Daily Rules, Proposed Rules, and Notices of the Federal Government
Title VII of the Dodd-Frank Act
On October 28, 2010, the Department of the Treasury (“Treasury”) published in the
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.
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.
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,
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.”
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,
Treasury believes, as do several commenters,
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.
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
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.
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.
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.
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.”
In addition, several commenters
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
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.
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.
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,
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.
The distinguishing characteristics of foreign exchange swaps and forwards, as described above, result in a risk profile that is largely concentrated on
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.
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.
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 (
Central clearing could provide foreign exchange swap and forward participants with protection against the risk of default by their counterparties (
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.
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.
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.
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.
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.
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.
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.”
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
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.
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.
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.
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.
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.
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.
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.
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.”
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.
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, throug