Margining of FX swaps could damage market structure, raise unnecessary costs, says GFMA

Russell J. Dinnage
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FX swaps and forwards should not be subjected to international margining regimes that might distort the market, says industry group the Global Financial Markets Association (GFMA).

GFMA’s position on a Basel Committee on Banking Supervision (BCBS) paper released in August looking at the need to manage risks associated with the settlement of FX transaction was submitted to the international group of regulators on Friday.

The BCBS proposal would require that all uncleared derivatives under the EU’s European Market Infrastructure Regulation (EMIR) be subject to mandatory variable margin and initial margin across all product types, including FX.

Those BCBS standards could be finalized in November.

In an interview with EuromoneyFXNews, GFMA global FX division managing director James Kemp – who authored his group’s comments on the BCBS paper – says it is important for the regulators managing the Basel process to realize that the key risk in FX is settlement risk.

GFMA says 94% of estimated maximum loss exposure in a trade for FX instruments with a maturity of six months or less is managed in a number of ways, chiefly by CLS.

The 6% of risk that the currency products pose to the stability of the FX market and the wider financial system is replacement risk, which Kemp says the industry manages through the increasing use of credit agreements called CSAs.

That risk expands to 11% as maturities on the deliverable FX swaps and forwards grow to one year.

"Having covered the key systemic risks, it is important to allow banks to take on well-managed risk to extend credit to fund economic growth," says Kemp.

 How FX settlement risk is handled

 Source: GFMA

GFMA says in its comments to the BCBS that requiring traders of FX swaps and forwards to post large margins to each other every time they trade would be a move inconsistent with "the well-established strategy of central banks" for addressing systemic risk in foreign exchange.

It adds: "A mandatory margin regime raises costs of trading deliverable foreign exchange swaps and forwards bilaterally."

The group says that the short lifespan of most FX forwards and swaps means counterparty default risk is absorbed by the flexible nature of the products.

Any mandatory margin requirements imposed by the Basel process would create a two-tiered marketplace for deliverable FX swaps and forwards where there is now only one, the group says.

"Regulatory intervention in the form of mandatory margin creates unsafe structural economic incentives that can harm the well-functioning market structure," says GFMA.

GFMA argues that raising the costs of trading the deliverable FX swaps and forwards would incentivize central clearing for these products when there is no safe clearing solution for them; jeopardize CLS’s role in the market by moving focus away from settlement risk reduction; and by discouraging legitimate trading in these products, adversely affect global trade.

GFMA says the "well established" approach for addressing settlement risk in the FX market is the "only prudent course of action for regulators to take".

"There is no compelling reason to do otherwise," says GFMA.

The group adds that, to date, no clearing house has demonstrated an ability to implement safe measures that ensure the FX market could manage the liquidity and credit risks associated with clearing currency swaps and forwards.

GFMA says that central banks are concerned that the weight of ensuring settlement risk could overwhelm a clearing house and cause it to crash.

"The failure of a foreign exchange CCP to guarantee settlement risk would largely defeat the purpose of clearing through the CCP, particularly for a market that is essentially a payment system," says GFMA.