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The U.S. as a Global Risk Generator

Are US regulators making it easier for Wall Street to return to pre-crash behaviors and export them to the world?

June 27, 2013

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.

And 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 not just be the United States’ national, but our common global future.

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 reoccurring 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 entire issue is Gary Gensler, a former Goldman Sachs partner, who is now the Commodity Futures Trading Commission Chairman.

Mr. 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 American financial industry.

And yet, the deck is stacked against him. The fundamental imbalance at the heart of this issue is not just very 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.

In sharp contrast, public interest groups have only been able to get 242 such meetings. Talking about being outgunned — by a factor of five to one.

But this unsettling imbalance in the U.S. political process has consequences way beyond U.S. borders. Not only is the U.S. financial industry still in a dominant position globally, it’s setting many of the standards and practices for “what goes.”

The G-20 and the Financial Stability Board pledged that powerful nations like the United States would see to it that the global impacts of their national rule-making would be taken into account.

But now the United States may blow a hole in the Dodd-Frank law that would allow many of the key global operations of U.S. banks to be entirely exempted from regulation.

The first blow came late last year.

Very quietly, when the U.S. Congress was on its Thanksgiving holiday, the U.S. Treasury Department exempted foreign exchange (FX) swaps and forwards from the regulations.

Why should the American and global public care about this? After all, when U.S. banks operating offshore, and in places like South Korea, sell FX derivatives to exporters, it allows them to hedge against foreign exchange risk. That sounds innocuous enough.

However, when the last financial crisis hit there was such a flight of capital out of emerging markets and back to the United States 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 very low interest rates and then invested in foreign currencies in a broad range of countries, from South Korea, Brazil, Chile, Colombia, Mexico, South Africa, Indonesia, to Thailand.

Financial pros that as they are, 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 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 is a familiar story. Financial engineers, largely by U.S.-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 US dollar appreciates as capital flies back to the United States.

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 United States 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 both 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 Gary 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 create major loopholes that could threaten the global financial system yet again.


Dodd-Frank left most of the actual detailed rule-making to rein in the industry for later.

Wall Street met with officials to influence new rules five times more often than public interest groups.

The US financial industry, beyond its dominance, is setting many of the global standards and practices.

The US Treasury has quietly exempted foreign exchange swaps and forwards from regulations.

Regulators are considering exempting foreign branches of US firms that package derivatives.