Swaps
Foreign exchange swaps appear to be about to emerge unscathed from the flurry of new regulation prompted by the recent financial turmoil.
By Gordon Platt
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Foreign exchange swaps, which have long been traded in the over-the-counter market, have become extremely popular with interbank dealers, as well as with traders and corporations. In fact, FX swaps are considered so crucial to the smooth functioning of the financial markets that they have been given a special exemption from a proposed US regulatory crackdown on OTC derivatives.
Not to be confused with cross-currency swaps, FX swaps have two legs to stand on: a spot trade, or purchase for immediate delivery, and a forward transaction. These contracts for the simultaneous purchase and sale of identical amounts of currency with the same counterparty are the most popular form of trading in the FX market. One currency is swapped for another for a period of time and then swapped back. The cost is determined by the interest rate differential between the two currencies.
FX swaps are widely used for managing liquidity and shifting delivery dates, as well as for hedging, speculating, taking positions on interest rates and other purposes, according to the Federal Reserve Bank of New York. These swaps also provide a way of using the FX market as a funding instrument and an alternative to borrowing and lending in offshore markets. They are the main instruments used for limiting currency risk in foreign investing through the use of currency-overlay programs used for selectively placing and removing hedges.
Of the $3.2 trillion daily average turnover in the foreign exchange market in April 2007, more than $1.7 trillion, or 53%, comprised FX swaps, according to the most recent triennial survey compiled from central bank data by the Basel-based Bank for International Settlements. The minimum size of an FX swap is usually more than $1 million, and most interbank swap trades are considerably larger than that.
Crisis Roils the Swaps Market
While the FX market continued to function throughout the financial crisis, BIS researchers Naohiko Baba and Frank Packer have documented a spillover of the turmoil in the money markets to FX swap and cross-currency swap markets. They found that the use of swap markets by non-US financial institutions to overcome dollar-funding shortages caused interest rate deviations that impaired liquidity in the markets.
Global funding pressures were evident in the virtual shutdown of the FX swap market after the bankruptcy of Lehman Brothers on September 15, 2008, and the Federal Reserve’s announcement of a bailout package for AIG the next day, Baba and Packer wrote in a BIS working paper published in July 2009. “Dealers reported that bid-ask spreads on FX swaps increased to as much as 10 times the levels that had prevailed before August 2007,” they wrote.
European financial institutions, which were struggling to obtain funding in the unsecured cash markets, turned to the effectively collateralized FX swap market as a primary channel for obtaining dollar funding. To address the problem, the Fed authorized a more than twofold increase in swap lines to the European Central Bank and the Swiss National Bank. At the same time, new dollar swap lines were opened with the central banks of Japan, England and Canada. As the financial crisis continued, additional swap lines were later opened with Australia, Sweden, Denmark, Norway and New Zealand, and existing lines were further expanded. Many emerging market economies were also brought into the swap lines, including Brazil, Mexico, South Korea and Singapore.
Meanwhile, credit default swaps and other derivatives unrelated to foreign exchange have been widely blamed for contributing to the financial crisis. On August 11 this year, the US Treasury Department released a 115-page draft of the Over-the-Counter Derivatives Market Act of 2009 (OCDMA), designed to comprehensively regulate OTC derivatives. The administration proposed moving all standardized OTC products onto regulated exchanges. It is also seeking to curtail non-standardized, or customized, derivatives by imposing higher capital and margin requirements on them.
The Treasury’s proposed legislation excludes FX swaps and forwards, saying these transactions are not considered OTC derivatives under the generally prevailing market conventions. It said these transactions have important economic differences from derivatives: They are generally very short term, have high turnover ratios and involve real physical exchanges of principal.
The exclusion of foreign exchange swaps and forwards from the definition of swaps effectively excludes these contracts from additional regulation under the OCDMA, according to an analysis by the law firm Sullivan & Cromwell. As currently written, OCDMA could limit or prohibit end-user access to customized swaps, the report says. Unless the swap is used precisely to hedge market or credit risks under generally accepted accounting principles (GAAP), any customized swap transaction will be subject to higher margin and capital requirements, creating a significant cash-flow issue for commercial entities, the law firm says.
Swaps Face Uncertain Future
Responding to complaints from a wide range of corporations that the proposed reforms would make it harder to manage risk using tailored financial products, Representative Barney Frank, a Democrat from Massachusetts, who chairs the House Financial Services Committee, released a revised bill in October that would not require OTC derivative trades to go through an exchange and a central clearinghouse if one of the counterparties to the swap is not a dealer or major market participant. Thus, companies could escape the new regulations if they were using swaps to manage business risks.
Gary Gensler, chairman of the Commodities Futures Trading Commission, says Frank’s revised bill would open too many loopholes. “I believe it is best for a clearinghouse that is managing its risk to determine if a particular product should be cleared,” he said at a hearing on the bill on October 7. Gensler also raised concerns that the exclusion of FX swaps might encourage market participants to re-engineer currency and interest rate swaps to make them more like FX swaps or forwards.
The Senate has yet to take up the issue, and it remains uncertain if broad financial market regulatory reforms can be passed this year, particularly with healthcare reform and a major climate-change bill vying for legislators’ attention.
Meanwhile, the CME Group, the largest futures and options exchange, has a vision of becoming a major central counterparty clearer for OTC markets, including FX swaps, says Craig Donohue, chief executive of the CME. “As the events of the last 12 months attest, structural risks such as counterparty risk and regulatory reform are creating yet another wave of change in global FX markets,” he told an industry conference in Chicago.
The CME is expanding its Clearport clearing system from the energy and metals markets into foreign exchange. “We are developing a flexible, secure clearing service for the global OTC foreign exchange market,” Donohue says. “This will combine the flexibility and user-choice of the OTC market with the risk management benefits of a clearing house,” he points out.
“Throughout the crisis, we have been reminded that OTC markets are complementary to and have a symbiotic relationship with exchange-traded markets,” Donohue says. “Therefore, we do not favor artificial and prescriptive government action, such as mandatory clearing,” he says.
LCH.Clearnet, which was formed by a merger of the London Clearing House and Clearnet and serves London and Continental exchanges, is also considering a move into clearing foreign exchange trades.
CLS, a bank-owned currency-settlement system introduced in 2002, settles more than half of all foreign exchange trades. Seventeen major currencies are eligible for settlement through the CLS system.
