Foreign exchange: FX clearing exemption could increase risk

On April 29 the US Treasury proposed exempting foreign exchange forwards and swaps from clearing and trading rules contained in the Dodd-Frank Act. The Global FX Division, a trade group representing the biggest users of foreign exchange, mainly banks, said at the time. “We very much welcome the US Treasury ‘proposed determination’, as moving FX swaps and forwards to centralized clearing will not only create additional costs for business users, but could also increase systemic risk.” However, one influential financial market academic argues that the proposal to exempt FX might be a mistake, and could indeed foster systemic risk.

Darrell Duffie, professor of finance at Stanford University’s business school, believes the arguments for an exemption are “not sufficient”.

Duffie says the idea that FX swaps and forwards exposures are small is unfounded. Indeed he goes as far as saying: “A failure to further regulate the control of counterparty risk in the foreign exchange derivatives market could be a significant mistake”, based on his analysis of data on FX volatilities, gross market value positions, volumes of derivatives trading by maturity and the total outstanding notional amounts.

For instance, he says, there is no public disclosure of the total outstanding notional amount of FX derivatives that exist at maturities of over one month, which would allow a more detailed analysis of market-wide counterparty risk. “It’s a critical gap in our knowledge of whether the risks from this asset class of derivatives are systemically important,” Duffie wrote in his paper submitted to the Treasury last month.

Larger market

The gross market value of FX – the amount that would be lost in the event of a default – is $925 billion – larger than the equity derivatives market ($706 billion) and commodity derivatives ($457 billion), neither of which received an exemption under Dodd-Frank. FX is second only to the credit derivatives market – the principal focus of recent reform. The gross market value for credit default swaps is $1.67 trillion, according to the Bank for International Settlements – so Duffie warns that FX shouldn’t be far from regulators’ minds. He says regulators might be blind to the potential bite in volatility, by underestimating some of the potential default risks associated with the FX market because they are not accounting for the extreme volatilities of some currency pairs that might arise in certain types of crises. In particular, he is thinking of tail event risk in a sovereign default – an event “which may plausibly occur in the coming years”. The 30-day comment period for the Treasury proposal to exclude FX trades ends on June 6.