16 Jan 2011
Rule Financial OTC clearing team
I have spent some time recently reviewing and commenting on the OTC clearing game. Like most commentary, there have been a lot of ifs and buts. One of those 'ifs' is whether FX swaps should be exempt from the OTC clearing regulations, something that the US Treasury Secretary has been given the power to decide on. Well, as a past arbitrageur, one of my axioms in life, as well as in the financial services industry, is that there should be no opportunity for arbitrage. The moment a crack of light appears in the treatment of one asset class, or one country, or one tax regime, then a coach-load of arbers will blast through it.
So, even though the 'FX industry' was not the cause of our recent market crash, I find it difficult to argue that this particular asset class, should be viewed as 'lower risk', 'not a problem', or 'different' and therefore deserving of exemption. So what if an FX swap (really just a Forward) is a different type of instrument to an Interest Rate Swap? And, it's great that settlement risk is tackled by the current CLS mechanism, but counterparty risk would still exist, and in the final analysis, it was counterparty risk that blew our world apart in 2008.
To be more precise, it was the poor-credit mortgagee that couldn't pay his monthly standing order that brought down the securitised instrument, which brought down the bank owner of the mortgage backed security (MBS), that pretty much brought down the large broker, which brought down the whole pack of cards, and stopped everybody lending a tenner to their mates! So to reiterate, it was counterparty risk that triggered the collapse.
We can now, with this new legislation, put circuit-breakers into the chain of collapse that comes with fear, and a correlation of one. By this I mean, that if I don't know what my bilateral counterparty is exposed to elsewhere, then I am going to be more scared when things go wrong, and act more irrationally than if I were to get a holistic view via a central counterparty (CCP). As an allegory, when travelling at high speed on the motorway, everybody brakes too hard on seeing the brake lights in front, to the end-point of bringing traffic to a complete halt. You end up parked in the outside lane wondering, "what happened to cause all this?" But, when the traffic is controlled at 55mph, it travels smoothly - no over-reaction, no concertina effect, and no traffic jam.
So FX, a huge market, probably could cause a seismic collapse not seen before, since it, de facto, crosses country boundaries like no other instrument. It is genuinely THE global asset and therefore deserves special attention. That, in my mind, means it needs to be watched carefully, and not be exempt from central clearing.
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This blog first appeared on Finextra. Click here to see the entry on the Finextra website
