[Federal Register Volume 76, Number 87 (Thursday, May 5, 2011)]
[Notices]
[Pages 25774-25782]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-10927]
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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: Notice of proposed 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 exempting foreign
exchange swaps, foreign exchange forwards, or both, from the definition
of a ``swap'' under the CEA. The Secretary proposes to issue a
determination that would exempt both foreign exchange swaps and foreign
exchange forwards from the definition of ``swap,'' in accordance with
the relevant provisions of the CEA and invites comment on the proposed
determination, as well as the factors supporting such a determination.
DATES: Written comments must be received on or before June 6, 2011, to
be assured of consideration.
ADDRESSES: Submission of Comments by mail: You may submit comments to:
Office of Financial Markets, Department of the Treasury, 1500
Pennsylvania Avenue, NW., Washington, DC 20220.
[[Page 25775]]
Submission of Comments via regulations.gov: You are encouraged to
submit comments electronically through the Federal eRulemaking Portal--
``Regulations.gov.'' Go to http://www.regulations.gov to submit or view
public comments. The Regulations.gov home page provides information on
using Regulations.gov, including instructions for submitting or viewing
public comments, viewing other supporting and related materials, and
viewing the docket.
Please include your name, affiliation, address, e-mail address and
telephone number(s) in your comment. In general, comments received will
be posted on regulations.gov without change, including any business or
personal information provided. Treasury will also make such comments
available for public inspection and copying in Treasury's Library, Room
1428, Department of the Treasury, 1500 Pennsylvania Avenue, NW.,
Washington, DC 20220, on official business days between the hours of 10
a.m. and 5 p.m. Eastern Time. You can make an appointment to inspect
comments by telephoning (202) 622-0990. Comments received, including
attachments and other supporting materials, are part of the public
record and subject to public disclosure. Do not include any information
in your comment or supporting materials that you consider confidential
or inappropriate for public disclosure.
FOR FURTHER INFORMATION CONTACT: Office of Financial Markets, 1500
Pennsylvania Avenue, NW., Washington, DC 20220, (202) 622-2730,
[email protected]; 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'' under the CEA 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\ Pub. L. 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\ 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, consulting with
Federal regulators, and preliminarily considering the factors set forth
in section 1b(a) of the CEA, as discussed below, the Secretary believes
that proposing a determination to exempt all ``foreign exchange swaps''
and ``foreign exchange forwards'' from the definition of the term
``swap'' under the CEA is appropriate.
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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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In making a determination pursuant to sections 1a(47)(E) and 1b of
the CEA, the Secretary must consider 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 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'' (i.e., as a result
of the underlying ``determination'').
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Treasury is soliciting comment on this proposed determination,\8\
as set forth below, which would exempt any foreign exchange swap and
foreign exchange forward from the definition of the term ``swap'' under
the CEA, as permitted by section 1a(47)(E) of the CEA.
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\8\ 5 U.S.C. 553(b).
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I. Summary of Proposed 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, 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 derivative contracts are based. As
a result, for most types of swaps and derivatives, the counterparties
do not know their payment obligations and the full extent of their
exposure throughout the life of the contract. Moreover, as the length
of a swap or derivative contract increases, a party generally is
exposed to greater counterparty credit risk. Settlement of most types
of swaps and derivatives involves only payments of net amounts (not
gross amounts) that are based on the change in value of the underlying
variables. Given the features of most derivatives, including some types
of foreign exchange derivatives, the clearing and exchange-trading
requirements under the CEA would mitigate the relevant risks, notably
counterparty credit risks.
Foreign exchange swaps and forwards generally are subject to the
requirements of the CEA. For these instruments, the most significant
requirements under the regulatory regime enacted by the Dodd-Frank Act
would be the potential for mandatory central clearing and exchange
trading,\9\ unless the Secretary
[[Page 25776]]
makes a determination 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].'' \10\
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\9\ 7 U.S.C. 2(h)(1)-(2). In general, this section provides that
the CFTC must act for each swap, or a category of swaps, to be
required to be cleared. In addition, the CEA provides several
exceptions to the clearing and trading requirements and authorizes
the CFTC to impose conditions or limitations on these exceptions.
\10\ 7 U.S.C. 1a(47)(E)(i).
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The Secretary proposes to issue a determination to exempt foreign
exchange swaps and forwards because of the distinctive characteristics
of these instruments. As discussed below, unlike most other
derivatives, foreign exchange swaps and forwards have fixed payment
obligations, are physically settled, and are predominantly short-term
instruments. This results in a risk profile that is different from
other derivatives, as it is centered on settlement risk, rather than
counterparty credit risk. Settlement risk in foreign exchange swaps and
forwards already has been addressed through the extensive use of
payment-versus-payment (``PVP'') settlement arrangements. Even though
central clearing could reduce counterparty credit risk, that risk is
relatively small in the foreign exchange swaps and forwards market.
Imposing central clearing and trading requirements under the CEA on
foreign exchange swaps and forwards would introduce risks and
operational challenges to the current settlement arrangements that
significantly outweigh the marginal benefits.
A. Foreign Exchange Swaps and Forwards Differ in Significant Ways From
Other Swaps and Derivatives
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.'' \11\ 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.'' \12\
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\11\ 7 U.S.C. 1a(25).
\12\ 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 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.
The payment obligations on foreign exchange swaps and forwards are
fixed and predetermined. 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, the actual settlement amounts do not. These features
make foreign exchange swaps and forwards more similar to funding
instruments, such as repurchase agreements, which are not covered under
the CEA. 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 the sale or investment is pending.
Foreign exchange swap and forward participants know their own and
their counterparties' payment obligations and the full extent of their
exposure throughout the life of the contract, whereas the
counterparties to other derivatives contracts do not. Moreover, foreign
exchange swap and forward contracts have a very short average length
and, therefore, relative to other swaps and derivatives, create
significantly lower levels of counterparty credit risk.
Settlement of foreign exchange swap and forward transactions
requires the exchange of the full principal amount of the contract in
two different currencies, whereas the payment obligations of most other
derivatives are based on the incremental profit or loss on a
transaction. The physical settlement requirement distinguishes foreign
exchange swaps and forwards from other derivatives and contributes to a
risk profile that is largely concentrated on settlement risk.
B. Settlement Risk Is the Main Risk and Already Is Effectively
Mitigated
Settlement of foreign exchange swap and forward transactions
requires the exchange of the full principal amount of the contract in
two different currencies.\13\ Settlement risk is the risk that one
party to a foreign exchange swap or forward transaction will deliver
the currency it owes its counterparty, but not receive the other
currency from its counterparty. In contrast to other derivatives,
including the other foreign exchange derivatives discussed above,
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 physical settlement requirement distinguishes foreign
exchange swaps and forwards from other derivatives and contributes to a
risk profile that is largely concentrated on settlement risk.
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\13\ By contrast, the payment obligations of most other
derivatives are 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 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. These settlement arrangements do
not guarantee the contract but prevent payment flows from occurring if
either party defaults. CLS Bank International (``CLS''), the
predominant PVP settlement system, currently provides settlement
services for 17 currencies that represent 94 percent of the total daily
value of foreign exchange swaps and forwards traded globally.
Currently, roughly 75 percent of the entire foreign exchange market
is estimated to settle without settlement risk to either party. This
figure includes trades settled by PVP arrangements, as well as trades
that are settled without settlement risk. (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.) 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. The use of CLS has also been growing steadily since
its introduction in 2002, and CLS has announced plans to further expand
its settlement services to include additional currencies, increase
volume capacity and add additional settlement times.
C. Foreign Exchange Swaps and Forwards Are Subject to Less Counterparty
Credit Risk Than Other Derivatives
Counterparty credit risk is the risk of economic loss if either
party defaults on a contract. 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
[[Page 25777]]
length. Sixty-eight 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.
Central clearing could provide foreign exchange swap and forward
participants with further protection against the risk of default by
their counterparties (i.e., the replacement cost of a transaction if a
counterparty fails to perform). However, 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.
We believe 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.
In addition, providing central clearing separately from settlement
presents the second concern, namely: required clearing 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 and potentially disruptive effects on
the foreign exchange swaps and forwards market associated with adding a
central clearing requirement for these instruments thus significantly
outweigh the marginal benefits that central clearing would provide.
D. Key Players Within the Foreign Exchange Market Already Are Subject
to Oversight
Unlike the derivatives markets, banks 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. Banks
are subject to consolidated supervision, and supervisors regularly
monitor their foreign exchange related exposures, internal controls,
risk management systems, and settlement practices.
The foreign exchange market itself also has long been subject to
comprehensive and coordinated oversight, reflecting its unique
characteristics and functioning. Since the introduction of floating
exchange rates in the early 1970s, G10 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, which was launched in
1996 by the Bank for International Settlements (``BIS''), 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 Committee on Payment and Settlement Systems
(``CPSS'') updates to bank supervisory guidelines on managing foreign
exchange settlement risk.
E. 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.\14\ The use of electronic trading platforms provides a high
level of pre- and post-trade transparency within the foreign exchange
swaps and forwards market. Thus, mandatory exchange trading
requirements would not significantly improve price transparency or
reduce trading costs within this market.
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\14\ BIS, Greenwich Associates, Oliver Wyman analysis.
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F. Foreign Exchange Swaps and Forwards Will Be Subject to Additional
Oversight Under the CEA
Even if the Secretary determines that foreign exchange swaps and
forwards should not be regulated as ``swaps'' under the CEA, that
determination would not affect the application of other provisions of
the CEA that will prevent evasion by market participants and improve
market transparency. Commenters who oppose an exemption argue that it
would create a large regulatory loophole that exacerbates systemic
risk. However, all foreign exchange transactions would remain subject
to the CFTC's new trade-reporting requirements, enhanced anti-evasion
authority, and strengthened business-conduct standards. Notably, the
creation of a global foreign exchange trade repository, plans for which
are already underway, will dramatically expand reporting to regulators
and the market more broadly.
II. Background and Statutory Considerations
A. Overview
(i) Foreign Exchange Swaps and Forwards Distinguished From Other Swaps
Foreign exchange swaps and forwards that would be exempt from the
CEA's definition of ``swap'' under the determination are narrowly
defined transactions that are qualitatively different from other
derivatives. First, foreign exchange swaps and forwards involve the
actual exchange of the principal amounts of the two currencies
exchanged and are settled on a physical basis. Unlike many other
derivative instruments (e.g., interest rate swaps) whose payment
obligations fluctuate daily in response to changes in the values of
underlying variables, such as interest rates, the payment obligations
of foreign exchange swaps and foreign exchange forwards, as defined by
the CEA, are fixed at the onset of the agreement and involve the actual
exchange of full principal for settlement.
Second, in stark contrast to other derivatives, over 98 percent of
foreign exchange swaps and forwards mature in less than one year, and
68 percent mature in less than one week. For example, interest rate
swaps and credit default swaps generally have maturity terms between
two and thirty years and five to ten years, respectively. Since
counterparty credit risk increases as the length of a contract
increases, foreign exchange swaps and forwards carry significantly
lower counterparty credit risk.
Third, the use of foreign exchange swaps and forwards is distinct
from other derivatives. Because of their unique structure and duration,
as outlined above, foreign exchange swaps and forwards are
predominantly used as short-term funding instruments similar to
repurchase agreements and other money market instruments and for
[[Page 25778]]
hedging foreign currency risks. Other derivatives, such as interest
rate and currency swaps, are used for a broader range of purposes.
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.\15\
Approximately 41and 72 percent of foreign exchange swaps and forwards,
respectively, already trade across a range of electronic platforms.\16\
As a result, mandatory exchange trading requirements under the CEA
would be unlikely to improve price transparency significantly.
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\15\ See, e.g., comment by Global FX Division of the Securities
Industry and Financial Markets Assoc., Assoc. for Financial Markets
in Europe, and the Asia Securities Industry and Financial Markets
Assoc. (``Global FX Division''), at 11.
\16\ BIS, Greenwich Associates, Oliver Wyman analysis.
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These distinguishing characteristics of foreign exchange swaps and
forwards result in a risk profile that is largely concentrated on
settlement risk, rather than counterparty credit risk. Settlement risk
is effectively addressed in the market for foreign exchange swaps and
forwards by the extensive use of CLS and other PVP settlement
arrangements. PVP is a foreign exchange settlement mechanism that
ensures that a final transfer of one currency occurs only if a final
transfer of the other currency (or currencies) takes place, thereby
virtually eliminating settlement risk. 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, which began operations in September
2002, is now the predominant global PVP settlement system. It currently
provides settlement services for 17 currencies, which represent 94
percent of the total daily value of currencies traded globally. CLS
estimates that it settles 58 percent of global foreign exchange
trading, through 60 settlement member banks and approximately 9,000
third-party users. According to a September 2010 Foreign Exchange
Committee (``FXC'') \17\ survey, roughly 75 percent of foreign exchange
transactions are settled without settlement risk to either party. 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.
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\17\ 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.
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(ii) Implications of a Determination to Exempt Foreign Exchange Swaps
and Forwards From the Term ``Swap'' Under the CEA
If the Secretary issues a written determination to exempt foreign
exchange swaps or forwards, or both, from the definition of a ``swap''
under the CEA, these transactions, as well as certain parties that
engage in these transactions, would not be subject to some requirements
under the CEA, notably the clearing and exchange-trading requirements.
However, even if the Secretary issues such a determination, foreign
exchange swaps and forwards and the parties to such transactions would
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 proposed determination--which reflects the language of section
1a(47)(E)(iii)-(iv), 1b(c) of the CEA--would provide that,
notwithstanding this determination, certain requirements under the CEA
would 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.
In addition, Treasury notes that section 1a(47)(F) of the CEA
contains two other provisions applicable to foreign exchange swaps and
foreign exchange forwards. First, subparagraph (47)(F)(i) provides that
``[a]ny foreign exchange swap and any 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.'' \18\ Second,
``[n]othing in subparagraph (E) [which authorizes the Secretary to
issue such a determination] shall 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].'' \19\
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\18\ 7 U.S.C. 1a(47)(F)(i).
\19\ 7 U.S.C. 1a(47)(F)(ii) (referring, in turn, to 7 U.S.C.
2(c)(2)).
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(iii) Summary of Comments in Response to 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, as defined by the CEA, involve an actual exchange
of principal, are predominantly very short in duration and have high
turnover rates. These commenters note that this market functions
predominantly as a global payments market and is used significantly by
end-users for hedging purposes.\20\ Many corporate participants
expressed concern that the additional costs associated with clearing
foreign exchange swaps and forwards would adversely impact their
business activities and discourage hedging activity. These commenters
also 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. They also
noted that central clearing could negatively affect U.S. dollar
liquidity and threaten the role of the dollar as the world's reserve
currency, citing the potential that such requirements could push
foreign exchange transactions further offshore and challenge the
Federal Reserve's ability to conduct monetary policy.
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\20\ See comment by 3M, Cargill Inc. et al., at 2.
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Settlement risk, they argue, is the primary risk associated with
foreign exchange swaps and forwards, and they state that the settlement
of trades through CLS has largely addressed these concerns.\21\
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\21\ See, e.g., comment by Global FX Division, at 12-14.
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Given the short duration of foreign exchange swaps and forwards,
most commenters emphasized that counterparty credit risk is not as
significant a risk for these transactions (relative to other derivative
transactions) and that the 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 heavily liquid,
efficient, and transparent inter-bank market, where bank regulators
have substantial visibility and exercise strong regulatory oversight
over the major market participants, which generally consist of either
depository institutions or affiliates of depository institutions. A
number of these commenters also stressed that the Federal Reserve has
[[Page 25779]]
ample authority to craft appropriate regulations governing systemically
important financial market utilities and payment, clearing, and
settlement activities under Title VIII of Dodd-Frank Act. These
commenters also cite the effective functioning of the foreign exchange
market during the financial crisis of 2008.
In contrast to these views, commenters who oppose an exemption for
foreign exchange swaps and forwards are primarily concerned that the
exemption would create a large regulatory 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.\22\ 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.
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\22\ See, e.g., comment by Council for Institutional Investors,
at 1-2.
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B. Statutory Factors
As discussed above, in considering whether to exempt foreign
exchange swaps and forwards from the definition of the term ``swap,''
the Secretary must consider five factors. Treasury is continuing to
consider each of these statutory factors and invites comment on the
analysis of each of these 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. Treasury
believes that, given the reduced counterparty credit risk profile of
this market, the challenges of implementing central clearing within
this market significantly outweigh the marginal benefits that central
clearing and exchange trading would provide.
Regulating foreign exchange swaps and forwards under the CEA would
require insertion of a CCP into an already well-functioning and highly
interconnected settlement process, which could result in unnecessary
operational and settlement challenges. Other derivative transactions,
such as interest rate swaps and credit default swaps, create settlement
obligations that equal only the change in the market price of the
notional value of the underlying instrument--not the full principal
amounts--and, thus, result in much 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 participants against the economic loss of profit on a
transaction. However, combining these two functions in a market that
involves settlement of the full principal amounts of the contracts
would require massive capital backing in a very large number of
currencies, representing a much greater commitment for a potential CCP
than for any other derivatives market.
To date, no CCP has developed a practical solution to guarantee the
extraordinarily large volumes of transactions in foreign exchange swaps
and forwards, including provision of or coordination with the
settlement services that are essential to the foreign exchange swaps
and forwards market. Introducing a central clearing facility without
settlement capabilities 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, Treasury believes that requiring the use of a CCP
for clearing foreign exchange swaps and forwards is not warranted,
particularly because existing settlement arrangements currently
function well and address the main source of risk, settlement risk.
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.\23\ 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.\24\ 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.\25\
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\23\ See, e.g., comment by National Assoc. of Manufacturers, at
4.
\24\ See, e.g., comment by 3M, Cargill Inc. et al., at 6.
\25\ See, e.g., comment by Coalition for Derivatives End-Users,
at 16-17.
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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.\26\
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\26\ Furthermore, Treasury understands that plans are being made
for the creation of at least one global foreign exchange trading
repository pursuant to section 21 of the CEA (7 U.S.C. 24a, as added
by section 728 of the Dodd-Frank Act), which will dramatically
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. 75 FR 76,574 (Dec. 8, 2010). (In its
proposed rule regarding swap data recordkeeping and reporting
requirements, the CFTC explains that, for the purposes of reporting
requirements, foreign exchange swaps and forwards would be included
within the category of ``currency swap.'' Id. at 76,586. The CFTC
also has proposed rules relating to the registration and regulation
of swap data repositories that would adopt new part 49 of the CFTC's
regulations, 17 CFR Part 49. See CFTC, Notice of Proposed
Rulemaking: Swap Data Repositories, 75 FR 80898 (Dec. 23, 2010)).
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In light of these and similar factors raised by the commenters,
Treasury believes that mandating centralized clearing and exchange
trading under the CEA for foreign exchange swaps and foreign exchange
forwards actually would introduce significant operational challenges
and potentially disruptive effects in this market which would outweigh
any marginal benefits for transparent trading or reducing risk in these
instruments.
(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.
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
[[Page 25780]]
exchange market because of the critical role this market plays in the
conduct of countries' monetary policy. More specifically, in 1996, the
Bank for International Settlements (``BIS'') launched a globally
coordinated strategy on behalf of the G10 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, mitigate counterparty credit risk and develop global
supervisory guidelines on managing foreign exchange risk. Largely as a
result of these measures, many market observers note that the foreign
exchange market was one of the few parts of the financial market that
functioned effectively throughout the financial crisis.\27\
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\27\ See, e.g., comment by Global FX Division, at 11-12.
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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, providing cross-border access to
central bank accounts and enhancing the legal certainty around such
settlement arrangements.
The creation of CLS was the most successful outcome of this work.
As noted earlier, CLS is the predominant PVP settlement system,
settling the majority of all global foreign exchange transactions in 17
currencies, through 60 settlement member banks and approximately 9,000
third party users.\28\
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\28\ See, e.g., http://www.cls-group.com.
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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 \29\ 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. This
group has also developed a set of risk management tests that CLS must
apply to each instruction it submits for settlement to mitigate the
associated credit, market and liquidity risks.
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\29\ Federal Reserve Board, ``Protocol for Cooperative Oversight
Arrangement for CLS,'' Nov. 25, 2008, available at http://www.federalreserve.gov/paymentsystems/cls_protocol.html.
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In addition, Treasury notes that the established regulatory scheme
also actively encourages the use of CSAs and master netting agreements
to reduce counterparty credit exposures. 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.
(iii) Adequacy of Supervision
Treasury also 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 which have long been subject to prudential
supervision. In fact, nearly all trading within the foreign exchange
market involves bank counterparties. Roughly 95 percent of foreign
exchange trading occurs between banks acting in the capacity of either
principal or agent. Compared to non-bank entities, 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 variable cash flows. In conjunction with
providing the liquidity and funding needs to conduct these
transactions, banks are uniquely qualified to have access to CLS to
settle transactions on a real-time basis, and thereby meet the payment
and short-term funding needs of the end users. Prudential supervisors
regularly monitor the activities, exposures, internal controls and risk
management systems of these banks.\30\ In order to meet safety-and-
soundness requirements, banks have implemented monitoring systems,
limits, internal controls, hedging techniques, and similar risk-
management measures. 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. In
addition, CLS itself is subject to comprehensive oversight by 22
central banks whose currencies are settled through its system.
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\30\ 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.
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As an example of the continuing supervisory efforts in this market,
the Federal Reserve will conduct an assessment of current risk
management practices, in conjunction with other jurisdictions, in order
to better inform the development of supervisory guidance covering the
use of CLS, CSAs, and other systems and controls. Treasury understands
that this process might ultimately highlight the need for any
additional supervisory or regulatory action, including potential
actions under Title VIII of the Dodd-Frank Act. This review will inform
BCBS and CPSS updates to bank supervisory guidelines on managing
foreign exchange settlement risk.
In addition to the supervisory measures discussed above, the OTC
Derivatives Supervisors Group, which includes market and banking
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. This group is currently
engaged with foreign exchange industry groups and market participants,
such as the FXC, to secure and monitor new commitments that advance
risk management in this 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 G10 strategy 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
[[Page 25781]]
books for its clients. 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. Furthermore, CLS 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.
(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 believes that the unique characteristics of
foreign exchange swaps and foreign exchange forwards, as defined by the
CEA, make it difficult for these products to be structured to replicate
currency or interest rate swaps to evade regulatory requirements under
the CEA.
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 an additional set of cash flows based upon
some floating reference rate (e.g. LIBOR), and (2) be settled on a
physical basis.\31\
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\31\ 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 some notional amount, whereas a foreign exchange swap (which
would 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.
While there is a possibility that foreign exchange swaps could be
used by some market participants to speculate on the short term path of
interest rates, Treasury believes that 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 actually do so in order to
evade regulatory requirements under the CEA.
To begin with, the transactions costs associated with replicating
currency swaps through the use of foreign exchange swaps would likely
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. Moreover, 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
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 (such as margin
costs), which could vary among market participants.
Importantly, a determination to exempt foreign exchange swaps and
forwards from regulation as ``swaps'' under the CEA would not affect
the application of other provisions that will prevent evasion by market
participants and improve market transparency. Opponents of an exemption
argue that such a determination would create a large regulatory
loophole that exacerbates systemic risk. However, all foreign exchange
swaps and forwards would 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.\32\ Notably, the creation of global foreign exchange
trade repositories, plans for one of which already are underway, will
dramatically expand reporting to regulators and the market more
broadly. This additional reporting will also provide regulators with
information that can be used to detect attempts by market participants
to use foreign exchange swaps or forwards to replicate other
derivatives in order to evade regulatory requirements. Lastly, the
Dodd-Frank Act amends the CEA and other laws to provide other measures
to enhance oversight of key players in the swaps market, which will
further reduce the risk that foreign exchange swaps and forwards could
be used to evade regulatory requirements.
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\32\ In addition, Treasury notes that 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.
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III. Procedural Analysis
A. Executive Order 12866 and Executive Order 13563
Executive Orders 13563 and 12866 direct agencies 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 agencies 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 proposed
determination, tend to be large entities. Accordingly, a regulatory
flexibility analysis is not required. Notwithstanding this
certification,
[[Page 25782]]
Treasury invites comments on the impact on small entities.
IV. Proposed Determination
For the reasons set forth in sections I and II, which are
incorporated into and made part of this section IV, the Secretary
proposes to issue a determination, as follows:
(a) Authority and purpose. This determination is issued under
section 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.
(b) 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.
(c) 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 antimanipulation provision of the Act.
(d) 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.
(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.
Dated: April 29, 2011.
Alastair Fitzpayne,
Deputy Chief of Staff and Executive Secretary.
[FR Doc. 2011-10927 Filed 5-4-11; 8:45 am]
BILLING CODE 4810-25-P