Regulation has a significant impact on how businesses operate across the world, and no industry is more tightly regulated than the financial sector. In the wake of the financial crisis of 2008 regulators responded with a raft of new proposals intended to prevent a future economic collapse. By far the most broad reaching of these is the Dodd Frank Act.
Originally proposed in 2009, the provisions in the Dodd Frank Act are by far the most sweeping reforms in financial markets to happen in living memory, mandating changes in market structure that US President Barak Obama has noted will revolutionise the way most financial institutions do business.
Among the most significant reforms are a consolidation of regulatory agencies, new consumer protection laws and changes designed to enforce more transparency across markets. It is hoped that such transparency will help to eliminate loopholes which enable risky and abusive practices to occur unnoticed, and a new independent watchdog will be created and housed at the Federal Reserve in the US to act where such practices are seen to occur.
The impact of Dodd Frank on US Capital market structure has been much discussed, and most of the significant reforms are now well understood. What is less clear is how these reforms will impact other areas of the global financial sector. In particular, there is a real lack of clarity around how businesses dealing in FX trading may be impacted, although some industry observers have speculated that they may find themselves affected far more than they might hope for.
Legal services provider Wilson Sonsini Goodrich & Rosati (WSGR) has commented on how the Dodd Frank will affect the treatment of derivatives, which are regarded as “swaps” under section 721 of the reforms, and highlighted that currently it is not known if FX linked products will be exempt from these rules.
Dodd Frank provides the registration and regulation of swaps dealers and major swap participants, as well as the implementation of clearing and trade execution requirements for swaps. Under the term swaps are a varied selection of foreign exchange derivatives, including FX swaps, FX forwards, currency swaps, currency options and non-deliverable forward contracts.
Many industry participants argue that an exemption should be made for FX products, for a number of reasons.
Firstly, such products are often used by non-financial corporations such as FMCG multi-nationals to hedge against genuine currency and commodity risk. In this context, the products are not used to speculate, but to protect the business against shocks in price and liquidity in a global supply chain. Should a business using FX products in this way on a regular basis be subject to the same regulatory regime as a hedge fund using complex derivatives to bet on movements in markets?
Secondly, most FX trading institutions have been quick to point out the very nature of the Foreign Exchange market should warrant it receiving less regulatory attention. FX markets exhibit a liquidity that exceeds any other by several orders of magnitude. They trade round the clock, are largely traded off-exchange, and have been self-regulating successfully for decades. Throughout the financial crisis and throughout the aftermath, although FX trading platforms saw similar spikes in volatility as equity and fixed income, there were not the same slumps in volume or value as seen elsewhere.
These characteristics, regulators argue, are making FX an attractive target for speculators who are no longer making their returns in high frequency trading on the world’s stock-markets. A pre-emptive regulatory strike, they say, is necessary to preserve the character and integrity of these markets for the future.
Exemptions have been proposed and are being considered, however.
It is likely that “end-user exemption” from Dodd Frank’s clearing and trading rules is available to firms in particular circumstances. In its alert, WSGR explained: “The End-User Exception will be available only to counterparties that are not financial entities. Most corporations that use FX derivatives to hedge their FX exposures should meet this requirement.”
The organisation also underlined though the recordkeeping and reporting requirements of the Dodd Frank laws, which stipulate that FX companies are required to keep and maintain records of the information needed to identify and value FX derivatives, prices of FX derivatives and whether it was subject to clearing. Who exactly will be bound by these rules is pending clarification.
Of greatest concern to many is the idea of ‘extraterritoriality’ that is bound up in Dodd Frank – the idea that non-US companies which have a base in the US, or trade with US counterparties, could find themselves subject to these US regulations. Some European companies may attempt to escape Dodd Frank’s reach by altering their legal structure, but this may not be enough.
CNN Money reported that German firm Deutsche Bank changed its operations so that it is no longer regarded as a “bank-holding company”, meaning that it can still qualify for US bailouts.
Michael Barr, a former Treasury Department official who helped write the Dodd Frank legislation, told the news provider that the US needs to “fully understand” the risks that may arise in America due to such actions from foreign banks.
While lawyers and compliance officers wrestle to adjust their businesses through this period of uncertainty they face an even greater challenge – the Dodd Frank act, whilst complicated and unclear, is just one piece of the regulatory jigsaw. At the same time these institutions are trying to adapt to Basel III, MiFID II, EMIR and several other new sets of rules. Identifying how these intersect and interact, and preparing for full compliance is going to be a difficult, demanding and expensive task.
For many, the solution will lie in a significant upgrade of the systems they use. Vendors have already come to market with new or upgraded FX trading platforms that promise to meet the demands of regulators in pre and post trade transparency, accounting, clearing and record keeping, but investing in new technology is a difficult task for a sector still recovering from a crisis that bought it to its knees.