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Lighting Up Dark Pools and Dissing Dodd-Frank

Shadow banking may sound like the demon brainchild of Dr. Evil and Gordon Gekko, but about half of the banking system’s assets are in this mostly unregulated realm of finance. And global regulators at the Financial Stability Board recently looked at taming that realm.

Liquidity buffers, leverage limits and standards on how to make calculations were among the FSB’s suggestions, AFP reported Sunday. The largest shadow banking sectors are in the U.S. and the Eurozone, but systems in other geographies are about five times the size of GDP, as with Hong Kong and the Netherlands.

Policymakers around the world are trying to shine lights on shadier parts of the financial services industry. But authorities are finding transparency in surprising places -- and hope in some unlikely places.

On The Dark Side

The almost-as-nefariously-named dark pools are also on international regulators’ hit list, according to The Financial Times on Monday. These off-exchange venues keep prices hidden until after the trade -- and keep identities a secret.

Stock trading via dark pools in the U.S. is up almost 50 percent since 2009. Asset managers like them because they reduce risk and prevent electronic traders from carving up orders, but U.S., European and Australian officials worry that dark pools will undermine public markets.

“If the majority of order flow is filled away from pre-trade transparent markets, investors could withdraw quotes because of the reduced likelihood of those orders being filled,” Rhodri Preece, director of capital markets policy at London-based investment association CFA Institute, told FT. “It would be prudent for authorities to monitor these developments closely.”

Regulators seem to agree, but they have their work cut out for them, as transparent markets still aren’t completely sorted either. The U.S. Securities and Exchange Commission is looking into allegations that American stock exchanges offer unfair advantages to their more sophisticated traders, The Wall Street Journal reported Monday.

Trading Darkness for Daylight

On the other hand, diminished risk got foreign exchange swaps and forwards off the hook for tighter regulation last week. The contracts, which guard against fluctuating currency, are transparent and liquid enough not to need regulation under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the U.S. Treasury Department said Friday.

Market participants, such as the big banks that lobbied for this decision, are understandably elated because they will dodge some of the most expensive Dodd-Frank rules -- but not all of them. They will still have to abide by conduct and reporting.

Oh yeah, and no more betting with taxpayer money.

Different Strokes for Different Volcks

One of the more notable components of Dodd-Frank is the Volcker Rule, which prohibits proprietary trading by banks with branches in the U.S. The rule would hold regardless of whether the banks are based there.

That would mean foreign banks with a U.S. footprint would suffer the same Volcker-induced headache that American banks have. Costs and other issues associated with Volcker Rule compliance could prompt foreign banks to flee the U.S., according to some American attorneys.

“I doubt that Volcker alone will lead to a mass exodus,” Alan Avery, a partner at Los Angeles-based law firm Latham & Watkins, told the International Financial Law Review. “But banks are beginning to conduct cost/benefit analyses to determine whether it’s worth maintaining a presence in the U.S.”

And the U.S. doesn’t need a mass exodus of banks as its budget is careening toward the fiscal cliff.

Beacon on a Cliff

Looking over the edge of that cliff may not get most people thinking optimistically. The fragile U.S. economy could crumble back into a recession if politicians do not reach accord on the federal budget, Ben Bernanke told the Economic Club of New York on Tuesday.

But détente could presage a prosperous 2013, the chairman of the Board of Governors of the Federal Reserve System also said.

“There’s important potential for the economy to strengthen significantly if there’s a greater level of security and confidence about where we’re going,” Bernanke said. “A plan for resolving the nation’s longer-term budgetary issues without harming the recovery could help make the New Year a very good one for the American economy.”

That might not solve the European debt crisis, rejuvenate the Chinese economy or even light up every dark pool, but it could be a beacon to the rest of the world.

Related Articles:

US ‘dark pool’ trades up 50%” by Philip Stafford

U.S. Treasury Exempts Foreign Exchange Swaps From Dodd-Frank” by Silla Brush

Bernanke: Fiscal Cliff Fix May Bring ‘Very Good’ Year” by Joshua Zumbrun



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