US Treasury exemption does not mean FX market is out of regulatory woods
The US Treasury decision to exempt FX swaps and forwards from regulation under the Dodd-Frank Act should not be a surprise to anyone participating in the FX markets.
Yes, there is a sense of relief that the US exemption was made official on Friday, but those working closely on regulatory issues within the industry have long viewed the exemption as a formality since the US Treasury announced its original proposed determination on the issue in May last year. The final decision was held back for a variety of reasons, not least the US presidential election. But now that the exemption is here, things can now progress with regard to EU decisions on FX regulation.
In the EU, the equivalent clearing legislation to Dodd-Frank – the European Market Infrastructure Regulation (EMIR) – does not contain a statute allowing regulator European Securities and Markets Authority (Esma) to rule on an exemption for FX swaps and forwards from central clearing.
However, as Patrick Pearson, head of financial markets infrastructure at the European Commission, said in March that Esma should follow the US Treasury’s lead.
“There are things you fight for and things you don’t fight for, and it doesn’t make a great deal of sense if the US exempts foreign exchange from central clearing, for the EU to introduce mandatory clearing,” said Pearson.
However, that does not mean FX products are completely out of the regulatory woods. There are still hurdles, particularly in Europe, to be overcome.
At issue are Basel III proposals from the Basel Committee on Banking Supervision (BCBS) that would impose margins on uncleared FX swaps and forwards.
FX market participants are concerned about how those proposals – which were finalized this month – will be applied consistently globally to enable a level playing field once the new Basel regime is fully implemented in all territories.
The BCBS proposals would require that the small amount of risk in the market for uncleared FX swaps and forwards not covered by CLS be covered instead by mandatory voluntary margining and initial margining on all trades in the products.
GFMA’s James Kemp told EuromoneyFXNews in September there is only a 6% risk that trading in uncleared FX swaps and forwards could destabilize the market.
Otherwise, settlement of trades in the products through CLS absorbs the remaining 94% of estimated maximum loss exposure in a trade for FX instruments with a maturity of six months, GFMA says.
In February, Esma chairman Steven Maijoor said in a speech in London that the “real issue” when considering EU plans to match US plans to exempt FX swaps and forwards from central clearing is how strictly the bloc will decide to comply with the BCBS proposals on margining versus how the US decides to comply with the plans.
That debate is set to continue throughout 2013, as US regulators said earlier this month they do not expect the Basel III rules to take effect as planned on January 1.
Indeed, the possibility that the size of the margins for these non-cleared swaps and forwards could have the effect of driving the products toward clearing houses, says a regulatory specialist at a large European bank.
If the FX industry finds that the level of margin needed to secure trades in those products becomes prohibitively expensive long term, then clearing houses may become the most capital efficient option, he says.
Under EMIR technical standards set for approval on January 1, clearing houses would be required to file requests to Esma for authorization to backstop trades in certain products such as credit default swaps, for example.
However in the short term, until the market has more clarification, it is unlikely that any EU-based clearing houses will ask Esma for permission to backstop trades on FX products.
And even if an EU-based clearing house did ask Esma for permission to backstop FX swaps and forwards trades, the agency has the authority to deny the request on a number of grounds, says Kay Swinburne, MEP for Wales and a member of the EU Parliament’s Committee on Economic and Monetary Affairs, which has oversight over the European Central Bank.
“While Esma does not have the same powers as the US Treasury to explicitly exempt FX, they will focus more on other products where central clearing will genuinely mitigate counterparty credit risk and more generally systemic risk,” says Swinburne.
The industry may see this differently when it comes to doing the sums on its margin requirements.