The US as a global risk generator

However, when the last financial crisis hit there was such a flight of capital out of emerging markets and back into the US that many of those positions were rapidly unwound - to the great detriment of those economies. Such are the massive - and global - transmission effects of today's tightly integrated financial markets.

Never relenting, these same FX derivatives market operators got very busy again right in the wake of the global financial crisis. Hedge funds and big banks engaged in the carry trade. They borrowed in US dollars at very low interest rates and then invested in foreign currencies in a broad range of countries, from the ROK, Brazil, Chile, Colombia and Mexico to South Africa, Indonesia and Thailand. Financial professionals, that as those running hedge funds and banks are, then built FX derivatives that shorted the dollar and went long on those currencies.

This fueled exchange rate appreciation and created asset bubbles that are part of the reason for the slowdown in emerging markets. Now that the Fed is looking to wind down its easing policies, capital is fleeing emerging markets again, causing exchange rates to depreciate and debt burdens to rise.

By now, it is a familiar story. Financial engineering, largely by US-owned companies, generates serious blowback in the real economy - and hurt themselves too in the process. Citigroup, a too-big-to-fail bank, may lose up to $7 billion in FX derivatives markets if the dollar appreciates as capital flies back to the US.

The next regulatory blow may hit any day. The CFTC and the SEC are now considering exempting the same foreign subsidiaries and branches of hedge funds and big banks headquartered or with stakes in the US that have been packaging derivatives overseas.

This would be disastrous for emerging markets and developing countries attempting to maintain financial stability for development. To their credit, the ROK and Brazil both have put in place their own regulations on FX derivatives, but emerging markets alone cannot carry the burden of regulating a $4 trillion-per-day market.

Gensler has said that, if these regulations are swapped out of rule making, hedge funds can evade the rules "by setting up shop in an offshore locale, even if it's not much more than a tropical island P.O. Box." Gensler needs a majority of commissioners to help him plug this loophole by July 12. Time is running out. The world cannot afford to create major loopholes that could threaten the global financial system yet again.

The author is co-director of Boston University's Global Economic Governance Initiative and co-chair of the Pardee Task Force For Regulating Global Capital Flows and Development, and a regular contributor to The Globalist.

The Globalist