Risk exclusive: Clearing exemption for FX swaps to be scrapped, says Frank

The US Congress will remove the exemption for foreign exchange (forex) swaps and forwards from new central clearing requirements when two over-the-counter derivatives reform bills moving through the House of Representatives are reconciled on the House floor early next month.

In an exclusive interview with Risk, House Financial Services Committee chairman Barney Frank confirmed the exemption for forex swaps and forwards, currently featured in both House derivatives reform drafts and in the Senate regulatory reform bill introduced by Senator Chris Dodd on November 10, will be eliminated from the House bills when they are reconciled into a single draft in December.   

“The Administration had asked for that amendment, but we are going to take away the exemption for foreign currency [swaps and forwards]. That will happen in the bill on the House floor,” Frank says.

The forex exemption is the legacy of the 1974 Treasury Amendment to the Commodities Exchange Act (CEA). Until that year the statutes of the CEA had been limited to regulation of futures, options on futures and options on commodities.

The expansion of the CEA in 1974, however, led to the inclusion of other products under the regulated framework. This led the Treasury Department to lobby for and secure an exemption for OTC transactions, including swaps and forwards on foreign currencies, from the newly expanded definition of a “commodity”, and to exclude such products from the purview of the new Commodity Futures Trading Commission (CFTC).

Frank’s clarification should go some way to calm the concerns of the European Commission (EC), which is currently working on a cost/benefit impact assessment as a precursor to its own OTC reform legislation. The Commission is known to be conscious of the potential for regulatory arbitrage by regulated entities should forex products be excluded from clearing requirements in the US but not in the European Union.

“We are aware [of the EC’s concerns] and we plan to continue to work very closely with them so that we have harmonisation,” says Frank.  

The chairman also confirmed that a carve-out from the clearing requirement for corporate users of derivatives will almost certainly be narrowed in the final version of the legislation, to ensure  all market players that act as “major swap participants” are caught under the definition. The definition is significant since any derivatives trade involving a swap dealer or a major swap participant must be cleared with a regulated central counterparty.  

Frank’s original October 2 discussion draft of the 'Over-the-Counter Derivatives Market Act of 2009' defined a major swap participant as a person “who maintains a substantial net position in outstanding swaps, excluding positions held for hedging or risk management purposes”.

The chairman then entered a mark-up into the final version of the bill that was passed by the Financial Services Committee on October 15, which broadened that definition by adding a supplementary clause to include any person “whose outstanding swaps create substantial net counterparty exposure and would expose counterparties to significant credit losses that could have material adverse effect on capital of the counterparties”.  

Frank explains the decision to broaden the major swap participant definition was reached after he was convinced that more market actors could be included without impeding the hedging activities of smaller firms.

 “We were concerned we didn’t capture enough people and that we should therefore narrow the exemption, but I originally talked about being even tighter. I think the more participants we have on exchanges the better, and I was concerned we had overwritten the exemption and that we could in fact get more participants onto exchanges without hurting people,” Frank says.

The chairman also stated his belief that his broader definition of major swap participant “will ultimately prevail” in the final bill over the House Committee on Agriculture’s definition of a major participant as one whose swaps “create substantial net counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system”.

Frank also reiterated what he wrote in a November 3 letter to the chairmen of both the Securities Exchange Commission (SEC) and the CFTC, confirming his intent to ensure the final law will give authority to the two regulators to determine which types of derivatives contracts are required to be cleared with a central counterparty.

“People have said that by letting the clearing houses make that ultimate decision we could have a big loophole, so we think the SEC and the CFTC should have to make the decision about whether things are clearable, not the clearing houses. We agree with the provision in the Agriculture bill that it should be the commission and not the clearing house that has the major say in what is clearable,” Frank concludes.