FTT, Dodd Frank and forex stability
On January 30, 2013, the Bank of England (BOE) released the latest semi-annual FX turnover survey results for the UK for October 2012. Similar surveys had been conducted at the same time by
– and the Australian Foreign Exchange Committee.
The following table presents an overview of volumes and annual changes:
Two aspects are remarkable. One is the clear, and partly massive, overall decline of trading volumes in spot markets. Secondly, this decline is not matched by developments in foreign exchange swap markets. There were modest reductions in swap trading in the US and the UK (possibly reflecting banks’ cutback of proprietary trading in reaction to the financial crisis and in face of looming financial regulations). But elsewhere, swap volumes have risen – in Canada and Japan even by over 20 per cent.
In all leading places, except New York, swaps have long outweighed spot trading. One possible explanation is a rising demand for hedging against adverse market movements in times of increased financial turbulence. Another, in my view more plausible one in this interbank wholesale market, is search of profits. In times of meagre returns elsewhere, and growing public criticism, this very traditional, straightforward market segment outside the limelight which, as I argued elsewhere, is characterised by high concentration, flexibility and volatility and, accordingly, high prospective returns, is a lucrative niche for big players.
These developments raise the question what will be won by recent regulations in the United States and Europe. In both parts of the world, new rules for foreign exchange trading are in course of implementation – in the US they come as part of the 2010 Dodd-Frank financial reform, and in the European Union they are included in the concept of the financial transaction tax (FTT). In both cases, some foreign exchange market segments have been exempted for various reasons – with possibly unintended consequences for financial market stability.
In the EU, the financial transaction tax will come into force in January 2014. Participating countries are Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia and Spain.
According to the 2011 draft Directive – the basis upon which the countries wished to proceed – spot trading will be exempt from the FTT. Foreign exchange swaps and forwards will be included as cash products, with a minimum tax level of 0.1 percent, and forex options will be treated as derivatives (with a minimum tax of 0.01 percent on notional value). As for foreign exchange swaps, only the forward leg will be taxed.
In the United States, on November 16, 2012, the Department of the Treasury confirmed that both foreign exchange swaps and forwards should be exempted from certain requirements of the Dodd Frank Wall Street Reform and Consumer Protection Act such as the trade execution, mandatory clearing and margin requirements. But, they are still subject to Dodd-Frank’s reporting requirements and business conduct standards. Furthermore, the exemption does not apply to foreign-exchange options, currency swaps and non-deliverable forwards. Foreign exchange spot trades, on the other side, are not swaps under the Dodd-Frank definition and will not be regulated at all.
In both cases, the explanations given for the special treatments do not live up to market reality.
According to the European Commission:
“Through the FTT, the financial sector will properly participate in the cost of re-building Europe’s economies and bolstering public finances. The proposed tax will generate significant revenues and help to ensure greater stability (my emphasis) of financial markets, without posing undue risk to EU competitiveness.”
The tax will apply to financial transactions with at least one of the parties being established in a participating EU member state and either or both parties being a financial institution. Beside foreign exchange spot transactions omissions include loans, deposits, emissions, credits and commodities (except commodity derivatives). Excluded are also most consumer financial products such as insurance contracts, mortgage lending and consumer credit.
Apparently, the idea behind these exemptions is to spare end users, consumers and nonfinancial firms as much as possible with the aim not to unduly hurt the “real” economy while skimming off profits made in the financial industry, and, at the same time, making the financial system more stable.
The aim of Dodd Frank, too, is market safety and stability. The framework was developed in reaction to the financial crisis of 2007-2010. Pete Karabatos summarises its major components:
– Consolidation of regulatory agencies, new oversight council,
– regulation of the financial markets, increased transparency,
– strengthened investor protection,
– new crisis resolution tools including the ability to wind down bankrupt firms,
– additional measures for adopting international standards and for accounting and tightened regulation of ratings agencies,
– separation of proprietary trading activities from banking activities, and
– new regulation for cross-border electronic transfers.
Title VII of Dodd-Frank deals with “Wall Street Transparency And Accountability” and regulates all those Over-the-Counter (OTC) derivatives the law is defining as “swaps”. Foreign-exchange swaps and forwards are not in this category as, according to the U.S. Treasury Department, they “already have high-levels of transparency and risk management” (Brush). Furthermore, the fact that about 41 per cent of forex swaps and 72 per cent of forex forwards in the US trade on electronic platforms is said to ensure a “high level of pre- and post-trade transparency” (Nasiripour and Ross).
Here we have the phenomenon that in the two regions with the biggest global centres of foreign exchange trading views apparently differ about the nature of the products traded – which is all the more remarkable as these are among the oldest, plainest and most standardised financial products worldwide.
There seems to be unanimity about spot trading which is exempt in both cases. Obviously, this is seen as a lesser threat to financial market stability than forwards and swaps. (Foreign exchange spots are also outside the scope of direct regulation by the FSA in the UK and the European Union’s MiFID.)
The focus of Dodd Frank and the European FTT is on longer maturities and their inherent speculative potential. Foreign exchange forwards and swaps are met with distrust in both parts of the world. But in the official US view they are harmless compared to other derivatives where markets are regarded as less transparent and risks less well-managed, and regulators settle for reporting requirements for better financial supervision.
In contrast, in Europe, forex forwards and swaps are treated even harsher than other derivatives which have a much lower tax rate. The motives are not clear. The wish to maximise tax revenues may play a role. As I argued elsewhere, the alleged aim to throw sand into the wheels of financial speculation has not much credibility in times of empty public coffers.
Attitudes of both sides are questionable. In order to see what is wrong with these arguments we have to recall how markets work. Let us start with definitions.*
* Those who are familiar with my earlier article on Financial Regulation of Forex Forwards and Swaps may wish to skip the following.
A foreign exchange spot transaction is an exchange of two currencies for settlement within two business days. This includes intraday settlement as well as overnight trading and tom next.
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 or spot trades with different maturities.
The foreign exchange market is largely a wholesale market, a money market in foreign currency. As a rule, as in national money markets trades are highly standardised. 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.
In principle, foreign exchange forwards do not differ from spots. 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 very short and renewing swaps continuously, traders are highly flexible in reacting to market events.
In contrast to a widespread view, foreign exchange forward and swap markets are not transparent. 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. The above-mentioned 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.
Will the new regulations increase transparency? So far, for the central bank surveys 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.
Under the new regulations there will be both more and less information. On the one hand, both Dodd-Frank reporting requirements and the EU tax exclude spot trades. They will remain largely intransparent. On the other hand, in principle, both concepts seem not to refer to the “nearness” of counterparties. Leaving problems of practical compliance aside, this could bring an increase of transparency.
Under Dodd-Frank, so far 65 entities were required to register as swap dealers with the supervisory authority, the US Commodity Futures Trading Commission (CFTC), representing nearly 40 banks. There is a $8bn notional threshold requiring registration which the 65 entities crossed in less than three weeks after implementation. Foreign exchange reporting will start in the coming months. Beside banks, other businesses will have to register as well as soon as they cross the threshold. Examples are Cargill, BP and Royal Dutch Shell (Nasiripour and Meyer).
In contrast, the European FTT will be restricted to financial transactions where at least one of the parties is a financial institution. Trades of nonbank businesses without involvement of a reporting financial institution will remain excluded.
Will the new rules for foreign exchange trading and reporting contribute to greater financial stability? More information may improve the conditions for financial supervision. But, given that in both cases important market segments and actors are excluded the effect may be limited.
Forwards and swaps cannot be regarded isolated from spots. The question whether trade will slow down as a consequence of recent regulations, for example, will largely depend on their effect on spot markets. In principle, as mentioned before, the distinction between spots and forward trades is a market convention. It may not pay, as Oliver Wyman found out, to replicate a seven day swap with a series of spot transactions. But both instruments allow forward-looking trades, and if one of them faces obstacles such as a tax, or only reporting requirements, market participants’ focus may shorten and activities may shift to the other.
As the following figure shows, the bulk of global foreign exchange trading is already of very short-term nature. Regrettably, the statistics do not provide a breakdown of the shortest interval of up to seven days giving no information about the presumably substantial share of spot and intraday trades.Triennial Central Bank Survey, Report on global foreign exchange market activity in 2010, December 2010, p. 11.
As financial institutions make efforts to avoid taxation, the European FTT may in particular cause a shortening of maturities within this interval, thereby shifting the weight to the least transparent and least regulated market segment. Whether the Dodd Frank reporting requirements are a great enough deterrent to reinforce this tendency remains to be seen. Contrary to the legislators’ intentions, the result may be not a deceleration, but an acceleration of market activity. At a time of major disruptions, when in Europe the experiment of a common currency is about to fail, the Chinese yuan is challenging the dominance of the traditional leading currencies and worldwide a currency war is looming this prospect is rather worrying.