An Excerpt From:
K&L Gates Global Government Solutions ® 2011: Mid-Year Outlook
July 2011
Financial Services
Treasury Narrowly Construes Exemption for Foreign Exchange Swaps and
Forwards and Does Not Exempt Them From All Dodd-Frank Act Requirements
Large banks and global enterprises manage currency risks by hedging in the very
deep and liquid markets for foreign exchange (“FX”) swaps and forward contracts.
These markets have generally been free of material defaults, due in part to the
typically short duration of the contracts (68 percent mature in less than a week)
and the market’s well-developed commercial and regulatory conventions.
In enacting the Dodd-Frank Wall Street
Reform and Consumer Protection Act
(“Dodd-Frank”), the U.S. Congress
authorized the U.S. Treasury Department
(“Treasury”) to exempt FX swaps and
forwards from the definition of “swap” in
the Commodity Exchange Act (“CEA”).
Such an exemption could effectively
free FX swaps and forwards from most
of Dodd-Frank’s regulatory requirements
applicable to other swaps, such as
centralized trading and clearing. Even if
Treasury exercises its exemptive authority,
however, Dodd-Frank will still require that
FX swaps and forwards be reported to a
swap data repository or the Commodity
Futures Trading Commission (“CFTC”)
and that swap dealers and major
swap participants entering into such
transactions comply with Dodd-Frank’s
business conduct standards.
FX market participants have generally
welcomed Treasury’s proposed exercise
of this exemptive authority (on May 5,
18
2011), except that it excludes nondeliverable forwards (“NDFs”), currency
swaps, and currency options from relief.
If Treasury adopts its proposal, in order
to gain the maximum relief from DoddFrank requirements, it will be necessary
to structure FX agreements so that they
come within the statutory definitions of
an FX swap or forward. Notwithstanding
the exemptive relief, however, parties
to those transactions still will need to
assure that their recordkeeping systems
will preserve all of the data required
by Dodd-Frank, and that they will have
the means to comply with Dodd-Frank’s
requirements for reporting to swap data
repositories or the CFTC.
What Would Be Exempt
Under Treasury’s proposed interpretation,
only those FX transactions that involve an
actual transfer of different currencies at
settlement would be exempted. This would
leave all other FX transactions subject to
K&L Gates Global Government Solutions ® 2011 Mid-Year Outlook
all Dodd-Frank requirements. Dodd-Frank
amended CEA Section 1a(24) to define
an FX forward as “a transaction that solely
involves the exchange of two different
currencies on a specific future date at a
fixed rate agreed upon on the inception
of the contract covering the exchange.”
It defined an FX swap in CEA Section
1a(25) as “a transaction that solely
involves—(A) an exchange of two different
currencies on a specific date at a fixed
rate that is agreed upon on the inception
of the contract covering the exchange;
and (B) a reverse exchange of the two
currencies described in subparagraph
(A) at a later date and at a fixed rate that
is agreed upon on the inception of the
contract covering the exchange.” Treasury
has construed the reference to “exchange”
of currency narrowly to mean, in effect,
a transfer of different currencies at
settlement—which consequently excludes
all FX transactions that are settled by the
netting of obligations with payment in a
single currency.
Financial Services
What Would Not Be Exempt
Pursuant to Treasury’s proposed
interpretation, currency swaps, currency
options, and NDFs will be treated as
swaps under the CEA. An NDF is similar
to an FX forward, except that settlement
is made in a single currency, usually U.S.
dollars. This is often referred to as cash
settlement. The other currency involved is
usually subject to restrictions on movement
imposed by a government authority.
Because an NDF results in settlement in a
single currency rather than an exchange
of currencies, it is being interpreted as
falling outside of the CEA definition
of an FX forward. Treasury’s proffered
construction of the CEA definitions would
effectively exclude currency swaps and
currency options from the exemptive
relief as well, because each of those
transactions is not settled by transfer of
different currencies, but rather by a net
payment, typically in U.S. dollars.
Some public commenters on Treasury’s
proposal have advocated that the
final exemption include NDFs. In this
regard, the treatment of NDFs, which
are commonly used in such important FX
forward markets as Brazil, China, Korea,
and emerging countries, is particularly
surprising because they have always been
an integral part of the forward market
and have been treated as forwards
under international regulation. NDFs are
specifically designed and documented as
forwards through standard agreements
developed by responsible organizations
such as the International Swaps and
Derivatives Association, Inc. (“ISDA”) and
have terms that are materially different from
swaps. The contracting parties to an NDF
end up with a single currency settlement
regime not because they want that result,
but because of government-imposed
currency controls.
Entities that trade various currency-related
instruments thus must carefully assess the
contours of any final Treasury exemption,
both to achieve the maximum possible
relief from the requirements of DoddFrank and to assure that their compliance
regimes are adequate to comply with
reporting and business conduct standards
that would be applicable even to exempt
FX swaps and forward contracts.
Lawrence B. Patent (Washington, D.C.)
lawrence.patent@klgates.com
Charles R. Mills (Washington, D.C.)
charles.mills@klgates.com
Conclusion
Treasury’s proposed interpretation would
treat currency swaps, currency options,
and NDFs as swaps under the CEA and
thus, if Treasury adopts the proposed
interpretation, parties entering into such
transactions will be, absent another basis
for an exemption, subject to all Dodd-Frank
requirements (the commercial end-user
exemption, which applies to all swaps,
would, for example, at least exempt
transactions with commercial end-users
from mandatory clearing requirements).
K&L Gates Global Government Solutions ® 2011 Mid-Year Outlook
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