After the financial world (and much of the press that covers it) had “powered down” for the weekend, the U.S. Department of the Treasury issued its long-awaited “final determination” on FX swaps and forwards last Friday. In the final ruling, Treasury essentially exempted these FX instruments from certain Dodd-Frank requirements such as mandatory clearing and trading on a designated contract market or a swap execution facility.

For a full summary of the rule and its history, I invite you to visit the FX Swaps Regulation page in MarketsReformWiki, but outlined below are a few salient points to consider when asking whether FX is indeed a “special case” in need of a special exemption, or whether Treasury just delivered an early Christmas present to the banking sector.

Of note, self-proclaimed industry watchdog Better Markets is livid, not only because of the exemption, but also the manner in which it was delivered. Important and controversial rulings such as this should not be issued after 5 pm on a Friday, right after the election, during Congressional recess, into the Thanksgiving-shortened week. “Shamefully manipulating the release of information to prevent scrutiny, analysis and criticism,” said Better Markets, “should simply never be engaged in or tolerated.”  

So here are a few arguments promulgated by Treasury when issuing its decision, followed by, in the words of Better Markets, “scrutiny, analysis and criticism.”

“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.”

Three words – Russian ruble crisis.

Plus, 2008-09 was no walk in the park for those of us trading FX derivatives at the time. Sure, the spot market was mostly orderly (except for a few key days when I really needed them to be orderly). At crunch time, though, the forward markets were just as unquantifiable as every other asset class.

Besides, if an asset class that “self-medicates” with its own transparency and risk management outside regulatory jurisdiction, does that mean it, too, can get an exemption? Is Treasury indicating to the interest rate and credit derivative markets that there is a path to exemption?  

“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.”

Wait a minute. Wasn’t it the blowing out of the LIBOR-OIS spread in 2008 that really got the ball rolling on the crisis? Very few financial instruments are shorter in duration than the overnight rate.

“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.”

Uh-oh. It looks to me as if a regulator may have conducted a bit of cost-benefit due diligence, and did not like the outcome. The lack of adequate cost-benefit analysis first sunk the proxy access rule in 2011 and was used to beat back the position limits rule in September. Most recently, CME Group cited it in its recent spat with the CFTC over data sharing. Now, Treasury says a market must be exempt because it would be too expensive and impractical to collateralize. Does this open the door for more challenges?

All that aside, Treasury does make a couple of compelling points to support a special exemption for FX:

FX derivatives involve fixed, predetermined payments, making them resemble, say, insurance obligations, which were specifically defined as “not swaps” in the product definition rules. Plus, parties to FX swaps and forwards typically do not exchange periodic payments during the life of the transaction. Finally, such instruments do involve the exchange of actual principal.

I certainly see the point here. Where foreign exchange is used as a facilitator to the global balance of payments, adding a central counterparty and margin requirements to the mix would add a cumbersome layer of bureaucracy that would not necessarily serve the public interest.

Besides, the Treasury determination has not given FX a full exemption. Options and non-deliverable forwards must comply with the full slate of Dodd-Frank mandates. Swaps and forwards will still need to follow the new business conduct standards and all data must still be sent to a repository.

Is this enough to make FX swaps and forwards a special case?

One thing we know for sure is that FX derivatives have been wildly profitable for the mega-banks – over $3 billion in trading revenue in the second quarter of 2012 alone, according to the US Office of the Comptroller of the Currency. These banks, who have been lobbying intensely for the special carve-out, are the same banks that received government assistance during the crisis and who, to this day, have access to the free borrowing at the Fed window. Allowing them their status quo does not sit well with some of us.

Isn’t that special?

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