Regulatory harmonization is an important principle for nations looking to regulate global financial markets because it is a defense against regulatory arbitrage – companies moving to countries with the weakest regulations. While the principle of regulatory harmonization has been relatively easy to articulate and understand, in practice it has been hard to achieve, having significant technology implications that impact cost and efficiency for institutions on both the buy- and sell-side. The agreement on the exemption for foreign exchange (FX) swaps and forwards from over-the-counter (OTC) derivatives requirements provides a good example.
In September 2009, in response to the financial crisis, global leaders of the G-20 countries agreed to a Leaders’ Statement, presenting a common vision for strengthening the international financial regulatory system. One component of their vision was an agreement that “all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.” Recognizing that international regulatory harmonization was an important concern, the G-20 statement tasked the US Financial Stability Board with monitoring the implementation of this principle.
One of the outstanding issues presented by the G-20 commitment to clear OTC products was whether the FX markets, particularly FX swaps and forwards, would be impacted. Should FX swaps and forwards be considered OTC derivatives for the purposes of the G-20 commitment? The FX market, the world’s largest financial market, functioned smoothly during the financial crisis, leading some to ask, why impose additional regulatory requirements and changes to existing infrastructure and technology on a market that already functions so effectively?
The answer to this question led the US Congress to provide the Secretary of the Treasury with the authority to exempt FX swaps and forwards from the central clearing requirements of Title VII of the Dodd-Frank Act, a section of the law enacted in keeping with the G-20 commitment to centrally clear OTC derivatives. Congress implemented this commitment by calling OTC derivatives “swaps” and expressly giving the Commodity Futures Trading Commission the authority to supervise swaps markets.
Dodd-Frank also provided the Secretary of the Treasury with the authority to exempt FX swaps from the definition of a swap upon a finding that FX swaps and forwards are “qualitatively different” from other classes of swaps. That, the finding further noted, would make FX swaps and forwards “ill-suited for regulation as swaps.” With regulatory harmonization on their minds, and concerned that they did not want to regulate a market that the US exempted, both European and Asian regulators waited on the Secretary of the Treasury’s determination before deciding on their own.
On May 5, 2011, the Treasury Department published a notice of proposed determination that FX swaps and forwards would be exempt from the definition of a swap. After engaging in a broad outreach to market representatives for 18 months, the Treasury Secretary determined on November 16, 2012 that FX swaps and forwards are not swaps for the purposes of the Commodity Exchange Act, thereby exempting those products from the central clearing and margin requirements. In doing so, Treasury wrote: “The extensive use of CLS and privately negotiated PVP (payment versus payment) settlement arrangements between banks, financial intermediaries, and their clients largely addresses settlement risk in the market for FX swaps and forwards, and, as a result, constitutes an important, objective difference between FX swaps and forwards and swaps that otherwise are subject to regulation under the Commodity Exchange Act.”
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Following this determination some Asian countries harmonized their approaches quickly. In June 2011, Australian financial regulators acknowledged the proposed US Treasury Department exemption and indicated they “would expect that Australian requirements would be harmonized with this.” Then, on February 13, 2012, Singapore proposed to exempt FX swaps and forwards from its own central clearing requirement for OTC derivatives, stating “the main source of systemic risk arising from these products is settlement risk, and there is already an established international settlement process to mitigate such risk.” Japan, pursuant to an ordinance that became effective on November 1, 2012, effectively exempted FX swaps and forwards from the definition of a derivative, thereby exempting them from the Japanese central clearing requirement.
While the Treasury decision was greeted with cheers in the US, and quick action by some Asian authorities, the European approach is still developing. On the subject of Dodd-Frank, Markus Ferber, the European Parliament’s designated rapporteur of the Markets in Financial Instruments Directive (MiFID), which includes FX, said: “the great advantage of MiFID is that we have one European standard and one European approach for the whole single market of the European Union. “If you add all the financial centres in the EU together, we have the largest financial market. I don’t follow that we have to adopt only Dodd-Frank and then everything is clear. No, Europe is different.” Critically, the euro is the second most heavily traded currency behind the US dollar.
Despite, Ferber’s remarks, recitals within the European Market Infrastructure Regulation (EMIR) make clear reference to the exceptional nature of the FX market, where settlement risk, not counterparty credit risk, is predominant. This leaves open the possibility that an exemption in Europe for FX swaps and forwards is possible, since regulators increasingly recognize the unique nature of risk in the FX market. So, while it remains unclear as to whether Europe will harmonize with the US and Asian approaches and exempt FX swaps and forwards from the central clearing requirement, the EMIR recitals are, so far, encouraging.
With a regulatory environment that appears to be moving slowly, most indications suggest it is heading in the direction of global harmonization. Regulatory regimes for OTC derivatives are in place and national regulators from the G-20 countries seem to agree that the predominant risk in FX markets, settlement risk, is well mitigated and that exempting FX swaps and forwards from the central clearing requirements is the right approach.
When it comes to regulatory harmonization, most differences are rooted in policy preferences. While some believe that FX markets have performed well under duress and further regulation is not necessary, others believe in a more preventive approach – regulating before a crisis emerges. Fortunately, with CLS responsible for the mitigation of settlement risk, the FX market has performed well in times of financial turmoil. Well enough, in fact, for regulators to agree that their policies should be consistent: FX swaps and forwards do not need to be centrally cleared. With that, the prospect of regulatory arbitrage in the FX market will be largely avoided and it will be well on its way to regulatory harmonization.
Dino Kos is head of global regulatory affairs at CLS.