The traded foreign exchange market is the big enchilada. It is the largest financial market in the world. The Bank for International Settlements estimates that the daily turnover in this market, including swaps, futures and spot purchases, is $4 trillion as of April 2010. This turnover increased more than 20% in the last 3 years. Trading is concentrated in London, accounting for 36.7%, while the New York share of the market is around 18%.
Since FX swaps and forwards are based on currency values, it is very easy to embed other financial transactions in a dealtransaction that involves exchange rates on its face. For instance, a loan can be the primary purpose for a swap of currency values. The danger in such obfuscation is illustrated by the foreign exchange transactions between the Greek government and Goldman Sachs, which disguised the debt burden of Greece and triggered a crisis.
In the Dodd-Frank Act, clearing (if available) is mandated for most derivatives, with "end user" hedging transactions carved out. But a second carve out, for FX swaps and forwards, is permitted if the Treasury orders it. There is significant concern among progressives monitoring the implementation of Dodd-Frank that the Secretary will soon exempt FX instruments from the clearing mandate. (See Mary Bottari, "Is Geithner Planning a Stealth Attack on the Wall Street Reform Bill" and David Wigan, "Traders Angered by Swaps Legislation.") Why did the Act envision this enormous exception? Why would Treasury implement the exemption? Why would it act now? These and other questions are shrouded in mystery, and that fact alone is of great concern.
Several knowledgeable individuals who were involved in the discussions of this provision during the drafting of Dodd-Frank report that Treasury never articulated a coherent rationale. It was clear that the New York Federal Reserve sought the exemption, but their motive was obscure. There was no structural impediment to mandating the clearing FX instruments: the Chicago Mercantile Exchange has a thriving FX futures business. It follows that Congress did not have the information to assess the proposed exemption, and the decision was delayed and delegated to Treasury.
According to Dodd-Frank, the Treasury Secretary must consider the following in deciding whether to grant the exemption:
1) "whether the required trading and clearing of foreign exchange swaps and foreign exchange forwards would create systemic risk, lower transparency, or threaten the financial stability of the United States;
2) whether foreign exchange swaps and foreign exchange forwards are already subject to a regulatory scheme that is materially comparable to that established by this Act for other classes of swaps;
3) the extent to which bank regulators of participants in the foreign exchange market provide adequate supervision, including capital and margin requirements;
4) the extent of adequate payment and settlement systems; and
5) the use of a potential exemption of foreign exchange swaps and foreign exchange forwards to evade otherwise applicable regulatory requirements."
If the Secretary decides to grant the exemption, he is required to submit specific information to the relevant congressional committees, including:
1) "an explanation regarding why foreign exchange swaps and foreign exchange forwards are qualitatively different from other classes of swaps in a way that would make the foreign exchange swaps and foreign exchange forwards ill-suited for regulation as swaps; and
2) an identification of the objective differences of foreign exchange swaps and foreign exchange forwards with respect to standard swaps that warrant an exempted status."
It is hard to imagine that, in the months of discussion that preceded the enactment of Dodd-Frank, these issues were not thoroughly analyzed by the Treasury and the Fed. Certainly there is nothing that has emerged since enactment that is relevant to these issues. Granting the exemption now doesn't make sense with the flow of events. Congress could have been presented with all relevant facts and arguments so it could have decided instead of delegating the decision to Treasury.
The process suggests that this delay and the procedure were designed to appease opponents to the exemption and those who were concerned that the rationale was insufficiently presented. If this is true, the result is probably inevitable, at least in the minds of those in charge of the Treasury and the Fed. It is really maddening that the administration and the Fed were unwilling or unable to lay out the necessary factors to allow Congress to decide on such an important segment of the market.
We are left to guess at the reasons the FX market is to be treated so differently from other derivatives markets. There are several distinctions:
• As stated above, it is large. Worldwide, it is the largest of the financial markets.
• There is no meaningful distinction between a forward purchase and sale and a swap. Buying euros for future delivery at a fixed dollar price is not materially different from a euro/US dollar swap. In contrast, if someone sells a bushel of corn, he or she must deliver it.
• There has been much debate about the proportion of hedging and speculation in the FX market. However, it is clear that, compared with other markets, the amount of speculation is quite large.
• Relative currency values are directly related to central bank activities.
• The London market, being twice the size of the US market, plays a central role.
• The market presence of US financial institutions is significant, but the larger participants are European banks.
None of these distinctions compels a decision to exclude FX transactions from mandatory clearing, a process in which trade data is reported and a standard system for margining is imposed. Until the Treasury and Fed fill the public in on their thinking, it is pointless to speculate (unless you are a bank speculating on foreign exchange rates). It is ironic that, in implementing legislation designed to bring transparency to the financial markets, the Treasury and the Fed are so unconcerned about their own lack of transparency.
Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co. He is Visiting Scholar at the Roosevelt Institute.