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Foreign Exchange

FX comment: OTC derivatives regulation – As clear as custard

There were those who thought that, once Dodd/Frank had passed, the world would know how financial markets would be regulated by the US authorities. But they were wrong.

More than a week has gone by since the Act was passed by the House of Representatives – time enough to have read through its 2,300+ pages. Not that I’ve read it, of course (although I did scan the 1,616 pages of the House draft, with Senate amendments, dated May 20); but I have read what is, by general consensus, the best summary of the legislation. Provided by the lovely people at the Harvard Law School, the summary, at 34 pages, does make life a little easier.

That the Act will now be passed by the Senate is quite certain but the detail regarding OTC derivatives is still unclear. As the Harvard summary says:

“The Act authorizes the CFTC and the SEC to mandate central clearing of OTC derivatives that are determined to be appropriate for clearing and capable of being cleared.” But such determination has not yet been made and the CFTC and SEC have a year to make it. And there is also the question, mentioned last week, as to whether the Treasury will write its “determination that either foreign exchange swaps or foreign exchange forwards or both — (I) should be not be [yes, that’s exactly what it says] regulated as swaps under this Act; and (II) are not structured to evade the Wall Street Transparency and Accountability Act of 2010 in violation of any rule promulgated by the Commission pursuant to section 111(c) of that Act”. (From the House of Representatives draft, p. 543 – told you I’d skimmed it, maybe you believe me now.)

Of course, the situation is even less clear in Europe. Louise Bowman writes in the latest Euromoney magazine of doubts, shared by Patrick Pearson, head of financial markets infrastructure at the EC’s DG Markt unit, about the efficacy of central clearing. And Pearson also pointed to the wooliness of the ‘where appropriate’ phraseology, this time in last year’s Pittsburgh G20 communiqué, as to whether OTC derivatives would be required to be centrally-cleared and/or exchange traded: “Look at those words ‘where appropriate’, Europe has not taken this decision. Jurisdictions will come up with different solutions.”

Bowman gives another quote that shows how far the authorities are from an agreement on the question of central clearing:

“When the G20 leaders met in Pittsburgh last year they said that all standardized OTC derivatives must be cleared through clearing houses,” said Pearson. “This is as clear as custard. It needs to be translated into regulation but there is no single definition of what standardized derivatives are.”

One can assume that Europe will follow whatever eventual decision the US makes about forward FX. The question of currency options is interesting, though: it is quite possible that those that can be ‘standardized’ – whatever that means, but probably vanillas and second-generation single and double barriers – will have to be centrally cleared. But standardization of options with partial or moving barriers is less likely. And more complex structures, particularly those which, from a buy-side perspective, are just as much speculative vehicles as hedges, like TARNs, are another matter entirely.

How the regulations end up for non-cleared derivatives, aside from the reporting to a data repository, is a ‘known unknown’. But they will hardly be less restrictive than those for cleared products; and quite possibly restrictive enough to frustrate their use. It might be back to the early ‘90s for the FX market in terms of product complexity. Or it might not – it’s still “as clear as custard”.

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