The Foreign Exchange Committee, which is sponsored by the Federal Reserve Bank of New York, last month issued a working paper that studies the FX market’s performance post-Lehman Brothers collapse. The paper sees opportunities to “further bolster the strength of the over-the-counter FX market”.
The FXC paper follows one released in September by the UK Joint Standing Committee (Profit & Loss, November issue) and reaches the same conclusion – the FX market functioned well during the crisis and people were able to execute their risk, albeit in thinner market conditions.
The FXC highlights the fact that corporations and investors use the foreign exchange market on a daily basis for non-speculative reasons and states, “It is critical for corporations and investors to access a wide range of OTC FX products and to tailor the settlement dates of such products to their business requirements. The flexibility of OTC FX markets and products allows these corporations and investors to manage their risk and their day-to-day business operations, more effectively.”
The paper also highlights some of the functions that served to mitigate risk levels during the crisis, the most obvious being that CLS was available and that following the announcement of the imminent default of Lehman Brothers it “served its stated function”.
The paper adds that over the past two years it has become clear that use of CLS’s services has been “critical to maintaining market integrity and functioning and to preventing further spread of the financial crisis”.
The FXC also observes that a great many FX trades are under one year in term and as such have relatively less credit risk associated with them. It adds that the level of transparency and liquidity in the FX markets also helps risk managers to accurately calculate the open exposures within the FX book and as such they can have greater confidence that the collateral posted can cover outstanding exposures.
The exchange of collateral itself is also a risk mitigant and the FXC argues that credit support annexes (CSAs) provide many of the risk reducing benefits of a central exchange while maintaining the flexibility of an OTC market. It also makes the argument that CSAs are transnational, whereas there could be “practical challenges” associated with a country-specific central counterparty model.
The paper reiterates the commitments to improving operational processes made by the major participants to the US authorities over the past four years and that industry best practices are often cited as a benchmarking tool.
Having highlighted the market’s strengths, the FXC, alongside its Buy Side Sub-Committee, goes on to highlight priorities for the industry that can further bolster its operational strength.
These break down into five key areas. Firstly, the extension of CLS into new currencies, geographies and products – the FXC states that all the largest market-makers should be “encouraged” to become direct members of CLS as long as they are eligible to do so, and that any large or significant counterparties that indirectly participate in CLS through a member institution should have a collateralised line in place to cover the exposure.
The committee also calls for the use of CSAs to be expanded to include clients that trade FX as an asset class to ensure their speculative or highly leveraged positions are adequately collateralised. It adds that ongoing efforts to standardise documentation and to improve operational efficiency are critical and must continue to be a priority.
The fourth priority highlighted is actually a message to the authorities. “It is imperative that any efforts to improve the resilience of the marketplace take into account the global and 24-hour nature of the foreign exchange market,” the paper states. “Each foreign exchange transaction involves at least two sovereign currencies. The marketplace itself is spread across a series of liquid trading centres in different time zones and operates 24 hours a day, each business day. Absent such consideration of these key characteristics of the foreign exchange market, the potential for negative unintended consequences of any efforts to improve market resiliency is quite large.”
The FXC reiterates a longstanding policy by stressing that the recommendations in the paper are targeted at the wholesale market and that the retail FX market “requires prudent regulation”.
The release of the paper is the first overt comment on the debate swirling around US circles regarding regulation. The response of the FXC at first glance appears to be subtler than that of the JSC, which made a point of highlighting the downsides of a centrally cleared model for the FX markets. That said, the points raised within this paper do represent a message to the US authorities and hopefully will be taken into account when those in authority come to make their decisions.