Dodd Frank Makes Non-U.S. Banks Reconsider Swap Trading With US Firms

Last July, the CFTC announced that beginning October 12,2012, all foreign banks that trade $8 billion worth of swaps annually with U.S.-based companies would have to register themselves as active traders in the derivatives markets. This is just one of the many changes that the CFTC wants done via the Dodd-Frank regulations, which are scheduled to be implemented by early 2013.

For those of you who aren’t familiar with swaps, here’s a simple explanation of what they are:

Swaps are derivatives where two parties (the buyer and the seller) exchange cash flows of two different financial instruments. Normally, only the net amount is exchanged and no principal is involved. Firms usually engage in swaps for hedging purposes (to lock in a certain price) or if they believe that market rates will change over the duration of the swap and there is money to be made.

For example, Tom and Joe decide to enter a swap agreement where they agree to pay each other the cash flows of the financial instruments that they are holding every year.

In this example, let’s say Jose has a fixed 5.0%, $1,000,000 bond while Joe holds a floating rate, $1,000,000 U.S. dollar bond. At the end of six months, the current interest rate is 3.0%. This means that Joe has to pay Tom the equivalent of (5.0% – 3.0%) X $1,000,000, which is $20,000.

If the interest rate at the time was 7.0%, then instead, Tom would have had to pay Joe the equivalent of (7.0% – 5.0%) X $1,000,000, or $20,000.

Now, this is called a plain vanilla swap, but be informed that swaps can come in many different forms. I won’t bore you further with the details, but you get the idea – it’s complicated!

Instead, I want to inform you on how this will affect banks, currency trading, and YOU.

Banks

Foreign banks have strongly reacted to the CFTC’s new regulations as being an active U.S. participant would mean that they would be required to meet Dodd-Frank’s highest capital, collateral, and trading standards. This would mean extra costs and less profit for these foreign banks.

In fact, due to the lack of details in the CFTC’s announcement, many foreign banks have stopped trading with U.S. counterparties altogether for fear that they would inadvertently reach the $8 billion threshold. Some major European and Asian banks have also stated that they have no plans on being registered as a U.S. participant.

The U.S. firms won’t have an easy time either. Aside from being subjected to the same high capital and trading standards, they could also lose customers in the long run. If the foreign counterparties conduct their business elsewhere, the U.S. banks would lose potential trading partners, making it difficult to execute their clients’ transactions.

Currency Trading

Finding non-U.S. counterparties for currency swap transactions won’t be a problem if firms are trading major currencies like the dollar or the euro. However, it might take more time for foreign banks to find counterparties for less common currencies if U.S. firms are no longer an option.

You

If banks and other firms pass on the extra cost of complying with Dodd-Frank’s requirements by raising its prices and spreads, then you, the customer, would essentially be paying more for the same products and services. On the other hand, it would also mean that your bank or dealer would be more easily regulated by the CFTC.

On October 12 the CFTC cleared up its plans a bit by saying that one way for foreign banks to bypass the registration requirements would be for those banks to trade with the U.S. firm’s overseas branches. The catch though, is that the U.S. bank will have to register itself as a swap dealer with the CFTC.

For now, the rules are still a bit unclear, but you can bet your bottom dollar that banks will be working hard to ensure that this provision will be included in the final proposal.