The U.S. Treasury finally announced late last week that it was exempting foreign exchange forwards and swaps from Dodd-Frank clearing requirements, but there are still several issues outstanding that could affect corporate end users of derivatives.
FX forwards and swaps remain subject to requirements including trade reporting, the Commodity Futures Trading Commission’s anti-evasion authority, which aims to keep Wall Street from tweaking cleared FX products to receive exempt status, and Dodd-Frank’s business conduct rules, according to an analysis by Cadwalader Wickersham & Taft.
In its announcement, Treasury said participants in FX forwards and swaps know their own and their counterparties’ payment obligations and their full exposures through the life of the contract, which distinguishes them from a handful of other FX derivatives that most likely will have to be cleared, including FX options, currency swaps, cross-currency swaps, contracts for differences, foreign-rate agreements and non-deliverable forwards (NDFs)
End users are hoping to get NDFs exempted from clearing as well. NDFs are used predominately by multinationals doing business in developing countries, such as China and Brazil, that have significant currency controls and restrict investments by foreign firms, making it hard to use deliverable forwards.
Tom Deas, treasurer at FMC Corp. and chairman of the National Association of Corporate Treasurers (NACT), notes that Treasury’s rule says FX options, currency swaps and NDFs are not exempted from the Commodity Exchange Act’s definition of a “swap.” Presumably that language was crafted in conjunction with the Commodity Futures Trading Commission and represents the government’s position.
“However, in August, in response to a question from CFTC Commissioner Jill Sommers, the [CFTC] staff responded that they do have the authority to exempt NDFs, which would put them in the same category as FX spot and forward trades,” says Deas, pictured above. “The ball is now in the CFTC’s court, at least to define NDFs as being exempt.”
Luke Zubrod, director at Chatham Financial, says the CFTC staff’s acknowledgement that the agency could exempt NDFs raised a spark of hope, especially since NDFs resemble deliverable forwards and are really the only option for companies hedging the risk of some currencies.
“Market participants need to assume that the current state of affairs will likely remain,” Zubrod says. “But there will probably be a debate in the background raising at least the possibility that NDFs could gain consideration for also being exempted.”
Another uncertainty involves companies’ central treasury centers and whether their hedging activities will be exempt from clearing requirements. That issue was partly resolved by CFTC guidance clarifying that trades between a company’s affiliates to hedge risk are exempt from clearing, Zubrod says. However, because central treasury centers typically seek to hedge their netted exposures with an outside party, the market-facing transaction with the outside party may be subject to clearing unless the CFTC opts to exempt such transactions.
Another open issue involves margin requirements, and whether banking regulators will carry through on indications they’ve given that they will require banks to impose margin requirements on end users, or exempt end users from margin as well as clearing requirements. Deas notes that NACT, as part of the Coalition for Derivatives End-Users, submitted a comment letter to the CFTC on Sept. 14 requesting a broad exemption from margin requirements for end users.
Even if corporate end users can avoid posting margin, however, it appears likely that their costs for engaging in FX transactions will rise, since Basel III capital requirements that start to take effect next year will increase costs for banks that they are almost certain to pass on to customers.
Some corporates may even decide that clearing transactions is the better option.
“If treatment of over-the-counter swaps is more costly, then dealers will offer preferential terms and better pricing on cleared deals, even if they could be exempt,” says Craig Pirrong, finance professor at the University of Houston’s Bauer College of Business.