WASHINGTON—The Treasury Department could decide soon whether to exempt some foreign-exchange instruments from new rules governing derivatives, a call that has divided regulators and pit big banks and businesses against those who fear a loophole that could undermine efforts to prevent a repeat of the financial crisis.
The Dodd-Frank financial-overhaul law enacted by Congress last year left open a big question: Whether foreign-exchange swaps and forward contracts should fall under the same rules as other derivatives.
Treasury officials say no decision has been made. But the person making it, Treasury Secretary Timothy Geithner, endorsed exempting foreign-exchange products from the new rules when they were being written. He argued then that foreign-exchange derivatives don’t pose the same risks to the financial system as others.
The Treasury faces no specific deadline to make its decision, but the department needs to make a decision soon in order to enable the Commodity Futures Trading Commission to finalize its rules by July, as the law requires.
Mr. Geithner’s position is backed by a number of business and banking groups, which late last year flooded the Treasury with letters in support of the exemption.
Opponents of an exemption contend that treating one class of derivatives differently will sabotage the intent of the financial-overhaul law.
“The same reasons that require regulation of other swaps and the other parts of the shadow banking system … apply equally to the foreign-exchange markets. The Fed’s own emergency actions to save the foreign exchange markets during the crisis prove this,” Dennis Kelleher, chief executive of Better Markets Inc., a nonprofit advocacy group wrote in a letter to Mr. Geithner on Friday.
After the 2008 financial crisis, lawmakers writing the Dodd-Frank law wanted to rein in the largely unregulated derivatives market. The law requires most routine derivatives to be traded on exchanges or similar electronic systems. These products would also be routed through clearinghouses, financial cooperatives that collect money and collateral from its members to cover shortfalls if a member defaults on an obligation.
However, business and banking groups say foreign-exchange swaps and forwards are less risky than other derivatives because they involve fewer payment fluctuations and less counterparty risk than more complex products. Foreign-exchange products allow for currencies to be exchanged at a fixed price at an agreed-upon time in the future, and the maturity is typically shorter in duration than other derivatives.
The products do entail some settlement risk, but even that has been in large part mitigated by the establishment of an agreed-upon settlement system through CLS Bank, exemption proponents argue. Foreign-exchange swaps and forwards, which make up the second-largest over-the-counter derivatives market, are used primarily by companies to hedge against foreign currency fluctuations, but also by central banks, private banks and traders.
“What is to be accomplished by forcing a market that works extremely well and efficiently under a regime that would require it to be almost cookie-cutter which wouldn’t meet the needs of the Caterpillars and John Deeres of the world to operate a global marketplace?” asked former Rep. Kenneth E. Bentsen Jr., who heads the Washington office of the Securities Industry and Financial Markets Association, a large industry trade group.
Supporters of an exemption say that the sheer size and breadth of the global foreign-exchange market doesn’t lend itself to the central clearing mechanism envisioned by the Dodd-Frank law. The Foreign Exchange Committee, which is made up of major financial institutions and sponsored by the Federal Reserve Bank of New York, said in a November letter to Treasury that risk to the financial system could be increased by not exempting foreign-exchange products.
The Federal Reserve and New York Fed declined to comment for this article. But industry groups such as Sifma said central banks, including the Fed already police foreign-exchange dealers and transactions because the foreign-exchange market is critical to a central bank’s ability to carry out monetary policy.
Mr. Kelleher of Better Markets counters that foreign-exchange derivatives still pose risks to the financial system. The group’s analysis of recently released Fed data shows that at the height of the financial crisis the Fed dramatically expanded its foreign-exchange exposure through the swap lines it set up with foreign central banks in order to provide access to U.S. dollars to foreign commercial banks. The group said this shows that without this significant intervention by the central bank, foreign-exchange markets would have sputtered to a stop.
The debate isn’t new: Lawmakers and regulators hashing out the financial-overhaul law were divided on the topic. The Treasury Department’s initial derivatives proposal to Congress in 2009 excluded the foreign-exchange products from any new regulations.
Mr. Geithner said during a December 2009 appearance on Capitol Hill that compared with other types of derivatives markets, foreign-exchange “markets are different from these, and they’re not really derivatives in this sense, and they don’t present the same set of risks.” He hasn’t commented publicly on the issue since the law was enacted last year.
CFTC Chairman Gary Gensler, however, openly disagreed with the Treasury and fought to include foreign-exchange swaps in the new rules. He has remained quiet on the issue since the law was enacted. He declined to comment for this article.
