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Dodd-Frank and FX... a case of unintended consequences?

So they decided to exclude FX derivatives from the requirement to clear centrally.  A case study in unintended consequences?

The effect of a pair of interest rate swaps can be synthesised through a non-deliverable FX forward trade combined with a long dated cross currency swap. So if a bank chooses to trade a synthetic IR products as an FX derivative structure, they are able to completely bypass Dodd-Frank, and avoid the costs of CCP membership, margin collateral and infrastructure consequences.

So at a stroke this decision will drive interest rate swaps, the largest portion of the OTC market, out of the reaches of the legislation. Is that really what they wanted? I don't think so.




Comments: (3)

John Wilson
John Wilson - Mpaua - London 05 May, 2011, 12:25Be the first to give this comment the thumbs up 0 likes


NDFs are not exempted from clearing and nor are cross currency swaps with the US Treasury decision.  Only FX Swaps [spot + forward] and Forwards are exempt, neither of which can be described at derivatives.

Hence, the trade structure you propose wouldn't be exempt.

A Finextra member
A Finextra member 05 May, 2011, 14:30Be the first to give this comment the thumbs up 0 likes

David, having reviewed the details of the recent CFTC announcement, it looks as though only FX swaps and FX forwards will be exempt from clearing requirements, while currency swaps, FX options and NDFs remain subject to clearing and exchange requirements.

However, FX swaps and forwards, when they are long-dated are extremely sensitive to changes in yield curves and can have swings in MTM value from moves in interest rates in the underlying currencies. These large valuation changes are the result of the exchange of principal amounts in FX swaps and forwards as compared to exchanges of interest only in the case of Interest Rate Swaps. These valuation changes can further introduce significant counterparty credit risk on a bilateral basis. In fact the credit risk profile for an FX swap generally increases during the lifetime of the trade, whereas credit risk on an IRS will diminish nearing maturity. In effect, non-cleared FX swaps could still lead to significant counterparty credit risk if the trades are not collateralised.

While only a limited type of FX derivatives are exempt from mandatory clearing, I agree that it looks like the announcement still goes very much against the grain of what regulators are attempting to achieve via Dodd-Frank!


John Wilson
John Wilson - Mpaua - London 05 May, 2011, 15:10Be the first to give this comment the thumbs up 0 likes

The volume of long-dated FX swap/forwards trades is relatively minor and aren't generally to be of a materiality to be considered "systemically" important. This was one of the considerations in US Treasury thinking.

Moreover, the majority of the embedded risk in the trades is settlement risk, as studies have shown and clearing doesn't remedy settlement risk, only credit risk.