Secretary of the Treasury Exempts Foreign Exchange Forwards and Foreign Exchange Swaps from the Definition of “Swap” Under the Commodity Exchange Act, as Amended by Dodd-Frank

SUMMARY

On November 20, 2012, the Secretary of the Treasury issued a determination that foreign exchange swaps and foreign exchange forwards should be exempted from the definition of “swap” in the Commodity Exchange Act, as amended by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act.1 As a result, certain foreign exchange swaps and foreign exchange forwards will be exempted from many of the requirements of Title VII applicable to swaps, but they will remain subject to the swap reporting requirements and business conduct standards under Title VII, and may not be used to evade other rules promulgated by the Commodity Futures Trading Commission. The Secretary of the Treasury’s determination does not extend to foreign exchange options, cross-currency swaps or nondeliverable forwards, which will remain fully subject to Title VII. Market participants that enter into foreign exchange forwards and foreign exchange swaps covered by the Secretary of the Treasury’s determination will not be required to include these transactions in their swap dealer or major swap participant registration determinations2 or in their assessments as to whether they must register with the Commodity Futures Trading Commission as a commodity pool operator or commodity trading advisor.

BACKGROUND

Title VII of the Dodd-Frank Frank Wall Street Reform and Consumer Protection Act (“Title VII”) created a new regulatory regime for swap transactions, including (but not limited to) mandatory central clearing and trading on an exchange or electronic facility, margin and capital requirements, and recordkeeping and reporting requirements. “Swap” is broadly defined under Title VII to include a number of foreign exchange transactions, including foreign exchange forwards, foreign exchange swaps, foreign exchange options, currency swaps, and non-deliverable forwards (“NDFs”).  

However, Title VII provided the Secretary of the Treasury with the authority to determine to exclude from the definition of a “swap” foreign exchange forwards and foreign exchange swaps (as such terms are defined under Title VII) after considering the following five factors specified in Title VII:

  • Whether the required trading and clearing of foreign exchange swaps and foreign exchange forwards would create systemic risk, lower transparency, or threaten the financial stability of the United States;
  • Whether foreign exchange swaps and foreign exchange forwards are already subject to a regulatory scheme that is materially comparable to that established by the Commodity Exchange Act, as amended by Title VII (the “CEA”) for other classes of swaps;
  • The extent to which bank regulators of participants in the foreign exchange market provide adequate supervision, including capital and margin requirements;
  • The extent of adequate payment and settlement systems; and
  • The use of a potential exemption of foreign exchange swaps and foreign exchange forwards to evade otherwise applicable regulatory requirements.  

In addition, the Secretary of the Treasury must submit a separate determination to the appropriate committees of Congress.3  

Absent this determination by the Secretary of the Treasury that foreign exchange swaps and foreign exchange forwards (i) should not be regulated as “swaps” under the CEA, and (ii) are not structured to evade Title VII in violation of any rule promulgated by the Commodity Futures Trading Commission (the “CFTC”), foreign exchange forwards and foreign exchange swaps would be included in the definition of “swap” and subject to the Title VII requirements applicable to swap transactions.  

On April 29, 2011, the Secretary of the Treasury issued a proposed determination that would have exempted foreign exchange forwards and forward exchange swaps that result in an actual exchange of currencies from the definition of “swap” and most of the Title VII requirements applicable to swaps.4 However, foreign exchange options, currency swaps and NDFs were not included in the proposed determination and the CFTC has determined that these foreign exchange products are within the definition of “swap” and are not eligible for any Treasury exemption.5 As noted below, these foreign exchange products are not covered by the final determination and will continue to be regulated as “swaps” under Title VII. The scope of the final determination remains essentially unchanged from the proposed determination.

TREASURY DETERMINATION AND SCOPE OF THE EXEMPTION

The determination by the Secretary of the Treasury (the “Determination”) states that foreign exchange forwards and foreign exchange swaps should not be regulated as swaps under the CEA, and are not structured to evade the requirements of Title VII, and, accordingly, should be exempted from the definition of “swap” under the CEA.

The CEA narrowly defines a foreign exchange swap as “a transaction that solely involves – (A) an exchange of 2 different currencies on a specific date at a fixed rate that is agreed upon on the inception of a contract covering the exchange” and “(B) a reverse exchange of [those two currencies] at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange.” A foreign exchange forward is similarly narrowly defined under the CEA as “a transaction that solely involves the exchange of 2 different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange.” Therefore, only foreign exchange forwards and foreign exchange swaps that result in a physical settlement (i.e., an actual exchange of currencies) are covered by the Determination.6

As required by Title VII, transactions involving foreign exchange forwards and foreign exchange swaps that are covered by the Determination (the “Covered FX Products”) must be reported to a swap data repository, or the CFTC, if no swap data repository accepts reporting of the Covered FX Products.7 In addition, any swap dealer or major swap participant (an “MSP”) that enters into a transaction involving a Covered FX Product remains subject to the business conduct rules under section 4s(h) of the CEA.8 Finally, any Covered FX Product that is traded on a designated contract market (i.e., an exchange) or swap execution facility will remain subject to the anti-manipulation provisions of the CEA.

The Determination, noting the distinctive characteristics of the Covered FX Products, found that unlike most other types of swaps, the Covered FX Products have fixed payment obligations, are settled by the exchange of actual currency, and are predominantly short-term instruments. Therefore, requiring central clearing and trading under the CEA would potentially introduce operational risks and challenges to the current settlement process of the Covered FX Products. Furthermore, the Covered FX Products are currently subject to a regulatory scheme that is materially comparable to the new Title VII regulatory regime for other classes of swaps and the existing regulatory regime for the Covered FX Products have required specific actions that address “settlement risk, mitigate counterparty credit risk, and manage other risks associated with” the Covered FX Products.9

The Determination also noted that the requirement in the statutory definition to “exchange” two currencies “should not be interpreted as requiring each foreign exchange swap or forward transaction to be settled independently.”10 Instead, an entity such as CLS Bank International or any other operator of a multilateral payment versus payment system that settles a series of Covered FX Products may net such transactions involving the same parties and same currencies, and deliver the resulting net amounts of currencies to the respective parties. The Determination states in this regard that “[a]pplying appropriate mechanisms during the settlement process to net qualifying foreign exchange swap and forward transactions conducted by a group of parties should satisfy the limitations under the CEA because the essential elements of each of those transactions – namely, an exchange of two different currencies at a predefined, fixed rate – are left intact.”11

The Determination became effective on November 20, 2012 upon its publication in the Federal Register.12

IMPLICATIONS OF THE DETERMINATION

Following publication of the Determination in the Federal Register, a person will not be required to include the Covered FX Products in its calculation of aggregate gross notional amount of swaps connected with its swap dealing activity for purposes of evaluating if it qualifies for the de minimis exclusion from the swap dealer definition. Likewise, a person will not be required to include the Covered FX Products in its calculation of its daily average aggregate uncollateralized outward exposure and daily average aggregate potential outward exposure for purposes of the MSP thresholds (“MSP Exposure calculations”). Finally, a person that operates a collective investment vehicle that trades the Covered FX Products or a person who provides advice concerning the Covered FX Products will not be required to register as a commodity pool operator or commodity trading advisor, solely as a result of activities related to the Covered FX Products.

In addition, the covered FX Products will not be subject to the Title VII clearing or execution requirements, nor will the Title VII margin or capital requirements apply to transactions in the covered FX products. However, transactions in cash-settled foreign exchange forwards or swaps, foreign exchange options, currency swaps, and NDFs will continue to be defined as “swaps” and fully regulated under the CEA as swaps. Any market participant that enters into transactions in such transactions will be subject to the various regulatory requirements applicable to swaps under Title VII.

In response to concerns regarding the status of foreign exchange forwards and foreign exchange swaps, absent an exemption from the Treasury Secretary prior to the compliance date of some of the Title VII regulatory requirements, the CFTC issued limited temporary no-action relief on October 12, 2012, with respect to inclusion of the Covered FX Products in the assessment of whether an entity is required to register as a swap dealer, MSP, commodity pool operator or commodity trading advisor.13 This temporary no-action relief allowed an entity to exclude from its swap dealer de minimis calculations or its MSP Exposure calculations any foreign exchange product covered by a Treasury exemption that was effective prior to December 31, 2012.14

The no-action relief also permitted a commodity pool operator or a commodity trading advisor that traded or provided advice on, respectively, any foreign exchange product covered by a Treasury exemption from registering with the CFTC solely as a result of these activities if a Determination was effective prior to December 31, 2012.