According to today’s FT, Europe is going through the same exercise the U.S. went through a few years ago regarding FX forwards. Are they swaps or are they not, and how tightly should they be regulated? Now, as was the case in the U.S., what hangs in the balance is whether the trillions of dollars exchanged each day should be subject to heightened reporting rules, central clearing and other mandates.
Again, the fundamental question has no clear answer – is FX a “special case” in that it is used primarily to facilitate commercial activity and to balance global payments, or is it an asset class with systemic risks and thus deserving of strict oversight and arguably cumbersome rules. At issue is where to draw the as to when a forex trade becomes a derivative. Some say anything that settles more than two days after the trade date is a forward. The U.K. would like to see a much broader interpretation.
For a little perspective, it is important to look at how the U.S. handled the FX derivative issue after the passage of Dodd-Frank. When the Treasury Department issued its final determination in November 2012, it argued several points in defense of FX as a special case:
- “The forex market has certain unique characteristics and pre-existing oversight functions which already reflect many of the Dodd-Frank Act’s objectives for reform – including high levels of transparency, effective risk management, and financial stability.”
- “FX swaps and forwards are predominantly short-term transactions (68 percent of the market matures in one week or less and 98 percent in one year or less). This greatly reduces the counterparty credit risk prevalent in other swaps contracts.”
- “Settlement of the full principal amounts of the contracts would require substantial capital backing in a very large number of currencies, representing a much greater commitment for a potential clearinghouse in the FX swaps and forwards market than for any other type of derivatives market.”
Treasury also said that, since FX derivatives involve fixed, predetermined payments, they are more akin to insurance, which was specifically defined as “not a swap” in the product definition rules. Plus, parties to FX derivatives typically do not exchange periodic payments during the life of the transaction but do exchange actual principal.
Now it is Europe’s turn. The only guarantee is that any decision will have plenty of dissenters.