[Federal Register Volume 77, Number 224 (Tuesday, November 20, 2012)]
[Notices]
[Pages 69694-69705]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-28319]
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DEPARTMENT OF THE TREASURY
Determination of Foreign Exchange Swaps and Foreign Exchange
Forwards Under the Commodity Exchange Act
AGENCY: Department of the Treasury, Departmental Offices.
ACTION: Final determination.
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SUMMARY: The Commodity Exchange Act (``CEA''), as amended by Title VII
of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(``Dodd-Frank Act''), authorizes the Secretary of the Treasury
(``Secretary'') to issue a written determination that foreign exchange
swaps, foreign exchange forwards, or both, should not be regulated as
swaps under the CEA. The Secretary is issuing a determination that
exempts both foreign exchange swaps and foreign exchange forwards from
the definition of ``swap,'' in accordance with the applicable
provisions of the CEA.
DATES: Effective November 20, 2012.
FOR FURTHER INFORMATION CONTACT: Office of Financial Markets, 1500
Pennsylvania Avenue NW., Washington, DC 20220, (202) 622-2000; Thomas
E. Scanlon, Office of the General Counsel, 1500 Pennsylvania Avenue
NW., Washington, DC 20220, (202) 622-8170.
SUPPLEMENTARY INFORMATION: Title VII of the Dodd-Frank Act \1\ amends
the CEA, as well as Federal securities laws, to provide a comprehensive
regulatory regime for swaps. Section 721 of the Dodd-Frank Act amends
section 1a of the CEA, which, in relevant part, defines the term
``swap'' and includes foreign exchange swaps and foreign exchange
forwards in the definition.\2\ Section 1a(47)(E) of the CEA authorizes
the Secretary to make a written determination that ``foreign exchange
swaps'' \3\ or ``foreign exchange forwards,'' \4\ or both-- (I) should
not be regulated as swaps under the CEA; and (II) are not structured to
evade the Dodd-Frank Act in violation of any rule promulgated by the
Commodity Futures Trading Commission (``CFTC'') pursuant to section
721(c) of the Dodd-Frank Act.\5\
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\1\ Public Law 111-203, title VII.
\2\ 7 U.S.C. 1a(47).
\3\ 7 U.S.C. 1a(25).
\4\ 7 U.S.C. 1a(24).
\5\ 7 U.S.C. 1(a)(47)(E)(i).
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On October 28, 2010, the Department of the Treasury (``Treasury'')
published in the Federal Register a Notice and Request for Comments
(``October 2010 Notice'') to solicit public comment on a wide range of
issues relating to whether foreign exchange swaps and foreign exchange
forwards should be exempt from the definition of the term ``swap''
under the CEA.\6\
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\6\ 75 FR 66,426 (Oct. 28, 2010). Thirty comments were submitted
in response to the October 2010 Notice.
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On May 5, 2011, Treasury published a notice of proposed
determination (``NPD'') seeking comment on a proposed determination
that would exempt both foreign exchange swaps and foreign exchange
forwards from the definition of ``swap,'' as well as on the factors
that would support such a determination.
In addition, Treasury staff has engaged in a broad outreach to
representatives from multiple market segments, as well as market
regulators and the Federal regulatory agencies. After assessing the
comments in response to the October 2010 Notice and the NPD, consulting
with Federal regulators, and considering the factors set forth in
section 1b(a) of the CEA, as discussed below, the Secretary finds that
a determination pursuant to sections 1a(47)(E) and 1b that ``foreign
exchange swaps'' and ``foreign exchange forwards'' should not be
regulated as swaps under the CEA, and therefore should be exempted from
the definition of the term ``swap'' under the CEA, is appropriate.
In making a determination pursuant to sections 1a(47)(E) and 1b of
the CEA, the Secretary must consider, and has considered, the following
factors:
(1) Whether the required trading and clearing of foreign exchange
swaps and foreign exchange forwards would create systemic risk, lower
transparency, or threaten the financial stability of the United States;
(2) Whether foreign exchange swaps and foreign exchange forwards
are already subject to a regulatory scheme that is materially
comparable to that established by the CEA for other classes of swaps;
(3) The extent to which bank regulators of participants in the
foreign exchange market provide adequate supervision, including capital
and margin requirements;
(4) The extent of adequate payment and settlement systems; and
(5) The use of a potential exemption of foreign exchange swaps and
foreign exchange forwards to evade otherwise applicable regulatory
requirements.\7\
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\7\ 7 U.S.C. 1b(a). In addition, section 1b(b) of the CEA
provides that, ``[i]f the Secretary makes a determination to exempt
foreign exchange swaps and foreign exchange forwards from the
definition of the term `swap','' the Secretary must submit a
separate ``determination'' to the appropriate committees of
Congress, which contains (1) an explanation as to why foreign
exchange swaps and foreign exchange forwards are ``qualitatively
different from other classes of swaps'' such that foreign exchange
swaps and foreign exchange forwards are ``ill-suited for regulation
as swaps'' and (2) an ``identification of the objective differences
of foreign exchange swaps and foreign exchange forwards with respect
to standard swaps that warrant an exempted status.'' The Secretary
has submitted this determination to the appropriate committees of
Congress, and, therefore, this determination is effective, pursuant
to section 1a(47)(E)(ii) of the CEA.
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I. Summary of Final Determination
The CEA, as amended by the Dodd-Frank Act, provides a comprehensive
regulatory regime for swaps and derivatives, including a wide range of
foreign exchange derivatives, such as foreign exchange options,
currency swaps, or non-deliverable forwards (``NDFs''). Among other
measures, this regulatory regime provides for clearing and exchange-
trading requirements that are designed to mitigate risks, promote price
transparency, and facilitate more stable, liquid markets for derivative
instruments.
In general, swaps, including foreign exchange derivatives, carry
three types of risks: (i) Counterparty credit risk prior to settlement;
(ii) market risk; and (iii) settlement risk. Counterparty credit risk
prior to settlement is the risk that a party to the transaction
potentially could default prior to the settlement date, which could
result in the non-defaulting party suffering an economic loss
associated with having to replace the defaulted contract with another
transaction at the then-current terms.
[[Page 69695]]
Market risk is the risk that the value of the contract changes over the
term of the transaction. In this context, market risk is intertwined
with counterparty credit risk prior to settlement because the non-
defaulting party (who thus bears the credit risk) also bears the risk
that the value of the prior contract might have declined when that
party seeks to replace the defaulted contract with another transaction.
Settlement risk, particularly in the context of a foreign exchange swap
or forward transaction, is the risk that the contract will not be
settled in accordance with the initial terms, including when one party
to the transaction delivers the currency it owes the counterparty, but
does not receive the other currency from that counterparty.
The payment obligations on currency swaps, interest rate swaps,
credit default swaps, commodity swaps and other derivatives fluctuate
in response to changes in the value of the underlying variables on
which those derivatives contracts are based. As a result, for most
types of swaps, the full extent of the future payments to be exchanged
is not known at the outset of the contract and is determined throughout
the life of the contract. Moreover, as the term of a swap or derivative
contract increases, a party generally is exposed to greater
counterparty credit risk and market risk prior to settlement.
Settlement of most types of swaps and derivatives involves only
payments of net amounts that are based on the changes in the value of
the variables underlying the derivatives contracts. Given the features
of most swaps and derivatives, including some types of foreign exchange
derivatives, the clearing and exchange-trading requirements under the
CEA, where applicable, would mitigate the relevant risks, notably
counterparty credit risks prior to settlement.
By contrast, foreign exchange swap and forward participants know
their own and their counterparties' payment obligations and the full
extent of their exposures at settlement throughout the life of the
contract. Thus, while the mark-to-market value of a position in a
foreign exchange swap or forward may vary based on changes in the
exchange rate or interest rates, the actual settlement amounts do not.
Under the regulatory regime enacted by the Dodd-Frank Act, foreign
exchange swaps and forwards generally are subject to the requirements
of the CEA and, in particular, would be subject to central clearing and
exchange trading,\8\ unless the Secretary determines that foreign
exchange swaps and forwards ``(I) should not be regulated as swaps
under [the CEA]; and (II) are not structured to evade [the Dodd-Frank
Act] in violation of any rules promulgated by the [CFTC] pursuant to
section 721(c) of the [Dodd-Frank Act].'' \9\
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\8\ 7 U.S.C. 2(h)(1)-(2). In general, section 2(h)(1) of the
CEA, as added by the Dodd-Frank Act, prohibits a person from
engaging in a swap unless the person submits such swap for clearing
to a derivatives clearing organization that is registered under the
CEA if the CFTC requires the swap, or a category of swaps, to be
cleared. 7 U.S.C. 2(h)(1). In addition, section 2(h)(8) of the CEA
provides that any swap required to be cleared is subject to trade-
execution requirements. 7 U.S.C. 2(h)(8). Pursuant to section 4s(e)
of the CEA, uncleared swaps are subject to margin requirements under
the CEA. 7 U.S.C. 6s(e). Thus, as a result of this determination
pursuant to sections 1a(47)(E) and 1b of the CEA, foreign exchange
swaps and forwards would not be subject to margin requirements under
the CEA.
\9\ 7 U.S.C. 1a(47)(E)(i).
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Under the CEA, a ``foreign exchange swap'' is narrowly defined 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 [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.'' \10\ Likewise, the CEA narrowly 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.'' \11\
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\10\ 7 U.S.C. 1a(25).
\11\ 7 U.S.C. 1a(24).
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The Secretary's authority to issue a determination is limited to
foreign exchange swaps and forwards and does not extend to other
foreign exchange derivatives. Foreign exchange options, currency swaps,
and NDFs (as discussed below) may not be exempted from the CEA's
definition of ``swap'' because they do not satisfy the statutory
definitions of a foreign exchange swap or forward.
After considering the statutory factors and the comments on the
NPD, the Secretary is issuing this determination to exempt foreign
exchange swaps and forwards because of the distinctive characteristics
of these instruments. Unlike most other swaps, foreign exchange swaps
and forwards have fixed payment obligations, are settled by the
exchange of actual currency, and are predominantly short-term
instruments.
Counterparty credit risk prior to settlement is significantly
reduced by the structure of a foreign exchange swap or forward
transaction, particularly because the term for each type of transaction
generally is very short. For the vast majority of foreign exchange swap
or forward contracts, the risk profile is centered on settlement risk.
Settlement risk often is addressed in foreign exchange swaps and
forwards through the use of payment-versus-payment (``PVP'') settlement
arrangements,\12\ particularly with large financial institutions.
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\12\ PVP settlement arrangements permit the final transfer of
one currency to take place only if the final transfer of the other
currency also takes place, thereby virtually eliminating settlement
risk.
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Treasury believes, as do several commenters,\13\ that requiring
central clearing and trading under the CEA on foreign exchange swaps
and forwards would potentially introduce operational risks and
challenges to the current settlement process. If central clearing were
to be required, the central clearing facility would be effectively
guaranteeing both settlement and market exposure to replacement cost.
As a result, combining clearing and settlement in a market that
involves settlement of the full principal amounts of the contracts
would require capital backing, in a very large number of currencies,
well in excess of what will be required for swaps that are settled on a
``net'' basis. Treasury believes that requiring foreign exchange swaps
and forwards to be cleared and settled through the use of new systems
and technologies could introduce new, unforeseen risks in this market.
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\13\ See, e.g., American Express Co., at 1; American Bankers
Ass'n et al., at 3; FX Investor Group, at 1; Global FX Division of
SIFMA, et al. (``Global FX Division''), at 1-2.
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II. Overview of the Comments on the NPD
In response to the NPD, Treasury received 26 comment letters. Of
these, 15 expressed support for the proposed determination, while 11
were generally opposed. Several commenters who support the proposed
determination filed letters that incorporated by reference--as well as
reconfirmed--statements and arguments they made in response to the
October 2010 Notice.\14\
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\14\ References made herein to the comment letters are to those
submitted in response to the NPD, unless otherwise noted.
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A. Comments Supporting Proposed Determination
Commenters who support issuing an exemption generally argue that
foreign exchange swaps and forwards are functionally different from
other over-the-counter (``OTC'') derivatives because foreign exchange
swaps and forwards involve an actual exchange of principal, are
predominantly very short in
[[Page 69696]]
duration and have high turnover rates.\15\ These commenters note that
this market functions predominantly as a global payments market and is
used significantly by end-users for hedging purposes.\16\ Many
corporate participants have expressed concern that the additional costs
and operational difficulty associated with clearing foreign exchange
swaps and forwards would adversely affect their business activities and
discourage hedging activity.\17\ Commenters also have cautioned that
imposing mandatory clearing and exchange trading requirements on the
foreign exchange market would increase systemic risk by concentrating
risk in one or more clearinghouses.\18\
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\15\ See, e.g., Alternative Investment Management Ass'n
(``AIMA''), at 2; BlackRock, Inc., at 2.
\16\ See comment on October 2010 Notice by 3M, Cargill Inc. et
al., at 2.
\17\ See Coalition for Derivatives End-Users, at 2.
\18\ See, e.g., BlackRock, at 2; FX Alliance, Inc. (``FXall''),
at 1.
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Commenters supporting the proposed determination argue that
settlement risk is the primary risk associated with foreign exchange
swaps and forwards, and they state that the settlement of trades
through CLS Bank International (``CLS''), has largely addressed these
concerns.19, 20
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\19\ See, e.g., comment on October 2010 Notice by Global FX
Division, at 12-14; Global FX Division comment on NPD, at 3; Thomson
Reuters, at 2.
\20\ CLS, which began operations in September 2002 and is the
predominant global PVP settlement system, currently provides
settlement services for 17 currencies that represent 93 percent of
the total daily value of foreign exchange swaps and forwards traded
globally; See date and figures issued by CLS, available at http://www.cls-group.com/About/Pages/History.aspx.
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Given the particular characteristics of foreign exchange swaps and
forwards, most commenters emphasize that counterparty credit risk is
not as significant a risk for these transactions, relative to other
derivative transactions, and that the widespread use of credit support
annexes (``CSAs'') and standard ISDA documentation mitigates this risk.
Moreover, commenters who favor an exemption maintain that foreign
exchange swaps and forwards generally trade in a highly liquid,
efficient, and transparent inter-bank market that is characterized by a
high degree of electronic trading.\21\ The major participants in the
foreign exchange swaps and forwards market predominantly are either
depository institutions or affiliates of depository institutions, over
which banking regulators have substantial visibility and exercise
strong regulatory oversight. A few of these commenters also observe
that the Federal Reserve Board has authority to craft appropriate
regulations governing systemically important financial market utilities
and payment, clearing, and settlement activities, as designated under
Title VIII of the Dodd-Frank Act.\22\
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\21\ Thomson Reuters, at 2 (supporting Treasury's statement
regarding the extent to which foreign exchange forwards trade on
electronic platforms and noting that ``these figures rise steadily
each year'').
\22\ See, e.g., BlackRock, Inc., at 2.
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B. Comments Opposing Proposed Determination
By contrast, commenters who urge Treasury not to issue a
determination to exempt foreign exchange swaps and forwards, as
proposed, criticize several aspects of Treasury's proposal. Some
commenters who oppose an exemption for foreign exchange swaps and
forwards raise a general concern that the exemption would create an
``enormous'' loophole, citing the large size of this market, as well as
the lack of a fundamental economic difference, in their view, between
foreign exchange swaps and forwards and other derivative products.\23\
In light of the recent financial crisis, these commenters argue that
such loopholes can play a significant role in undermining financial
stability by preserving an opaque, unregulated and under-capitalized
market. Opponents also express concerns that an exemption could be used
to mask complex transactions in an effort to avoid subjecting them to
clearing and trading requirements.\24\
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\23\ Quantitative Investment Management, at 1; see also, e.g.,
Council of Institutional Investors, at 1-2; Americans for Financial
Reform, at 13.
\24\ Americans for Financial Reform, at 13; Better Markets,
Inc., at 11-13.
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One commenter, for example, contends that ``foreign exchange swaps
and forwards have all of the relevant characteristics of other
categories of derivatives that are subject to the clearing and exchange
trading requirements of the Dodd-Frank Act,'' and states that the
``case for the exemption [presented in the NPD] is especially weak
since the [NPD] concedes that many critical measures that support such
an exemption simply do not exist.'' \25\
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\25\ Better Markets, Inc., at 2.
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In addition, several commenters \26\ contend that foreign exchange
swap and forward contracts pose significant counterparty credit risk
which, as one commenter states, arises precisely because these
transactions entail fixed payment obligations.\27\ In this regard, some
commenters have outlined potential techniques, systems ``analogous to
traditional central counterparty clearing'' \28\ that, in their view,
could be developed in order to conduct foreign exchange swap and
forward transactions that can be subject to initial and variation
margin payments designed to minimize the credit risk exposures to the
parties.\29\
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\26\ See, e.g., Duffie, at 3-5; Better Markets, Inc., at 14-15.
\27\ Better Markets, Inc., at 14.
\28\ Better Markets, at 17.
\29\ Better Markets, Inc., at 16-19; Duffie at 5-9.
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III. Analysis, Consideration of Statutory Factors, and Implications of
Final Determination and Treatment of NDFs
A. Analysis of Why Foreign Exchange Swaps and Forwards Should Not Be
Regulated as Swaps Under the CEA
(i) Foreign Exchange Swaps and Forwards Differ in Significant Ways From
Other Classes of Swaps
Foreign exchange swaps and forwards are particular types of
transactions that are qualitatively different from other classes of
derivatives covered under the definition of ``swap'' in the CEA. The
distinctive structural characteristics of foreign exchange swaps and
forwards, particularly the certainty of payment amounts and shorter
maturities, as well as the market characteristics of these instruments,
merit different regulatory treatment pursuant to this determination.
Moreover, largely due to the required exchange of principal amounts,
foreign exchange swaps and forwards are not structured to evade the
requirements of the Dodd-Frank Act or regulations prescribed by the
CFTC.
First, foreign exchange swaps and forwards involve the actual
exchange of the principal amounts of the two currencies in the contract
(i.e., they are settled on a physical basis). Unlike many other
derivative instruments whose payment obligations fluctuate frequently
in response to changes in the value of the underlying variables on
which those derivatives contracts are based, the payment obligations of
foreign exchange swaps and foreign exchange forwards, as defined by the
CEA, are fixed at the inception of the agreement and involve the
exchange of full principal for settlement. A currency swap, also known
as a cross-currency basis swap, differs significantly from a foreign
exchange swap or forward because the actual amount of the cash flow
exchanged by a party is unknown at the onset of the transaction;
instead, in a currency swap, a payment obligation on either party is
dependent on the fluctuation of one or more floating interest rates
during the term of the transaction. As a result, the cash flows
underlying the transaction can be
[[Page 69697]]
affected by market volatility or illiquidity. By contrast, foreign
exchange swap and forward participants know their own and their
counterparties' payment obligations and the full extent of their
exposure at settlement throughout the life of the contract. Thus, while
the mark-to-market value of a position in a foreign exchange swap or
forward may vary based on changes in the exchange rate or interest
rates, the actual settlement amounts do not. The requirement to
exchange the full principal amounts of two different currencies
qualitatively distinguishes foreign exchange swaps and forwards from
other swaps, and contributes to a risk profile that is largely
concentrated on settlement risk.
Second, foreign exchange swaps and forwards typically have much
shorter maturities as compared to other derivatives. For example,
interest rate swaps and credit default swaps generally have maturity
terms between two and thirty years, and five to ten years,
respectively.\30\ In stark contrast, over 98 percent of foreign
exchange swaps and forwards mature in less than one year, and 68
percent mature in less than one week.\31\ BIS data since 1998,
collected on a triennial basis, generally show that foreign exchange
swaps and forwards consistently have had shorter maturities, in line
with the current levels (i.e., prior reports also show approximately 98
percent of these transactions maturing in less than one year, and
approximately 68 percent maturing in less than one week).\32\ Since
counterparty credit risk increases as the term of a contract increases,
foreign exchange swaps and forwards carry significantly lower levels of
counterparty credit risk, relative to other swaps and derivatives.
Correspondingly, the market risk associated with foreign exchange swaps
and forwards is relatively lower because these transactions have
shorter maturities.
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\30\ Foreign Exchange Committee (``FXC''), comment on October
2010 Notice (``FXC Letter''), at 3.
\31\ FXC Letter, at 3; FXJSC survey data; Bank for International
Settlements (``BIS'') Triennial Central Bank Survey of Foreign
Exchange and Derivatives Market Activity, available at http://www.bis.org/publ/rpfxf10t.htm.
\32\ BIS Triennial Central Bank Survey of Foreign Exchange and
Derivatives Market Activity, available at http://www.bis.org/publ/rpfxf10t.htm.
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Third, foreign exchange swaps and forwards are not structured to
evade regulatory requirements that apply to other types of swaps.
Rather, the uses of foreign exchange swaps and forwards are distinct
from other swaps. Because of their unique structure and duration, as
outlined above, foreign exchange swaps and forwards are predominantly
used as a source of funding to hedge risk associated with short-term
fluctuations in foreign currency values and to manage global cash-flow
needs. For example, businesses that sell goods in international trade,
or that make investments in foreign countries, frequently ask their
banks to arrange foreign exchange swaps and forwards to control the
risk that their own country's currency will rise or fall against the
other country's currency while a sale or investment is pending.\33\
Other derivatives, such as currency swaps or interest rate swaps, are
used for a broader range of purposes. For example, a business that
conducts transactions in several countries, each with a different
currency, could use currency swaps to stabilize the value of its sales
revenue (or costs), instead of actually obtaining those currencies to
fund transactions to parties located in those countries. Likewise, a
business that obtains a syndicated loan with a floating interest rate
could use an interest rate swap to stabilize the level of its loan
payments.
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\33\ AIMA, at 2.
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Fourth, foreign exchange swaps and forwards already trade in a
highly transparent and liquid market. Market participants have access
to readily available pricing information through multiple sources,\34\
and one commenter noted that these developments have lowered
transactions costs.\35\ Today, it is estimated that approximately 41and
72 percent of foreign exchange swaps and forwards, respectively,
already trade across a range of electronic platforms.\36\ As a result,
mandatory exchange trading requirements under the CEA would be unlikely
to improve price transparency significantly. Additionally, the
Depository Trust and Clearing Corporation (``DTCC'') has submitted an
application to register with the CFTC as a swap data repository
(``SDR''), and is testing a foreign exchange trade repository service
through which DTCC intends to provide both public and regulatory
reporting, as early as the first quarter of 2013.\37\
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\34\ See, e.g., comment on October 2010 Notice by Global FX
Division of the Securities Industry and Financial Markets Ass'n,
Association for Financial Markets in Europe, and the Asia Securities
Industry and Financial Markets Ass'n (``Global FX Division''), at
11.
\35\ Global FX Division, comment on NPD, at 2 (noting that these
developments have ``resulted in tight spreads'').
\36\ NPD, 76 FR at 25,777; BIS, Greenwich Associates, Oliver
Wyman analysis.
\37\ See DTCC release, ``DTCC Begins User Testing on Foreign
Exchange Repository,'' May 3, 2012, available at http://www.dtcc.com/news/press/releases/2012/press_release_dtcc_begins_user_testing.php.
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(ii) Settlement Risk Is the Main Risk and Is Effectively Mitigated
Through Various Measures
As discussed above, counterparties to foreign exchange swaps and
forwards face three distinct risks: (i) Counterparty credit risk prior
to settlement; (ii) market risk; and (iii) settlement risk.
Counterparty credit risk and market risk prior to settlement exist in
foreign exchange swaps and forwards transactions, but the risk of
economic loss largely is attributable to the fluctuating exchange rate
or interest rate of the two currencies. For example, if a counterparty
defaults on a foreign exchange forward prior to the settlement date
(e.g., as a consequence of bankruptcy) and the exchange rate of the two
specified currencies were to have moved during that period, the non-
defaulting party would be exposed to market risk if that party were to
be required to replace that contract (i.e., actually obtain the
currency desired in the original forward contract) at a higher price.
Settlement risk, in the context of a foreign exchange swap or
forward transaction, is the risk that the contract will not be settled
in accordance with the initial terms, including when one party to the
transaction delivers the currency it owes the counterparty, but does
not receive the other currency due from that counterparty.
The key distinction between counterparty credit risk prior to
settlement and settlement risk is that, with the latter, a party's
failure to deliver a currency under a foreign exchange swap or forward
agreement entails a risk to the non-defaulting party of the loss of
principal as a result of the non-defaulting party's delivery of the
underlying principal sum of currency under the agreement coupled with
the other party's failure to deliver its required principal payment.
In contrast to other derivatives, including other foreign exchange
derivatives, the parties' ultimate payment obligations on a foreign
exchange swap or forward are known and fixed from the beginning of the
contract and involve the actual ``exchange'' of a predetermined amount
of principal at settlement.\38\
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\38\ By contrast, the payment obligations of most other
derivatives occur on an interim basis (e.g., monthly or quarterly),
based on the incremental profit or loss on a transaction and either
party's payment may be made with a common currency.
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The distinguishing characteristics of foreign exchange swaps and
forwards, as described above, result in a risk profile that is largely
concentrated on
[[Page 69698]]
settlement risk, rather than counterparty credit risk prior to
settlement.
The foreign exchange swap and forward market relies on the
extensive use of PVP settlement arrangements, which permit the final
transfer of one currency to take place only if the final transfer of
the other currency also takes place, thereby virtually eliminating
settlement risk. Even though these settlement arrangements do not
guarantee performance on the contract, they do prevent principal
payment flows from occurring if either party defaults.
As noted above, CLS, which began operations in September 2002 and
is the predominant global PVP settlement system, currently provides
settlement services for 17 currencies that represent 93 percent of the
total daily value of foreign exchange swaps and forwards traded
globally. CLS is a specialized settlement system that operates a
multilateral PVP settlement system to reduce foreign exchange
settlement risk (but not credit risk, which is mitigated by other
measures). CLS estimates that it settles 68 percent of global foreign
exchange trading, through 63 settlement member banks and approximately
15,000 third-party users.\39\ In the foreign exchange swaps and
forwards market in particular (exclusive of other transactions
involving currencies), CLS estimates that it settles more than 50
percent of foreign exchange swap and forward transactions that are
subject to settlement risk.
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\39\ See figures issued by CLS, available at http://www.cls-group.com/About/Pages/History.aspx.
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According to a September 2010 Foreign Exchange Committee (``FXC'')
survey, roughly 75 percent of foreign exchange transactions are settled
without settlement risk to either party.\40\ This figure includes
trades settled by CLS, settled between affiliates of the same
corporation, and settled across a single bank's books for its clients.
(Transactions that are internally settled between corporate affiliates,
cash settled, or settled across a single-bank's books for its clients
are not subject to settlement risk.) The extensive use of CLS and
privately negotiated PVP settlement arrangements between banks,
financial intermediaries, and their clients largely addresses
settlement risk in the market for foreign exchange swaps and forwards,
and, as a result, constitutes an important, objective difference
between foreign exchange swaps and forwards and swaps that otherwise
are subject to regulation under the CEA.\41\
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\40\ FXC Letter, at 5. Formed in 1978 under the sponsorship of
the Federal Reserve Bank of New York, the FXC is an industry group
that produces best practice recommendations for the foreign exchange
industry, addressing topics such as management of risk in operations
and trading.
\41\ Additionally, the vast majority of foreign exchange swap
and forward transactions are transacted by well-capitalized and
regulated financial institutions; the financial and operational
safeguards used by these financial institutions mitigates the
settlement risk that a counterparty otherwise would face in a
foreign exchange swap or forward.
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(iii) Foreign Exchange Swaps and Forwards Are Subject to Less
Counterparty Credit Risk Prior To Settlement Than Other Derivatives
Counterparty credit risk increases with the length of a contract
because that increases the length of time during which a counterparty
could suffer from adverse developments. Foreign exchange swap and
forward contracts have a very short average length. As noted above, 68
percent of foreign exchange swap and forward contracts mature in less
than a week, and 98 percent mature in less than a year. Other
derivatives, such as interest rate swaps, generally have much longer
maturity terms (e.g., between two and thirty years) than foreign
exchange swaps and forwards, and thus pose significantly more
counterparty credit risk than foreign exchange swaps and forwards.\42\
---------------------------------------------------------------------------
\42\ As noted above, some commenters contend that counterparty
credit risk ``remains a significant concern in the foreign exchange
markets,'' even though ``non-crisis risk is more concentrated in
longer-duration contracts.'' Better Markets, Inc., at 14-15.
---------------------------------------------------------------------------
Central clearing could provide foreign exchange swap and forward
participants with protection against the risk of default by their
counterparties (i.e., the replacement cost of a transaction if a
counterparty fails to perform). However, as noted in the NPD, imposing
a central clearing requirement on the foreign exchange swaps and
forwards market raises two concerns. First, requiring central clearing
may lead to combining clearing and settlement in one facility, which
would create large currency and capital needs for that entity due to:
(i) The sheer size and volume of the foreign exchange swaps and
forwards market; and (ii) the fact that the central clearing facility
would be effectively guaranteeing both settlement and market exposure
to replacement cost. Treasury believes that it is unlikely a central
counterparty (``CCP'') would be able to provide the settlement services
required by this market, either directly or in conjunction with another
service provider, such as CLS.
Providing central clearing separately from settlement presents the
second concern, namely: required clearing likely would disrupt the
existing settlement process by introducing additional steps between
trade execution and settlement that pose significant operational
challenges. The existing settlement process for this market functions
well and has been critical to mitigating this market's main source of
risk. The operational challenges associated with the addition of a
central clearing requirement, one that is very different from the core
clearing functions currently handled by CCPs, and the potentially
disruptive effects on transactions in the large market of foreign
exchange swaps and forwards, outweigh the benefits that central
clearing would provide, thus making these instruments ill-suited for
regulation as swaps.
(iv) Foreign Exchange Swaps and Forwards Transacted by Banks in the
Foreign Exchange Market Already Are Subject to Oversight
The foreign exchange market itself has long been subject to
extensive and coordinated oversight, reflecting its unique
characteristics and functioning. Since the introduction of floating
exchange rates in the early 1970s, the largest central banks and
regulators have undertaken strong and coordinated oversight measures
for the foreign exchange market, given its critical role in monetary
policy and the global payments system. This global strategy, led by the
Committee on Payment and Settlement Systems (``CPSS''), resulted in the
design and implementation of CLS and other PVP settlement arrangements.
The Federal Reserve regularly conducts reviews of the risk management
and operational processes of major foreign exchange market
participants. These reviews inform Basel Committee on Banking
Supervision (``BCBS'') and CPSS updates to bank supervisory guidelines
on managing foreign exchange settlement risk.\43\
---------------------------------------------------------------------------
\43\ See Bank for Int'l Settlements, Supervisory guidance for
managing risks associated with the settlement of foreign exchange
transactions, (Aug. 2012), available at http://www.bis.org/publ/bcbs229.htm.
---------------------------------------------------------------------------
As referenced above, banks, affiliates in bank holding companies in
the U.S., and banking organizations operating in other jurisdictions
are the key players in the foreign exchange swaps and forwards market.
Roughly 95 percent of foreign exchange swaps and forwards transactions
occur between banks acting either on their own behalf or on behalf of
their clients.\44\ More specifically, the clients of banks that
typically engage in foreign exchange swaps and forwards are companies,
particularly multi-
[[Page 69699]]
national corporations, that engage in cross-border investments or other
commercial transactions that require payments in the local
currency.\45\ Banks are subject to ongoing consolidated supervision,
and supervisors regularly monitor their foreign exchange related
exposures, internal controls, risk management systems, and settlement
practices.
---------------------------------------------------------------------------
\44\ American Bankers Ass'n et al., at 1.
\45\ For example, a U.S.-based company seeking to acquire
specialized brewery equipment from a manufacturer in Germany could
agree to pay for the purchase in euros, on a specified future date
(e.g., the delivery date of the equipment). If the U.S.-based
company needs to fix its payment of euros based on the current
exchange rate (to control the risk that the price of the euro will
rise while the sale is pending), then the company could enter into a
foreign exchange forward with its bank under which, on the specified
date, (i) the company would deliver the dollars to its bank and (ii)
the bank would deliver the euros to the company, payable to the
manufacturer.
---------------------------------------------------------------------------
(v) The Foreign Exchange Swaps and Forwards Market Already Is Highly
Transparent and Traded Over Electronic Trading Platforms
Foreign exchange swaps and forwards already trade in a highly
transparent market. Market participants have access to readily
available pricing information through multiple sources. Approximately
41 percent and 72 percent of foreign exchange swaps and forwards,
respectively, already trade across a range of electronic platforms and
the use of such platforms has been steadily increasing in recent
years.\46\ The use of electronic trading platforms provides a high
level of pre- and post-trade transparency within the foreign exchange
swaps and forwards market.\47\ Thus, mandatory exchange trading
requirements would not significantly improve price transparency or
reduce trading costs within this market.
---------------------------------------------------------------------------
\46\ BIS, Greenwich Associates, Oliver Wyman analysis.
\47\ American Bankers Ass'n et al., at 3.
---------------------------------------------------------------------------
(vi) Foreign Exchange Swaps and Forwards Will Be Subject to Oversight
Under the CEA
The Secretary's determination that foreign exchange swaps and
forwards should not be regulated as ``swaps'' under the CEA does not
affect the application of relevant provisions of the CEA that are
designed to prevent evasion and improve market transparency. Commenters
who oppose an exemption argue that the exemption would create a large
regulatory loophole that could exacerbate systemic risk.\48\ However,
all foreign exchange transactions would remain subject to the CFTC's
new trade-reporting (but not the real-time reporting) requirements,\49\
enhanced anti-evasion authority,\50\ and strengthened business-conduct
standards.\51\ As noted above, the creation of a global foreign
exchange trade repository, such as the SDR created by DTCC, will expand
reporting to regulators and the public more broadly.
---------------------------------------------------------------------------
\48\ For example, Better Markets, Inc., at 3, states:
``[Exchange-trading and clearing systems] offer the only feasible
way to create a marketplace that is relatively free from the
[information] asymmetry that can convert inevitable market
disturbances into catastrophes. An exemption for the large and
diverse foreign exchange market undercuts that essential goal.''
\49\ 7 U.S.C. 1a(47)(E)(iii). See also Swap Data Recordkeeping
and Reporting Requirements, 77 FR 2136 (Jan. 13, 2012); Swap Data
Recordkeeping and Reporting Requirements: Pre-Enactment and
Transition Swaps, 77 FR 35200 (June 12, 2012).
\50\ See note 77, infra.
\51\ 7 U.S.C. 1a(47)(E)(iv). See also Business Conduct Standards
for Swap Dealers and Major Swap Participants with Counterparties, 77
FR 9734 (Feb. 17, 2012); Swap Dealer and Major Swap Participant
Recordkeeping, Reporting, and Duties Rules; Futures Commission
Merchant and Introducing Broker Conflicts of Interest Rules; and
Chief Compliance Officer Rules for Swap Dealers, Major Swap
Participants, and Futures Commission Merchants, 77 FR 20128 (Apr. 3,
2012); Confirmation, Portfolio Reconciliation, Portfolio
Compression, and Swap Trading Relationship Documentation
Requirements for Swap Dealers and Major Swap Participants, 77 FR
55904 (Sept. 11, 2012).
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B. Statutory Considerations
In considering whether to exempt foreign exchange swaps and
forwards from the definition of the term ``swap,'' the Secretary must
consider, and has considered (including in light of the comments
received), five factors, as follows.
(i) Systemic Risk, Transparency, Financial Stability
Treasury has considered several factors to assess whether the
required trading and clearing of foreign exchange swaps and foreign
exchange forwards would create systemic risk, lower transparency, or
threaten the financial stability of the United States. As stated in the
NPD, given the reduced counterparty credit risk profile of this market
as compared to the markets for other swaps and derivatives, the
logistical challenges of implementing central clearing within this
market significantly outweigh the marginal benefits that central
clearing and exchange trading might provide.
Several commenters have challenged Treasury's consideration of this
statutory factor, contending, for example, that Treasury's proposed
analysis regarding the ``operational challenges'' that would arise by
interposing a CCP into the settlement process ``carries no weight under
the statutory test.'' \52\ One commenter offers its belief that
``exempting foreign exchange forwards and swaps at this time from the
clearing and trading requirements of [the Dodd-Frank Act] could
increase systemic risk at a time when regulators around the globe are
trying to reduce it.'' \53\
---------------------------------------------------------------------------
\52\ Better Markets, Inc., at 8. Separately, Americans for
Financial Reform (``AFR'') contends that, under section 721 of the
Dodd-Frank Act, ``Treasury must present an actual independent
analysis which clearly demonstrates that this risk is not
significant.'' AFR, at 8. Sections 1a(47)(E) and 1b of the CEA do
not require Treasury to conduct an ``independent'' analysis of each
of the statutory factors, as AFR contends. Rather, section 1b(a) of
the CEA plainly requires the Secretary to ``consider'' each of the
five factors, and does not contain any provision that suggests that
any one or more of those factors may be pivotal in reaching any
determination. Furthermore, subsection 1b(b) of the CEA requires the
Secretary to ``submit to the appropriate committees of Congress a
determination that contains--(1) an explanation [regarding
qualitative differences between foreign exchange swaps and forwards
and other classes of swaps]; and (2) an identification of the
objective differences of foreign exchange swaps and foreign exchange
forwards with respect to standard swaps that warrant an exempted
status.'' A ``determination'' that explains those ``qualitative''
differences and identifies those ``objective'' differences satisfies
the law; neither subsection 1b(b)(1) or 1b(b)(2) requires Treasury
to conduct an ``independent'' analysis of the type that AFR
describes in its comment letter.
\53\ Commodity Markets Council, at 1-2.
---------------------------------------------------------------------------
Regulating foreign exchange swaps and forwards under the CEA would
require insertion of a CCP into an already well-functioning settlement
process. Currently, no entity or system exists that can efficiently
clear and settle the thousands of foreign exchange swaps and forwards
transactions that are executed on a daily basis, and Treasury is not
aware of any proposal to build sufficient capabilities in this area.
Requiring the use of new systems and technologies could introduce new
risks and challenges for the settlement process of foreign exchange
swaps and forwards. Other derivative transactions, such as interest
rate swaps and credit default swaps, create settlement obligations that
equal only the change in the market price or other financial variable
relative to a fixed or predefined amount--not the full principal
amounts--and, thus, result in materially smaller daily payment
obligations for those markets. While the existing CLS and other PVP
settlement systems protect against the risk of principal loss in the
foreign exchange swaps and forwards market, central clearing would
further protect a participant against the economic loss of profit on a
transaction if the counterparty to the transaction defaults before
final settlement. However, combining these two functions in a market
that involves settlement of the full principal amounts
[[Page 69700]]
of the contracts would require massive capital backing in a very large
number of currencies, representing a much greater commitment for a
potential CCP in the foreign exchange swaps and forwards market than
for any other type of derivatives market.
The CPSS and the Technical Committee of the International
Organization of Securities Commissions (``IOSCO'') recently issued
principles for financial market infrastructures (``FMIs'') (herein
``FMI Principles'') that highlight the close connection between
clearing systems and settlement systems.\54\ The FMI Principles are
intended to apply to several types of FMIs, including a CCP, and
establish heightened risk-management standards for the relevant FMIs in
the jurisdictions of the CPSS-IOSCO members.\55\ In particular, the FMI
Principles state:
---------------------------------------------------------------------------
\54\ Bank for Int'l Settlements, ``Principles for financial
market infrastructures,'' Apr. 2012, available at http://www.bis.org/publ/cpss101a.pdf. The FMI Principles were issued
following a proposal, issued in April 2011, and public comment. The
Federal Reserve Board and the Federal Reserve Bank of New York are
members of the CPSS, and the CFTC and Securities and Exchange
Commission (``SEC'') are members of the Technical Committee of
IOSCO. Treasury expects that the FMI Principles will be applied
through rules and regulatory guidance issued, as appropriate, by the
Federal agencies that supervise the relevant FMIs which are subject
to their jurisdiction. Accordingly, Treasury believes that the FMI
Principles reasonably should be taken into account with respect to
the consideration of clearing and settlement systems for foreign
exchange swaps and forwards.
\55\ FMI Principles, at 5-7, 12.
An FMI's processes should be designed to complete final
settlement, at a minimum no later than the end of the value date.
This means that any payment, transfer instruction, or other
obligation that has been submitted to and accepted by an FMI in
accordance with its risk management and other relevant acceptance
criteria should be settled on the intended value date. An FMI that
is not designed to provide final settlement on the value date (or
same-day settlement) would not satisfy this principle, even if the
transaction's settlement date is adjusted back to the value date
after settlement * * *. [D]eferral of final settlement to the next-
business day can entail overnight risk exposures. For example, if a
[central securities depository] or CCP conducts its money
settlements using instruments or arrangements that involve next-day
settlement, a participant's default on its settlement obligations
between the initiation and finality of settlement could pose
significant credit and liquidity risks to the FMI and its other
participants.\56\
---------------------------------------------------------------------------
\56\ FMI Principles, at 65.
Consistent with the FMI Principles, considering whether the
required clearing for foreign exchange swaps and forwards would create
systemic risk, pursuant to section 1b(a)(1) of the CEA, entails
considering whether the required clearing can prudently be undertaken
in conjunction with the settlement systems necessary for the foreign
exchange swaps and forwards market.
To date, no CCP has developed a practical solution to guarantee the
timely settlement of the payment obligations of the extraordinarily
large volumes of transactions in foreign exchange swaps and forwards,
including the provision of or coordination with the settlement services
that are essential to the market.\57\ Introducing a central clearing
facility without settlement capabilities would be inconsistent with the
standards being developed by regulators through CPSS-IOSCO, and would
not improve market functioning. Instead, requiring central clearing
would raise unnecessary operational challenges by introducing
additional steps between trade execution and settlement. Given that any
risks created through the increased complexity would be magnified by
the number of currencies involved, among other factors, requiring the
use of a CCP for clearing foreign exchange swaps and forwards is not
warranted.
---------------------------------------------------------------------------
\57\ In addition, even though a few commenters have outlined
mechanisms for clearing foreign exchange swaps and forwards, none of
these mechanisms clearly contemplate a system for clearing that
would also settle those foreign exchange swaps and forwards,
particularly given the scale and complexity for physical settlement
of multiple currencies in the current market for foreign exchange
swaps and forwards. See, e.g., Better Markets, Inc., at 16-19 (This
commenter outlines two mechanisms for clearing involving the use of
a derivatives clearing organization (``DCO''). Under one option, the
DCO apparently would conduct both the clearing and settlement
functions (but the outline does not describe how the DCO itself
would establish the systems necessary to settle the massive volume
of currencies flowing through the foreign exchange swaps and
forwards contracts); the second option stipulates that the DCO would
clear transactions, but settlement would be conducted through ``CLS
or a similar institution [that is] a PVP provider'' or through an
alternative mechanism.); Duffie, at 7-9 (outlining a scheme using a
``financial utility'' that operates as a ``quasi-CCP,'' only to
compute and collect margin payments, and that operates independently
of, yet coordinated with, a PVP provider (such as CLS), which
settles the foreign exchange swaps and forwards).
---------------------------------------------------------------------------
In response to the October 2010 Notice, end-users of foreign
exchange swaps and forwards have expressed significant concern that
requiring centralized clearing would substantially increase the costs
of hedging foreign exchange risks. Commenters argue that additional
costs associated with collateral, margin, and capital requirements
required by the CCP would potentially reduce their incentives to manage
foreign exchange risks.\58\ Such additional costs borne by non-
financial end-users could lead to lower cash flows or earnings, which
would divert financial resources from investment and discourage
international trade, thereby limiting the growth of U.S.
businesses.\59\ Several commenters also suggest that requiring
centralized clearing of foreign exchange swaps and forwards could lead
non-financial end-users to move production facilities overseas in order
to establish ``natural hedges'' through the consistent use of local
currencies and force them to reconsider the use of CLS in light of the
additional costs associated with central clearing.\60\
---------------------------------------------------------------------------
\58\ See, e.g., comment on October 2010 Notice by National Ass'n
of Manufacturers, at 4.
\59\ See, e.g., comment on October 2010 Notice by 3M, Cargill
Inc. et al., at 6.
\60\ See, e.g., comment on October 2010 Notice by Coalition for
Derivatives End-Users, at 16-17.
---------------------------------------------------------------------------
As noted above, the market for foreign exchange transactions is one
of the most transparent and liquid global trading markets. Pricing is
readily available through multiple sources and a large portion of
foreign exchange trades currently are executed through electronic
trading platforms.\61\
---------------------------------------------------------------------------
\61\ See, e.g., comment on NPD by Coalition for Derivatives End-
Users, at 1-2 (``[T]he [foreign exchange] market has pioneered the
adoption of more transparent electronic trading platforms. Because
the market is highly liquid and decentralized, liquidity can exist
more easily on multiple electronic platforms and pricing
transparency is more readily available. Applying the clearing and
exchange trading requirements to these transactions would not
improve pricing transparency to any notable degree.'').
Furthermore, Treasury understands that at least one global
foreign exchange trading repository has been created pursuant to
section 21 of the CEA (7 U.S.C. 24a, as added by section 728 of the
Dodd-Frank Act), which will expand reporting coverage for swaps,
including foreign exchange swaps and forwards, regardless of whether
the Secretary issues a determination that these transactions should
not be regulated as ``swaps'' under the CEA. See DTCC release,
available at http://www.dtcc.com/news/press/releases/2012/press_release_dtcc_begins_user_testing.php. The CFTC has adopted final
rules relating to the registration and regulation of SDRs. 17 CFR
Part 49. See CFTC, Final Rule on Swap Data Repositories:
Registration Standards, Duties, and Core Principles, 76 FR 5453
(Sept. 1, 2011)).
---------------------------------------------------------------------------
In light of these and similar factors raised by the commenters,
mandating centralized clearing and exchange trading under the CEA for
foreign exchange swaps and foreign exchange forwards would actually
introduce operational challenges. These challenges and risks could
potentially lead to disruptive effects in this market which likely
would outweigh any benefits associated with mandated clearing and
exchange trading.\62\
---------------------------------------------------------------------------
\62\ See also comment by FXall, at 1.
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[[Page 69701]]
(ii) Regulatory Scheme Comparable to That of the CEA
Treasury has considered several factors to assess whether foreign
exchange swaps and foreign exchange forwards are already subject to a
regulatory scheme that is materially comparable to that established by
the CEA for other classes of swaps.
One commenter has noted that foreign exchange swaps and forwards
will not fall outside of the scope of regulatory oversight under the
CEA; ``[o]n the contrary, foreign exchange swaps and forwards will be
required to be reported to swap data repositories and regulated swaps
market actors (i.e., swap dealers and major swap participants) will be
required to comply with applicable conduct of business rules when
engaging in foreign exchange swaps and forwards transactions.'' \63\
Other commenters, however, have stated that currently there is no
``regulatory regime'' that is ``comparable to the framework mandated
under the Dodd-Frank Act.'' \64\
---------------------------------------------------------------------------
\63\ AIMA, at 2. See also Thomson Reuters, at 2 (commenting on
the presence of ``enhanced oversight'').
\64\ See Better Markets, at 8.
---------------------------------------------------------------------------
Since the introduction of floating exchange rates in the early
1970s, central banks and regulators have undertaken strong and
coordinated oversight measures for the foreign exchange market because
of the critical role this market plays in the conduct of countries'
monetary policy. More specifically, in 1996, the CPSS launched a
globally coordinated strategy on behalf of central banks, calling for
specific actions by individual banks, industry groups and central banks
to address and reduce risk in the foreign exchange market. This
strategy has resulted in specific actions undertaken to address
settlement risk, to mitigate counterparty credit risk and, in
conjunction with the BCBS, to develop global supervisory guidelines on
managing foreign exchange risk. Largely as a result of these measures,
liquidity in the foreign exchange market was maintained during the
recent financial crisis, and, as noted by many market observers, the
foreign exchange market was one of the few parts of the financial
market that remained liquid throughout the financial crisis.\65\
---------------------------------------------------------------------------
\65\ See, e.g., Global FX Division, at 11-12. But see Better
Markets, Inc. at 19-28.
---------------------------------------------------------------------------
One of the key goals of this work was to expand the use of PVP
settlement systems. Such systems largely eliminate settlement risk,
which is the predominant risk in a foreign exchange swap or forward. As
noted, PVP settlement ensures that the final transfer of one currency
occurs only if a final transfer of the other currency or currencies
takes place, thereby virtually eliminating settlement risk. In order to
support such PVP arrangements, central banks undertook significant
actions by extending operating hours of payment systems, providing
cross-border access to central bank accounts and enhancing the legal
certainty around such settlement arrangements.
The creation of CLS was an important outcome of this work. CLS is
the predominant PVP settlement system, settling the majority of all
global foreign exchange transactions in 17 currencies, through 63
settlement member banks and approximately 15,000 third party users.
A comparable regulatory scheme applies to the settlement system
conducted through CLS. While the Federal Reserve is the primary
regulator for CLS, a CLS Oversight Committee \66\ consisting of 22
central banks was established to provide coordinated oversight of CLS
by all central banks whose currencies are settled through its system.
As a result of this group's efforts, each participating central bank
now maintains accounts for CLS and has created a window period during
which real-time gross settlement systems are open to accommodate the
funding necessary for the settlement of payment instructions. CLS also
has developed a set of risk management tests that it applies to each
instruction it submits for settlement to mitigate the associated
credit, market and liquidity risks.
---------------------------------------------------------------------------
\66\ Federal Reserve Board, ``Protocol for Cooperative Oversight
Arrangement for CLS,'' Nov. 25, 2008, available at http://www.federalreserve.gov/paymentsystems/cls_protocol.html.
---------------------------------------------------------------------------
On July 18, 2012, the Financial Stability Oversight Council
(``Council'') designated CLS as a financial market utility that is
systemically important, pursuant to section 804 of the Dodd-Frank
Act.\67\ The designation of CLS by the Council subjects CLS to
requirements under Title VIII of the Dodd-Frank Act, including risk-
management standards, reporting and recordkeeping requirements, and
examinations (as well as potential enforcement actions) by the Federal
Reserve.
---------------------------------------------------------------------------
\67\ 12 U.S.C. 5463; 12 CFR part 1320 (Designation of Financial
Market Utilities).
---------------------------------------------------------------------------
Participants in the foreign exchange swaps and forwards market
largely consist of banks that are subject to prudential supervision,
including comprehensive risk-management oversight. In addition,
Treasury notes that the vast majority of established regulatory schemes
also actively encourage the use of CSAs and master netting agreements
to reduce counterparty credit risk exposures.\68\ Similar to changes
made to enable the use of PVP settlement arrangements, central banks
and governments worked to strengthen the legal foundations of bilateral
and multilateral netting. Master netting agreements mitigate credit
risk by enabling closeout netting in the event of a default or
bankruptcy. CSAs can also be negotiated as a supplement to master
agreements to further reduce and mitigate exposures to counterparties
by collateralizing transactions.
---------------------------------------------------------------------------
\68\ With respect to this factor, one commenter states that
``the `encouraged' use of private contractual provisions is not a
credible substitute for mandatory clearing mechanisms operated by
entities that are registered and subject to a host of core
principles covering virtually every aspect of a clearing
operation.'' Better Markets, at 9.
---------------------------------------------------------------------------
(iii) Adequacy of Supervision by Bank Regulators, Including Capital and
Margin Requirements
Treasury has assessed the extent to which bank regulators supervise
participants in the foreign exchange market, including by imposing
capital and margin requirements.
The predominant participants in the foreign exchange swaps and
forwards market are banks that long have been subject to prudential
supervision. In fact, nearly all trading within the foreign exchange
market involves bank counterparties.\69\ Roughly 95 percent of foreign
exchange trading involves banks acting in the capacity of either
principal or agent. For a number of structural reasons, banks have
distinct advantages to provide the liquidity and funding necessary to
conduct foreign exchange swaps and forwards, which involve the exchange
of principal, rather than just interim variable cash flows. In
conjunction with providing the liquidity, funding, and foreign exchange
risk-management needed to conduct these transactions, banks have
efficient and ready access to CLS to settle transactions on a PVP
basis. Prudential supervisors regularly monitor the activities,
exposures, internal controls and risk management systems of these
banks.\70\ In order to meet safety-and-
[[Page 69702]]
soundness requirements, banks have implemented monitoring systems,
limits, internal controls, hedging techniques, and similar risk-
management measures. Furthermore, counterparty credit risk management
is a fundamental issue for banking supervisors and is extensively
addressed in bank supervisory guidelines as well as under the Basel
Accords.
---------------------------------------------------------------------------
\69\ One commenter takes issue with this point, noting that
while the ``vast majority of trading in foreign exchange swaps and
forwards may involve banks,'' not all such transactions do. This
commenter further argues that, in the absence of ``mandatory,
uniform, and transparent margin requirements,'' there is ``an ad hoc
assortment of voluntary `banking' practices aimed at `risk
management.' '' Better Markets, at 10.
\70\ See, e.g., supervisory and examination standards for
wholesale payments systems developed by the Federal Financial
Institutions Examination Council, available at http://ithandbook.ffiec.gov/it-booklets/wholesale-payment-systems/wholesale-payment-systems-risk-management.aspx.
---------------------------------------------------------------------------
In addition to the supervisory measures discussed above, the OTC
Derivatives Supervisors Group, which includes market and bank
regulators from the U.S., France, Germany, Japan, Switzerland and the
U.K., has been securing commitments from market participants since 2005
to strengthen market infrastructure, risk management practices, and
transparency in the OTC derivatives market.
(iv) Adequacy of Payment and Settlement Systems
Treasury also has assessed the extent of adequate payment and
settlement systems for foreign exchange swaps and forwards. With
respect to this factor, as noted, the strategy developed by central
banks successfully resulted in the establishment of PVP settlement
systems to virtually eliminate the settlement risk associated with
foreign exchange swaps and forwards, with CLS being the primary example
of this work. Central banks undertook significant actions to support
these robust PVP settlement arrangements. As a result, roughly 75
percent of notional foreign exchange is either settled through CLS or
otherwise settled without risk, including trades that are settled
between affiliates of the same corporation or across a single bank's
books for its clients.\71\ In the foreign exchange swaps and forwards
market in particular, CLS estimates that it settles more than 50
percent of foreign exchange swap and forward transactions that are
subject to settlement risk.\72\ CLS also has announced a multi-year
strategic objective to expand settlement services to include additional
currencies, increase volume capacity, and add additional settlement
times. Treasury understands that the Federal Reserve and the CLS
Oversight Committee are currently reviewing these plans, as well as
encouraging the expansion of other PVP settlement services.
Furthermore, the vast majority of foreign exchange swaps and forwards
that are not settled with CLS, or through some other internal netting
mechanism, have a regulated banking entity as one (or both) of the
counterparties. In light of the prudential supervision of these
entities, particularly the controls that must be applied to meet the
expectations of their regulators, these financial institutions must
maintain adequate payment and settlement arrangements.
---------------------------------------------------------------------------
\71\ One commenter disputes this position, stating that ``[t]he
CLS system completely disregards the counterparty credit risk.''
Americans for Financial Reform, at 12. This commenter asserts that
``CLS merely settles transactions between the parties by collecting
payments from each party and distributing payments once all parties
meet their obligations.'' Id.
\72\ In this regard, one commenter notes that, notwithstanding
the settlement of more than 50 percent of foreign exchange swaps and
forwards transactions by CLS, a ``significant volume'' of those
transactions are not settled by CLS, and asserts that ``[t]his state
of affairs is not `adequate' under any reasonable interpretation.''
Better Markets, at 11.
---------------------------------------------------------------------------
(v) Possible Use of Exemption To Evade Requirements
Treasury has considered several factors to assess whether the use
of an exemption for foreign exchange swaps and foreign exchange
forwards could be used to evade otherwise applicable regulatory
requirements. Treasury shares the concern, expressed by several
commenters,\73\ that issuing an exemption for foreign exchange swaps
and forwards potentially could be exploited by some market participants
to evade regulatory requirements that otherwise would apply to the
substance of a transaction. Nonetheless, the nature of foreign exchange
swaps and forwards transactions (as defined by the CEA) makes it
difficult for these products to be structured to replicate the cash
flows associated with currency or interest rate swaps to evade
regulatory requirements under the CEA. The likelihood that foreign
exchange swaps and forwards might be structured to evade other
regulatory requirements is further reduced by the extensive oversight
by regulators, particularly the supervision of banks which are the main
participants in this market.
---------------------------------------------------------------------------
\73\ As one commenter contends, for example, ``market
participants have a boundless ingenuity for developing new products
and strategies that fall within the interstices of any regulatory
framework.'' Better Markets, Inc. at 11.
---------------------------------------------------------------------------
Unlike other types of swaps, foreign exchange swaps and forwards
are distinct because, as defined by the CEA, these transactions must
(1) involve the exchange of the principal amounts of the two currencies
exchanged, as opposed to a set of cash flows based upon some floating
reference rate, and (2) be settled on a physical basis.\74\
---------------------------------------------------------------------------
\74\ In this regard, Treasury notes that, in other swaps
transactions, the parties may, by agreement, physically settle their
obligations.
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A ``swap'' regulated under the CEA, such as a currency swap,
interest rate swap, or other derivative, generally involves a periodic
exchange of a floating amount of cash flows between the counterparties
based on the value of the underlying variable(s) on which the
derivative contract is based. In contrast, a foreign exchange swap
(which will be exempt from the definition of ``swap'' under this
determination) involves a simple exchange of principal at one point in
time and a reversal of that exchange at some later date. For example, a
user of a currency swap could seek funding advantages by obtaining
financing in a foreign currency and swapping those cash flows back to
the user's locally denominated currency. This would then entail paying
or receiving a series of floating interest rate payments (i.e., based
on prevailing interest rates) over the life of the transaction. This
ability to receive periodic payments during the term of a transaction
is a significant feature of ``swaps'' that will be regulated under the
CEA, which is absent from a foreign exchange swap or foreign exchange
forward.
As discussed above, in a foreign exchange swap transaction, the
payment obligations are fixed at the onset of the transaction--with the
prices of both legs of the transaction set by highly transparent and
liquid markets--and the payments must be made in the currencies
involved in the swap. In contrast, the actual amount of the cash flow
exchanged by a party to a currency swap (or other derivatives
transaction) is unknown at the onset of the transaction. Instead, a
payment obligation on either party is dependent on the future value of
one or more rates or some future event. The price of the payment itself
can be hindered by market volatility or illiquidity, which could affect
the value of the transaction.
While foreign exchange swaps could be used by some market
participants to speculate on the short-term path of interest rates in
some contexts, the operational challenges and transaction costs
associated with transforming these instruments to replicate currency or
interest rate swaps significantly reduce the likelihood that market
participants would do so in order to evade regulatory requirements
under the CEA.\75\
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\75\ Some commenters share this view. Thomson Reuters, for
example, states: ``Although transactions costs are becoming lower
each year, transforming an interest rate swap into a foreign
exchange swap would entail operational challenges and transactions
costs. Thomson Reuters believes that increased reporting obligations
for all swaps and the enhanced CFTC anti-evasion authority will
deter participants from overbroad use of the FX exemption under
consideration.'' See also FX Investor Group, at 2.
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[[Page 69703]]
To begin with, the transactions costs associated with replicating
currency swaps through the use of foreign exchange swaps likely would
be significant because a market participant would need to regularly
roll over its foreign exchange swap position as it seeks to replicate a
currency swap. For example, a participant would need to consider the
costs associated with the series of separate bid-ask spreads
accompanying each of the foreign exchange swap transactions, as well as
the costs of monitoring those positions. Thus, whether a participant
would structure foreign exchange swap transactions in order to
replicate other, non-exempt swaps that are subject to central clearing
requirements would be highly dependent on the costs associated with the
operational or systems arrangements necessary to execute the foreign
exchange swap transactions, relative to the costs imposed by CCPs to
clear the other, non-exempt swap transactions, which could vary among
market participants. Moreover, as discussed above, approximately 95
percent of foreign exchange swaps and forwards transactions occur
between banks. The systems that banks use to conduct foreign exchange
swaps and forwards transactions are subject to consolidated
supervision, including oversight of the internal controls used to
monitor foreign exchange swaps and forwards. Treasury believes, as one
commenter similarly noted, that because regulated banks conduct the
bulk of foreign exchange swaps and forwards transactions, the risk of
using these transactions to evade otherwise applicable regulatory
requirements is relatively lower.\76\
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\76\ FX Investor Group, at 2 (observing that ``there is little
risk of such institutions not ensuring that the spirit of this rule
is met'').
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Importantly, a determination to exempt foreign exchange swaps and
forwards from regulation as ``swaps'' under the CEA will not affect the
application of other provisions that are designed to prevent evasion by
market participants and improve market transparency. In particular,
under the Dodd-Frank Act all foreign exchange swaps and forwards will
remain subject to the CFTC's new trade-reporting requirements, enhanced
anti-evasion authority, and strengthened business-conduct standards for
swaps dealers and major swap participants.\77\ Furthermore, the planned
opening of global foreign exchange trade repositories will expand
reporting to regulators and the public more broadly. This additional
reporting will also provide regulators with enhanced information that
can be used to detect attempts by market participants to use foreign
exchange swaps or forwards to replicate the cash flows associated with
currency, interest rate swaps, or other derivatives in order to evade
regulatory requirements.
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\77\ See CEA section 1a(47)(E)(iii) (reporting) and (iv)
(business conduct standards), 7 U.S.C 1a(47)(E)(iii) and (iv). See
also Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap
Agreement Recordkeeping, 77 FR 48,208, 48,253 (``CFTC-SEC Joint
Products Rule'') (addressing the application of certain reporting
requirements and business-conduct standards). In addition, Treasury
notes that: (i) CEA section 1a(47)(F)(i), 7 U.S.C. 1a(47)(F)(i),
provides that foreign exchange swaps and forwards that are listed
and traded on or subject to the rules of a designated contract
market or swap execution facility, or are cleared by a derivatives
clearing organization, shall not be exempt from the fraud and
manipulation provisions of the CEA; and (ii) section 753 of the
Dodd-Frank Act amends section 6(c) of the CEA to provide, in
relevant part, that ``it shall be unlawful for any person, directly
or indirectly, to manipulate or attempt to manipulate the price of
any swap, or of any commodity in interstate commerce, or for future
delivery on or subject to the rules of any registered entity.'' 7
U.S.C. 9, 15. See also CFTC-SEC Joint Products Rule, 77 FR at
48,253, n. 512.
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C. Implications of Determination; Treatment of NDFs
(i) Implications of a Determination To Exempt Foreign Exchange Swaps
and Forwards From the Term ``Swap'' Under the CEA
Because the Secretary is issuing a written determination to exempt
both foreign exchange swaps and forwards from the definition of a
``swap'' under the CEA, these transactions, as well as certain parties
that engage in these transactions, will not be subject to some
requirements under the CEA, notably the clearing and exchange-trading
requirements.
However, foreign exchange swaps and forwards and the parties to
such transactions will still be subject to trade-reporting
requirements, business conduct standards (including the anti-fraud
provision) in section 4s(h) of the CEA and the rules promulgated
thereunder by the CFTC, and anti-evasion requirements promulgated by
the CFTC. In this regard, section (c) of the determination--which
reflects the language of sections 1a(47)(E)(iii)-(iv) and 1b(c) of the
CEA--provides that, notwithstanding this determination, certain
requirements under the CEA will apply to any foreign exchange swap or
foreign exchange forward, or to any party engaged in such a
transaction, to the extent provided by such requirements.
Under section 1a(47)(F) of the CEA, a foreign exchange swap or
foreign exchange forward that is ``listed and traded on or subject to
the rules of a designated contract market or a swap execution facility,
or that is cleared by a derivatives clearing organization, shall not be
exempt from any provision of [CEA], or the amendments under [Title VII
of the Dodd-Frank Act] prohibiting fraud or manipulation.'' \78\
Additionally, a determination issued by the Secretary shall not
``affect, or be construed to affect, the applicability of [the CEA] or
the jurisdiction of the [CFTC] with respect to agreements, contracts,
or transactions in foreign currency pursuant to section 2(c)(2) [of the
CEA, regarding retail transactions].'' \79\
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\78\ 7 U.S.C. 1a(47)(F)(i).
\79\ 7 U.S.C. 1a(47)(F)(ii) (referring, in turn, to 7 U.S.C.
2(c)(2)).
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(ii) Treatment of NDFs Under the Determination
Several commenters who support issuing a determination to exempt
foreign exchange swaps and forwards urge Treasury to extend the
determination to apply to NDFs involving foreign exchange.
In general, an NDF is a swap that is cash-settled between two
counterparties, with the value of the contract determined by the
movement of exchange rates between two currencies. On the contracted
settlement date, the profit to one party is paid by the other based on
the difference between the contracted NDF rate (set at the trade's
inception) and the prevailing NDF fix (usually a close approximation of
the spot foreign exchange rate) on an agreed notional amount. NDF
contracts do not involve an exchange of the agreed-upon notional
amounts of the currencies involved. Instead, NDFs are cash settled in a
single currency, usually a reserve currency. NDFs generally are used
when international trading of a physical currency is relatively
difficult or prohibited.\80\
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\80\ See CFTC-SEC Joint Products Rule, 77 FR at 48,254-255.
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Several commenters acknowledge the distinction between NDFs and
foreign exchange swaps and forwards, as defined by the CEA. One
commenter, for example, states that ``NDFs are cash-settled, short-term
forward contracts in a foreign currency, in which the profit or loss is
calculated as the difference between the contractually agreed upon
[foreign exchange] rate and the [foreign exchange] rate on the date of
settlement.'' \81\ Nonetheless,
[[Page 69704]]
commenters who urge Treasury to extend the proposed determination to
cover NDFs contend that ``NDFs are economically and functionally
identical to [foreign exchange] forwards, despite the fact that they
are cash settled in just one currency and do not involve the exchange
of underlying currencies because of currency controls or local law
restrictions in certain foreign jurisdictions.'' \82\ These commenters
argue, therefore, that the grounds that Treasury identified in the NPD
for issuing an exemption for foreign exchange forwards likewise should
apply to NDFs.\83\ Moreover, one commenter argues that the definition
of a ``foreign exchange forward'' in the CEA does not require the
``physical exchange'' of the two currencies and, thus, this term should
not be interpreted as precluding the inclusion of an NDF within the
scope of an exemption.\84\
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\81\ Coalition for Derivatives End-Users (``Coalition''), at 3.
See also Covington & Burling, LLP, at 2 (``in an NDF, the trade
closes out at maturity upon delivery of the net value of the
underlying exchange, denominated in a pre-determined currency
(usually the deliverable currency in the currency pair)'').
\82\ Investment Company Institute, at 4.
\83\ Investment Company Institute, at 4 (contending that ``the
minimal benefits to overseeing systemic risk from including NDFs
within the central clearing and exchange trading regime do not
justify the costs of narrowly interpreting the definition of
[foreign exchange] forward to exclude NDFs'').
\84\ MFX Solutions, Inc., at 2 (``[The definitions of foreign
exchange forward and foreign exchange swap] set limits on the scope
of Treasury's exemptive authority under Section 721 of the Dodd-
Frank Act and as such seem to rule out an exemption from the
definition of `swap' for non-fixed rate foreign exchange swaps and
forwards. The definitions, however, do not appear to preclude
exemption of non-deliverable swaps and forwards since the need for a
`physical exchange' is not specified in the CEA's definitions.'').
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The statutory provisions that limit a ``foreign exchange forward''
or a ``foreign exchange swap'' to an ``exchange'' of two different
currencies entail the actual delivery of those currencies as an
integral part of the transaction, rather than simply a transfer of the
value corresponding to the difference in the prices of the two
currencies on a specified date.\85\ Treasury observes that, recognizing
the foregoing, the CFTC and Securities and Exchange Commission
(collectively, the ``Commissions'') have defined the term ``swap'' to
include an NDF.\86\ Correspondingly, the Commissions have determined
that ``foreign exchange forward'' or ``foreign exchange swap'' do not
encompass an NDF.\87\ In the preamble to the CFTC-SEC Joint Products
Rule, the Commissions explain that ``NDFs do not meet the definitions
of `foreign exchange forward' or `foreign exchange swap' set forth in
the CEA [because] NDFs do not involve an `exchange' of two different
currencies (an element of the definition of both a foreign exchange
forward and a foreign exchange swap); instead, they are settled by
payment in one currency (usually U.S. dollars).'' \88\ Accordingly,
Treasury concludes that an NDF would not meet either definition under
the CEA for the purposes of this determination.\89\
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\85\ Accord Further Definition of ``Swap''; ``Security-Based
Swap''; and ``Security-Based Swap Agreement''; Mixed Swaps;
Security-Based Swap Agreement Recordkeeping, 77 FR at 48,256 (Aug.
13, 2012) (``CFTC-SEC Joint Products Rules'').
\86\ 17 CFR 1.3(xxx)(3)(v)(C).
\87\ 17 CFR 1.3(xxx)(3)(iii) (defining the term foreign exchange
forward); 17 CFR 1.3(xxx)(3)(iv) (defining the term foreign exchange
swap).
\88\ CFTC-SEC Joint Products Rule, 77 FR at 48,255.
\89\ Under section 712(d)(1) of the Dodd-Frank Act, 15 U.S.C.
8302(d)(1), the Commissions are authorized to further define the
term ``swap'' under the CEA, and Treasury does not intend that the
Commissions' joint rules in respect of the status of NDFs as swaps
be affected by this written determination issued under other
provisions of the CEA.
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The requirement in the definitions of ``foreign exchange forward''
and ``foreign exchange swap,'' respectively, to ``exchange'' the two
currencies should not be interpreted as requiring each foreign exchange
swap or forward transaction to be settled independently. Rather, an
entity, such as CLS or any other operator of a multilateral PVP
settlement system, that settles a series of foreign exchange swap and
forward transactions may use appropriate mechanisms to net transactions
involving the same parties and the same currencies, and deliver each of
the currencies to the respective parties. Applying appropriate
mechanisms during the settlement process to net qualifying foreign
exchange swap and forward transactions conducted by a group of parties
should satisfy the limitations under the CEA because the essential
elements of each of those transactions--namely, an exchange of two
different currencies at a predefined, fixed rate--are left intact.\90\
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\90\ Nothing in this paragraph is intended to: (1) Address
transactions described in footnote 539 of the CFTC-SEC Joint
Products Rule; or (2) establish a ``bookout'' right allowing parties
to avoid exchanging currencies, each of which, depending on the
relevant facts and circumstances, may fall within CFTC regulation
1.3(xxx)(6)(ii). Regarding the former, in the CFTC-SEC Joint
Products Rule, the Commissions stated:
[l]ikewise, the Commissions have determined that a foreign
exchange transaction, which initially is styled as or intended to be
a ``foreign exchange forward,'' and which is modified so that the
parties settle in a reference currency (rather than settle through
the exchange of the 2 specified currencies), does not conform with
the definition of ``foreign exchange forward'' in the CEA.
See CFTC-SEC Joint Products Rule at 48255 n.539 (internal
citation omitted).
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III. Procedural Analysis
A. Executive Order 12866 and Executive Order 13563
Executive Orders 13563 and 12866 direct an agency to assess all
costs and benefits of available regulatory alternatives and, if
regulation is necessary, to select regulatory approaches that maximize
net benefits (including potential economic, environmental, public
health and safety effects, distributive impacts, and equity). Executive
Order 13563 emphasizes the importance of quantifying both costs and
benefits, of reducing costs, of harmonizing rules, and of promoting
flexibility. This rule has been designated a ``significant regulatory
action'' although not economically significant, under section 3(f) of
Executive Order 12866. Accordingly, the rule has been reviewed by the
Office of Management and Budget.
B. Regulatory Flexibility Act
The Regulatory Flexibility Act (5 U.S.C. 601 et seq.) generally
requires an agency to prepare a regulatory flexibility analysis unless
the agency certifies that the rule will not have a significant economic
impact on a substantial number of small entities. It is hereby
certified that this determination would not have a significant economic
impact on a substantial number of small entities. This certification is
based on the fact that entities that engage in foreign exchange swaps
and forwards, as defined by the CEA and as described in this
determination, tend to be large entities. Accordingly, a regulatory
flexibility analysis is not required.
IV. Final Determination
Pursuant to section 1a(47)(E)(ii), the Secretary will submit this
final determination to the appropriate committees of Congress as of
November 20, 2012. For the reasons set forth in sections I and II,
which are incorporated into and made part of this section IV, the
Secretary issues a determination, as follows:
(a) Definitions.
For the purposes of this determination, the following definitions
apply:
(1) Act means the Commodity Exchange Act.
(2) Commission means the Commodity Futures Trading Commission.
(3) Dodd-Frank Act means the Dodd-Frank Wall Street Reform and
Consumer Protection Act.
[[Page 69705]]
(4) Foreign exchange forward shall have the same meaning as in
section 1a(24) of the Act.
(5) Foreign exchange swap shall have the same meaning as in section
1a(25) of the Act.
(6) Swap shall have the same meaning as in section 1a(47) of the
Act.
(b) Authority and purpose. This determination is issued under
sections 1a(47)(E) and 1b of the Act in order to implement the
provisions of the Act relating to the treatment of foreign exchange
swaps and foreign exchange forwards as swaps under the Act.
(c) Findings and exemption. (1) Considerations. The Secretary has
considered--
(i) Whether the required trading and clearing of foreign exchange
swaps and foreign exchange forwards would create systemic risk, lower
transparency, or threaten the financial stability of the United States,
and finds that the required trading and clearing of these instruments
would introduce new challenges and could result in negative
consequences, without improving transparency;
(ii) Whether foreign exchange swaps and foreign exchange forwards
are already subject to a regulatory scheme that is materially
comparable to that established by this Act for other classes of swaps,
and finds that the regulatory scheme for foreign exchange swaps and
foreign exchange forwards applicable in the U.S., as well as the
regulatory schemes in other jurisdictions, have required specific
actions that address settlement risk, mitigate counterparty credit
risk, and manage other risks associated with foreign exchange swaps and
forwards;
(iii) The extent to which bank regulators of participants in the
foreign exchange market provide adequate supervision, including capital
and margin requirements, and finds that regulators are adequately
supervising these participants, in part by requiring the implementation
of risk-management and operational processes, including the use of
payment-versus-payment settlement arrangements for settling
transactions and the adoption of credit support annexes with
counterparties;
(iv) The extent of adequate payment and settlement systems, and
finds that these systems are adequate for foreign exchange swaps and
foreign exchange forwards, particularly because a specialized
settlement system, which is subject to Federal oversight, has proven
capabilities to settle the majority of all global foreign exchange
transactions in multiple currencies; and
(v) The use of a potential exemption of foreign exchange swaps and
foreign exchange forwards to evade otherwise applicable regulatory
requirements, and finds that foreign exchange swaps and foreign
exchange forwards, as defined under the Act, are distinguished from
other derivatives, widely used by supervised banks for bona fide
funding transactions, and not likely to be used to evade otherwise
applicable regulatory requirements because of operational and
transactions costs associated with potentially transforming these
instruments into other derivatives that are subject to regulatory
requirements under the Act.
(2) Exemption. Upon consideration of each of the factors set forth
in section 1b of the Act, the Secretary finds that--
(i) Foreign exchange swaps and foreign exchange forwards should not
be regulated as swaps under the Act; and
(ii) Foreign exchange swaps and foreign exchange forwards are not
structured to evade the requirements of the Dodd-Frank Act, in
violation of any rule promulgated by the Commission, pursuant to
section 721(c) of the Dodd-Frank Act (15 U.S.C. 8321)--and,
accordingly, hereby determines that any foreign exchange swap or
foreign exchange forward hereby is exempt from the definition of the
term ``swap'' under the Act.
(d) Scope--As provided in sections 1a(47)(E) and 1b(c) of the Act--
(1) Reporting. Notwithstanding this determination, all foreign
exchange swaps and foreign exchange forwards shall be reported to a
either a swap data repository or, if there is no swap data repository
that would accept such swaps or forwards, to the Commission, pursuant
to section 4r of the Act (7 U.S.C. 6r) within such time period as the
Commission may by rule or regulation prescribe.
(2) Business standards. Notwithstanding this determination, any
party to a foreign exchange swap or forward that is a swap dealer or
major swap participant (as such terms are defined under the Act or
under section 721(c) of the Dodd-Frank Act (15 U.S.C. 8321)) shall
conform to the business conduct standards contained in section 4s(h) of
the Act (7 U.S.C. 6s(h)).
(3) Effect of determination. This determination shall not exempt
any foreign exchange swap or foreign exchange forward traded on a
designated contract market or swap execution facility from any
applicable anti-manipulation provision of the Act.
Dated: November 16, 2012.
Timothy F. Geithner,
Secretary.
[FR Doc. 2012-28319 Filed 11-19-12; 8:45 am]
BILLING CODE 4810-25-P