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June 07, 2011

New Wall Street loophole opens U.S. up to WTO attack

The New York Times' Louise Story reported this morning that the pace of Wall Street reform has slowed to a crawl:

The rules are mandated by the Dodd-Frank financial regulatory law and range from curbs on executive compensation to consumer banking protection provisions to more transparency in the trading of derivatives, those complex financial instruments that contributed to the 2008 financial crisis.

So far, 28 of the financial overhaul rule-making deadlines have been missed, according to Davis Polk, a law firm that is tracking the rules. Of the 385 new rules to be written, the law firm says, regulators have completed only 24 requirements; they were supposed to have taken 41 such actions by now.

“There’s an attempt to kill this through delay,” said Michael Greenberger, a law professor at the University of Maryland and a former official at the Commodity Futures Trading Commission, which is in charge of writing batches of the rules.

But that's not the full story. Some derivatives rules are moving forward. They just happen to be rules that create new loopholes, as the NYT editorial page wrote last month in an editorial entitled "Mr. Geithner's loophole":

Until recently, the big threats to the Dodd-Frank financial reform law came from Republican lawmakers, who have vowed to derail it, and from banks and their lobbyists, who are determined to retain the status quo that enriched them so well in the years before, and since, the financial crisis. Now, the Obama Treasury Department has joined their ranks.

In an announcement on Friday afternoon — the time slot favored by officials eager to avoid scrutiny — the Treasury Department said it intends to exempt certain foreign exchange derivatives from key new regulations under the Dodd-Frank law. These derivatives represent a $4 trillion-a-day market, one that is very lucrative for the big banks that trade them.

There are numerous reasons to oppose the exemption of so-called foreign exchange (FX) swaps and forwards from the Dodd-Frank rules, as is ably argued by players and followers of the market themselves (see commentary from Zero Hedge, Quantitative Investment Management, Council of Institutional Investors, Stanford Professor Darrell Duffie, and the World Federation of Exchanges). The Wall Street banks that are among the huge players in this market want to preserve their elite club, even though Main Street sees little to no benefit from the trillions of dollars sloshing around the FX markets every day, much of it in speculative bets on interest rate and exchange rate movements around the world).

But there's an additional reason to oppose the swiss-cheese-ification of Dodd-Frank. The World Trade Organization's (WTO) services agreement groups FX swaps and non-FX derivatives in the same category, and subject them to similar de-regulation promoting rules. (The only exemption that the Clinton adminstration took in this sector is for ONIONS futures. You cannot make this stuff up.) These stability weakening WTO rules are strongly enforceable, unlike the stability-promoting global financial rules that others in the U.S. government are advocating.

As we noted in comments to the Treasury Department yesterday, WTO members are already suggesting that Dodd-Frank derivatives regulation may not be compatible with the WTO financial services commitments assumed by the Clinton administration during the 1990s.

The U.S. would have few strong defenses if Dodd-Frank were attacked at the WTO (or worse, by a private investor under one of our bilateral NAFTA-style deals).But the U.S. would likely cripple one of the few defenses it had if it argued that Wall Street self-regulation was merited for certain classes of financial exotica, but not for others. How then would the U.S. defend the "necessity" (a key test in trade law) of strong regulation for the non-exempted derivatives? Either government regulation is necessary across the board within the securities trading sector, or not at all. The time for carving out FX markets to a regime of self-regulation passed a long time ago - this handout to Wall Street banks should not now emperil the systemic regulation of shadow markets.

This conflict with Dodd-Frank shows the desperate need to have our "trade" rules catch up with our "financial" rules. Unfortunately, the services trade regime was crafted before the lessons of the financial crisis. The good news is, there's appetite from our trading partners - many of whom were cajoled into overcommitting in the WTO talks by Geithner in the 1990s - to reform the outdated rules. They just need to see a helping hand from the Obama administration, which up until now has simply been pushing further financial services deregulation through the Doha Round talks of the WTO.

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