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Regulation of U.S. Currency Transactions Reprinted with permission from Futures and Derivatives Law Report, Vol- ume 37, Issue 5, K2017 Thomson Reuters. Further reproduction without permission of the publisher is prohibited. For additional information about this publication, please visit www.legalsolutions.thomsonreuters.com. May 2017 ▪ Volume 37 ▪ Issue 5 REPORT REGULATION OF U.S. Notwithstanding the broad reach of the current U.S. regulatory regime governing CURRENCY foreign exchange, there are still issues that TRANSACTIONS are open to interpretation. For example, language in regulatory releases suggests By David Aron, P. Georgia Bullitt and Jed Doench that there is uncertainty about whether a physically-settled currency contract4 David Aron is Special Counsel in the Division of Market Oversight (“DMO”) could be recharacterized as a swap if it is at the Commodity Futures Trading Com- settled through an offsetting physically- mission (“CFTC”). P. Georgia Bullitt is settled contract rather than an exchange of a partner, and Jed Doench is an associ- the designated currencies. Such a charac- ate, in the Asset Management Group of Willkie Farr & Gallagher LLP.* terization would result in substantially dif- ferent regulatory and operational treat- Introduction ment, including with respect to mandatory Currency transactions, which prior to clearing, margin, trade execution on a the market disruption of 2008 were among designated contract market (“DCM”) or the least regulated transactions in the U.S. swap execution facility (“SEF”) and re- financial markets, are now highly regu- porting requirements.5 There is also uncer- lated and are subject to one of the most tainty with respect to the applicability and complex regulatory regimes. The Dodd- scope of margin requirements as a result Frank Wall Street Transparency and Ac- of a supervisory policy issued by the countability Act of 2010 (“Dodd-Frank”)1 Board of Governors of the Federal Re- made substantial changes to the Commod- serve System (“Federal Reserve”) that ity Exchange Act (“CEA”) relating to cur- suggests that banking institutions under rency trading, some of which are still be- the supervision of the Federal Reserve, The Journal on the Law of Investment & Risk Management Products ing implemented and defined. The current which includes the largest foreign ex- regulatory architecture imposes different change dealers, may be expected to post requirements on currency transactions and collect variation margin in connection depending upon factors including: the with OTC physically-settled foreign ex- type of product being traded; whether the change derivatives, even though such transaction is physically or cash-settled; products are otherwise excepted from the the type of person trading the product (i.e., margin requirements under Dodd-Frank whether institutional or retail investors are as a result of the determination made by the counterparties);2 and whether the in- the U.S. Department of the Treasury (the strument is traded on a securities or futures “Treasury”).6 There also continue to be ar- exchange or in the over-the-counter eas of uncertainty in the retail context. For Futures & Derivatives Law (“OTC”) market.3 example, under the current guidance, it is May 2017 | Volume 37 | Issue 5 Futures and Derivatives Law Report not clear how an OTC transaction with a retail into with persons who are not ECPs and that are investor should be treated at unwind if that inves- regulated pursuant to CEA Sections 2(c)(2)(B), tor has, since the trade commenced, attained (C) and (E), which we refer to as “Retail Forex.”10 institutional status by qualifying as an ECP. We We do not discuss regulation of (i) currency op- discuss each of the issues in greater detail in Sec- tions traded on regulated securities exchanges,11 tion III of this article. which are regulated by the SEC and margined, traded, cleared and settled in substantially the Most foreign exchange and currency transac- same way as U.S. listed securities options,12 or tions (“Currency Transactions”) conducted in the U.S. market are subject to the CEA and the rules (ii) currency futures and options on currency of the CFTC and the National Futures Associa- futures, which are regulated, margined, traded, tion (“NFA”). Other financial regulators, such as cleared and settled in substantially the same way the federal banking regulators and the SEC, also as other U.S. financial futures contracts and op- play a significant role. This article provides an tions thereon. overview of the history of the regulation of Cur- I. History of Foreign Exchange rency Transactions in the United States, includ- and Currency Regulation ing the patterns of bad conduct and aberrations in that market that have led to the increase in The regulation of Currency Transactions has regulation. We summarize below the existing evolved significantly over time as Congress, the regulatory framework and focus on the regula- CFTC, NFA and other regulators have attempted tion of both retail and institutional OTC Currency to curb various forms of misconduct and respond Transactions by the CFTC. In terms of the scope to market disruptions, while still preserving the of Currency Transactions discussed in this article, liquidity and robustness of the market. The most we consider: (i) swaps and options on foreign comprehensive change to the regulation of Cur- exchange, including non-deliverable forwards rency Transactions came in 2010 with the adop- (“NDFs”), which are primarily traded in the OTC tion of Dodd-Frank. Under Dodd-Frank, Con- market between ECPs but which Dodd-Frank gress enacted a new regulatory framework for contemplates migrating to trading on a DCM or institutional OTC Currency Transactions (among SEF and being subject to central clearing through other products) entered into between ECPs. This a derivatives clearing organization (“DCO”) if framework distinguishes between cash-settled the transactions become sufficiently commod- and physically-settled Currency Transactions and itized; (ii) physically-settled currency forwards contemplates that physically-settled Currency defined as “foreign exchange forwards” under the Transactions may be eligible for exemption from CEA7 (“Currency Forwards”) and physically- many of the regulatory requirements applicable settled foreign exchange swaps defined as “for- to cash-settled Currency Transactions that are eign exchange swaps” under the CEA fully regulated as “swaps.” Dodd-Frank also (“Physically-Settled FX Swaps”)8 traded be- enhanced regulation of Retail Forex by requiring tween ECPs; (iii) spot transactions that result in those regulators that oversee entities conducting an exchange of currencies within two days;9 and Retail Forex to adopt substantive regulations ap- (iv) off-exchange Currency Transactions entered plicable to such entities addressing disclosures, 2 K 2017 Thomson Reuters Futures and Derivatives Law Report May 2017 | Volume 37 | Issue 5 recordkeeping, capital and margin, reporting, eign currency transactions in the Treasury business conduct, documentation and other re- Amendment broadly and significantly limited the quirements deemed to be necessary by such CFTC’s jurisdiction over OTC Currency regulators.13 Transactions. The debate around the scope of the Treasury Amendment culminated in a U.S. Su- A. Regulation Prior to Dodd-Frank preme Court decision in Dunn v. CFTC in 1997.20 Federal regulation of Currency Transactions In that case, the U.S. Supreme Court held that dates back to the passage of the Commodity OTC foreign currency options were among the Futures Trading Commission Act of 1974, which products excluded from CFTC jurisdiction by the created the CFTC. When the bill was being Treasury Amendment, noting that “[t]he legisla- considered, the Treasury expressed concerns that tive history strongly suggests ... that Congress’ the CFTC’s jurisdiction as proposed in the bill broad purpose in enacting the Treasury Amend- would overreach and capture the OTC foreign ment was to provide a general exemption from currency market, which was characterized by CFTC regulation for sophisticated off exchange foreign currency trading, which had previously trading between banks and large institutional developed entirely free from supervision under customers and viewed by the Treasury as being the commodities laws.”21 In an even more sweep- more properly regulated by federal banking ing decision, the U.S. Court of Appeals for the regulators.14 The bill was amended to include Ninth Circuit held that the Treasury Amendment language proposed by the Treasury (the “Trea- precluded the CFTC’s jurisdiction over OTC sury Amendment”)15 that excluded from regula- Currency Transactions because the Treasury tion under the CEA specified transactions involv- Amendment was intended to apply to all OTC ing foreign currency, which were not transactions Currency Transactions.22 These judicially- “for future delivery conducted on a board of imposed restrictions on the CFTC’s jurisdiction trade.” The CFTC generally interpreted the Trea- impeded the ability of the CFTC to bring enforce- sury Amendment narrowly to exclude from ment actions against foreign exchange “bucket CFTC oversight only those Currency Transac- shops,” a proliferating group of foreign exchange tions conducted in the OTC market between dealers that targeted retail investors with fraudu- banks and other institutional market lent practices. This situation prompted calls for participants.16 In the years that followed, the Congress to rethink the Treasury Amendment to CFTC bolstered its jurisdiction over retail
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