On November 16, 2012, under specific authority granted under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the US Secretary of the Treasury (Secretary) issued the long-awaited final determination (Determination), which states that physically settled “foreign exchange swaps” (FX Swaps) and “foreign exchange forwards” (FX Forwards) are exempt from the definition of “swap” and not subject to many of the swap requirements under the Commodity Exchange Act (CEA). In particular, FX Swaps and FX Forwards will not be subject to central clearing, margin or exchange trading requirements, although they will remain subject to the CEA’s new trade reporting requirements, enhanced anti-evasion authority and business-conduct standards for swap dealers and major swap participants.
One welcome consequence of the Determination is that it excludes FX Swaps and FX Forwards from otherwise applicable thresholds for registration of swap dealers and major swap participants. Another is that securitization and other entities will not be at risk of being treated as “commodity pools” solely as a result of investing in FX Swaps or FX Forwards, and related parties will not face the risk of being “commodity pool operators” or “commodity trading advisors” on those grounds.
The Treasury and the CEA define FX Swaps and FX Forwards in the same way. An FX Swap is 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 [those two currencies] at a later date and at a fixed rate that is agreed upon on inception of the contract.” An FX Forward is defined 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.”
In the preamble to the Determination, the Secretary summarizes Treasury’s conclusions on how FX Swaps and FX Forwards are qualitatively different from other swaps that are not exempt, such as currency swaps and FX options, including:
- The actual exchange of principal amounts of specified currencies that are fixed at inception of the related contract;
- The shorter maturities that are typical for FX Swaps and FX Forwards;
- That FX Swaps and FX Forwards are not structured to evade regulatory requirements that apply to other swaps and are predominantly used to hedge risks associated with short-term fluctuations in foreign currency values or to manage global cash flow needs; and
- That FX Swaps and FX Forwards are traded in highly transparent and liquid markets.
The Determination preamble also notes that FX Swaps and FX Forwards have less counterparty risk than other swaps and that requiring FX Swaps and FX Forwards to be regulated as swaps might impair the existing markets. For example, requiring central clearing of FX Swaps and FX Forwards could add costs (by requiring large capital and currency needs) and disrupt the existing settlement process (stated to function well) by imposing additional steps between trade execution and settlement that would pose significant operational challenges.
The preamble also notes that:
- The foreign exchange markets have long been subject to extensive and coordinated oversight given the critical role of these markets in monetary policy and the global payments system;
- FX Swaps and FX Forwards already trade in a highly transparent market across a range of electronic platforms, the use of which has been steadily increasing in recent years; and
- The exemption will not affect the application of those CEA provisions designed to prevent evasion and improve market transparency.
As noted above, currency swaps (such as those commonly used to hedge the interest rate risk of foreign currency borrowings), foreign exchange options and non-deliverable foreign exchange transactions are not covered by this relief. The preamble also states that the Secretary is not extending the exemption for FX Swaps and FX Forwards to non-deliverable forwards (NDFs) involving foreign exchange, although this had been sought by several commenters who had argued that NDFs are “economically and functionally identical” to FX Forwards. According to Treasury, NDFs do not meet the statutory requirement for an actual delivery of physical currencies (rather than an exchange of equivalent values under a NDF); in support of this, Treasury cites the recent determination by the US Commodity and Futures Trading Commission (CFTC) and the US Securities and Exchange Commission (SEC) in their joint Swap Product Rule that “swap” includes an NDF, while an NDF is not an FX Swap or FX Forward.
The Determination will become effective upon publication in the Federal Register, which is scheduled for Tuesday, November 20, and upon the Determination being provided to the appropriate Congressional committees as required under CEA section 1a(47)(E)(ii), which we understand from Treasury staff has taken place.