On November 16, 2012, the Secretary of the U.S. Department of the Treasury (the “Secretary”) issued its final determination that foreign exchange forwards and foreign exchange swaps are exempt from the definition of the term “swap” and should not be regulated as swaps under the Commodities Exchange Act (the “Act”), as amended by the Dodd-Frank Act. The final determination closely follows the Notice of Proposed Determination issued by the Treasury in April 2011. As a result, foreign exchange forwards and foreign exchange swaps are not required to be cleared or traded on an exchange. Foreign exchange forwards and foreign exchange swaps remain subject to reporting requirements, recordkeeping requirements and business conduct standards. The determination does not extend to other foreign exchange derivatives (e.g., foreign exchange options and non-deliverable forwards).

What are foreign exchange forwards and foreign exchange swaps?

A “foreign exchange forward” is a transaction that solely involves the exchange of two different currencies on a specific future date at a fixed rate agreed upon on at the inception of the contract covering the exchange.1 A “foreign exchange swap” is a transaction that solely involves (1) an exchange of two different currencies on a specific date at a fixed rate that is agreed upon at the inception of the contract covering the exchange and (2) a reverse exchange of those two currencies at a later date and at a fixed rate that is agreed upon at the inception of the contract covering the exchange.2 Foreign exchange forwards and foreign exchange swaps can be contrasted with “non-deliverable forwards,” which are cash-settled (i.e., they do not involve an exchange of the underlying currencies), with the value of the contract determined by the movement of exchange rates between two currencies. On the settlement date, the profit to one party is paid by the other party based on the difference of the contracted currency exchange rate and the prevailing exchange rate.

Background

Title VII of the Dodd-Frank Act amended the CEA and the federal securities laws to create a comprehensive regulatory regime for swaps. Section 721 of the Dodd-Frank Act amended the CEA definition of “swap” to include foreign exchange swaps and foreign exchange forwards, but authorized the Secretary to make a determination that foreign exchange swaps and foreign exchange forwards (1) should be excluded from the definition of “swap” and (2) are not structured to evade the Dodd-Frank Act in violation of any rule promulgated by the Commodity Futures Trading Commission (the “CFTC”) pursuant to Section 721 of the Dodd-Frank Act. This determination excludes foreign exchange swaps and foreign exchange forwards from certain regulations applicable to swaps.

In making its determination, the Secretary was required to consider (1) 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; (2) whether foreign exchange swaps and foreign exchange forwards are already subject to a regulatory scheme that is materially comparable to that established by the CEA for other classes of swaps; (3) the extent to which bank regulators of participants in the foreign exchange market provide adequate supervision, including capital and margin requirements; (4) the extent of adequate payment and settlement systems; and (5) the use of a potential exemption of foreign exchange swaps and foreign exchange forwards to evade otherwise applicable regulatory requirements.

Treasury determination

The Secretary distinguished foreign exchange swaps and foreign exchange forwards from other classes of swaps in several ways, including that they are physically settled (i.e., the parties exchange the actual currencies), the payment obligations are fixed at inception, the maturities are typically much shorter than with other derivatives, they are not structured to evade regulatory requirements and that they already trade in a highly transparent and liquid market. The Secretary determined that the main risk for foreign exchange swaps and foreign exchange forwards is settlement risk, which is largely mitigated through the market’s use of payment-versus-payment settlement arrangements. Payment-versus-payment settlement arrangements permit the final transfer of one currency to occur only if the final transfer of the other currency also takes place.

The Secretary believes that requiring foreign exchange swaps and foreign exchange forwards to be cleared would disrupt the existing settlement process and may lead to combining clearing and settlement in one facility, which would create large currency and capital needs for that facility and it is unlikely that a facility would be able to provide the settlement services required by this market, either directly or in conjunction with another entity.

Effect on end-users of determination

The determination does not affect any compliance dates of other regulations passed pursuant to the Dodd-Frank Act, nor does it exempt foreign exchange swaps and foreign exchange forwards from reporting requirements, recordkeeping requirements, or business conduct standards applicable to swap dealers and major swap participants. The determination does, however, remove foreign exchange swaps and foreign exchange forwards from the analysis of whether a person is a swap dealer or major swap participant.

An end-user that enters into only foreign exchange forwards and foreign exchange swaps can disregard clearing requirements and does not need to concern itself with qualifying for the end-user exception with respect to these types of transactions.

The determination only affects foreign exchange swaps and foreign exchange forwards. Other foreign exchange and currency products (e.g., foreign exchange options, cross-currency swaps and non-deliverable forwards) remain within the definition of “swap” and subject to the regulations applicable to swaps. In addition, end-users of all foreign exchange products (including foreign exchange forwards and foreign exchange swaps) must comply with the reporting requirements and recordkeeping requirements.