Treasury Issues Final Determination Exempting FX Swaps and Forwards: What’s In and What’s Out

The Commodity Exchange Act, as amended by Dodd-Frank (the “CEA”), empowers the Secretary of the Treasury to determine that foreign exchange swaps and foreign exchange forwards should not be regulated as swaps. On Nov. 16, 2012, Treasury issued a final determination that exempts both foreign exchange swaps and foreign exchange forwards from the swap definition. The determination will be effective upon publication in the Federal Register and submission to the appropriate committees of Congress, expected to be the same date as publication.

Below we summarize:

• Treasury’s determination;
• The impact of Treasury’s determination;
• Which foreign exchange products are, and which are not, exempted by Treasury’s determination; and
• What CFTC rules will apply to the exempted products.

Treasury’s Determination

Dodd-Frank grants Treasury the authority to exempt from regulation as swaps both foreign exchange swaps and foreign exchange forwards, as each is narrowly defined in the CEA. In concluding that the exemption should be granted with respect to both of these products, Treasury addressed the following matters, among others:

• Whether trading of the instruments would create systemic risk or lower transparency;
• Whether the products are already subject to a materially comparable regulatory scheme to that of the CEA for other swaps;
• The extent to which bank regulators provide adequate supervision of the market; and
• The extent of adequate payment and settlement systems.

Treasury considered each of these items in the context of the inter-bank market in which foreign exchange swaps and forwards predominantly trade. Treasury pointed to the short-term nature of the contracts, the way settlement risk is handled in the market and the possibility that CFTC regulation could introduce new risks to a market that functions smoothly. Treasury emphasized the potential risks that could arise from a central clearing facility guaranteeing settlement in this very large, bank-dominated market.

Impact of Treasury’s Determination

As a result of Treasury’s determination, the exempted foreign exchange products will not be subject to mandatory clearing, mandatory on-facility trade execution or margin requirements. In addition, the exempted products will not be considered swaps for purposes of conducting the de minimis test for swap dealers or for calculating whether a person is a major swap participant.

There remains a separate interpretive question as to whether the exempted foreign exchange products would be considered retail foreign exchange transactions (and thus commodity interests) for a fund sponsor seeking to rely on an exemption from registration as a commodity pool operator.

What Is, and What Is Not, Exempted

Treasury’s determination covers foreign exchange swaps and foreign exchange forwards, each as narrowly defined under the CEA. Importantly, they are defined only to include instruments that call for actual physical delivery.

A “foreign exchange swap” is defined as a transaction that provides for (i) an actual exchange of two different currencies on a specific date at a fixed rate that is agreed at the inception of the contract, and (ii) an actual reverse exchange of those same two currencies at a later date at a fixed rate agreed upon at inception of the contract.

A “foreign exchange forward” is defined as a transaction that solely involves the actual exchange of two different currencies on a specific future date at a fixed rate agreed at the inception of the contract.

Given these narrow definitions — which Congress established in Dodd-Frank — a number of frequently traded foreign exchange derivatives continue to come within the definition of “swap” under the CEA, including: (i) currency swaps, (ii) non-deliverable forwards, and (iii) foreign exchange options. In addition, as provided in the CEA, Treasury’s determination does not affect the CFTC’s jurisdiction over retail foreign exchange transactions.

What CFTC Rules Will Apply to Exempted Foreign Exchange Products?

Treasury’s exemption does not provide relief from all CEA and CFTC rules and requirements for the exempted products. CEA and CFTC provisions that will still be applicable include:

• External business conduct rules for swap dealers and major swap participants,
• Swap data reporting requirements (but not real-time reporting requirements), and
• The CFTC’s anti-evasion authority.

Additionally, CEA provisions with respect to fraud and manipulation will continue to apply to any foreign exchange swap or forward that is traded on a designated contract market or a swap execution facility, or that is cleared by a derivatives clearing organization.

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Please feel free to reach out to your regular contacts at the firm if you have any questions about the matters addressed in this Alert. In addition, you are welcome to contact the members of the firm’s CFTC Working Group: Rich Goldman and Kenneth Kopelman.

*This alert was co-authored by Geoffrey Aronow, Kenneth Kopelman and Kate Lashley.