Blog article
See all stories ยป

To Clear or Not to Clear...just use Treasurers logic

On April 29th, the US Treasury Secretary proposed to exempt foreign exchange forwards and swaps transactions from forced clearing under the Dodd-Frank act. FX swaps and forwards shouldn't fall under the same rules as other derivatives. By Alexander Jacobs 

In this article, I want to set out that the arguments given by the US Treasury to support there proposal fails any logic, is misleading and if their proposal is to be accepted, would put a bomb under the legal reforms imposed by the Dodd-Frank act and EU proposals, thereby killing the change to reduce systemic risk in the OTC market. 

The economic crisis made it very clear to the regulators that the absence of any regulatory framework for OTC derivatives was the cause of the Lehman default and the near collapse of the financial system in 2008. The OTC market contrary to the exchange traded and CCP cleared market was totally unregulated and that the large bilateral exposures between financial institutions (banks), responsible for the economic crisis, were completely outside the radar of regulatory control. 

To counteract this economic and systemic thread, Regulators on both sides of the Atlantic responded by introducing a comprehensive set of new legislation (Dodd-Frank act in the US and Commission Communication in the EU) to mandate that all OTC traded products eligible for clearing are to be traded on Exchanges and to be centrally cleared by an organised clearing organisation.   

The big question that regulators still need to answer is: Which OTC traded derivatives (e.g. Swaps and Forwards, Options) are "clearing" eligible and which derivatives are not and therefore will not be subjected to the new regulations?

To be eligible for clearing, derivatives must meet the following criteria:

  1. High liquidity and trading volumes
  2. Many active market participants
  3. Standardised contract types
  4. Easy to model, price and risk manage
  5. Suitable for listing on an exchange or Swap Execution Facility (SEF)
  6. Representation of the derivative in computer-readable language.  

In my opinion, as OTC product specialist and former derivative trader, the FX swaps and forwards will pass the criteria test with flying colours and therefore should be first in line, before IRS and CDS to be subjected to the Dodd-Frank act and mandated for regulated exchange trading and central clearing. 

As already stated above, the absence of any regulatory framework for OTC derivatives is generally considered as the sole reason for the near collapse of the financial system in 2008.  Transparency and regulation of the OTC market is essential.  

US Treasury does however not agree with the general consensus that the OTC market should be more regulated. Therefore they proposed that FX swaps and forward should not be mandated to be centrally cleared for the following reasons: 

The US Treasury is in the opinion that FX swaps and forwards presents less risk to the financial system than other types of swaps

The FX market is in size (transactions volumes per day) by far the biggest and most important market in the world. The FX market is a multi trillion dollar market with exposures so big that the FED needed to jump in during the 2008 crisis to prevent an upcoming catastrophe. The Federal Reserve (FED) had to establish emergency lines of credit, with many foreign central banks to bring back liquidity in the fully dried up FX market, which caused a major shortages of dollars with European banks which in turn could have resulted in these banks not being able to meet their payment obligations. Therefore... by stating that the FX market presents less risk, the US Treasury simply ignores recent facts of history.  

The US Treasury claims that FX swaps and forwards are markedly different from other types of swaps in that they are physically settled

The US Treasury states and I quote: "in contrast to other derivatives, FX swaps and forwards always require both parties to physically exchange the full amount of currency on fixed terms that are set at the outset of the contract."    After reading this quote a couple of times...I am still puzzled and do not know how and where to start reacting on this without degrading this article. To put it mildly, this argument makes it very clear to me that the FX market needs to be regulated under the Dodd-Frank act ASAP. 

The quote actually contains multiple incorrect aspects which need to be addressed.

First, using the terminology "physical settlement" as argument for exempting FX swaps and forwards is nothing more that simple semantics and miss-use of terminology. Treasury could also correctly have claimed that the FX swaps and forwards should be exempt because they are always cash settled. The funny thing with the FX market is that it is the only market in which cash and physical settlement are one and the same.

Second, physical settlement, many and many more derivatives like Commodity, Energy and Equity derivatives can all be traded with physical settlement. I therefore fail to see why physical settlement makes FX swaps and Forwards in the eyes of Treasury any different.

Thirdly and last, settlement on fixed terms as agreed in the contract. Again, what is Treasury saying here? That with other swaps it's always a gamble to what amount will be settled!? 

The US Treasury claims that FX swaps and forwards that most transaction are of short duration.

Most of the transactions are of short duration! This is not an argument, it is like saying most of the time I do behave and therefore, I do not need a babysitter. Duration is not a valid argument. Given the size and volumes of the FX market regulation is required and especially for the swaps and forwards with "long" durations. 

The US Treasury claims that central clearing of FX swaps and FX forwards like any other derivative could expose the market to greater risk and instability.   

How could central clearing, which increases price transparency, which reduces counterparty exposure, which is controlled by government regulation and oversight, lead to greater risk and instability?  The only risk and instability the US Treasury fears is the vanishing of the Dealer bank controlled and dominated FX market

If the US Treasury proposal is going to be approved and FX swaps and forwards were to be exempt from the comprehensive new regulations, than roughly 90% of the entire OTC market would be exempt. Exempt for reasons that do not hold from every angle you look at them. And therefore the proposal, in my opinion, should be considered, as nothing else than to sabotage the intent of the upcoming financial reforms and save guarding the commercial interest of the dealer banks that caused the crisis in the first place. 

Be aware, there is no middle ground in this. The arguments of the US Treasury, fully contradicts the essence of the Dodd Frank act. And both visions can't be right at the same time. Granting Treasury's claims would kill all that the Dodd Frank stands for. Believing the arguments presented by the US Treasury is like saying; "Yes, the banks can regulate themselves. Why not!?  They have proven so in the past. And sure leaving the biggest OTC market unchanged is the best way to reduce the change of another financial crisis". 

Therefore, I urge all market participants to take up the invitation to comment within 30 day on the Treasury Secretary's proposed exemption for FX swaps and FX forwards to make sure we prevent another crisis instead of creating one.



Comments: (1)

A Finextra member
A Finextra member 13 May, 2011, 15:59Be the first to give this comment the thumbs up 0 likes

Very well said and great argument. I fail to see any logical reason why all OTC should not be cleared although i have great reservations on the existing CH. I hope to cover some of these concerns and no doubt the points you raise in the first Post Trade debate on the 23rd June hosted by the London Stock Exchange. See Finextra for details

Well said again