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E-MailAnnette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP, and a former commissioner at the U.S. Securities and Exchange Commission. This post is based on a Davis Polk client memorandum.
On November 16, 2012, the Secretary of the Treasury issued a much awaited determination that foreign exchange (“FX”) swaps and FX forwards should not be regulated as swaps under the Commodity Exchange Act for most purposes, including registration, mandatory clearing and trade execution, and margin. As was the case in the proposed determination, FX derivatives other than FX swaps and forwards, such as FX options, currency swaps and non-deliverable forwards, are not covered by the exemption and would be regulated as swaps.
FX swaps and forwards will be subject to swap data repository trade reporting requirements applicable to swaps and to historical swaps. They will not be subject to “real-time” trade reporting requirements, however. Furthermore, the Commodity Futures Trading Commission’s enhanced anti-evasion authority will apply to FX swaps and forwards. In addition, swap dealers and major swap participants transacting in FX swaps and forwards must comply with “business conduct standards” contained in Section 4s(h) of the Commodity Exchange Act and implementing regulations. [1] These include the external business conduct rules, which impose on swap dealers and major swap participants various due diligence, fair dealing and disclosure obligations, certain heightened obligations when dealing with “special entities” and, in the case of swap dealers recommending swaps or swap trading strategies, suitability obligations. They also include the CFTC’s internal business conduct rules relating to diligent supervision. Finally, in discussing enhanced business conduct standards applicable to FX swaps and forwards, the final determination cites to the CFTC’s recently finalized rules on swap confirmation, portfolio reconciliation, portfolio compression and trading relationship documentation, which were adopted in part pursuant to Section 4s(h).
With the Secretary’s issuance of the final determination, FX swaps and forwards entered into after October 12, 2012 may now be excluded retroactively from the determination of whether an entity is a swap dealer or major swap participant. However, in accordance with the CFTC’s No-Action Letter 12-21, an entity must consider its FX swaps and forward dealing activities in determining the date by which it must apply to be registered as a swap dealer.
“FX swap” is defined as a transaction that solely involves an exchange of two different currencies on a specific date at a fixed rate that is agreed upon on the inception of the contract covering the exchange and 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. “FX forward” is defined as a transaction that solely involves the exchange of two different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange. The CFTC and the SEC have stated that an FX transaction that is initially styled as or intended to be an FX forward transaction, but is later modified so that parties cash settle in a reference currency, will not meet the definition of an FX forward transaction. The final determination stated that applying appropriate mechanisms during the settlement process to net transactions involving the same parties and the same currencies, however, should not cause otherwise qualifying FX swap or forward transactions to fall outside the scope of the exemption.
The Secretary considered that FX swaps and forwards differ from other FX derivatives in that they have fixed and predetermined payment obligations that make them more similar to instruments that are not covered by the Dodd-Frank Act. Specifically, FX swaps and forwards do not involve the exchange of periodic payments during the term of a transaction, involve the exchange of actual principal amounts, have a short time to maturity and are generally traded in a transparent and liquid interbank market characterized by a high degree of electronic trading. The requirement to exchange the full principal amounts and the short time to maturity, in particular, concentrate the risk profile of an FX swap or forward on settlement risk, which in the Secretary’s view was adequately addressed through the use of payment-versus-payment settlement providers such as the CLS Bank International. Finally, the Secretary expressed concern that regulating FX swaps and forwards as swaps would require insertion of a central clearing counterparty into the settlement process, which could introduce unforeseen risks and disrupt the existing settlement process.
The determination would not exempt FX swaps and forwards traded on a designated contract market or swap execution facility from any applicable anti-manipulation provisions of the Commodity Exchange Act, nor would it impact the regulation of retail FX transactions pursuant to Section 2(c)(2) of the Commodity Exchange Act.
Endnote
[1] CFTC rules promulgated under CEA §4s(h) include: CFTC Rule §23.400 et seq. (External Business Conduct); CFTC Rule §23.602 (Diligent Supervision); and CFTC Rules §§ 23.500-23.505 (Swap Confirmation, Portfolio Reconciliation, Portfolio Compression and Swap Trading Relationship Documentation).
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