On November 16, 2012, the United States Department of the Treasury (“Treasury”) declared that foreign exchange swaps and foreign exchange forward contracts would not be subject to clearing or exchange-trading requirements by the Commodity Futures Trading Commission (the “CFTC”).2 While the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd Frank Act”) created the possibility that such contracts would be subject to full regulation as “swaps” by the CFTC,3 the legislation expressly granted to the Treasury Department authority to exempt those transactions from the clearing and exchange-trading requirements. Market participants have long expected Treasury to exercise that authority.4 Significantly, however, Treasury Department’s ruling does not exempt cross-currency swaps, foreign exchange options, and non-deliverable forwards from Dodd-Frank’s mandatory clearing and exchange-trading requirements.5 Moreover, all foreign exchange transactions (including foreign exchange swaps and forwards) will remain subject to the CFTC’s trade reporting requirements, business conduct standards, and anti-evasion authority.6 As a practical matter, the Treasury determination means that foreign exchange swaps and forwards, as defined by the statute and regulations, may continue to be entered bilaterally and likely will not be subject to government-mandated margin or collateral requirements.
Defining and Explaining Foreign Exchange Swaps and Forwards
The foreign exchange markets are the largest financial markets in the world.7 Average daily turnover in these markets in 2010 was estimated at four trillion dollars, of which 1.8 trillion dollars consisted of swaps, 1.5 trillion dollars consisted of spot transactions, and 0.5 trillion dollars consisted of forwards.8
By way of background, a “foreign exchange swap” is a transaction consisting solely of (a) the exchange of two different currencies on a specific date in fixed amounts (i.e., at a fixed rate) and (b) a reverse exchange of those currencies at a later date and different fixed rate, in each instance explicitly agreed upon at inception.9 A foreign exchange forward is a transaction consisting solely of the exchange of two different currencies on a specific future date in fixed amounts (i.e., at a fixed rate) agreed upon at inception.10 By contrast, a cross-currency swap transaction is primarily based on rates of exchange between different currencies, changes in such rates, or other aspects of such rates.11
Unlike most swaps, foreign exchange swaps and forwards are settled on a physical basis, i.e., by actually exchanging the specified principal amounts of the two currencies. Thus, parties to these transactions know at the outset what their respective future obligations will be. Indeed, some have argued that foreign exchange swap and forward transactions are not “derivative” transactions at all, as all that distinguishes them from foreign exchange “spot” (i.e., present conversion) transactions is the delay in delivery.12
Foreign exchange swaps and forwards also often have shorter maturities than other derivatives. According to the Treasury Department, while interest rate swaps and credit default swaps have typical maturities of between two to thirty years, and five to ten years, respectively, 98 percent of foreign exchange swaps and forwards mature in less than one year, and 68 percent in less than one week.13
Foreign Exchange Swaps and Forwards Under Dodd-Frank
The Dodd-Frank Act provided a general regulatory framework for “swaps” having a sufficient connection to the United States, but left it to the CFTC and Treasury Department to determine whether and to what extent foreign exchange forwards and swaps would be subject to the general regulatory scheme. In April 2011, Treasury formally proposed to exempt foreign exchange swaps and forwards from the clearing and exchange-trading requirements under the Dodd-Frank Act and sought comment on its proposal. On August 13, 2012, in their joint rulemaking further defining the terms “swap” and “security-based swap,” the CFTC and SEC classified foreign exchange swaps and forwards as “swaps” covered by the full panoply of Dodd-Frank regulation, subject to the Treasury Department’s final determination on whether to exempt those instruments from the Dodd-Frank clearing and exchange-trading requirements. On October 12, 2012, recognizing that the Treasury Department had yet to issue its final determination and in order to alleviate market uncertainty, the CFTC granted “no-action” relief until December 31, 2012, from the requirement to count foreign exchange swaps and forwards in determining an entity’s status as a “swap dealer” or “major swap participant.” The CFTC’s no-action relief became moot in the wake of the Treasury Department’s final determination.
Bases for the Treasury Department Final Determination
In reaching its decision to exempt foreign exchange swaps and forwards from the Dodd-Frank clearing and exchange-trading requirements, the Treasury Department relied in large part on the characteristics of such transactions noted above. Treasury noted that, in most swaps, the full extent of the future payments is not known to the parties at the outset, and settlement involves the payment of net amounts based on changes in underlying variables. In foreign exchange swaps and forwards, on the other hand, future payment amounts are known at the outset and do not change over the life of the transaction, though the “market to market” value of the positions to be exchanged do, and settlement involves each party paying the stipulated amount in the specified currencies.
The most significant non-market risk in these transactions is settlement risk, a risk which the Treasury Department found ameliorated through the widespread use of “payment versus payment” settlement mechanisms which prevent the payment of notional settlement amounts when either party to such transactions defaults. According to the Treasury Department, approximately 75 percent of currency transactions settle without settlement risk, 63 percent through a particular multilateral settlement system and 12 percent because they are either settled between affiliates of the same corporation or clients of the same bank.14
Other bases for the Treasury Department’s determination were that the foreign exchange markets were transparent, that most transactions involve banks who are themselves highly regulated, and that the CFTC would still have indirect oversight through trade-reporting and (as to swap dealers and major swap participant) business conduct rules.15 The Treasury Department noted the serious logistical difficulties that would have arisen had it reached a contrary conclusion, as no entity currently exists or has been proposed which could clear and settle thousands of transactions in multiple currencies daily.16 Since foreign currency swaps and forwards settle through an exchange of the entire value - not just the profit - of a transaction, central settlement “would require massive capital backing in a very large number of currencies, representing a much greater commitment . . . than for any other type of derivatives market.”17
The practical impact of the Treasury Department’s final determination is that counterparties to foreign exchange swaps and forwards will not be required to clear those transactions on an exchange or to post initial and variation margin to a clearinghouse. It is likely that U.S. prudential regulators ultimately will not require bank swap dealers to collect margin for these transactions (either through an express margin requirement or higher capital reserves for uncollateralized transactions), given Treasury’s determination that foreign exchange swaps and forwards pose less counterparty and systemic risk than other types of swaps.18 While the CFTC has made clear that it will regulate to the outer limits of its authority even with respect to these transactions, the Treasury determination should materially limit the increase in direct and indirect costs for entering into these garden-variety foreign exchange transactions.