Proposed Treasury Exemption for Foreign Exchange Swaps and Forwards

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1 Proposed Treasury Exemption for Foreign Exchange Swaps and Forwards Treasury proposes to exempt foreign exchange swaps and foreign exchange forwards from the definition of swap under the Commodity Exchange Act, as amended by the Dodd-Frank Act SUMMARY On April 29, 2011, the Department of the Treasury issued a Notice of Proposed Determination providing that foreign exchange swaps and forwards should not be regulated as swaps under the Commodity Exchange Act. Foreign exchange swaps and forwards would remain subject to the trade reporting requirements and business conduct standards set forth in the Dodd-Frank Act, as mandated by the statute, and may not be used to evade other rules promulgated by the Commodity Futures Trading Commission. The proposed determination does not extend to foreign exchange options, currency swaps and non-deliverable forwards, which will remain fully subject to the Dodd-Frank Act. Comments on the proposal are due on June 6, I. BACKGROUND The comprehensive regulatory regime provided for by the Commodity Exchange Act ( CEA ), as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ) 1, provides for mandatory central clearing and exchange-trading of most derivatives. 2 These requirements are designed to mitigate risks, promote price transparency, and facilitate liquidity. This regime potentially, subject to CFTC determination, applies to a wide range of foreign exchange instruments, including foreign exchange options, currency swaps, and non-deliverable forwards ( NDFs ). Foreign exchange swaps and forwards similarly would be subject to these requirements, unless the Secretary of the Department of the Treasury makes a determination that all foreign exchange swaps and foreign exchange forwards (i) should not be regulated as swaps under the CEA, as amended by the Dodd-Frank Act, and (ii) are New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 not structured to evade the Dodd-Frank Act in violation of any rule promulgated by the Commodity Futures Trading Commission ( CFTC ). 3 On April 29, 2011, the Secretary of the Treasury proposed to make such a determination. 4 The Treasury indicated that since foreign exchange swaps and forwards have fixed payment obligations, are physically settled and are predominantly short-term instruments, their risk profile is different from other derivatives as they are centered on settlement risk, rather than counterparty credit risk. In response to previously received comments, 5 the Treasury concluded that the central clearing and execution requirements, when applied to foreign exchange swaps and futures, would present such operational challenges to the current settlement arrangements as to significantly outweigh the marginal benefits. II. DEFINITION OF FOREIGN EXCHANGE SWAP AND FOREIGN EXCHANGE FORWARD AND SCOPE OF EXEMPTION The scope of the Secretary s exemption would be limited to foreign exchange swaps and forwards, as defined in the CEA. Section 1a(25) of the CEA 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 the contract covering the exchange and (B) a reverse exchange of [these currencies] at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange. Section 1a(24) of the CEA defines a foreign exchange forward 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. The release accompanying the proposed determination states that it will be limited to these types of instruments, narrowly defined. It should be noted that foreign exchange options, currency swaps and NDFs do not satisfy these statutory definitions and, therefore, would not be exempted from the CEA definition of a swap. III. DISTINCTIVE CHARACTERISTICS OF FOREIGN EXCHANGE SWAPS AND FORWARDS THAT JUSTIFY THE EXEMPTION The Treasury indicated that foreign exchange swaps and forwards would be exempted from the swap definition because of their distinctive characteristics, which result in a risk profile that is different from that of other derivatives. Some of these particular features are summarized below. A. THE RISK PROFILE IS CONCENTRATED ON SETTLEMENT RISK The proposal emphasizes that the physical settlement requirement, which requires the exchange of the full principal amount of the contract in two different currencies, distinguishes foreign exchange swaps and forwards from other derivatives. The parties payment obligations on foreign exchange swaps and forwards are predetermined. While the mark-to-market value of a position in a foreign exchange swap or forward may vary based on the exchange rate, the settlement amounts are fixed. Thus, the risk profile of -2-

3 foreign exchange swaps and forwards is concentrated mostly on settlement risk. In addition, the market in foreign exchange swaps and forwards relies on the extensive use of payment vs. payment ( PVP ) settlement arrangements. While PVP settlement arrangements do not guarantee performance of the contract, they prevent a final transfer of one currency if the final transfer of the other currency has not occurred, thereby mitigating settlement risk. Settlement risk is also currently dealt with through settlement systems, such as Continuous Linked Settlement ( CLS ) through CLS Bank International. 6 By contrast, a swap regulated under the CEA, such as a currency swap or interest rate swap, involves a periodic exchange of a floating amount of cash between the counterparties based on a notional amount. The payment obligations in connection with most derivatives, other than foreign exchange swaps and forwards, are based on the incremental profit or loss on a transaction. B. COUNTERPARTY CREDIT RISK DECREASES WITH SHORTER MATURITIES Among the characteristics of foreign exchange swaps and forwards that justify their exemption from the definition of a swap, the proposal mentions the short average maturity term of these instruments typically less than one year which results in a reduced risk that a counterparty could suffer adverse circumstances and, as a result, fail to meet its payment obligations. In addition, the use of credit support annexes and standard ISDA documentation further mitigates this risk. In this context, the Treasury views the imposition of a central clearing requirement for foreign exchange swaps and forwards as creating operational difficulties unmatched by its marginal benefits. Central clearing for foreign exchange swaps and forwards would be impractical because, to improve market functioning, a central clearing facility would need to have settlement capabilities as well. Due to the size and volume of the market, the provision of these services would require large capital backing in a large number of currencies, thereby representing a substantial commitment for the clearing facility. In addition, a central clearing requirement would create operational challenges by introducing an additional central counterparty phase into an already well-functioning and interconnected settlement process. C. THE FOREIGN EXCHANGE MARKET IS ALREADY HIGHLY TRANSPARENT The proposal notes that the market for foreign exchange transactions is one of the most transparent and liquid global markets. Nearly half of all foreign exchange swaps and almost three quarters of foreign exchange forwards trade on electronic platforms, which readily provide access to pricing information and grant a high level of pre- and post-trade transparency. A mandatory exchange trading requirement would neither significantly raise transparency levels, nor lower trading costs. D. INTER-BANK TRANSACTIONS ARE ALREADY SUBJECT TO ADEQUATE OVERSIGHT The Treasury was required to consider whether foreign exchange swaps and forwards are already subject to a regulatory regime that is comparable to that established by the CEA for other classes of swaps. The proposal notes that, unlike other derivatives markets, the vast majority around 95% of -3-

4 foreign exchange transactions occur between banks, which act either on their own account or on their clients behalf. Unlike non-banking entities, banks have the liquidity and funding capabilities necessary to engage in foreign exchange transactions. Banks are subject to consolidated supervision, including with regard to their capital and margin requirements. Banks foreign exchange related exposures, internal controls, risk management systems, and settlement practices are routinely monitored by prudential regulators, including the Federal Reserve. In addition, the foreign exchange market has long been subject to global oversight, including by the Bank of International Settlement through the implementation of PVP settlement systems. CLS, the predominant PVP settlement system, has an oversight committee composed of 22 central banks. 7 IV. ANTI-EVASION PROVISIONS The Treasury believes that the unique characteristics of foreign exchange swaps and forwards, as outlined in section III above, make it difficult for these products to be structured to replicate currency or interest rate swaps to evade regulatory requirements imposed by the CEA, as amended by the Dodd- Frank Act. As a related consideration, the Treasury believes that the operational and systems arrangements inherent in structuring foreign exchange swaps and forwards for improper purposes would not necessarily be cost-effective when compared with the cost of executing and clearing non-exempt swaps. Despite the considerations outlined above, however, all foreign exchange transactions would remain subject to the provisions of the CEA designed to promote market transparency and to prevent evasion by market participants of other CFTC derivatives rules, including trade-reporting requirements, 8 business conduct standards 9 for swap dealers and major swap participants, and anti-fraud and anti-manipulation provisions. 10 For example, the proposal references plans for the creation of a global foreign exchange trade repository, which would greatly expand reporting to regulators for foreign exchange swaps and forwards. 11 * * * Copyright Sullivan & Cromwell LLP

5 ENDNOTES Pub. L , 124 Stat (2010). Section 2(h) of the CEA. This determination is authorized by Section 1a(47)(E) of the CEA. Department of the Treasury, Notice of Proposed Determination on Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange Act, 76 FR (May 5, 2011). Department of the Treasury, Notice and Request for Comments on Determination of Foreign Exchange Swaps and Forwards, 75 FR (October 28, 2010). CLS Settlement is offered by CLS Bank International, which is owned by the foreign exchange community. See Board of Governors of the Federal Reserve System, Protocol for the Cooperative Oversight Arrangement of CLS (November 25, 2008), available at Section 1a(47)(E)(iii) of the CEA. Section 1a(47)(E)(iv) of the CEA. Section 1a(47)(F) of the CEA. See Section 21 of the CEA. -5-

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