The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.
This article provides a brief overview of the Dodd-Frank Act as it relates to foreign exchange activities. It is intended as a summary of the recent regulatory proposals that may affect, or the changes that will affect our clients who engage in FX hedging. The article contains our best predictions about what regulators will do, but the regulations are far from settled. We hope you will find this article to be useful in planning for the upcoming regulations, but it is not meant as legal advice.
Dodd-Frank is a product of widespread calls for reform after the financial crisis of 2007-2010. The major components of Dodd-Frank include:
- Consolidation of regulatory agencies, new oversight council
- Regulation of the financial markets, increased transparency
- Strengthened investor protection
- New crisis resolution tools including the ability to wind down bankrupt firms
- Additional measures for adopting international standards and for accounting and tightened regulation of ratings agencies
- Separation of proprietary trading activities from banking activities
- New regulations for cross-border electronic transfers
As part of the move to increase transparency, Title VII of Dodd-Frank— the Wall Street Transparency and Accountability Act of 2010 — deals with the Over-the-Counter (OTC) derivatives market, the market for derivatives traded off an exchange.
Under Title VII, the OTC derivatives market will be regulated for the first time. The Commodities Futures Trading Commission (CFTC) will be regulating foreign exchange and interest rate derivatives and the Securities Exchange Commission (SEC) will be regulating security-based derivatives. The OTC derivatives market encompasses some products within foreign exchange (those that will be defined as swaps, this will be further defined below), as well as interest rate, commodity and equity derivatives, and credit default swaps. At present, the final definition for which products will be deemed swaps has not yet been completed.
The intent of Title VII is to reduce systemic risk in the financial markets that is in part caused by speculation and poor risk management practices. In addition, it provides oversight that helps to ensure regulated products are transacted only for risk mitigation and/or by qualified investors (Eligible Contract Participants “ECPs.” Dodd-Frank generally prohibits trading swaps with non-ECPs although some exceptions for certain products may be allowed.
Banks will be required to report all activity in regulated products to approved Swap Data Repositories (SDR’s). Any hedges done by non-financial end users forentities hedging commercial risk, will be reported by the bank counterpart to the Swap Data Repository. Products considered swaps will require central clearing if traded by a financial entity or by a speculator or investor. As a result of the cost of complying with Dodd-Frank, some banks have or are planning to limit their foreign exchange product offering. Silicon Valley Bank has no plans to reduce its product offering for commercial clients who meet the threshold of eligibility to be considered qualified to transact in regulated foreign exchange products defined as swaps.
The regulations under Dodd-Frank will treat non-financial end users, companies hedging commercial risk, different than financial entities, banks, and speculators. Non-financial entities may qualify for end-user exceptions to avoid central clearing. It is likely that swaps that are not centrally cleared will still require off-exchange collateralization by a mechanism that uses both initial margin and a variation margin. The variation margin is based in part on the market value of an existing collection of contracts transacted with a hedge bank. Not all products will require margin, this requirement will be based on the classification given to the product by the regulators and the reason for its use. The classifications for the foreign exchange and interest rate derivatives markets are as follows:
Foreign Exchange Market
- FX Spot - Not a swap under Dodd-Frank, this product will not be regulated.
- FX Forward - Classification under review but will likely not be considered a swap in final rule. Will likely not require collateralization with initial and variation margin.
- FX Swap - Classification under review but will likely not be considered a swap in final rule. Will likely not require collateralization with initial and variation margin.
- FX Option - Product will be classified as a swap under Dodd-Frank. Product may in the future be subject to a collateralization methodology that includes initial and variation margin.
- Non-deliverable forward - Product will be classified as a swap under Dodd-Frank. Product may in the future be subject to a collateralization methodology that includes initial and variation margin.
Interest Rate Derivative Market
- Cross currency swap - Product will be classified as a swap under Dodd-Frank. Product may in the future be subject to a collateralization methodology that includes initial and variation margin.
- Interest rate swap - Product will be classified as a swap under Dodd-Frank. Product may in the future be subject to a collateralization methodology that includes initial and variation margin. An exemption may be allowed if executed by a non-financial business entity in connection with a loan.
In summary, all activity in OTC derivatives will likely require collateralization in the future. Swap dealers and financial entities will be required to centrally clear derivative trades. Corporate clients may be required to have collateral agreements that contain provisions for both initial and variation margin. It is likely that trades executed prior to the implementation of Dodd-Frank will be grandfathered, but this is not certain. The calculation of any margin amounts required under Dodd-Frank will be performed by the bank counterpart on the derivative.
The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.
Foreign exchange transactions can be highly risky, and losses may occur in short periods of time if there is an adverse movement of exchange rates. Exchange rates can be highly volatile and are impacted by numerous economic, political and social factors, as well as supply and demand and governmental intervention, control and adjustments. Investments in financial instruments carry significant risk, including the possible loss of the principal amount invested. Before entering any foreign exchange transaction, you should obtain advice from your own tax, financial, legal and other advisors, and only make investment decisions on the basis of your own objectives, experience and resources.