CFTC Staff Provides Clarification on Regulatory Treatment of Certain Foreign Exchange Products

Authors: William Breslin (Washington, DC), David Mitchell (New York), Priyanka Shivakumar (New York)

Summary

The Market Participants Division ("MPD") and the Division of Market Oversight ("DMO"), and together with MPD, (the "Divisions") of the Commodity Futures Trading Commission (the "CFTC" or "Commission") recently issued Letter No. 25-10 to clarify the Divisions' views on the regulatory treatment of two commonly traded foreign exchange products: (1) Foreign Exchange Forwards with Multiple Settlement Dates ("Window FX Forwards"), and (2) Foreign Exchange Spot Package Transactions ("Package Spot FX Transactions").[1] This memorandum provides a summary of the guidance issued by the Divisions on the regulatory treatment of these products based on the relevant definitions set forth in the Commodity Exchange Act (the "CEA").

Background

I. Under the 2010 Dodd-Frank Act amendments to the CEA, any "swap" as defined in Section 1a(47) of the CEA is subject to a comprehensive scheme of regulation under the CEA and the rules promulgated thereunder.[2] However, Section 1a(47) also authorizes the Secretary of the Treasury (the "Secretary") to make a written determination that two specific categories of FX products which are included in the swap definition should not be regulated as swaps under the CEA. Under this authority, the Secretary issued a determination in 2012 to exempt "foreign exchange forwards" as defined in Section 1a(24)[3] and "foreign exchange swaps" as defined in Section 1a(25)[4] from the "swap" definition, which exempts such products from most swap regulation under the CEA, with the exception of certain swap reporting and business conduct requirements[5] (the "Treasury Determination").

Separately, with regard to FX spot transactions, the Commission has previously issued guidance that a bona fide FX transaction that is settled on the customary timeline of the relevant spot market is not within the definition of the term "swap." That guidance further provides that an FX transaction will be considered a bona fide spot transaction if it settles via an actual delivery of the relevant currencies within two business days.[6]

II. The Divisions' view is that Window FX Forwards, as described below, should be considered a "foreign exchange forward" as defined in Section 1a(24) of the CEA, and as such, exempt from the swap definition in Section 1a(47) of the CEA and CFTC Regulation 1.3 pursuant to the Treasury Determination. As a result, Window FX Forwards remain exempt from most swap regulation under the CEA including central clearing and trading requirements, but continue to be subject to certain swap reporting and business conduct requirements under the CEA.

III. The Divisions' view is that Package Spot FX transactions should not be considered to be "foreign exchange swaps" as defined in Section 1a(25) of the CEA[7] or otherwise as "swaps" as defined in Section 1a(47) of the CEA, provided that such transactions are executed, confirmed, and settled as individual bona fide spot transactions.

Discussion

Foreign Exchange Forwards with Multiple Settlement Dates (Window FX Forwards)

Market participants often use Window FX Forwards, which are foreign exchange forward contracts allowing for multiple settlement dates (i.e. on one or more pre-specified dates within a defined window). Apparently, some dealers have treated these products as swaps rather than foreign exchange forwards. A "foreign exchange forward," as defined under CEA Section 1a(24), 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. As described to the Divisions, Window FX Forwards, although allowing flexibility in the settlement date, specify those dates upfront and require delivery by the final date in the window (i.e. the exchange is not optional). On that basis, Commission staff clarified that such a transaction meets the definition of a foreign exchange forward and thus is exempt from most swap regulation under the CEA pursuant to the Treasury Determination.

Foreign Exchange Spot Package Transactions

Package Spot FX Transactions involve two deliverable spot FX trades that occur during a set spot time frame. These types of transactions are relatively common where two parties may enter into a package of foreign exchange spot transactions and extend the settlement date for a certain foreign exchange position or for funding purposes. Due to the nature of the timing of these transactions, there has been uncertainty regarding their regulatory status, which has apparently led to some firms treating them as swaps or foreign exchange swaps rather than as individual spot FX transactions. It appears that the Divisions have concluded that as long as the Package Spot FX transactions meet the following requirements, they would not be considered to be "foreign exchange swaps" as defined in CEA Section 1a(25) or otherwise as "swaps" as defined in CEA Section 1a(47):

• Each leg in these packages is a "bona fide" spot transaction that must settle in two business days (settling within T+2)
• Each leg is documented and confirmed separately allowing it to be an independent, enforceable legal obligation
• Execution of one leg may not be contingent on the performance of the other leg in the package

Conclusion

CFTC Letter No. 25-10 provides helpful guidance on the regulatory treatment of two commonly used foreign exchange products which should ease compliance concerns and facilitate access to important hedging and risk management tools for market participants. Financial institutions should review their FX documentation to ensure consistency with this guidance, particularly around settlement terms and confirmations. Additionally, legal and compliance derivatives teams may look to revisit prior categorizations of FX products in light of this guidance. For commercial end-users, especially small and mid-sized institutions that may not be "eligible contract participants" as defined in Section 1a(18) of the CEA, this guidance should ensure continued access to a broad array of foreign exchange products, without the risk of incurring the additional burdens and costs associated with swap compliance.

We will continue to monitor and report on developments in this area.

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