The road to hell is paved with good intentions, Samuel Johnson famously said. He probably wasn’t thinking of the Dodd-Frank Act when he said it, but the well-intentioned statute is driving dealers to despair over its treatment of certain foreign exchange derivatives. Of particular concern are definitions that threaten to force firms into dealer status when they could hardly be considered systemic.
“We think this issue was an accident, we don’t think it was intentional. We have spoken with people who were there at the creation of Dodd-Frank who said they never intended to create this distinction. It’s a nonsensical result,” says Bruce Bennett, a partner at law firm Covington in New York.
At issue is what legal experts say is the different treatment of essentially identical forex instruments. In 2012, then-Treasury secretary Timothy Geithner exempted physically settled forex forwards from Dodd-Frank’s definition of swaps.
However, non-deliverable forwards (NDFs) and a lesser-traded instrument called a window forward were not included in the exemption, meaning they must still be collateralised and count towards a firm’s de minimis threshold for swap dealer registration.
The Commodity Futures Trading Commission published a consultation paper on potential changes to the de minimis threshold in June. Bowing to lobbying on the issue, the CFTC included a question on whether NDFs should be exempt from the calculation of aggregate gross notional for the purposes of the threshold. The consultation closes on August 13.
“There are market participants that would be a swap dealer solely by virtue of NDF volumes they engage in and otherwise would not be a swap dealer for any other product,” says Bennett.
We think this issue was an accident, we don’t think it was intentional. We have spoken with people who were there at the creation of Dodd-Frank who said they never intended to create this distinction. It’s a nonsensical resultBruce Bennett, Covington
The CFTC requires all firms trading more than $8 billion in notional swaps over a 12-month period to register as a swap dealer. Officially designated swap dealers are subject to heightened requirements around risk management, reporting and record-keeping – duties that would be onerous for smaller trading firms.
Although the consultation paper does not include window forwards among its terms of reference, some users believe the instrument should be granted an exemption from the swap definition. Julian Hammar, a lawyer at Morrison & Foerster in Washington, DC, says: “Window forwards if treated as swaps … represent a part of what my clients count toward the de minimis threshold. Their argument essentially is that because window forwards are similar to FX forwards that have been exempted by the Treasury secretary, they should be treated the same way and not have to be counted. That would give them a little more breathing room before having to register.”
Hammar is a former assistant general counsel at the CFTC. During his time at the regulator, he led the teams that drafted some of Dodd-Frank’s key definitions, including that of “swap”. He now represents firms that provide window forwards, as well as other forex instruments such as NDFs, to small and medium-sized enterprises in the US.
Exceptions to the rule
The issue stems from Section 721 of Dodd-Frank, which amends the definitions of instruments and dealers under the Commodity Exchange Act. In writing this section, Congress considered that foreign exchange derivatives were already transacted in liquid, efficient and electronified markets. The risks of these instruments were lower than those of, say, interest rate swaps. And so with a nod to future exigencies, Congress included a provision that gave the Treasury secretary the authority to exclude forex swaps and forwards from derivatives requirements such as mandatory clearing and from the calculation of the threshold for swap dealer registration.
When Geithner decided to exercise this authority for forex swaps and forwards, NDFs remained outside the exclusion because they failed to meet Dodd-Frank’s definition of a forward: namely, a contract that requires the exchange of two different currencies on a future date at a rate agreed upon at the beginning of the transaction.
NDFs are used by counterparties wishing to hedge currency risk in restricted, mostly emerging markets, currencies or for speculation on these currencies. They are cash-settled in the major currency, unlike forex forwards which are physically settled. Window forwards are, like any other forward, characterised by a precise amount to be paid in the foreign currency at a fixed exchange rate. However, rather than an exact settlement date, they provide the option of settling at any point in a given time period, or window.
Bennett says that in response to Geithner’s determination in 2012, Covington submitted a comment letter advocating that both deliverables and non-deliverables should be excluded “because they are the same product with the same economic function. It’s just the accident of whether one currency is deliverable or not.”
Geithner responded that he lacked the authority to exclude NDFs because of the limitations of statutory language, says Bennett; a forward necessitates exchange of currencies. “However, in his determination, Geithner said that the CFTC has the authority to exclude NDFs and we are in front of the CFTC right now, still advocating for that position,” Bennett says.
Unlike a normal forex forward, NDFs don’t physically settle, they net settle. And so, all you are doing is moving your net gain or lossJoseph Hoffman, Mesirow Financial
Hammar assisted in drafting a comment letter on behalf of two firms, Afex and GPS Capital Markets, which was submitted in response to the CFTC’s 2017 initiative to cut back unnecessary regulation. The letter states that the prejudicial treatment of window forwards raises costs for market participants. The two firms currently operate under the de minimis threshold. In the absence of a formal determination from the CFTC over whether window forwards fall into the swaps classification or not, these companies are forced to continue to employ two distinct formulas to assess aggregate gross notional amounts of swap dealing activity, one calculation with window forwards and another without.
“In addition to the operational burden of the redundant calculations, the companies incur significant staffing and information technology expenses to carry out this daily task,” says the letter.
Including window forwards in the de minimis calculation also means the companies are pushed closer to the threshold. This may require them to stop offering window forwards to clients at all. And as market participants treat these instruments as swaps “from an abundance of caution”, margin costs add yet more burden, the letter states.
“When the majority of regulators globally decided to treat NDFs differently from standard deliverable forwards, it surprised me because these are such a small component of the market,” says Joseph Hoffman, CEO of the currency management business at Mesirow Financial in Chicago.
According to data from the Bank for International Settlements, NDF turnover accounted for about 19% of forwards trading and only 2.6% of overall forex trading. Within emerging market currency products, NDFs accounted for 17% of activity (see figure 1).
As Treasury and Congress recognised, NDFs do not constitute significant systemic risk either, says Hoffman.
“Unlike a normal forex forward, NDFs don’t physically settle, they net settle. And so, all you are doing is moving your net gain or loss. If you buy euro versus dollars, a lot of times in a deliverable case you are delivering out both sides of the trade. In the NDF space, that risk is much less because you are moving the P&L, the net amount, on settlement day.”
The way forward
Lawyers say that while treatment of NDFs could only be changed by an act of Congress, the CFTC could sidestep that by excluding NDFs from the de minimis counting exercise, as it suggests doing in the consultation paper. Bennett believes this is within the CFTC’s power to do. NDFs would still, however, be subject to non-cleared margin rules.
Carl Kennedy, a lawyer at Gibson Dunn & Crutcher, represents a group of derivatives users who have also commented on window forwards. He says the rules governing window forwards are more easily addressed.
“I think we would not need an act of Congress. The commissions could take regulatory action. Unlike forex NDFs, the issue here is not the form of settlement. Forex window forwards are physically settled like forex forwards. The issue is really about not knowing just when that settlement will occur. So this is something the CFTC can address,” Kennedy says.
Legally, the commission would first have to consult the Securities and Exchange Commission to determine whether it had the authority to issue an interpretation on its own, he adds.
Unlike forex NDFs, the issue here is not the form of settlement… The issue is really about not knowing just when that settlement will occurCarl Kennedy, Gibson Dunn & Crutcher
“Clearly, these products are within the CFTC’s jurisdiction. But Dodd-Frank requires the CFTC to co-ordinate and jointly take action with the SEC in further defining the term ‘swap’. It might be likely that the commissions would have to work together in issuing an official interpretation.”
Hammar says he has asked the CFTC to issue an interpretation that would treat window forwards in the same way as forex forwards. “This could be done by interpreting the statutory definition of forex forwards as covering window forwards. Likely, this would require the Treasury secretary to amend his determination to exempt forex forwards, since the Treasury determination basically states which types of foreign exchange derivatives are covered by the exemption and which are not.”
Window forwards would then only be subject to reporting, record-keeping, business conduct standards for swap dealers, and anti-fraud and anti-manipulation rules, just as forex forwards are. Window forwards would not have to count towards the de minimis total or be subject to non-cleared margin rules.
The CFTC could also extend the same relief it suggests for NDFs to windows, says Hammar. “Again, that would provide some breathing room before having to register. It would not relieve window forwards from the non-cleared margin rules, however.”
That the CFTC has not acted on window forwards before could be testament to some uncertainty about the window timeframe, says Eric Juzenas, a director in the global regulatory solutions business at Chatham Financial. The flexibility of the window has historically presented the commission with a challenge in terms of where the line falls between forwards and options.
“The commission has recognised that in some instances, forward contracts with some optionality on the amount of a commodity to be delivered are still forwards,” he says. “The question for the commission is likely to be: how long a window is acceptable for the contract still to be considered a forward? Thirty days? Six months? One year? And whether delivery is binding at the end of the window period if delivery does not occur while the window is open.”
Technical questions aside, Bennett is generally optimistic that the CFTC will listen to the industry’s concerns that well-intentioned regulation has increased the cost of a fairly simple hedging tool such as NDFs. “It is hard to see justifications for [the rule] and it’s easy to see costs that it imposes. The commission does seem to get that and has been encouraging,” he says.
Editing by Alex Krohn