Risk of Default in FX Swaps High

Professor argues for no exceptions in processing trades through clearinghouses.

The risk of investor default in the foreign-exchange swap and forward markets is large enough to justify processing trades through clearinghouses, Stanford University professor Darrell Duffie said.

The U.S. Treasury Department in April proposed exempting the trades from most rules required by the Dodd-Frank Act, in part because default risk “is relatively small.” The law requires foreign-exchange swaps and forwards to be subject to clearing and trading rules unless Treasury decides the derivatives are different from other types of swaps.

Banks and investors would have been owed $925 billion as of June 2010 if all foreign-exchange swaps and forwards had been settled, before the effect of netting positions, Duffie wrote in a comment submitted to the Treasury Department. That’s more than the amount for equities or commodities swaps and about 60 percent of the number associated with credit-default swaps.

“There’s as much reason to clear this class as any other class of derivative,” Duffie said in a telephone interview today. The market, which consists of all the largest global banks, for foreign-exchange forwards and swaps is $25.6 trillion in notional value, according to the Bank for International Settlements.

“If those were to suddenly revalue, we don’t know whose ability to pay is threatened,” Duffie said.

‘Critical Gap’ The absence of publicly available data on the average life of currency forwards and swaps is “a critical gap in our knowledge,” wrote Duffie, who serves as a member of the Federal Reserve Bank of New York’s financial advisory roundtable.

“Equity and commodity derivatives were not exempted from the clearing and other requirements of the Dodd-Frank Act,” Duffie wrote. “Additional analysis, if carefully conducted, would likely reveal that such exemptions are inappropriate.”

Foreign-exchange contracts were the largest source of trading revenue for banks’ derivatives and cash positions in 2010, according to the U.S. Office of the Comptroller of the Currency. U.S. commercial banks recorded $9.1 billion in revenue on trading of foreign-exchange derivatives.

Clearinghouses, which are capitalized by their members, are meant to reduce systemic risk by absorbing and sharing responsibility if a member defaults on its payment obligations. They use daily margin calls to keep accounts current and provide regulators with access to prices and positions.

Comment Period A coalition of 20 firms, including Deutsche Bank AG, Bank of New York Mellon Corp. and UBS AG, asked Treasury Secretary Timothy F. Geithner to grant an exemption for swaps and forwards in a November letter. The Treasury proposal to exclude the trades from being routed through clearinghouses is now in its 30-day public comment period.

Assistant Treasury Secretary Mary Miller, who helps oversee financial markets, said April 29 that foreign-exchange swaps and forwards, known as the FX market, present significantly less counterparty credit risk than other derivatives and there are procedures to mitigate risk.

“Central clearing could actually jeopardize the practices in the FX swaps and forwards market,” Miller said.

Duffie said he is proposing to create clearing contracts for foreign-exchange forwards and swaps that would be margined at clearinghouses during the life of the trade and would then be settled through the standard exchange of currencies like U.S. dollars and Japanese yen.

He said he favors clearing and settlement systems for all financial markets with substantial risk.

Renminbi Risk The possible addition of Chinese renminbi to the global market in coming years “is likely to add significantly to the volume of FX markets and to total FX counterparty risk,” he said. There’s also a high concentration of foreign-exchange trades linking the U.S. dollar and the euro, a connection that’s less evident in the credit-default swap market, he said.

Price swings are also greater in foreign-exchange swaps and forwards than in credit swaps, Duffie wrote.

“Absent the disclosure of data allowing a proper quantitative analysis, the total effective amount of counterparty risk in the FX derivatives market could be of a magnitude similar to that of the market for credit-default swaps,” Duffie wrote. “Unless treated by regulation, counterparty risk in the FX derivatives market could easily grow substantially.”

Investors use credit-default swaps to hedge against losses when corporate or government borrowers fail to pay their debts. The contracts pay the buyer face value if a debtor fails to meet its obligations, less the value of the defaulted debt. The contracts were faulted for complicating efforts to resolve the financial crisis.

In addition to his work with the New York Fed, Duffie studies credit risk, asset pricing and the over-the-counter derivatives market. He is the Stanford Graduate School of Business’s Dean Witter Distinguished Professor of Finance.


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