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DERIVATIVES -Treasury Exempts Foreign Exchange Swaps and Forwards from Regulation

By Lene Powell, J.D.

The Department of the Treasury issued a final determination that certain mandatory derivatives requirements, including central clearing and exchange trading, will not apply to foreign exchange (FX) swaps and forwards. The instruments remain subject to other provisions of the Dodd-Frank Act. The exemption does not extend to other FX derivatives, such as FX options, currency swaps, and non-deliverable forwards.

What instruments are covered

An FX swap is the simultaneous purchase and sale of identical amounts of one currency for another with two different value dates. FX swaps are used for both currency speculation and hedging purposes. Under the Commodity Exchange Act (CEA), the term is specifically defined 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 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. Likewise, the CEA narrowly defines a foreign exchange 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.

FX options, currency swaps, and non-deliverable forwards do not meet the statutory definition and thus are not covered by the exemption.FX swaps will remain subject to Dodd-Frank's requirement to report trades to swap data repositories, and also to rigorous business conduct standards. Additionally, Dodd-Frank makes it illegal to use the instruments to evade other derivatives reforms.

Why FX swaps are being exempted

The Secretary of the Treasury was given the authority under the Dodd-Frank Act to determine whether mandatory clearing and exchange trading requirements should apply to FX swaps and forwards. According to the Treasury Department, the unique characteristics and pre-existing oversight of the FX swaps and forwards market already reflect many of the Dodd-Frank Act's objectives for reform, including high levels of transparency, effective risk management, and financial stability. According to the Treasury, the FX swaps and forwards market plays an important role in helping businesses manage their everyday funding and investment needs throughout the world, and disruptions to its operations could have serious negative economic consequences. Furthermore, settlement of the full principal amounts of the contracts would require substantial capital backing in a very large number of currencies, representing a much greater commitment for a potential clearinghouse in the FX swaps and forwards market than for any other type of derivatives market.

The Treasury Department stated that a number of unique factors mitigate risk in the FX swaps and forwards market. Unlike most other derivatives, FX swaps and forwards have fixed payment obligations, are physically settled, and are predominantly short-term instruments. The contracts always require both parties to physically exchange the full amount of currency on fixed terms that are set at the outset of the contract. Market participants know the full extent of their own payment obligations to the other party throughout the life of the contract. The contracts are also short-term transactions, which reduces risk. Most of the market matures in one week or less, and 98 percent in one year or less, in contrast to other derivatives that have much longer average maturity terms from two to 30 years. Additionally, the market has a well-functioning, secure, internationally coordinated settlement process.

Moreover, said Treasury, the FX swaps and forwards market and its key participants have been subject to strong, comprehensive, and internationally coordinated oversight by central banks for more than three decades. Prudential regulators impose capital and margin requirements and monitor the use of FX-related settlement arrangements and other measures to reduce counterparty credit risk. In addition, the Dodd-Frank Act subjects market participants to heightened business conduct standards and provided the CFTC with strong powers to prevent market participants from using FX swaps and forwards to evade requirements imposed on other derivatives.


In a 2010 letter to Treasury Secretary Geithner, Senator Carl Levin (D-MI) expressed concern that a blanket exemption would open the door to financially engineered FX swaps and forwards that could be used to disguise other types of transactions. For example, in 2001 Goldman Sachs structured a purported foreign currency swap that was used by the government of Greece to disguise a billion dollar loan and create undisclosed long-term debt. Subsequently, Greece's disclosure of the debt precipitated for the ongoing Eurozone sovereign debt crisis. There is no reason to believe that Greece's actions were unique, the senator said. Because financial markets are increasingly global, transactions designed for an entirely different purpose can easily be structured as foreign exchange swaps simply by incorporating use of a foreign currency in the transaction. Loans are particularly easy to re-engineer as FX swaps and forwards, and indeed some speculate that the use of FX swaps to conceal loans may already be commonplace, said the senator.

In addition, said Senator Levin, establishing regulatory requirements for similar financial instruments opens the door to regulatory arbitrage and financial gamesmanship. There is little economic difference between the exempted FX swaps and forwards and FX options, which are not eligible for exemption. It makes little economic sense to regulate FX options but not their functional equivalents. Exempting FX swaps and forwards would not only leave a key, multi-trillion dollar market unregulated, but would also create a powerful new incentive for derivative dealers to favor the issuance of non-cleared, off-exchange foreign exchange swaps and forwards over standardized products that are cleared and traded on an exchange. According to the senator, this undermines the objectives of Dodd-Frank and increases systemic risk.

Finally, the senator said, with respect to the industry's assertion that cross-clearing on the interbank market is sufficient to negate interbank settlement risk, the counterparties to Bear Stearns and Lehman Brothers might respectfully disagree.

The senator's concerns were strongly echoed by Dennis Kelleher, President and CEO of Better Markets, a nonprofit organization that protects the public interest in the financial markets. In a statement, Mr. Kelleher noted that during the 2008 financial crisis, the market for foreign exchange swaps and forwards collapsed along with the other markets. This required the Federal Reserve Bank to bail out the foreign exchange markets with $5.4 trillion in the three months following the Lehman Brothers bankruptcy.

"This exemption is a loophole that Wall Street's financial engineers will undoubtedly exploit. It is an early Christmas gift to Wall Street and a piece of coal to American taxpayers who will be at increased risk of having to fund yet more bailouts in the next crisis," said Mr. Kelleher.

Derivatives: DoddFrankAct: ExchangesMarketRegulation

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