Alert May 03, 2011

Treasury Proposes to Exempt Foreign Exchange Swaps and Forwards from Mandatory Central Clearing and Exchange Trading Requirements under Dodd Frank

As authorized under Section 1a(47)(E) of the Commodity Exchange Act (the “CEA”), as amended by Section 721 of the Dodd-Frank Act, the Department of the Treasury (“Treasury”) has proposed to make a written determination that “foreign exchange swaps” and “foreign exchange forwards” (a) should not be regulated as swaps under the CEA and (b) are not structured to evade the Dodd-Frank Act in violation of any rule promulgated by the CFTC pursuant to Section 721(c) of the Dodd-Frank Act, and exempt foreign exchange swaps and foreign exchange forwards from the CEA’s definition of “swap.” 

Under the CEA, foreign exchange swaps and foreign exchange forwards are narrowly defined. 

  • A foreign exchange swap is a transaction that involves an exchange of two currencies on a set date at an agreed-upon price followed by a reverse exchange of those two currencies at a later date at an agreed‑upon price. 
  • A foreign exchange forward is a future exchange of two currencies on a set date at an agreed-upon price. 

Notably, other foreign exchange and currency derivatives, including foreign exchange options, currency swaps and non-deliverable forwards, would continue to be regulated as swaps under the CEA. 

The most significant consequence of exempting foreign exchange swaps and forwards from the definition of swap under the CEA is to exclude them from the mandatory central clearing and exchange trading requirements under the CEA introduced by the Dodd‑Frank Act.  However, even if they are exempted from the definition of swap under the CEA, foreign exchange swaps and forwards would remain subject to regulation by the CFTC, including the CFTC’s new trade-reporting requirements, enhanced anti-evasion authority, and strengthened business-conduct standards. 

Treasury considered the following factors in making its proposed determination:

  • whether regulating FX swaps and forwards would create systemic risks to the market, lower transparency or threats to the financial stability of the U.S.;
  • whether FX swaps and forwards are already subject to a regulatory scheme comparable to CEA for other types of swaps;
  • the extent to which bank regulators provide adequate supervision, including through capital and margin requirements;
  • the extent of adequate payment and settlement systems; and
  • potential use of the exemption to evade other regulations.

In addressing these factors, Treasury noted that foreign exchange swaps and forwards have characteristics that distinguish their risk profile from the risk profiles of other swaps:  only fixed payment obligations, physical settlement and generally short terms.  Treasury observed that because of these characteristics, foreign exchange swap and forward participants generally face settlement risk rather than, as is the case with other derivatives, counterparty risk.  Treasury viewed this settlement risk as being effectively addressed through standard terms such as payment-versus-payment settlement arrangements (in which each party’s delivery is conditioned on the other party’s delivery), including through CLS Bank International, and other market characteristics. 

In support of the exemption, Treasury also cited the manner in which participants in foreign exchange swap and forward transactions are regulated and the nature of foreign exchange swap and forward markets themselves, observing that centralized trading could potentially increase costs and mandatory exchange trading would yield only marginal improvements in transparency. 

  • Banks (on their own behalf and on behalf of their clients) account for approximately 95% of foreign exchange swap and forward transactions. Banks’ foreign exchange activities are already subject to coordinated supervision (e.g., through the Bank of International Settlements), including to ensure that they have adequate funding and capital, stability, internal control measures, and risk-management protocols, according to Treasury. 
  • Central clearing would likely have a number of potentially negative consequences, according to Treasury, including potentially increasing risk and presenting operational challenges and costs:  combining clearing and settlement in a central clearing party (CCP) would create such large currency and capital needs for the CCP, potentially no CCP would be able to provide central clearing for the market; central clearing, with its margin and capital requirements, would significantly increase the cost of foreign exchange swaps and forwards for end-users (and, of particular note, non-financial end users); and requiring clearing would disrupt the existing, and otherwise well‑functioning, foreign exchange swap and forward markets. 
  • Foreign exchange swaps and futures markets are also generally transparent (e.g., multiple sources of pricing within markets) and liquid with, as reported by Treasury, approximately 41% and 72% of foreign exchange swaps and forwards already being traded on electronic exchanges.

The public has 30 days to comment on Treasury’s proposed determination after publication of the proposal in the Federal Register