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EXCLUSIVE: Two Leading House Dems Will Close $50 Trillion Loophole In Derivatives Reform Bills

Derivatives

First Posted: 06/17/10 11:57 PM ET Updated: 05/25/11 03:40 PM ET

The two House Democrats shepherding derivatives reform proposals through Congress will close an existing $50 trillion loophole for foreign currency contracts, the Huffington Post has learned.

Financial Services Committee Chairman Barney Frank and Agriculture Committee Chairman Collin Peterson will insist that foreign exchange derivatives be subject to the same transparency and accountability rules as other derivatives. The legislation as proposed by the Obama administration had exempted them.

Dave Smith, chief economist for the House Financial Services Committee, told HuffPost on Wednesday that an agreement to close that loophole was reached over the last few days by the two committee chairmen.

Like the complex and opaque derivatives contracts that nearly brought down the financial markets last year, foreign exchange derivatives will be forced to either go through clearing houses or traded on exchanges. "We want to promote as much transparency as possible," Smith said.

And the author of the leading Senate proposal, Banking Committee Chairman Christopher Dodd, told HuffPost on Tuesday night that he is reconsidering the loophole as well. "Well, it's hard. It's easier to say than do. But it's a legitimate issue. That much I agree with. The question is, how do we do that?"

Foreign exchange derivatives -- essentially private contracts to buy or sell currencies in the future -- make up about eight percent of the largely opaque derivatives market. U.S. firms with extensive sales overseas like Coca-Cola and General Electric use them as insurance against currency fluctuations. Virtually the entire market is traded in the shadows by the biggest banks.

Defenders of the exemption currently written into all three major versions of the legislation make the point that foreign currency derivatives trading is a long-established practice that doesn't pose anywhere near the risk associated with more complex derivatives.

They argue that the exemption is justified because bank regulators have a good handle on the market, that these types of derivatives performed well during the crisis, and that increased regulation could result in adverse effects on the dollar's status as the world's reserve currency, as traders would flock to other currencies that are easier to trade.

But concerns about the dollar's status as the world's reserve currency are overstated, experts say. "That's a stretch. There's a reason why foreign central banks hold the dollar as a reserve currency, and it's because of the stability of our government," said Walter Dolde, a finance professor at the University of Connecticut and an expert on derivatives. "A minor inconvenience about how you trade this stuff" won't affect the dollar's status, he said.

Independent experts say the overall benefits of moving these contracts to exchanges -- where they'd be publicly traded -- or clearing houses -- which would organize the contracts for the parties -- would be considerable.

For one thing, the experts say, the increased transparency that would result from moving this market away from the shadows would result in better pricing of these contracts, which would have the effect of lowering costs for businesses, which would then pass on the savings to consumers.

"The broker-dealers are gouging their customers," said Dolde, who once was a top executive at Lehman Brothers and Citibank Investment Bank. Broker-dealers are the big Wall Street banks that dominate the market in derivatives, like Goldman Sachs, Morgan Stanley and JPMorgan Chase. The top five -- JPMorgan Chase, Goldman Sachs, Bank of America, Citibank and Wells Fargo -- control 97 percent of the market.

"Firms that are hedging [like a Coca-Cola] don't know if they're getting the best price. More transparency would lead to better pricing and more competition. It's good for consumers."

Also, it would lessen the overall risk in the financial system. Moving these contracts from the shadows of the interbank market -- where everyone is tied together in ways they don't even know because of the web of complex contracts -- and into exchanges and clearing houses would require firms that are losing money on their positions to pony up the cash to cover their losses. Experts say this is better than allowing them to delay and wait until the losses are so great that the firm goes belly up, like AIG.

"You put cash into the system for the losses as they occur," Dolde said. "It doesn't permit the strategy of, 'This money-losing contract closes in four years, so I'll keep it open so in two years I'll collect my $100 million retirement bonus and let my successor worry about it.'

"CEOs will do almost anything to push it into the next year," Dolde said. "You can't do that with an exchange."

Some corporations argue that they need the exemption in place because they need to be able to draw up customized contracts that exchanges and clearing houses may not accept.

A company like Dell, for example, may use these derivatives to hedge against currency fluctuations in the countries in which it does business, said Gregory W. Brown, a finance professor at the University of North Carolina at Chapel Hill who's published academic research papers on derivatives. A customized contract would allow them to have insurance on a specific basket of currencies that reflect their foreign sales, he said.

"You'd be hard-pressed to find any U.S. non-financial company that had any major problems with derivatives products over the last few years," Brown said. "It looks like what they were doing was completely prudent."

But at the same time, Brown said: "The U.S. Chamber of Commerce, the National Association of Manufacturers -- they're way overstating the cost of complying with exchanges."

In a recent letter to Congress, the head of the federal agency that regulates most of the derivatives market that falls under government oversight, Chairman Gary Gensler of the Commodity Futures Trading Commission, said the foreign exchange exemption could be manipulated by traders to evade other forms of regulation.

"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," he wrote in August.

"The same folks who dreamed up these complex derivatives contracts in the first place will dream up another way to fit contracts into this loophole," Brown said.

But foreign exchange derivatives make up a huge part of big banks' profits, and they're loath to change a good thing. Banks made more than $18 billion off foreign exchange derivatives in 2007 and 2008, according to a report by national bank regulator the Office of the Comptroller of the Currency. By comparison, these same banks lost about $13.7 billion during the same period from all other types of derivatives trades.

U.S. banks have made an average of about $1.5 billion off trading in foreign exchange derivatives every quarter since 1997, according to the OCC, by far their most profitable derivatives trading activity. They made $2.1 billion in the second quarter of this year.

"Foreign exchange contracts continue to provide the most consistent source of trading revenues," the OCC said in its 2008 year-end report on bank derivatives activities.

"End users [like a Coca-Cola] will hold these contracts till maturity; broker-dealers will do hundreds of trades a day," Brown said. Indeed, according to the most recent Bank of International Settlements' Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity -- widely considered the most authoritative source on these matters -- in 2007 non-financial firms made up less than 20 percent of the daily deals in foreign exchange derivatives in the U.S.

One concern is that increased regulation at home could move the market abroad, likely to opaque markets. "It's a tough nut to crack," Brown said.

But reform advocates insist that the market doesn't need any type of exemption.

"I start with the premise that we don't need unnecessary risks to the system," said Adam K. White, director of research at White Knight Research and Trading, an independent research consulting firm. "Exemptions [from oversight] cause unnecessary risk."

But despite Frank's and Peterson's commitment to eliminate the loophole, it will likely be an uphill struggle - because Wall Street doesn't like the idea, and will fight it.

"And what they're hoping is that if they make it complicated enough, people will just throw up their hands and go back to what they were doing and forget it," Brown said.

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