I have mixed feelings about an article by Robert Kuttner, “Blowing a Hole in Dodd-Frank.” On the one hand, he’s found an important example of the Administration’s lack of interest in meaningful financial reforms, which is its intent to exempt foreign exchange derivatives from the implementation of Dodd-Frank. But his discussion of what this matters at critical junctures confuses foreign exchange cash market trading with derivatives and thus leaves the piece open to criticism.
Kuttner warns that Geithner has signaled strongly his preference to exempt foreign exchange from Dodd Frank implementation:
Treasury Secretary Timothy Geithner is close to a decision to exempt the $4 trillion-a-day foreign-currency market from key provisions of the Dodd-Frank Act requiring greater transparency in the trading of derivatives. In the horse-trading over the final conference version of that legislation last year, both Geithner and financial-industry executives lobbied extensively to give the Treasury secretary the right to create this loophole.
We need to be clear: Dodd Frank was never intended to cover the cash (spot) foreign exchange market, which is where the bulk of the $4 trillion of FX trading takes place. There is an open question as to whether simple forwards, which are not exchange traded and hence not typically margined, would be considered to be “standardized” derivatives and hence moved to an exchange. Not that I sympathize with the Treasury’s position, but London has long been the biggest foreign exchange trading center in the world, both for historical reasons and due to its time zone advantage. In theory, requiring forwards and other simple FX derivatives to be exchange trades would lead dealers to try to shift activity to London. The flip side is some customers would no doubt prefer the greater transparency of exchange prices.
Geithner is clearly using the spot/forward issue to muddy the discussion:
In testimony before the Senate Agricultural Committee in December 2009, he declared that the foreign-exchange market needed no special regulation. “The FX [foreign exchange] markets are different,” he said. “They are not really derivative in a sense, and they don’t present the same sort of risk, and there is an elaborate framework in place already to limit settlement risk.”
And unfortunately Kuttner falls into Geithner’s trap by discussing the intervention of the Fed in FX markets post the Lehman collapse (in fairness, he later cites some bad practices in derivatives land, like the Greek government using foreign exchange derivatives to mask the magnitude of its borrowing). This was actually a dollar market intervention. The regulatory regime we have, per Basel II, is home/host. The home country regulator is responsible for capital adequacy. That’s why the US was responsible for bailing out AIG and Citigroup even though both have globe-straddingly operations. The idea is that the bank is also subject to host country regulations, which means it normally doesn’t have to keep a lot of capital in the host country, but if the host country gets nervous, it can tell the local sub to ring the mother ship and get some capital injected.
So what happened in Sept. 2008 was that the US was acting as lender of last resort to the dollar market and to the US operations of foreign banks. First, foreign banks had dollar exposures of (IIRC) north of a $1 trillion. As markets got nervous, interbank funding started to dry up. The foreign central banks could lend directly in their own currencies, but they could not fund the dollar exposures (as in with the markets so volatile, and many of the instruments paying interest based on LIBOR, there were tons of reasons to dollar fund rather than incur currency risk). So, for instance, the Swiss Central Bank would lend to UBS in Swiss Franc on its Swiss Franc exposures, and would use swap lines with the Fed to obtain dollars to provide dollar funding for the UBS dollar exposures.
Similarly, foreign central banks were also providing both dollar and local currency funding to foreign branches of Citibank, since there was a great deal of concern that there might be a run on Citi’s uninsured foreign deposits.
So the currency operations were not a FX intervention in any normal sense of the word.
But that is not to say Geithner is at all right in his argument. Complex FX derivatives are a great way for dealers to take advantage of clients. Making the plain vanilla ones more transparent might allow some companies to construct some of their own hedges. Most complex FX derivatives (like most derivatives) have fat margins because the customer can’t decompose the trade. And most customers who engage in complex FX hedging are either being exploited by their dealer (most businesses have so much optionality in their underlying exposures that doing anything fancy is unlikely to prove cost effective) or else are engaging in regulatory arbitrage or playing accounting games (and clients expect to pay a lot for that sort of service.
And there is plenty of evidence that complex foreign exchange hedging strategies have increased systemic instability. For instance, Satyajit Das, in his upcoming book Extreme Money describes how a popular trade served as a transmission mechanism during the global financial crisis, creating large losses at emerging markets companies who were not otherwise exposed to the risks of US or European banks:
In 2008, exporters in Asia, Eastern Europe and Latin America suffered large currency losses. The companies exported to Europe and North America, who paid in dollars that had to be converted into the Japanese Yen, South Korean Won, Taiwanese dollar, Chinese Renminbi or the Indian Rupee to meet costs. If the dollar fell, then the exporters lost money as revenues fell in local currency terms.
In 2007, the dollar started to fall causing panic amongst exporters with unhedged dollar revenues. Exporters sought help from financial engineers who helped clients travel back in time on Dr. Who’s Tardis to when the dollar was stronger.
Assume that the Japanese exporter has $1 million of revenue. It budgeted on an exchange rate of $1 equal to Yen 100 giving it Yen 100 million of revenue. If the dollar falls to Yen 90 (dollar depreciation or yen appreciation), then the exporters revenue falls to Yen 90 million, a loss of Yen 10 million (10%). The bank enters into a hedge where the exporter sells dollars at Yen 95 (Yen 9.5 million in revenue), better than the current market rate of Yen 90. It has the right to convert at Yen 95 only if the Yen does not strengthen above Yen 92. At that level, the contract disappears, knocks out. If the Yen weakens below Yen 100 then the exporter must sell double the amount of dollars ($2 million) at Yen 100 to the bank, the knock in provision. This was known as the currency accumulator. Its relative, the target redemption forward, was similar but knocked out after the exporter made an agreed profit.
The exporter sold its dollars at better than market rates but risked large losses. It was selling double the amount of insurance on a stronger dollar than it was getting against a weaker dollar. If the dollar strengthened significantly, the exporter was not hedged.
In early 2008, as US investors repatriated overseas funds to cover losses, the dollar strengthened sharply triggering the knock-in provision, forcing the exporter to sell double the dollars. If the exporters had dollars then they sold them at unfavorable rates. Some didn’t have sufficient dollars because exports had fallen due to the global financial crisis or had sold more dollars than they actually were contracted to receive.
As many as 50,000 companies in at least 12 countries including Korea, Taiwan, China, Philippines, India, Eastern Europe and Latin America suffered losses of as much as $530 billion. Mexican cement producer Cemex revealed a loss of $500 million on derivatives. Controladora Comercial Mexicana SAB, Mexico’s third-largest supermarket operator, filed for bankruptcy after losing $1.1 billion from currency derivative deals.
An IMF paper by Randall Dodd, “Exotic Derivatives Losses in Emerging Markets: Questions of Suitability, Concerns for Stability,” describes the bigger economic ramifications:
There were enough non-financial firms impaired by large losses on these transactions that it put stress back on their counterparties in the banking sector. Several local Korean banks suffered when their customers sued or became bankrupt. This left the banks with losses instead of gains because the banks had to honor their offsetting hedging obligations on the trades. This was also a problem in other countries, including Indonesian banks Mandiri, Danamon and Permata.
The damage to firms in the tradable goods sector and the reverberation through the banking sector have had macro-prudential impacts that have contributed to further weakening of the local currencies and economies.
Unfortunately, Dodd Frank, by limiting exchange clearing to “standard” derivatives, has already provided a supertanker-sized loophole. It’s therefore pretty egregious to see that the Treasury Secretary is inclined to enlarge it.