In this posting, we muse on a simple - YET VERY IMPORTANT - issue: the treatment of a foreign exchange forward (also known as, "currency forward" or "FX forward") as a "swap" for purposes of the derivative market regulatory reforms embodied in Title VII of the Dodd-Frank Act.
WHY EVERYBODY THAT TRADES FX FORWARDS SHOULD CARE (AND WHY FUNDS AND ADVISERS SHOULD REALLY CARE)
As a threshold matter, if FX forwards are "swaps," then they may become more expensive to trade. The added expense could arise by virtue of the fact that these contracts would be subject to the full panoply of Title VII's reforms, including capital and margin requirements and the now "almost famous" central clearing and trade execution mandates.
Furthermore, if FX forwards are "swaps," then the contracts would fall within the definition of a "commodity interest" under the Commodity Exchange Act ("CEA"). As a consequence, such designation would require heightened analysis of whether or not a particular investment fund or its adviser is acting as a commodity pool operator ("CPO") or commodity trading advisor ("CTA") or, at a minimum, subject to rigorous compliance testing required to be conducted to qualify for exemptions from CPO / CTA analysis.
THE CONVENTIONAL WISDOM: DELIVERABLE FX ARE NOT SWAPS
Based upon our experience, the current thinking on the Street -- the "CW" if you will - is that a deliverable foreign exchange forward is not going to be a swap. As far as we can tell, such thinking is rooted in the definition of a currency forward under Section 1a(24) of the CEA...
[A foreign exchange forward is] 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.
...coupled with the added facts that:
1) CEA Section 1a(47)(E)(i) authorizes the Secretary of Treasury to issue a written determination under Section 1b of the CEA that FX forwards should not be regulated as swaps;
2) The Secretary of Treasury has, in fact, issued a request for comment on its proposed exemption of FX forwards from the definition of a swap; and
3) In the final "swap definitional" rule - issued in pre-publication form on July 13, 2012 - the CFTC and the SEC (the "Commissions") acknowledged that a "foreign exchange forward," as defined under Section 1a(24) will not be considered to be a "swap," if the Secretary of Treasury issues a written determination to exempt the product from the swap definition.
So, according to the conventional wisdom, the market just needs to wait for that final determination by the Secretary of the Treasury.
BUT, IS THE CONVENTIONAL WISDOM RIGHT?
If you are a regular reader of TSR, then you know that we respect conventional wisdom, although rarely trust it.
In this case, we think there is ambiguity in key guidance from the Secretary of Treasury and the Commissions, especially when read against the language in the statute itself.
| CEA Section 1(a)(24) | Secretary of Treasury - April 2011 | CFTC/SEC - July 2012 |
| Treasury can exempt a "foreign exchange forward," which Section 1a(24) defines 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." | To qualify for the exemption, foreign exchange forwards should "involve the actual exchange of the principal amounts of the two currencies exchanged and are settled on a physical basis" (75 FR at 25777). |
"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." (Footnote 539, cross-citing note 626.) |
In other words, the statute focused on the intention of the parties at the inception of the forward contract, but the Secretary of Treasury and the Commissions suggest that the actual exchange of currencies at settlement is what matters the most.
And, as explained in our May 6, 2011 posting, "OTC Currency Forward: A Diagnostic View of Offsetting Positions In the Wake of the Treasury's Proposed Determination to Exempt FX Forwards" (just click the title to go there), this focus is potentially problematic, given that most "deliverable" FX do not actually settle by the physical exchange of currencies. Instead, the parties enter into an offsetting deliverable position to close-out the trade with one party making a net payment in a single currency that it owes to the other party.
While it may be that both Treasury and the Commissions are referring to a situation in which the confirmation of a deliverable FX transaction - that is a "foreign exchange forward" - is amended subsequent to the inception of the contract, so as to restructure the trade as a non-deliverable forward or NDF. But, that is not entirely clear based upon a plain English reading of the above-cited language.
Finally, in closing, it is worth noting that in the context of a physical commodity forward, the CFTC focuses on the terms of the contract, rather than what happens at settlement of that contract - (hint: look at the treatment of so-called "book outs" of a physical commodity forward, if you are interested) . In other words, there is precedent for taking the position that the terms of the contract, rather than the settlement mechanisms matter. While it is quite possible that the conventional wisdom is right after all....we think that the final swap definition release has further muddied the analysis for market participants.
But, perhaps all hope is not lost, since the Treasury and the Commissions may be willing to clarify this point, by way of example, in response to a comment letter from interested market participants.
Good day. Good ambiguity? TSR