On May 2nd, we posted a summary (available here) of the Treasury's proposed determination (available here) to exempt foreign exchange swaps and foreign exchange forwards from the definition of the term "swap" under the Commodity Exchange Act. In this posting, we would like to provide some additional thoughts about the following statement that we made in the May 2nd posting:
[T]o qualify from the central clearing exemption, every FX Forward will need to settle by an actual exchange of currencies on Settlement Date, if the proposed interpretation is read literally.
We continue to believe that our statement represents a plain English reading of what is in the Treasury Department's proposed determination and interpretation of the term "FX Forward," as defined by the Dodd-Frank Act. And that is the topic of this posting. But, first, an overview - this is a bit longer than recent postings, so we want you to have a guide.
AN OVERVIEW OF THIS POSTING
1) As an introductory matter, we will review the statutory definition of foreign exchange forward and the Treasury's recent proposed interpretation.
2) We will examine the structure of a hypothetical OTC currency forward from A) a transactional perspective and B) a documentation perspective - the hypothetical involves the use of currency forwards by a mutual fund. In particular, the fund will enter into a deliverable currency forward with a bank and, prior to the physical settlement of the contract, enter into an offsetting trade with the same bank- the effect is that a net payment in a single currency is made by the
3) Finally, we will offer our thoughts on what we believe is the appropriate analysis of the hypothetical transactions.
Thus, explaining our not-so-creative, and not-so-brief title to this posting: OTC Currency Forward: A Diagnostic View of Offsetting Positions In the Wake of the Treasury's Proposed Determination to Exempt FX Forwards.
FOREIGN EXCHANGE FORWARD: THE STATUTORY DEFINITION
Section 1a(24) of the Commodity Exchange Act (as amended by Section 720(a)(12) of the Dodd-Frank Act) defines the term "foreign exchange forward" to mean,
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.
FOREIGN EXCHANGE FORWARD: TREASURY'S STATUTORY RIGHT TO EXEMPT
Section 1a(47) of the CEA (as amended by Section 720(a)(21) of DFA) defines the term "Swap" and in subparagraph (E) authorizes the Secretary of the Treasury, in pertinent part, to exempt foreign exchange forwards from regulation as swaps with the exception of trade reporting and business conduct standards under Section 4r and 4s(h), respectively, of DFA.
Section 1b of the CEA (as added by Section 722(h) of DFA) requires the the Secretary of the Treasury to consider the following 5 factors in making the determination to exempt foreign exchange forwards:
1) Whether the imposition of the central clearing and trading mandates of DFA would create systemic risk, lower transparency or threaten the financial stability of the United States;
2) Whether foreign exchange forwards are already subject to a regulatory scheme that is materially comparable to that established by DFA for other types of OTC derivatives;
3) The extent to which bank regulators provide adequate supervision of participants in the FX market;
4) The extent of adequate payment and settlement systems; and
5) The use of a potential exemption of foreign exchange forwards to evade otherwise applicable regulatory requirements.
THE PROPOSED DETERMINATION TO EXEMPT FX FORWARDS
The Treasury Department has issued a proposed determination (Determination of Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange Act, 75 FR 25774) to exempt foreign exchange forwards from the definition of swaps and, by extension, the central clearing and trading mandates of the DFA.
In issuing its proposed determination, Treasury specifically stated that, "Foreign exchange options, currency swaps, and [non-deliverable forwards or 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" (75 FR at25776). Among the factors cited by Treasury in support of its determination is the fact that foreign exchange forwards, "involve the actual exchange of the principal amounts of the two currencies exchanged and are settled on a physical basis" (75 FR at 25777). Treasury did not offer a definition of an NDF.
The following is a tabular summary of the Treasury's analysis of the 5 factors that it must consider under Section 1b of the CEA, in order to make such a determination.
TREASURY'S ANALYSIS OF THE 5 STATUTORY FACTORS
||ANALYSIS & CONCLUSION
|Whether central clearing and trading of FX forwards would create systemic risk, lower transparency, or threaten the financial stability of the U.S.
Analysis: The FX market is well-functioning and one of the most transparent and liquid global trading markets. The settlement process in this market is highly interconnected among its financial institution participants and the imposition of central clearing and trading could result in unnecessary operational and settlement challenges. Further, the volume of trading in this market is extremely large - on an absolute basis and relative to other derivatives - and no central counterparty has developed a practical solution to guarantee such a large volume of trades.
Conclusion: Mandated centralized clearing and trading for foreign exchange forwards would introduce significant operational challenges and potentially disruptive effects in this market; such burdens outweigh any marginal benefits for transparent trading or reducing risk in these instruments.
| Whether foreign exchange forwards are already subject to a regulatory scheme that is materially comparable to that established by DFA for other types of OTC derivatives
Analysis: The Bank of International Settlements has developed a globally coordinated strategy to reduce risk in the FX market through the regulation of FX settlement activity undertaken by individual and central banks, as well as industry groups. A key goal of this work was the development of a settlement system (payment-versus-payment or PVP settlement) that eliminates settlement risk - the predominant risk in a foreign exchange forward.
Conclusion: The existing settlement system used in respect of foreign exchange forwards is comparable to that established by DFA for other types of OTC derivatives.
|The extent to which bank regulators provide adequate supervision of participants in the FX market
|| Analysis: Banks are the predominant participants in the FX market; regulators (i.e., prudential supervisors) impose capital and margin requirements on the banks and supervise their activities, exposures, internal controls and risk management systems. Additionally, bank regulatory initiatives are marked by a relatively high degree of cooperation among global supervisory and central banking bodies.
Conclusion: Regulators provide adequate supervision of participants in the FX market
|The extent of adequate payment and settlement systems
|| Analysis: The development of the PVP settlement system resulted in the virtual elimination of settlement risk. Presently, the institution that administers this system (CLS Bank International) is expanding the PVP system to include additional currencies, increased volume capacity, and additional settlement times.
Conclusion: The existing payment and settlement systems are adequate.
|The use of a potential exemption of foreign exchange forwards to evade otherwise applicable regulatory requirements
Analysis: Two unique characteristics of foreign exchange forwards make it difficult for these instruments to be used to evade regulatory requirements under the CEA: 1) fx forwards must involve the exchange of the principal amounts of the two currencies exchange and 2) fx forwards must be settled on a physical basis. (As an aside, Treasury did not discuss forwards to any great extent in connection with this factor, choosing instead to focus on why it did not believe that qualifying foreign exchange swaps were not likely to be used for purposes of evading regulatory requirements. We do not discuss that aspect of Treasury's analysis, since we have focused on the foreign exchange forwards in this posting.) Furthermore, the DFA enhanced the anti-evasion and manipulation provisions in the CEA.
Conclusion: The exemption for foreign exchange forwards and swaps, as defined under the CEA, is not likely to be used for purposes of evading the requirements of the CEA.
Having laid the groundwork of the "law," let's now turn our attention to the transactional and documentation underpinnings of two hypothetical transactions.
OTC CURRENCY FORWARDS: A TRANSACTIONAL VIEW
Here is our hypothetical: The principal investment strategy of Z-Best Bond Fund, an SEC registered investment company (the "Fund"), is to provide its shareholders with exposure to a diversified portfolio of U.S. dollar and non-U.S. dollar denominated fixed income investments. As such, exposure to different currencies is a key aspect of the Fund's investment strategy and its investment manager, Z-Best Adviser (the "Adviser"), takes the relative value of portfolio currencies into consideration when making portfolio investment decisions. The Adviser uses securities, currencies and derivatives to implement its investment views.
The Adviser anticipates that the USD will strengthen relative to to the Canadian Dollar (CAD) over the next two months. So, consistent with the Fund's investment strategy, the Adviser (on behalf of the Fund) enters into an OTC currency forward with a bank that routinely makes markets in FX products, including OTC currency derivatives. The following are the terms of the forward:
Trade Date: May 6th
Amount and Currency Payable by Fund:100,000 CAD
Amount and Currency Payable by Bank: 102,000 USD
Settlement Date: June 30, 2011
The Fund and the Bank confirm the terms of this forward via an exchange of messages in an electronic trading platform.
Now, fast forward a few weeks...the exact opposite of what the Adviser expected to happened has happened- the USD has weakened relative to the CAD. By mid-June, the Adviser decides to unwind the position, since it believes that further weakening is likely to ensue between now and the Settlement Date. To unwind the trade, the Adviser enters into the following offsetting trade (on behalf of the Fund) with the same bank:
Trade Date: June 15th
Amount and Currency Payable by Fund: 107,000 USD
Amount and Currency Payable by Bank: 100,000 CAD
Settlement Date: June 30, 2011
Like their original trade, the Fund and the Bank confirm the terms of this currency forward via an exchange of messages in an electronic trading platform.
SO, WHAT HAPPENS ON JUNE 30TH?
The two CAD legs offset one another and the Fund pays the dealer 5,000 USD. In other words, the two currencies are not exchanged. And, now the BIG QUESTION:
|Do these two OTC currency forwards qualify as "foreign exchange forwards" (as defined in Section 1a(47) of the CEA) and, by virtue of such qualification, the exemption from the central clearing and trading mandates of the Dodd-Frank Act?
We will share our thoughts in a bit...first, however, we would like to provide you with a missing piece of the puzzle: the documentation that makes all of this possible.
OTC CURRENCY FORWARDS: A DOCUMENTATION VIEW
In our hypothetical, the Fund and the Bank have executed an ISDA Master Agreement (the "Master Agreement") utilizing the 1992, Multiple-Currency, Mutiple-Jurisdiction form of agreement published by the International Swaps and Derivatives Association or ISDA. The Schedule to that Master Agreement includes a provision that specifically states that:
The 1998 FX and Currency Option Definitions as published by the International Swaps and Derivatives Association, the Emerging Markets Traders Association, and the Foreign Exchange Committee (the "1998 FX Definitions") are hereby incorporated in their entirety and shall apply to any FX Transaction or Currency Option Transaction as defined in Section 1.12 and Section 1.5, respectively, of Article 1 of the 1998 FX Definitions. Each FX Transaction and Currency Option (as defined in the 1998 FX Definitions) entered into between the parties shall be governed by the terms of and form part of this Master Agreement.
Section 1.12 of the 1998 FX and Currency Option Definitions defines an "FX Transaction" as a "transaction providing for the purchase of an agreed amount in one currency by one party to such transaction in exchange for the sale by it of an agreed amount in another currency to the other party to such transaction." Additionally,Section 1.7 of the 1998 FX Definitions provides that, "Unless the parties otherwise specify, Deliverable will be deemed to apply to [an FX Transaction]" and, as used in the 1998 FX Definitions, "Deliverable" means that, on the Settlement Date, each party will pay the amount specified as payable by it in the related Confirmation (defined under Section 9(e)(ii) of the Master Agreement to include any exchange of electronic messages in an electronic trading platform).
Additionally, the parties have elected to net regularly scheduled payments in the same currency that they owe to one another on the same day, even if those payment obligations arise under different Transactions entered into under the Master Agreement. (i.e., Since this is a 1992 ISDA, the parties have elected that Section 2(c)(ii) of the Master Agreement does not apply; they could have accomplished this result under a 2002 ISDA Master by specifying that "Multiple Transaction Payment Netting" does apply...but we digress...)
As a result of this netting election, under the terms of our two hypothetical currency forwards, on June 30, 2011, the USD legs of the two forwards offset one another and the Fund owes the Bank 5,000 (which represents the amount of USD owed by the Fund to the Bank under the June 15th forward less the amount of USD owed by the Bank to the Fund under the May 6th forward).
TREATMENT OF THE TRANSACTIONS UNDER THE TREASURY'S PROPOSED EXEMPTION?
Let us start by saying, Answers are the easy part; questions raise the doubt. (Jimmy Buffett from "Off to See the Lizard" 1989 from album of same title. Full lyrics available here - they are good.)
Well, what is the answer????? It depends (a lawyer's favorite words!).
Based upon plain reading of the statute, each transaction, standing alone, appears to qualify for the exemption:
each transaction solely involves the exchange of 2 different currencies (USD:CAD) on a specific future date (June 30, 2011) at a fixed rate that is agreed upon on the3 inception of the contract.
There is simply NO requirement in the statutory language that prevents the offset of exposures - i.e., the CAD legs in our hypothetical transactions - that results from the use of the widely accepted the payment netting mechanisms of the ISDA Master Agreement. Indeed, such payment mechanisms share a common objective as the PVP settlement systems: the elimination of settlement risk.
Further, analyzing the transactions through the lens of Treasury's own analysis of the five factors (see the table above) produces a similar conclusion with one exception: a precondition of Treasury's analysis appears to be that qualifying foreign exchange forwards, "involve the actual exchange of the principal amounts of the two currencies exchanged and are settled on a physical basis" (75 FR at 25777). And, as noted, non-deliverable forwards - a term that is used, but not defined in the proposed determination - do not qualify for the exemption.
Is an NDF any forward that does NOT involve the actual exchange of principal amounts or is there some way to reconcile the application of the exemption to a trade and its offsetting trade, such as the two transactions used in our hypothetical?
Yes, we believe that there is: multiple foreign exchange forward transactions that are "Deliverable" transactions, as that term is defined under the 1998 Definitions, should qualify as "foreign exchange forwards," even if the payment netting mechanisms of Section 2 of the ISDA Master Agreement are utilized as a substitute for the actual, physical exchange of currencies between the two parties to the trade. The basis for this is simple: the contracts do solely involve the exchange of 2 currencies - in satisfaction of the statutory definition and requirements of the statute.
Does anybody else think that a comment letter is in order?
Good weekend. Good reading. TSR