Champions of financial reform who fought hard for a strong Wall Street reform bill this year know they cannot let down their guard. They are tracking and countering the moves of the big banks as they try to weaken the Dodd–Frank Wall Street Reform and Consumer Protection Act [3] during its implementation phase. They are bracing for a battle with Republicans who are threatening to repeal key parts of the law. What they were not expecting was a rear-guard attack on the recently passed measure from the Obama administration.

Evidently, Geithner is interested in exempting the $24 trillion – that is trillion with a "t" – foreign exchange (or forex) market from the clearing and transparency requirements of the act.

Derivatives Chapter Was a Victory for Reformers

The $600 trillion off-book derivatives market was critical in turning the collapse of a domestic housing bubble into a global international catastrophe. In the United State, taxpayers found out that they were on the hook for the big bank's reckless bets in the derivatives market and $4.7 trillion [4] in taxpayer funds was disbursed to stabilize the system.

One of the reformers' great victories was the strong derivatives chapter of the Dodd-Frank law. It will bring the vast majority of all derivatives trades out of the shadows onto an open exchange with capital requirements to mitigate risk and real-time information about pricing and volume. No longer will Goldman Sachs [5] be able to hire one client behind closed doors to design a toxic product, then turn around and peddle that same product to another client in a secretive, bilateral fashion.

During the debate in Congress, the House passed a version of the derivatives chapter riddled with dangerous loopholes covering only 60 percent of derivatives trades. Reformers, working under the umbrella of Americans for Financial Reform [6], succeeded in closing those loopholes in the final version of the bill and covering almost all derivatives trades -- over 90 percent of the market -- with a very narrow exception for legitimate end-users.

This triumph over the big banks that want to keep these trades in the shadows may now be in jeopardy.

Financial Instability Council?

One of the Obama administration's much-touted reforms in the Dodd-Frank law was the creation of the Financial Stability Oversight Council. It is made up of top state and federal regulators, including the Federal Reserve [7] Board Chair, the heads of the FDIC [8], SEC [9], the Commodity Futures Trading Commission [10] (CFTC) and the new Consumer Protection Bureau. According to the Treasury Department, the Council will provide "comprehensive oversight over the stability of our nation's financial system."

The first meeting of the Stability Council took place this week. Treasury Secretary Tim Geithner [11] is the chair. Ironically, it looks like Geithner is considering exploiting language in the law that allows him to exempt the $24 trillion forex market from the clearing and transparency requirements, throwing these trades back into the shadows. The forex market is a worldwide, over-the-counter market for the trading of currencies. Forex traders argue that the market performed well during the financial crisis, but the risk is that without transparency in this enormous, interconnected market, the failure of a major dealer could contribute to another crisis which could cascade through the entire financial system.

"I have no idea what the current thinking is about an exemption for foreign exchange swaps and trading, but the first thing that a chairman of the FSOC should focus on is ensuring that everything is cleared. Clearing is just another word for transparency and accountability in the system. If we don't get that aspect of things right, taxpayers will be on the hook again," says Dennis Kelleher, former staffer for Senator Byron Dorgan and current President and CEO of Better Markets, an independent nonprofit watchdog organization.

The derivatives portion of the forex market represents only a small portion, about four percent, of the total derivatives market worldwide. What is the harm in exempting four percent of the market? Because it won't remain four percent, says Michael Greenberger, former Director of Trading and Markets at the CFTC. "If you exempt part of the market, Wall Street will try to use that loophole to mask other transactions," says Greenberger. In other words, the $24 trillion dollar loophole could rapidly grow to an even larger loophole bringing an even greater degree of risk to the system.

Given the risk, how can one rationally make the argument that forex derivatives should be treated differently? "Explaining why they should be treated differently will take some work," Joe Palumbo of Ernst and Young told the Financial Times [12]. Yet the bill only requires Geithner to write a letter to Congress justifying his position on the matter.

"At the very least, before you create any loophole to the clearing requirements there should be extensive study and consultation with all the parties and the public. So far this has not taken place," says Kelleher.

As the Financial Stability Oversight Council begins its work, perhaps its first task to engender public confidence should be to scrutinize closely the plans by any member of the council to introduce risk into the system.