Will Currency Derivatives Get a Pass on Oversight?

Treasury Secretary Timothy Geithner is in a difficult spot. Last year, as Congress was negotiating what became the Dodd-Frank financial-reform law, he sought to exclude foreign exchange derivatives from new regulations. Gary Gensler, the Commodity Futures Trading Commission chief and soon-to-be-regulator of derivatives, opposed the move. Congress split the difference by including currencies but also giving Geithner the authority to study the instruments and decide whether to exempt them.

Now a coalition of 20 companies, including Deutsche Bank (DB), Bank of New York Mellon (BK), and UBS (UBS), is pushing Geithner to give currency derivatives a pass from oversight. They argue that foreign exchange is less complex than other derivatives and played no role in the financial crisis, unlike the credit default swaps that brought down American International Group (AIG).

At $42 trillion, currency swaps and forwards—the types of derivatives in question—make up the second-largest over-the-counter derivatives market after interest-rate swaps. "This is the ultimate unregulated market," says Bill Brown, a professor at Duke University School of Law who once oversaw exchange-traded derivatives at Morgan Stanley (MS). "You'd better believe if you leave the currency markets totally unwatched they will probably be one of the places that blow up next," says Brown, who thinks both sides have valid arguments.

Currency derivatives are contracts that allow importers and exporters to lock in favorable rates when they must convert funds from one currency to another. Ford Motor (F) used them to protect profits on U.S.-made F-Series trucks sold in Mexico and Canada, Neil M. Schloss, vice-president and treasurer at Ford, testified to Congress in November 2009. Hedge funds and other investors also use them as speculative instruments.

The banks warn that new rules would drive trades offshore and could even threaten the Federal Reserve's ability to set monetary policy. During the congressional debate, the Fed agreed that currency derivatives should be exempted. U.S. commercial banks recorded $4.3 billion in second-quarter revenue from trading of foreign exchange derivatives, according to the U.S. Office of the Comptroller of the Currency. While 85 percent of foreign exchange transactions involve the U.S. dollar, only 18 percent of dollar-based trades are handled in the U.S. Britain holds the biggest market share, with 37 percent.

The banks' opponents say an exemption would open a giant gap in the new law. "I urge Treasury not to create a potentially dangerous loophole," says Senator Maria Cantwell (D-Wash.). She agrees with Gensler, who last year wrote to lawmakers that Treasury's proposed exemption threatened to "swallow up the regulation." Gensler declined to comment further.

Now Geithner must find a way to satisfy lawmakers and regulators without disrupting the market or causing job losses if banks move traders offshore. Signed by President Barack Obama in July, the Wall Street reform law requires most derivatives to be traded on an exchange or through a clearinghouse, where the parties would be required to post collateral. The idea is to make the process more transparent and guarantee the trades can be settled in an orderly fashion, thus reducing the risk that excessive speculation or trades gone bad threaten the entire financial system.

Even if Geithner agreed to exclude currency derivatives from regulation, banks would still have to report information about their trades to new central databases. Treasury is accepting public comment until Nov. 29 and notes that Geithner hasn't decided whether an exclusion is warranted.

The bottom line: Geithner is caught between bankers and regulators on how much oversight to give currency derivatives.

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