Financial derivatives are sometimes a savior, but in other times, a curse. Although their earliest documented use was in the form of rice futures in the 1700s, they have grown in popularity in recent times for hedging known risks, but have also drawn criticism as a tool of speculation. American International Group, for example, lost $18 billion on credit default swaps during the financial crisis.

Nearly $40 billion has been lost in derivative-related events over the past decade, forcing government officials and regulators to develop controls to prevent such massive losses from occurring with such frequency. As a result, we have the Dodd-Frank Act, more than 2,200 pages of new rules, not including the many interpretative regulations that have followed. Hedging foreign exchange risk is a legitimate activity for any corporation engaged in cross-border commerce, but Dodd-Frank did not choose to exclude altogether this valid risk-mitigating activity.

The Commodity Futures Trading Commission is the regulatory body tasked with administering the legislation with regards to foreign exchange and with oversight of over-the-counter derivatives and swaps. Title VII of Dodd-Frank deals specifically with derivatives. There are a series of definitions and exceptions for compliance purposes that must be followed by Treasury analysts, individuals typically assigned to hedging or mitigating corporate risks of all sorts, forex being just one, but the largest, of their risk-mitigating areas.

The intent of Dodd-Frank is obviously to put new controls around speculative activities while strictly defining “hedge or mitigate commercial risk” (HMCR) criteria. Although seemingly arbitrary, the CFTC has described speculation, investment or trading “as activities involving swap positions held primarily to take an outright view on market direction, including positions held for short term resale, or to obtain arbitrage profits.” Exceptions for HMCR are the goal of Treasury analysts, but occasionally transactions made for economic optimization in some circles appear as speculation in others.

Within a Treasury department, a detailed policy document typically defines what risks must be measured, assessed and hedged based on specific accounting rules. These transactions must also be monitored and reported in financial statement disclosures according to very specific criteria, forming a basis for hedge-accounting applicability. These types of activities also qualify for HMCR exceptions.

For transactions that fall outside these boundaries, the last qualification for exemption must be “economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise.” The gray area in this qualifier revolves around whether the derivative instrument clearly mitigates or creates risk for the organization. Foreign exchange hedges are normally designed to qualify for generally accepted accounting principles treatment, thereby suggesting that few of these transactions will need to qualify under this final criterion.

Speculative forex positions would normally require senior management intervention and trigger policy restrictions related to outright speculation. Auditors and regulators will naturally focus on these gray areas, requiring corporate staff to document more thoroughly the justifications sought for exemption relief. Entity classifications, another major portion of Dodd-Frank, will rarely apply to a straightforward corporate entity. For those companies engaged in dealing or selling derivatives, especially financial institutions, escape from the legislation’s restrictive rules will be difficult.

Derivatives are typically sold over the counter, since their very nature requires a level of customization to address the unique risks of the situation at hand. The Dodd-Frank Act imposes rules to reduce risk in the overall system, but previous attempts to regulate human judgment have only delayed the inevitable core issue — the financial world is not a perfect place.

Tom Cleveland has had an extensive career in the international payments industry with more than 30 years of experience in executive management, corporate governance and business development. Read more of his analysis at ForexTraders.com

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