Duffie sparks debate over credit risk in FX swaps and forwards

Market participants have expressed concern in response to calls from academic Darrell Duffie for more analysis before finalising exemption of FX swaps and forwards from clearing requirements.

A disagreement has broken out between academics and foreign exchange market participants over the true extent to which FX swaps and forwards pose sufficiently low counterparty credit risk to merit a complete exemption from mandatory central clearing under the US Dodd-Frank Act.

On 29 Apri, the US Department of the Treasury issued a proposed determination to exempt FX swaps and forwards, which is open for comment for 30 days. On `12 May, Darrell Duffie, professor of finance at Stanford University’s Graduate School of Business, submitted a comment letter to the Treasury arguing more analysis is needed before that determination can be finalised.

In his 10-page submission, Duffie argued that full analysis of publicly available data undermines an argument voiced by market participants, that FX swaps and forwards are predominately short-dated, have little counterparty risk and therefore do not need to be cleared.

“There is no publicly available data bearing on the effective average maturity of FX forwards and swaps, a critical gap in our knowledge of whether the risks from this class of derivatives are systemically important,” Duffie wrote.

Citing data from the Foreign Exchange Committee of the Federal Reserve Bank of New York, Duffie noted more than half of the monthly volume of new FX forwards contracts have maturities of more than one month, constituting a total notional monthly volume of $1.4 trillion.

“If anything, the available data suggests the maturities of FX swaps and forwards are long enough to create concerns about the amount of counterparty credit risk in this market if it’s not mandated for clearing. I believe the claims that most of the contracts are of very short maturities and that there is therefore no significant amount of credit risk have been taken at face value. Equally the claims that there’s no feasible way to safely clear these derivatives have been taken at face value and it seems few have taken the trouble to look more deeply,” Duffie told FX Week.

While Duffie focuses predominantly on clearing, his paper also dismissed arguments that FX swaps and forwards should be exempted from other elements of the Dodd-Frank Act, including a requirement to trade products on swap execution facilities.

The paper came as an unwelcome surprise to FX banks and industry associations that have lobbied hard for an exemption in recent months and were delighted by the draft text from the Treasury.

“The paper is a reminder that the exemption is still not final. It’s a proposal, which is warmly welcomed by market participants but it’s not a done deal so we still have to make the case to regulators over why the proposed determination makes sense,” said the head of electronic commerce at one European bank.

Justyn Trenner, chief executive of research and advisory firm ClientKnowledge in London, criticised Duffie for failing to address the unique nature of FX compared with other over-the-counter asset classes, but accepts it could be influential in determining whether the Treasury maintains its course towards an exemption.

“Although FX swaps and forwards are loosely referred to as derivatives, they are in fact straightforward cash lending products with known cashflows – a key point of the Treasury’s determination that Duffie fails to consider. We mustn’t miss the point that this paper will influence politicians, even if the industry disagrees with it. It is still likely FX swaps and forwards will be exempt in the US, but it’s not yet a done deal,” said Trenner.

But not everyone disagrees with Duffie’s position. Jon Gregory, partner at London-based consultancy Solum Financial and formerly global head of credit quantitative analytics at Barclays Capital, believes a blanket exemption for FX swaps and forwards is a step too far, given the uncertainty around maturities.

“It’s possible FX has been able to slip under the radar. The emphasis in central clearing has been mainly on credit derivatives because they were seen to be much more toxic. Set against credit default swaps, a short-dated FX contract certainly doesn’t look very risky, but I don’t think that kind of comparison is the right way to go about it,” said Gregory.

Meanwhile Duffie has also criticised the arguments put forward by the global FX division of the Association for Financial Markets Europe (Afme) and the Securities Industry and Financial Markets Association (Sifma) in their submission to the US Treasury’s consultation last November.

“The Sifma-Afme letter did not bring forward some of the points it could have and the points it brought forward, while correct, were misleading. The data on maturities in the letter do not look consistent with the information available from the FX Committee. I’m not really sure how to reconcile those two data sets,” said Duffie.

Although it remains to be seen whether Duffie’s submission will alter the course of the Treasury’s decision-making process, he insists there are market participants that share his views. “There are participants on the buy side and the sell side that tell me of concerns over whether this asset class should be exempted. Perhaps few want to criticise the exemption on-the-record because there is an industry position on this,” he said.

Afme’s global FX division declined to comment.

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