Streetwise Professor

April 30, 2011

F(X) Scott Fitzgerald Goes to Timmy!’s Treasury Department

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 8:19 pm

Timmy!’s Treasury Department has released a decision exempting foreign currency swaps from Dodd-Frank clearing and SEF rules.  I agree with the decision, because I think clearing and SEF mandates are a bad idea (if you haven’t noticed).  But the “reasoning” behind the Treasury’s decision would embarrass South Park Timmy!  Really.

Where to begin?  First of all, the Notice of Proposed Determination (NOPD) completely undercuts all of the justifications for Frank-n-Dodd clearing mandates.  In multiple ways.

The NOPD tries to distinguish between FX swaps and other swaps: For instance [with my numbering for subsequent reference]:

(1) [f]oreign exchange swap and forward participants know their own and their counterparties’ payment obligations and their full extent of the exposure throughout the life of the contract, whereas the counterparties to other derivatives contracts do not.  (2) Moreover, foreign exchange swap and forward contracts have a very short average length and, therefore, relative to other swaps and derivatives, create significantly lower levels of counterparty credit risk.

(3) Settlement of foreign exchange swap and forward contracts requires the exchange of the full principal amount of the contract . . . whereas the payment obligations of most other derivatives are based on the incremental profit or loss on a transaction.  The physical settlement requirement distinguishes foreign exchange swaps and forwards from other derivates and contributes to a risk profile that is largely concentrated on settlement risk.

To which I say:

(1) So what? And, so misleading.  As the Treasury acknowledges on the prior page, the market value of the FX swap can change.  That’s what creates counterparty risk.  If the dollar crashes (despite Timmy!’s–Turbo Tax Timmy!’s, not South Park Timmy!’s–and Banana Ben’s assurances that it won’t which is primarily why I think it will), those long the dollar under swap agreements will suffer a big loss thereby creating a credit exposure for their counterparties.  That’s what matters.

What’s more, there are a lot of derivatives that are cleared that have this feature.  The counterparties to every physically settled commodity contract, and to every standard stock option, know exactly what the delivery and payment obligations are.  A buyer of a corn futures contract knows the seller has to delivery 5000 bushels of corn, and the seller knows exactly how much money the buyer has to deliver in return.  The buyer of a put on IBM knows exactly what he has to pay on exercise (the strike price times the number of shares), and the seller knows exactly how many shares he will have to deliver.  It’s variations in the market values on these contracts that create credit risk, and that’s the risk that the CME clearinghouse or the OCC take on. If the certainty of delivery and payment obligations meant clearing didn’t add value, why would these kind of products be cleared?  Why have they been cleared for decades?  Why?  Precisely because changes in market values may result in one party to a contract not performing on the fixed and known obligation, and thereby imposing a replacement cost loss on the counterparty.  So how is FX different in any way?

(2) This may be relevant on average, but there are many long tenor FX derivatives.   The NOPD states that 68 percent of FX derivatives mature in less than a week, and that 98 percent mature in less than a year.  This, plus the focus on CLS Bank (the FX settlement service), suggests that they are lumping in all FX trades in their analysis.  By doing so, Treasury mixes apples and oranges.  The logic of Frank-n-Dodd may still compel the clearing of the longer-dated products–which still make up a big chunk of change.  Interesting that the Treasury reports percentages without saying exactly what goes into the calculation, and doesn’t report the amount of principal at risk on longer dated contracts.

(3) Here’s the real whopper.  This actually means that an FX forward or swap has greater counterparty risk than other derivatives (e.g., interest rate swaps) of the same tenor and underlying volatility.   That’s because principal is at risk in a default of an FX swap, but it isn’t at risk in a typical interest rate, equity, or commodity swap.  To quote The Man when it comes to counterparty credit risk, Jon Gregory:

Foreign exchange exposures can be considerable due the high FX volatility driving the risk coupled to the long maturities and the final exchanges of notional required in most swap contracts.  The risk of these instruments is driven by a large final payment and thus the profile increases monotonically until the maturity of the trade (p. 85).

Gregory also has some charts that show FX swap credit exposures being larger than the exposures on IR deals.

All of which pretty much calls Bull! on the Treasury’s “argument” as to why differences between FX swaps and other swaps means that it’s not necessary to clear the former.  If anything, to a Frank-n-Dodd fan, the reverse should be true, at least for longer-dated swaps.  Similarly, the NOPD makes it clear that non-delivery settled forwards are not exempted–even though the lack of principal being at risk means that all else (e.g., tenor, currencies) equal NDSFs entail less counterparty risk.

So, if you believe that counterparty risk is best handled through CCPs–which you have to believe if you are a Frank-n-Dodd clearing mandate pom-pom squad member–you should think longer tenor FX swaps are especially important to clear.

But it gets better!  Or worse, depending on your point of view.  Treasury also argues that a clearing mandate would be burdensome because it could lead firms to eschew risk management.

Seriously!  Let me repeat that: Treasury also argues that a clearing mandate would be burdensome because it could lead firms to eschew risk management.

Don’t believe me?  Read it for yourself:

Commenters argue that additional costs associated with collateral, margin, and capital requirements required by the CCP would potentially reduce their incentives to manage foreign exchange risks.  Such additional costs borne by non-financial end-users could lead to lower cash flows or earnings, which would divert financial resources from investment and discourage international trade, thereby limiting the growth of U.S. businesses.

. . . .

In light of these and similar factors raised by the commenters, Treasury believes that mandating centralized clearing and exchange trading under the CEA for foreign exchange swaps and foreign exchange forwards actually would introduce significant operational challenges and potentially disruptive effects in this market which would outweigh any marginal benefits for transparent trading or reducing risk in these instruments.

So don’t these burdens exist in other markets?  If “additional costs associated with collateral, margin, and capital requirements required by the CCP” lead to less FX hedging, won’t they also lead to less interest rate, credit risk, and commodity price hedging?  If the reduction in risk management is such a serious concern in FX, why not in these other markets?

But we’re not done yet!  Get this: another justification for the exemption is that most FX derivatives are traded by banks either directly or on behalf of clients, and–wait for it–

[b]anks are subject to consolidated supervision, and supervisors regularly monitor their foreign exchange related exposures, internal controls, risk management systems, and settlement practices.

In case you didn’t catch that, FX derivatives should be exempted from clearing because:

Banks are subject to consolidated supervision, and supervisors regularly monitor their foreign exchange related exposures, internal controls, risk management systems, and settlement practices.

Here’s more:

The predominant participants in the foreign exchange swaps and forwards market are banks which have long been subject to prudential supervision.  In fact, nearly all trading within the foreign exchange market involves bank counterparties.  Roughly 95 percent of foreign exchange trading occurs between banks acting in the capacity of either principal or agent.  Compared to non-bank entities, banks have distinct advantages to provide the liquidity and funding necessary to conduct foreign exchange swaps and forwards, which involve the exchange of principal, rather than variable cash flows.  In conjunction with providing the liquidity and funding needs to conduct these transactions, banks are uniquely qualified to have access to CLS to settle transactions on a real-time basis, and thereby meet the payment and short-term funding needs of the end users.

Prudential supervisors regularly monitor the activities, exposures, internal controls and risk management systems of these banks.  In order to meet safety-and-soundness requirements, banks have implemented monitoring systems, limits, internal controls, hedging techniques, and similar risk-management measures.  Counterparty credit risk management is a fundamental issue for banking supervisors and is extensively addressed in bank supervisory guidelines as well as under the Basel Accords.

So let me make sure I have this right:  bank dominated markets need not be cleared because banks are subject to rigorous prudential regulation.

But wait a minute.  The whole point of Frank-n-Dodd was that derivatives trading was uniquely dangerous for banks, and clearing mandates were necessary to reduce the risk of the derivatives-induced collapse of a too big to fail bank, all because prudential oversight hadn’t worked and couldn’t be relied on. Moreover, whereas Dodd-Frank contemplated the exemption of non-bank firms from clearing mandates, margining on non-cleared trades, and capital requirements, the Act forces banks to clear standardized products, and to collateralize non-cleared trades.  All in the name of reducing systemic risk and shifting counterparty risk from banks to CCPs (which are capitalized by banks, but let’s ignore that little detail).

In order for this to make any sense whatsoever, it must be the case that prudential regulation is insufficient to reduce derivatives-related systemic risks.  But the NOPD relies heavily on the adequacy of prudential regulation to justify exempting FX swaps from the clearing mandate.

I ask, in all seriousness: if dominance by banks that are prudentially supervised implies that clearing is not necessary, why are CDS subject to a mandate?  After all, they’re bank dominated.  And don’t banks have “distinct advantages to provide the liquidity and funding necessary to conduct” other kinds of swaps?

F. Scott Fitzgerald said “the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.”  You have to be a genius and hold Frank-n-Dodd and the Treasury NOPD in your mind simultaneously, because they are definitely opposed ideas.  Every substantive justification for the exemption in the NOPD is diametrically at odds with the justifications for the Dodd-Frank clearing mandates.

But the fun isn’t finished!  The NOPD’s rationalization for exempting FX from SEF requirements is also entertaining.  I quote:

Foreign exchange swaps and forwards already trade in a highly transparent market.  Market participants have access to readily available pricing information through multiple sources.  Approximately 41 percent and 72 percent of foreign exchange swaps and forwards, respectively, already trade across a range of electronic platforms and the use of such platforms has been steadily increasing in recent years.14  The use of electronic trading platforms provides a high level of pre- and post-trade transparency within the foreign exchange swaps and forwards market.  Thus, mandatory exchange trading requirements would not significantly improve price transparency or reduce trading costs within this market.

I’m not disputing any of this, but  just think of all the questions that this should raise in the minds of those who argue that it is necessary to force open electronic trading on swap market participants–but which it evidently hasn’t.

Recall that the NOPD makes a big deal out of the fact that FX is bank-dominated–dominated, in fact, by the same banks that dominate IR, credit, and equity derivatives trading.  In IR, credit, and equity, the argument goes that banks have actively fought pre- and post-trade transparency and electronic execution in order to protect their market power.  So . . . why didn’t they try and succeed in doing that in FX?  To create a natural experiment?  I kinda doubt that.

Maybe–just maybe–it’s because trading structure is endogenous and reflects the nature of the instruments traded and the firms that trade them, and there are enough differences across markets to make different trading structures optimal.  Maybe–just maybe–market structures and trading mechanisms have evolved to match in a discriminating way the characteristics of instruments and participants.

I don’t know that’s definitely the case, but it’s certainly a possibility, and it makes economic sense.  It’s certainly a more plausible explanation of cross sectional variation in trading mechanisms than the Treasury or SEF mandate boosters offer–because they don’t offer any.  Another F. Scott Fitzgerald moment here, apparently,  for the very facts in the Treasury NOPD undercut the narrative used to justify SEF mandates that Treasury has advocated strongly in the past.

Of course I seriously doubt that the espousal of completely contrary positions on all these matters is a reflection of first rate intellects at work.  Nor is it an exercise in eristics.  Instead, it is a symptom of complete intellectual muddle and confusion, blended with politics and rent seeking. Timmy!, Dodd, Frank and all the other Sorcerer’s Apprentices have no real understanding of the economic forces they have unleashed, and what will result.  The FX swap exemption is a first order issue, and the completely intellectually discreditable way with it has been handled provides a very sobering preview of how derivatives market regulation generally, and CCP regulation in particular, is likely to be carried out in the future.  If they can’t think carefully and seriously about this, what can they think carefully and seriously about?  Are they incapable of self-reflection?  Of embarrassment?  Do they not see the glaring contradictions between the NOPD and the entire rationale for the Dodd-Frank Act that gave birth to the NOPD in the first place?

I’ve said it often before, but it still bears repeating.  Regulators create systemic risks because they act on the entire system, and there are few of the kind of ameliorative feedback mechanisms that work in markets.  I fear that the NOPD is a harbinger of the kinds of regulation- and regulator-created systemic risks that will haunt derivatives markets for years to come.

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  1. [...] As usual, the Streetwise Professor has a good analysis of the determination, worth reading here [...]

    Pingback by FX Swaps & Fwds EXEMPT from Dodd Frank – OFFICIAL! « SerenDiPity — May 1, 2011 @ 5:47 am

  2. An interesting an valid summary – misses out one interesting argument against the FX exclusion. Given the penchant for regulating to resolve the last crisis, the enormous debt burden of many sovereign western economies, the fractures in the Euro and the potential down-grading of the US and the rise of the Chinese economy, there must be a significant potential for the next financial crisis to be FX based, but of course we wouldn’t want to pre-regulate would we.

    Comment by Kerry Evans — May 1, 2011 @ 10:25 am

  3. Hi Craig,

    Great post, and always a pleasure to read your thoughts!

    I have question for you regarding non-deliverable forwards (NDFs). Under Dodd Frank/CFTC, NDFs will be subject to central clearing, and trade reporting. But given that the NDF market is characterized by punctuated/discontinuous liquidity, what in your opinion is the likelihood of mandatory trading of NDFs on SEFs?

    I have taken a stab at this on my blog, but please don’t tear it apart; it’s not a rigorous analysis like your own!



    Comment by Paul — May 1, 2011 @ 2:46 pm

  4. @Paul–Thanks so much. Your post just came up on my RSS. I’ll read it in a bit. Re your question, it seems nuts to require trading of NDFs on SEFs, and clearing them. The features that you mention, namely poor liquidity, makes them difficult to clear and likely unsuitable for SEF style trading too. But of course the fact that it makes no sense probably means that SEF trading and clearing will be mandated.

    It’s also strange that swaps get a pass but options don’t. The whole Treasury NOPD is just bizarre.

    The ProfessorComment by The Professor — May 1, 2011 @ 4:00 pm

  5. Professor-

    I, too, am SHOCKED that political considerations are ruling the debate on derivatives regulation and that economic considerations are seemilgly being given short shrift.

    Dodd – Frank is a pig and the regulations are simply lipstick. The financial meltdown was caused mostly by regulators failing to have in place adequate market surveillance to allow them to understand the risks building up within the system and the failure of regulators to properly interpret the information being presented to them at the time. As long as those in power to enact financial reforms refuse to accept their responsibility for past regulatory failures and to reform the regulatory processes, no new regulations will make our financial system any more capable of weathering future systemic shocks.

    My take on Dodd – Frank implementation is that those crafting the regulations needed to implement the Act realize the task if far beyond their capabilities and implementation of new regulations will even be more problematic. We seem to be quickly moving to a political face saving phase where political interests must be preserved, unintended consequences of new regulations can be minimized and a hollow victory can be claimed going into the 2012 election cycle.

    The goal of regulatory reform was, in part, to protect against banks being “too big to fail” yet, with the various failures/ mergers of major banks, financial institutions today are far larger then they were going into the crisis and the taxpayers are still on the hook for any failures. Derivatives reform is quickly devolving into political considerations creating one class of economic winners and one class of economic losers. Expect it to get worse before the political leadership extracts itself from an intractable situation and allows the system to remain largely ungoverned by a group of incompetent regulators.

    Comment by Charles — May 2, 2011 @ 8:09 am

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