Financial Regulation of Forex Forwards and Swaps – Eight Questions and One Opinion
The Dodd-Frank Wall Street Reform and Consumer Protection aims at making the financial system safer. The list of provisions is long (the law has 849 pages). One controversial issue is the treatment of foreign exchange forwards and swaps: They will be subject to Dodd Frank requirements on trade reporting and business conduct standards, but not to central clearing and exchange requirements. Furthermore, the exemption would not extend to other foreign exchange derivatives such as fx options, currency swaps and non-deliverable forwards. In the debate, several questions arise.
At the beginning, let us agree on some definitions.
A foreign exchange spot transaction is an exchange of two currencies for settlement within two business days.
An outright foreign exchange forward transaction is an exchange for more than two business days. The counterparties agree on periods stretching days or months or even years into the future with the exchange rate fixed at the time the transaction is agreed.
A foreign exchange swap is an exchange of two currencies for a specific period with a reversal of that exchange at the end of the period. A foreign exchange swap consists either of a combination of a spot and a forward leg or of two forward trades with different maturities.
Non-deliverable forward foreign exchange contracts (NDFs) are used to hedge exposure or speculate on a move in a currency where local market authorities limit such activity. NDFs do not require physical delivery of currencies at maturity. Typically they are settled in an international financial center in U.S. dollars. International banks both take positions in NDF currencies and act as market makers for customers. Differences between onshore currency forward prices (where available) and NDFs arise because of capital controls and may signal changes in market expectations or perceived risks.
Currency swaps are a combination of interest rate and currency instruments. They consist of an exchange of streams of interest payments in different currencies for an agreed period of time and of principal amounts in different currencies at a pre-agreed exchange rate at maturity.
Foreign exchange futures are standardized forward contracts traded on an exchange with the exchange’s clearing house becoming the opposite party to both buyer and seller once a trade has been completed.
Currency options are contracts sold for a premium that give the buyer the right, but not the obligation, to buy (in case of a call option) or sell (put option) a specific quantity of a currency at a specified price.
The main questions arising in this context are
- Do forwards and swaps differ from other financial derivatives?
- Do forwards differ from spots?
- Are forward and swap markets transparent?
- Are forward and swap markets efficient?
- Are forwards and swaps less risky than other derivatives?
- Do risks differ in forex spot and forward markets?
- Do forwards and swaps need a central counterparty?
- Would the financial system become more stable by including fx forwards and swaps in Dodd Frank?
Do forwards and swaps differ from other financial derivatives?
Yes and no. Some say they are different because
- in being typically physically settled by delivery of the underlying currency (and not of anything else) they are more similar to physically-settled commodity forwards;
- markets are transparent and efficient and
- they do not present the same sort of risk because there is a well-developed settlement system.
Others stress the similarities between fx forwards and swaps and other financial derivatives:
- foreign currency derivatives and interest rate derivatives are closely correlated. Both respond to financial variables such as interest rates of the underlying currencies. Exempting fx forwards and swaps would create a regulatory loophole since they can be structured to achieve similar purposes as interest rate derivatives.
- Risk dynamics in fx spot and forward markets differ.
- The current infrastructure is adequate to adress settlement risk in spot market trading, but not in markets for longer maturities.
In my view, the most important difference is between OTC and exchange-traded instruments:
The fx market is largely a wholesale market, a money market in foreign currency. It is the biggest international financial market with an estimated daily turnover of 3,981bn US dollar in April 2010. By comparison: Total issue of international debt securities such as bonds and notes amounted to $26,751 bn. World annual exports in 2010 were $14,950 bn.
The market is called “footlose” meaning that there is no physical market place. This poses a particular challenge to regulators and supervisors requiring a high degree of cooperation and flexibility.
As a rule, as in national money markets trades are highly standardized. The market is highly liquid and transactions are very large with traders buying and selling the equivalent of millions of US dollars in a few seconds. Standardization is also a characteristic of exchange-traded derivatives which serves as one argument of proponents to include forex trades in Dodd Frank. However, above all, in forex markets standardization is an indispensible prerequisite of speed and liquidity – no time to tailor trades to individual needs – and is not intended to serve customer protection and convenience.
Do forwards differ from spots?
No. If a derivative is defined as an asset that derives its value from another asset, then both spot and forward trades are in this category. The difference is between short and long-dated trades and is a market convention.
Both spots and forwards are leveraged instruments. The potential return of trades is not on notional amounts but on margins. Due to established customs, when a currency is bought or sold spot or forward, no accounts are debited or credited, that is no money actually changes hands, until settlement, and it is only the difference, i.e. the gain or loss, that has to be paid and settled. In combination with forex swaps both instruments offer a high degree of flexibility and profitability in taking positions which is one explanation for market size:
Dealers wanting to hold an open position for an undefined short time period buy or sell the currency spot or forward and then, when expectations do not fulfill in time or prospects continue to look favourable, prolong the position by a swap. As the Bank for International Settlement once put it: “...foreign exchange swaps are often initiated to move the delivery date of foreign currency originating from spot or outright forward transactions to a more optimal point in time. By keeping maturities to less than a week and renewing swaps continuously, market participants maximise their flexibility in reacting to market events.”
Spots and forwards are closely related and tied to interest rates in different currencies through what is called interest rate parity: The difference between interest rates in two currencies always equals the swap rate which is the difference between spot and forward rate. Deviations from interest rate parity would instantaneously be eliminated by classic riskless arbitrage and since this mechanism is known to all parties, normally they would not happen. It needs to be stressed that this reaction is an automatism. In this case the markets do not “respond” to interest rates in an active and deliberate manner.
Are forward and swap markets transparent?
No. The foreign exchange market is largely an unknown quantity. There is no way to state how much bigger it is than other markets for financial derivatives. The only coherent source of information on market volumes is a survey conducted in April every three years by central banks and monetary authorities of countries with large and medium-sized foreign exchange markets under the auspices of the Bank for International Settlements. Regional surveys which are conducted more often differ in methodology and results. All those represent only a fraction of total foreign exchange business worldwide and allow only a momentary glimpse at a market which is permanently in motion and where actors, amounts, and types of transactions can vary considerably from month to month.
Participants are asked to report all arm’s-length trades which means trades in which the dealer is indifferent as to the counterparty. For example, not included are in-house deals and deals with other offices of the same institution. Excluded are also deals of large globally operating firms within private corporate networks “bypassing” banks.
Are forward and swap markets efficient?
Presumably not. The market is highly concentrated and there is a long-term trend towards even greater concentration in a few global banks. In 2010, in the UK, the single largest centre of foreign exchange activity, the combined market share of the ten institutions with the highest turnover accounted for 77%, the share of the top twenty was 93%. End of the 1990s, the numbers had been 40% and 69% respectively.
True, high liquidity ensures that trading takes place 24 hours a day and prices on screens are public information. However, the process of price determination is far from clear. Instead of consistent concepts of demand and supply, the market is driven by rumours and expectations, the influence of individual players is unknown and there is a bewildering variety of competing trading methods, motives and beliefs. Observers and authorities debating market regulation have no idea how to distinguish between “good” and “bad” trades, or between unwanted “bets” (i.e. speculation) and welcome commercial transactions.
Are forwards and swaps less risky than other derivatives?
Yes and no, depending on the kind of risk, on leverage and on institutional factors such as the degree of standardization, availability of hedges and clearing and settlement procedures.
On the one hand, forex markets are relatively straightforward. There is an agreement to exchange cash flows in two different currencies in a given manner on a given date. Prices are readily available, cash flows are readily fungible and economic risks are easy to net and to offset.
On the other hand, there are special risks explaining why the market is highly concentrated. Volatility is high. As a rule, fluctuations in exchange rates are more erratic than in interest rates or prices of other financial instrument and profits are made by exploiting even smallest price movements. Traded amounts are high and great financial strength is required to continuously make two way prices in multiple currency pairs in different trading centres. Risks (but also rewards) can be even higher in trading in emerging market currencies as the experience of recent financial crises demonstrates.
Do risks differ in forex spot and forward markets?
Generally, on the level of the individual firm a distinction is made between
- credit risk, which is the likelihood of counterparty default,
- market risk, which is the danger of losses from adverse movements in prices,
- liquidity risk arising from the cost or inconvenience involved in the unintended unwinding of a position,
- legal risk, which includes the danger that contracts may not be enforced and
- operational risks related to running the business.
Some of these risks rise with duration and in this respects, forwards and spots differ.
For the global economy some risks are more important than others bearing additional dangers such as systemic risk or the risk of contagion where individual failure may trigger a chain reaction which then threatens the stability of the whole financial system. One aspect of systemic risk is settlement risk.
Dodd Frank has a strong focus on settlement risk which is the risk that, having paid away the currency being sold, a counterparty defaults and does not pay for the currency bought. The best-known example of this kind of risk is Herstatt. Here is another one (taken from Reszat 1997, chapter 7):
When Barings Brothers collapsed end of February 1995 one of the immediate effects widely unnoticed by the broad public was the problems emerging in the ECU clearing system which threatened to block the settlement of ECU50 billion of payments although Barings itself was involved in less than one per cent of those payments. On 24 Friday that month, a clearing bank had sent a payment order of a comparably small amount in ECU to the Baring correspondent with value date Monday, 27 February. When the desaster became known on Saturday, the clearing bank which tried to cancel the order had to learn that this was not possible under the rules of ECU-Clearing. On the other hand, the receiving bank was not allowed to reverse the transaction either. Thus, at the end of the day the clearing bank had a net liability which threatened to block the clearing of all fourty-five banks participating in the system. Under time pressure the bank agreed to cover the position by taking a loan from a bank with a net selling position. Otherwise settlement at the end of the day would have become impossible, clearing between all banks would have had to be cancelled and no payments whatsoever would have been settled between the fourty-five institutes on that day. The situation would have become extremely difficult, not only for the banks but also for their clients in the ECU markets and beyond.
The argument for an inclusion of forex forwards and swaps in Dodd Frank is that while the existing CLS Bank International is adequate to address settlement risk settling transactions on a “payment vs. payment” basis it does not address counterparty credit risk. Payments from one party to another flow through CLS and are only released after both payments are received. However, what would happen if one party defaults? In this case CLS would return to the counterparty the currency it is selling.
On the other hand, including forwards and swaps in the Dodd Frank central clearing and exchange requirements actually would be an alternative. Standing between buyers and sellers – and in effect, becoming the buyer to all sellers and the seller to all buyers – a central counterparty (CCP) could help maintain market liquidity in stressed market conditions.
However, there are several drawbacks which have been discussed in detail elsewhere. An important one is that any regional approach risks fragmenting the global market thereby limiting possible benefits. One prerequisite for a central counterparty to work effectively would be a respective international regulatory framework. The footlose nature of trades explains why so far central banks shun to establish an official CCP solution and aimed for a private sector arrangement, the CLS, which is owned by the foreign exchange community.
Do forwards and swaps need a central counterparty?
Given the record of CLS during recent crises the answer is no. For example, as forex transaction volumes grew markedly after the Lehman bankruptcy in September 2008 CLS settled a peak volume of 1.5 million instructions on a single day. Lehman operated in over 40 countries through more than 650 legal entities outside the US posing an extraordinary challenge to the system. During one single week of 15 September CLS settled a total of $26.5 trillion and 4.4 million instructions without incident.*
Would the financial system become more stable by including fx forwards and swaps in Dodd Franks?
No. There is a functioning settlement system for forwards and swaps. Dodd Frank is a regional approach that would include only a small part of the market. There can be no doubt that actors would try to find ways to circumvent the official rules – with the danger of disrupting the well-functioning whole.
In general, economists would hesitate considering a market as highly concentrated as the global foreign exchange market to be efficient. In my view, they would be right. The market is very liquid, prices are readily available, and trading is fast. On the other hand, transparency with respect to trading motives and the forces behind market dynamics is low and activities are often perceived as excessive resulting in unwanted outcomes. However, this is not a settlement problem. Stronger regulation in order to prevent currency crises and, in particular, to shelter emerging economies from market turbulences threatening economic successes and growth prospects were highly desirable but they would call for another approach. Above all, this would have to be an international concept balancing between the requirements of the market and the demands of the global economic community.
* The value of settlement obligations is a multiple of market turnover. For example, a spot or forward trade has two currency legs (one for each currency) while a swap has four (two for the spot trade and two for the forward trade).