Foreign exchange always has operated differently from other markets. Traditionally a bank- driven product, the majority of FX is traded directly between a client and its bank. While stocks and commodities trade over regulated exchanges, the banks have always been firmly in control of currency markets. Be it that currency is a bank's core product, that banks control the payments infrastructure or that banks are critical in implementing monetary policy, the banks have historically dominated FX.
Whether it's because of this dominance, or just a coincidence, automation has been slower to gain traction in FX than in traditional markets. Central clearing of equities occurred in the 1970s and clearing of bonds in the '80s; but it took until the mid- to late-1990s for the currency markets to reduce one of the most significant operational risks that banks face — Herstatt risk. Herstatt risk is a form of settlement risk that occurs when non-overlapping time zones create the risk that a bank will go bust after receiving one leg of a cross-border currency trade and then default on its compensating payment to you.
The Continuous Linked Settlement (CLS) Bank solved this risk by creating what is basically a clearinghouse, or more accurately, an automated linked settlement process, so both legs of a currency transaction clear concurrently. While CLS Bank reduces settlement risk for spot FX, however, there still are gaping holes in the settlement process for FX forwards, NDFs (non-deliverable forwards) and swaps.
For those who don't know, a currency forward is just a promise to deliver an amount of currency on a specific date in the future. The amount can, and usually is, a non-standardized amount, the settlement date (the date when currencies are to be transferred) often is non-standard and/or the transaction is in a non-standard currency. These transactions are heavily used in the corporate world to lock in exchange rates, manage currency exposures, and help both financial and non-financial firms ensure that future costs or revenues are not lost through currency volatility.
While these transactions are very valuable to currency hedgers, though, they historically have been problematic. Because of their bespoke nature; their duration (which can be days, weeks, months or even years); and the lack of centralized trading, global reporting, matching, reconciliation or clearing processes, FX forwards, NDFs and swaps have little more rigor behind them beyond the manually written trade ticket, a SWIFT message and/or a printed confirmation that may or may not be sent, confirmed or reconciled. This can be especially problematic for long-dated agreements, for which there may not be a confirming payment for weeks, months or even years.
A Hot Debate
One of the hotly debated aspects of Dodd-Frank (and global financial reform in general) was whether FX forwards and swaps would be included under Title VII's transparency and accountability requirements. While central banks, and generally the Federal Reserve, were worried that financial regulation would hinder their ability to manage exchange rates, eventually legislators got their way and FX forwards and swaps were folded into the regulation.
The challenge now is, how do we develop reporting, margin and clearing facilitates for these products? Well, that is exactly what the three major swaps clearinghouses — LCH.Clearnet, CME and ICE — are beginning to build out as they wrestle with messaging, confirmation, matching, margining, reporting and risk management standards and processes.
As FX swaps and forward agreements move into the centrally cleared realms, the use of these products likely will increase. While costs may initially increase, greater transparency because of the new infrastructure, reduced counterparty risk, increased oversight and proper margining will increase the amount of liquidity in these products and act as a self-sustaining engine driving growth over the next few years.
While central banks may not like a third party snooping around their monetary objectives, at the end of the day, the more-robust capturing, reporting and clearing of FX forwards, NDFs and swaps should be counted as one of the more positive aspects created by the Dodd-Frank process. That is, if FX clearing doesn't fragment into a vast geo-political mess.
[Former CFTC Acting Chairman Appointed Head of DTCC’s U.S. Swap Data Repository]