Foreign exchange markets have been in operational limbo for the past five months. The Dodd-Frank Act, which came into force in the US last July, introduced mandatory clearing for all over-the-counter derivatives and swaps. While the legislation had initially exempted the $2.5 trillion FX swaps and forwards market from the new rules, the final version contained no exemption. The final decision, left to the US Treasury secretary, is expected in the first quarter.
In the interim, FX participants have had no choice but to start preparing for that eventuality. But they are lobbying strongly their case that FX derivatives markets are a distinctly different animal from other asset classes, such as credit, which politicians and regulators successfully argued helped cause the financial crisis. Its inclusion in the OTC derivatives regulations would also mean oversight was turned over to the Commodity Futures Trading Commission (CFTC) from its existing regulator, the worlds main central banks.
"Unfortunately were resigned to the fact that it is going to be expensive to implement, all of which ultimately isnt good for the end users"
In mid November, the Global Foreign Exchange Division, a lobby group formed out of the three financial markets trade associations, AFME, Sifma, and ASifma, presented their written submissions to the US Treasury, and their case for FX swaps and forwards to be made exempt. While arguing that the FX markets central role in the global payment system should mean they remain subject to just central bank supervision, their most compelling point was that any systemic concerns about the FX markets were well in hand. They argued that the biggest risk in FX transactions was settlement risk, not counterparty risk, largely because most transactions mature in less than two years. The issue of settlement risk had been addressed with the launch in 2002 of Continuously Linked Settlement (CLS), a process performed by CLS Bank International, now owned by 72 big banks. The CLS process eliminates settlement risk for about 90% of inter-dealer transactions. In short, the industry argues that risk mitigation is being duplicated, and only increases costs, with few positive benefits.
"Clearing house requirements will add to the costs of trading, not only due to clearing fees but also margin requirements that will be new to many FX clients," says Andy Coyne, head of FX prime brokerage and G10 e-commerce at Citi. "Unfortunately were resigned to the fact that it is going to be expensive to implement, all of which ultimately isnt good for the end users."
A banks decision on what infrastructure it will need to build will depend on where it sits in the food chain. Some large institutions are planning for the worst and hoping for the best, says the chief operating officer of a top-five FX bank. That entails building clearing services for options, forwards and swaps, while smaller players might offer clearing on just currency options, which are already included in the legislation, and then make a decision as to whether to clear through a firm that has built out the full product. In the meantime, market participants are cautiously optimistic as they await a decision from Treasury secretary Timothy Geithner. "The right questions are being asked, and youre probably always going to find a difference between where the CFTC is and where the Treasury is. The CFTC tends to be more hard-line," says the chief operating officer.