the U.S. dollar appreciates as capital flies back to the U.S.

The next regulatory blow may hit any day. The CFTC and the SEC are now considering exempting those same foreign subsidiaries and branches of hedge funds and big banks headquartered, or with stakes, in the U.S. that have been packaging derivatives overseas. This would be disastrous for emerging market and developing countries attempting to maintain financial stability for development.

To their credit, South Korea and Brazil have put in place their own regulations on FX derivatives, but emerging markets alone cannot carry the burden of regulating a $4 trillion per day market.

CFTC chair Gensler has said that, if these regulations are swapped out of the rule-making, hedge funds can evade the rules “by setting up shop in an offshore locale, even if it’s not much more than a tropical island P.O. Box.” Gensler needs a majority of commissioners to help him close this loophole by July 12.

Time is running out. The world cannot afford to allow the creation of major loopholes that could threaten the global financial system yet again.

Kevin P. Gallagher is co-director of Boston University’s Global Economic Governance Initiative and co-chair of the Pardee Task Force For Regulating Global Capital Flows and Development. © 2013 The Globalist, Washington.

  • nobuo takamura

    July 12 is the key day for surviving this terrible situation. Who knows next?