Dodd-Frank Could Sideswipe the Nondeliverable Forward Market

FOREIGN EXCHANGE HASN'T ESCAPED THE SWEEPING IMPACT of the Dodd-Frank Wall Street Reform and Consumer Protection Act. One area that will probably take a serious hit is the trade in so-called nondeliverable forwards, U.S. dollar–denominated currency contracts for currencies such as the Chinese renminbi that can’t be delivered offshore because of capital controls.

The U.S. Commodity Futures Trading Commission, which is writing the rules for derivatives trading, still hasn’t laid out some key points of the new Dodd-Frank requirements. (Despite repeated requests, the CFTC refused to comment.) But the NDF market has already been buffeted by change.

一位要求不透露姓名的交易商间经纪公司because his clients were involved, says that traders, mainly in Asia but also in Europe and elsewhere, have started demanding that all NDF trades be booked outside the U.S. to avoid the chance of getting swept up by Dodd-Frank. “These requests began to trickle in during September and turned into a torrent in October from the Far East, Europe and South America,” he explains. “They don’t want to face a U.S. entity.”

NDFs are typically used as a hedging tool by asset managers and corporations. The exact size of the NDF market is unknown because those transactions had been over-the-counter trades that didn’t have to be reported to a central registry, as Dodd-Frank now requires. ForexClear, a London-based clearinghouse, estimates the volume of NDFs for such currencies as the renminbi and the Korean won at $120 billion a day, with about $36 billion of that total in the Americas, $36 billion in Europe and $48 billion in Asia. For U.S. traders, the potential loss of business is huge.

The renminbi NDF market, the world’s largest, is also under threat from competition by the offshore renminbi, a currency known as CNH, which is traded in Hong Kong and used for forwards and other financial instruments. By HSBC Holdings’ estimates, CNH forwards now constitute 65 percent of daily turnover and NDFs only 35 percent, according to Ju Wang, a currency strategist at HSBC in Hong Kong.

What are foreign dealers so worried about? Under Dodd-Frank, NDFs are included under the rubric of swaps. Swaps not covered by a special Treasury exemption — NDFs among them — will now have to be cleared through a central exchange and the transaction reported to a central swaps registry. In anticipation of that, ForexClear and the Chicago Mercantile Exchange have begun clearing a large number of NDFs through their facilities.

Also, the CFTC set a clock ticking on October 12, with all traders who have at least $8 billion in swap volume the first year ($3 billion in subsequent years) required to register with the commission as an official swaps dealer. Although traders like Citigroup and JPMorgan Chase & Co. know they will fall under these rules, foreign players like Asian banks worry that if their level of swap trades with U.S. banks reaches the $8 billion threshold, they too will fall under U.S. laws even if they’re based in faraway capitals.

This could dramatically affect their bottom line because cleared trades will need two types of collateral, called variation margin and initial margin, as buffers to protect one counterparty in case the other goes bankrupt before the deal closes. Previously, most NDF trades were not subject to such a requirement. Determined by a risk model, the amount of margin under Dodd-Frank could reach 5 percent of the transaction’s notional value.

“For the NDF market, the requirement for collateral is going to be a huge deal,” says David Felsenthal, a New York–based attorney specializing in financial transactions at law firm Clifford Chance. “It will completely change the economic calculus of trading NDFs.” For one thing, banks will have to cover the collateral by setting aside capital, a scarce commodity in current market conditions, Felsenthal adds.

Another requirement of the new law is that when a pension fund or asset manager wants to trade an NDF, they can no longer ask just one bank for a quote. They must now request quotes from a minimum of five dealers, a process known as RFQ to 5. “Because of the liquidity in some of these markets, most people do not go to five brokers because that’s just sharing too much information,” notes Michael O’Brien, Boston-based head of global trading for Eaton Vance Investment Managers, which manages $193 billion in assets.

O’Brien, whose firm trades in NDFs daily across all regions of the world, says the change in collateral rules could heavily affect his mutual funds. In the past, mutual funds didn’t need to post collateral, but now they may be forced to put up $4 or $5 for every $100 in NDFs traded.

“It could impact whether or not we’re going to do an NDF trade at all,” O’Brien says. Traders might choose to buy locally denominated Treasury bills instead of NDFs because it would cost less to put on a currency hedge. “These new rules are going to impact the way people are implementing their portfolios,” O’Brien predicts.