Under the requirements of the Dodd-Frank legislation, all FX swaps and forwards are supposed to be reported to a swap data repository or, if there wasn't one, to a regulator like the U.S. Commodities Futures Trading Commission (CFTC). The regulator is supposed to investigate irregular activity. Foreign exchange forwards and swaps represent about $50 trillion in nominal value of a total derivatives market of almost $600 trillion. Unfortunately, Congress gave some leyway to the U.S. Treasury to exempt some derivatives from regulation. If the U.S. Treasury has its way, FX swaps and forwards will not be regulated, and trillions of dollars of interest rate swaps and OTC forward contracts are almost certainly going to be restructured into the form of FX swaps and forward contracts, defeating the purpose of Congress.
Regardless of what the U.S. Treasury claims, FX swaps and forwards are high risk derivatives and were one of the primary reasons currency markets froze after the demise of Lehman Brothers. That freezing, in turn, was part of the cause of the 2008 Financial Crisis. The Federal Reserve established emergency currency exchange swaps with many foreign central banks in the hope of stabilizing the world financial system because of an alleged "shortage" of dollars. We thought that doing it was a mistake. We still feel that way. However, there are other people whose opinions we respect, who think otherwise. They think it was the correct decision.
Correct or not, those emergency lines of "credit" were established because European banks could not find enough dollars to make their payments under these type of derivatives because most of them bet on a declining dollar. The U.S. claims that there is no need to post performance bonds at a clearing house like the CME and Ice exchanges. While the exchanges are certainly not perfect places, and we have critiqued them heavily in the past, they are better than the extreme instability that follows the OTC market for derivatives.
Yet, according to the Treasury, it is too problematic to post performance bonds. Indeed, the Treasury says that no bond is needed to insure performance. But, if no bond is needed, why would a clearing exchange force banks to put up anything more than the most nominal bond, if any at all? After all, isn't it a no-risk FX swap or forwards contract? However, that isn't going to happen, because it isn't true. The exchanges would require substantial performance bonds on these type of derivatives. They are highly risky, and other clearing members prefer not to be bankrupted, or at least "lose their shirts" because of the capricious gambles of other banks.
Performance bonds are just a small part of the story. Even more important is the fact that by exempting FX swaps and forwards, the Treasury defeats the so-called "Lincoln" provision of the Dodd-Frank legislation. Swap dealers are supposed to get " No Federal assistance" including "loans" from Federal Reserve credit facilities, discount windows, emergency lending facilities etc. can be provided to any "swaps entity." If FX swaps and forwards are exempted, financial institutions that write them will have full access to the Federal Reserve (a/k/a big bank slush fund) at the ultimate expense and risk of the taxpayers of America. That is probably what this exemption is all about.
Being able to access Federal Reserve funding will allow swap dealers, such as the biggest banks with the most systemic risk, to engage in high leverage derivative writing. When backstopped by the Federal Reserve, such derivatives allow sophisticated entities to control cash markets that trade the underlying product. Levels of leverage that are typical in OTC and even exchange traded derivatives have been illegal in the cash stock markets since the Crash of 1929. Not in the derivatives markets. A tiny amount of collateral can buy control over a huge swath of the market, especially when the leverage is infinite, as it is when you aren't required to post any bond at all. If you are backed up by the ability to access the Federal Reserve lending windows, then its bombs away! You can do whatever you want, makes tons of money temporarily and, when the gamesmanship finally blows up in your face, you can shift the loss to the American taxpayer, while you retire to a nice island in the Carribean.
Changes to prices created in derivatives enter the cash market by way of arbitrage. Consequently, dealers in derivatives who have access to a large source of backstop money have the power to manipulate the value of all assets, including stocks, bonds, commodities, precious metals and currencies, at least in the short run. The changes in psychology that repeated short term manipulations can induce, will also profoundly affect the long term perception of various assets, unless most market participants become aware of the manipulated nature of the pricing structure.
Most market participants do not understand the interaction of derivatives and cash markets. Most believe, for example, that they can predict future market behavior by carefully crafting elaborate technical charts and graphs using historical pricing data. This could work, in theory. However, in practice, blind adherence to charts results in deep losses because technical analysis in cash markets cannot fully account for the interference from small numbers of market participants, playing in derivatives, who use a very small amount of assets to create large marking-moving price fluctuations in the cash markets. If they can be backstopped by the Federal Reserve, as they will be, with respect to FX swaps and forwards, if they are exempted from Dodd-Frank, there is no end to the mischief they can create with no long term adverse effect on themselves if they screw up.
A case in point is the so-called "Flash Crash." According to the U.S. Securities & Exchange Commission (SEC) report, it was precipitated by heavy buying of short positions at the CME Group's mini-S&P 500 futures on May 6, 2010. In response, the Dow industrial average plunged by 900 points, and a similar plunge in the market as a whole. Just one investment fund wanted to hedge stock positions, and its brokers sold too many Mini-S&P 500 short contracts at one time. The cash market was not aware of what was happening, and responded with panic. Many market participants erroneously concluded that massive selling was happening in the real cash market by persons holding real stock positions, a lot of market makers withdrew in fear of big losses, and everyone began dumping equities. Not mentioned in the official report is the fact that stock prices collapsed until a mysterious "force" began to buy huge numbers of long mini-S&P contracts in sudden and concentrated pulses, without regard to the losses that such buying habits would give to a profit-oriented entity. Cash markets recovered almost immediately as this buying "force" rescued the mini-S&P 500 derivatives market.
There is yet another concern. Exclusion of FX swaps and forwards from transparency and clearing requirements, applied to other derivatives, will cause banks to restructure interest rate and credit swaps as foreign exchange swaps or forwards. A notional amount of about $450 trillion dollars worth of interest rate swaps are now floating around in the world, for one example. If even a fraction of those are converted to exempt FX swaps and forwards, tens or even a hundred trillions or so of non-transparent, inherently unstable derivatives will hit the Street, with no performance bonds to insure compliance. We have written, in the past, critiquing the game of strategically changing performance bonds levels to achieve desired prices in precious metals. However, requiring no performance bond at all, and having no ostensibly "third party" entity to hold them, is an even greater folly.
The potential for instability is enormous. If banks can issue FX swaps and forwards that are not subject to Dodd-Frank, they will be able to hide this activity from shareholders and regulators. Enormous and irresponsible risks are sure to follow. We've already seen this in the past. The legislation was meant to change the sitution. With this new Treasury initiative, change will be torpedoed. Large banks have not been broken up. They are even bigger than before. If they were perceived as "too big to fail" back then, they are certainly too big now. U.S. Treasury action seems guaranteed to insure that private profits will, yet again, be pocketed by bank executives, while private losses are socialized by being shifted to taxpayers and savers in the U.S. dollar denominated investments.
As we noted, earlier, the need for the opening of Federal Reserve swap lines in 2008/2009 was partly the result of FX swaps and forwards which drained U.S. dollars from banks in Europe. The next freeze could involve these same instruments draining foreign currencies from American banks. There is no guarantee that foreigners will be as kind to us as we were with them. The World Financial Crisis of 2008 was not caused by sub-prime mortgages, but by the triggering of derivatives. When the contingency of massive mortgage default occured, credit default swaps were triggered. The hoarding of dollars by banks who needed to pay off on these obligations sapped demand from other areas of the economy. A massive shock to the system that could not be slowly and laboriously healed occured. Non-reportable credit default swaps are a similar threat.
The risk is simply too great to be allowing banks to engage in non-reportable, non-marginable activities, especially when they will be allowed to obtain sponsorship of the Federal Reserve in their speculations. Yet, Mary Miller, Assistant Treasury Secretary for Financial Markets, has tried to explain that this will not be a problem. She says that the CFTC has anti-evasion authority, and that will prevent financial institutions from using exemptions to evade derivatives regulations. That doesn't make sense. As long as the bank employees have decided that whatever they've structured is an exempted "FX swap" or forward, they won't need to report it. How, then, can the CFTC hope to spot evasion? Identifying restructured transactions will be impossible. The agency will never even know that a transaction took place.
Allowing banks to retain the ability to make mistakes that put the entire world financial system into jeopardy is a big mistake. Transparency and accountability that were supposed to enter the world of OTC derivatives, as a result of Dodd-Frank, will be replaced by opacity. Opaque transactions invariably are a recipe for corruption, and behind-the-scenes manipulations. Allowing the U.S. Treasury to exempt deliverable foreign currency swaps and forwards gives us more darkness, when the financial system is in desperate need of light.
From a practical standpoint, once this proposal becomes a regulation, as it probably will, currency market traders will need to deal with the consequences. We may see greater short term dollar stability and/or currency exchange value increases than would otherwise be expected after QE-2 ends if the Treasury encourages the banks and Federal Reserve to enter into the type of FX swap and forward transactions that help dictate that result. This desire to manipulate currency markets may well be why the Treasury support the exemption.
Without that, we will probably see a big increase in currency volatility right away. But, even if the banks do as the Treasury would like, and help stabilize the dollar from collapsing, with such swaps and forwards, the pay back will be heavier volatility in the long run, once the instruments mature. In any case, U.S. regulations tend to affect almost all banks, all over the world, since most are involved, in some way or another, with the American financial system, due to current U.S. economic dominance. Exempting these derivatives means foreign banks, which are not as influenced by U.S. government policy regarding the dollar, to restructure other types of derivatives.
The main result is that the shadow world of derivatives will get yet another "pass" from the need for transparency and regulation. Traders can expect to deal with much greater currency volatility than ever seen before, and regular citizens will need to deal with this too. With this exemption, instead of adding stability as it was intended to, the net effect of Dodd-Frank will be greater instability. Tens or even hundreds of trillions of notional derivatives are going to be restructured to become exempt FX swaps and forwards. These have the potential to profoundly destabilize the cash currency markets in ways that we cannot fully anticipate. A bigger crash than the one in 2008 is ahead and market participants should begin preparing for it. It is no longer a matter of "if" but only of "when."