Second Update: Dodd-Frank Rules Impact End-Users of
Foreign Exchange Derivatives - Next Steps
February 13, 2013
This February 2013 update is a summary of certain recent developments under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) that impact corporate end-users of foreign exchange (FX) derivative transactions and should be read in conjunction with two prior WSGR Alerts from October 2011 and September 2012 on Dodd-Frank FX issues.
Title VII of Dodd-Frank amends the Commodity Exchange Act (CEA) and other federal securities laws to provide a comprehensive new regulatory framework for the treatment of derivatives, which are generally defined as "swaps" under Section 721 of the CEA. Among other things, Dodd-Frank provides for:
- the registration and regulation of swaps dealers and major swap participants;
- the implementation of clearing and trade-execution requirements for swaps; and
- the establishment of recordkeeping and reporting requirements for swaps.
The definition of "swaps" under Dodd-Frank is quite broad and includes a wide variety of FX derivatives, such as FX swaps, FX forwards, currency swaps, cross-currency swaps, foreign currency options (including collared options), and non-deliverable FX forward contracts (NDFs), each as described in Annex A to this alert.
1. U.S. Department of Treasury Final Rule
In November 2012, the Treasury issued a final rule that exempts both FX swaps and FX forwards (exempt FX swaps) from the definition of "swaps" under the CEA (Treasury Exemption). The Treasury release clearly states that the Treasury Exemption applies only to exempt FX swaps (described in Annex A) and does not extend to any other type of FX derivative transaction.
In August 2012, the Commodity and Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) jointly issued rules further defining the term "swap" under Dodd-Frank. These rules clearly distinguished FX derivatives that could be subject to the Treasury Exemption from FX derivatives that would not be subject to the Treasury Secretary's determination. The final rules thus confirmed that the following FX derivatives (described in Annex A) would be treated as swaps (non-exempt FX swaps) under the CEA without regard to the Secretary's determination:
- Foreign currency options
- Non-deliverable forward contracts involving foreign exchange
- Currency swaps
- Cross-currency swaps
2. Overview of FX Swap Regulatory Framework after the Department of Treasury Final Rule
While the Treasury Exemption provides that exempt FX swaps, such as FX swaps and FX forwards, will not be subject to Dodd-Frank's clearing and trading requirements, FX swaps and FX forwards will continue to be subject to the following Dodd-Frank provisions: (1) the requirement to report swap trade data to swap data repositories (SDRs), (2) the external business conduct standards described in Section 3 of this alert, and (3) the anti-evasion provisions of Dodd-Frank described in Section 5 of this alert (anti-evasion rules).
In contrast, non-exempt FX swaps are subject to the following Dodd-Frank provisions: (1) the clearing and trading requirements of Dodd-Frank discussed below (unless another exemption, such as the End-User Exception discussed in the September 2012 WSGR Alert, is available), (2) the proposed margin requirements imposed by either the CFTC or prudential regulators, (3) all three categories of reporting and recordkeeping requirements described in Section 4 of this alert, (4) the external business conduct standards, (5) the swap documentation requirements described below in Section 3 of this alert, and (6) the anti-evasion rules.
3. Documentation Requirements
The CFTC has promulgated final rules that impose various documentation requirements on swap dealers and major swap participants under the external business conduct standards, swap data reporting requirements, and swap documentation rules.
On December 18, 2012, the CFTC issued interim final rules extending the compliance date (Deadline Extension Release) for certain external business conduct requirements, including the "know your customer" requirements from January 1, 2013, to May 1, 2013. In addition, on December 18, 2012, the CFTC extended the compliance date for certain swap documentation requirements described below under the final rule entitled "Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants" (Swap Documentation Rules), from January 1, 2013, to July 1, 2013.
Swap Documentation Rules
In late August 2012, the CFTC approved the Swap Documentation Rules, which apply to non-exempt FX swaps but do not apply to exempt FX swaps. These rules require swap dealers, among other things, to (1) limit the time between the execution of a foreign exchange swap transaction and the time that the swap dealer distributes and executes legally binding documentation with respect to such FX swap transaction with a corporate end-user of FX derivatives (Confirmation Documentation) and (2) to establish and follow written policies and procedures reasonably designed to ensure that the swap dealer executes written swap trading relationship documentation with corporate end-users of FX swaps "prior to or contemporaneously with" entering into an FX swap transaction with the corporate end-user (Trading Documentation). The Trading Documentation must be in writing and include all terms governing the trading relationship between the swap dealer and the FX corporate end-users, including terms such as payment obligations, events of default, netting, termination events, and calculation of obligations upon termination. The Deadline Extension Release extended the compliance date for the Trading Documentation requirement but DID NOT extend the deadline for the Confirmation Documentation requirement. Please note that the swap dealer is required to provide the Confirmation Documentation.
External Business Conduct Standards and the ISDA August Protocol
The external business conduct standards prohibit certain abusive practices and require swap dealers to (1) disclose certain material information to counterparties and (2) conduct due diligence relating to their dealings with counterparties (the "know your customer" requirements). Accordingly, end-users should expect to amend their existing trade documentation to facilitate swap dealers' and major swap participants' compliance with the external business conduct rules by May 1, 2013. Failure to do so would prevent an end-user from trading with a swap dealer or a major swap participant counterparty after such date.
We expect that most corporate end-users of FX derivatives will meet the documentation requirements required by swap dealers under the external business conduct standards by using the online International Swaps and Derivatives Association (ISDA) August Protocol. While the parties to a swap could individually amend the documentation for each swap transaction on a one-by-one basis, the ISDA August Protocol allows parties to amend their existing documentation by agreeing to certain supplements published by ISDA. It is important to note that each corporate entity that is a party to a swap must amend its existing trade documentation to facilitate its swap dealer's or major swap participant's compliance with the external business conduct standards. For example, if both a parent company and a subsidiary of the parent company trade FX derivatives, each entity must enter into the ISDA August Protocol documentation separately. In addition, a corporate end-user should obtain a swap identifier number, referred to as a CFTC Interim Compliant Identifier (CICI), for each legal entity in the corporate structure trading FX derivatives.
An end-user may use the protocol to supplement its existing swap documentation with a counterparty by (1) agreeing to an adherence letter published by ISDA for viewing by other swap participants and (2) exchanging a questionnaire with each of its counterparties. The end-user will submit the adherence letter via an online form, which will contain the end-user's agreement to the protocol and specify the manner in which questionnaires should be exchanged. Questionnaires may be exchanged in a variety of ways, including via an electronic platform called ISDA Amend. However, it is important to note that an exchange of questionnaires with every counterparty is not required. Thus, an end-user may elect to exchange questionnaires with some, but not all, of its counterparties. After submission of the adherence letter and delivery by each counterparty of a questionnaire to the other counterparty, the existing swap documentation will be amended. The protocol can be used to supplement both ISDA Master Agreements and other FX derivative documentation between the parties. End-users who do not have ISDA Master Agreements in place will need to agree to the DF Terms Agreement, which also is made available through the ISDA August Protocol.
The questionnaire includes various representations to be made by the end-user, such as corporate status and power, no violations or conflicts with charter documents or existing contracts, no required consents, and the binding nature of its obligations under the protocol. It also contains the required "know your counterparty" information, which includes the end-user's name, legal identifier (i.e., CICI number), and address, as well as the identity of any guarantors and any person exercising control over the end-user. The questionnaire requires the end-user to verify that it is an "eligible contract participant" under the CEA and permits the end-user to specify whether it is a "specified entity" or "financial entity." By adhering to the protocol, an end-user agrees to notify its counterparty of any material change in the information provided pursuant to the protocol, including whether any representation has become untrue or misleading in any material respect, and to provide notice of any "life-cycle event."1 Most of our corporate end-users have elected to incorporate Schedules 1 through 3 of the ISDA DF Supplement when completing the questionnaire. In order to make certain representations set forth in Schedule 3 of the ISDA DF Supplement, the corporate end-user should have in place written policies and procedures that are reasonably designed to ensure that the person evaluating swap recommendations from the swap dealer and making trading decisions for the corporate end-user has the requisite capabilities (capable-person representation). Most of our end-user clients have amended their FX trading policies to implement the written policies and procedures necessary to make this capable-person representation.
Furthermore, ISDA is considering adding an addendum to the ISDA August Protocol that would include an election by end-users not to receive pre-trade mid-market marks from their counterparties with respect to certain FX transactions.2 Absent such an election, swap dealers and major swap participants would be required to make such disclosures with respect to both exempt and non-exempt FX swaps.
4. Reporting and Recordkeeping Requirements
The reporting and recordkeeping requirements for swaps under Dodd-Frank (including FX derivatives) are quite complex.
There are three general categories of reporting requirements:
- Real-Time Reporting: Provides for real-time reporting and public dissemination of certain swap data, including pricing data for certain newly executed swaps and amendments to existing swaps.
- Regulatory Reporting: Provides for reporting to SDRs of primary economic terms and confirmation data of swaps, life cycle data, and valuation data, but the information will not become publicly available.
- Historical Reporting: Provides for similar reporting requirements as regulatory reporting to SDRs of historical swap information.
Dodd-Frank requires all transactions in swaps to be reported to a SDR, or if no SDR is available, to the CFTC or SEC, as applicable. These reporting requirements are applicable to you as a corporate end-user of FX derivatives only in the event that your counterparty is neither (1) a clearinghouse in the case of a cleared swap nor (2) a swap dealer or major swap participant in the case of an uncleared swap. As a result, you will be subject to these reporting requirements only if your counterparty is another end-user, which will be extremely unlikely for most corporate end-users of FX derivatives. The regulatory reporting requirement as it applies to FX swaps will become effective by April 10, 2013, and will apply to both exempt and non-exempt FX swaps. The real-time and historical reporting requirements will only apply to non-exempt FX swaps.
Recordkeeping for New FX Swaps
Under the general recordkeeping requirements for new FX swaps, corporate end-users will be required to keep full, complete, and systematic records, together with all pertinent data and memoranda, with respect to each swap to which it is a counterparty, including, without limitation, all records demonstrating that it is entitled with respect to any swap to elect the End-User Exception to the clearing requirement. Records are to be made available for CFTC inspection and may be maintained in paper or electronic form. FX swap records must be maintained from the date of creation of the FX swap through at least five years after the termination of a swap. Swap records must be retrievable within five business days. In addition, corporate end-users must keep records of all required identifiers, including the unique swap identifier, the CICI, and any product identifier. These recordkeeping obligations will require corporate end-users to establish swap recordkeeping policies and procedures. We expect that complying with these new rules may require investment in new recordkeeping systems, depending on the nature and extent of trading activity.
Recordkeeping for Historical FX Swaps
For each historical swap that terminated or expired prior to April 25, 2011, end-users must retain the records of the primary economic terms of the swap that were in their possession as of October 1, 2010 (in the case of pre-enactment swaps), or as of December 17, 2010 (in the case of transition swaps). In each case, the end-user must retain the records for five years after the termination or expiration date of such a swap. Additionally, end-users must retain copies of (1) any confirmation executed by the parties, (2) any master agreement governing the swap and any amendment or modification thereof, and (3) any credit support agreement relating to the swap and any amendment or modification thereof. Records of historical swaps may be kept in paper or electronic form and must be retrievable within five business days.
5. Anti-Evasion Rules
The anti-evasion rules apply to both exempt and non-exempt FX swaps and provide that any transaction that is "willfully structured" as a foreign exchange forward or foreign exchange swap to evade any provision of the CEA shall be deemed a swap for purposes of the CEA. Accordingly, end-users should be sensitive to any actions or communications that could be construed as evidence of a willful intent to evade swap treatment under the CEA.
6. End-User Exception and FX Clearing and Trading Requirements
As of the date of this WSGR Alert, the CFTC has yet to issue any proposed rule that would require the clearing and trading of any FX derivative. We do not expect any such final rule requiring the clearing and trading of FX derivatives to become effective for corporate end-users prior to the end of 2013, based on the expectation that the CFTC would allow 270 days after the effective date of the final rule for such a clearing requirement to be applicable to a corporate end-user. Therefore, we expect that there will be no need to implement the End-User Exception for any corporate end-use of FX derivatives prior to the end of 2013. Furthermore, the End-User Exception is only relevant to non-exempt FX swaps because the Treasury Exemption already exempts exempt FX swaps from the clearing and trading requirements of Dodd-Frank.
What You Should Do Now
Corporate end-users of FX derivatives should take the following steps, among others, in order to comply with the regulations described above:
- Confirm by March 31, 2013, that no historical FX swaps are subject to reporting requirements that would require you to be a reporting party (i.e., that you have no historical FX swaps where the counterparty is not a swap dealer or major swap participant).
- Report any FX swaps after April 10, 2013, where your counterparty is neither a swap dealer nor a major swap participant—unless your end-user counterparty agrees to report such FX swaps.
- Obtain a CICI identifier for any legal entity in the corporate structure trading FX swaps (both for reporting requirements and the ISDA August Protocol).
- Amend your existing ISDA documents by reviewing and completing the ISDA August Protocol documentation for each legal entity in the corporate structure trading FX swaps.
- Amend your existing FX trading policy, if necessary, to comply with the capable-person representation set forth in Schedule 3 to the ISDA August Protocol.
- Confirm your compliance with recordkeeping requirements for both new swaps and historical swaps.
- Look out for any potential non-compliance with regard to the anti-evasion rules.
- Monitor CFTC future pending releases with respect to the clearing and trading of FX swaps.
- Monitor future ISDA protocols, which may be forthcoming. For example, ISDA is developing a new protocol concerning Dodd-Frank's portfolio reconciliation requirements.
If you have any questions about this alert, please contact Michael Occhiolini at (650) 320-4688 or firstname.lastname@example.org, Erik Franks at (650) 565-3879 or email@example.com, Joe Bailey at (650) 849-3362 or firstname.lastname@example.org, or your regular Wilson Sonsini Goodrich & Rosati contact.
Foreign Exchange Swap (Exempted by Treasury Exemption)
A transaction that solely involves (A) an exchange of two 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 the two currencies involved in (A) at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange.
Foreign Exchange Forward (Exempted by Treasury Exemption)
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 covering the exchange.
Currency Swap and Cross-Currency Swap (Each a Swap under the CEA)
Each generally can be described as a swap in which the fixed legs or floating legs based on various interest rates are exchanged in different currencies.
- A currency swap exchanges a fixed rate in one currency against a fixed rate in another currency.
- A cross-currency swap is the swap of an interest rate in one currency for an interest-rate payment in another currency (i.e., an interest-rate swap with a currency component).
- A cross-currency swap may be categorized as a cross-currency coupon swap to the extent that it has a fixed leg based on one rate and a floating rate based on another rate (where the two rates are denominated in different currencies), or a cross-currency basis swap, where it has a floating leg based on one rate and another floating rate based on a different rate.
- Cross-currency swaps also include annuity swaps and amortizing swaps. In cross-currency annuity swaps, level cash flows in different currencies are exchanged with no exchange of principal; annuity swaps are priced such that the level payment cash flows in each currency have the same net present value at the inception of the transaction. An amortizing cross-currency swap is structured with a declining principal schedule, usually designed to match that of an amortizing asset or liability.
Foreign Currency Option (A Swap under the CEA)
Any agreement, contract, or transaction that is a put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of one or more currencies. (Foreign exchange options traded on a national securities exchange, however, are securities under federal securities laws and are not swaps or security-based swaps.)
Non-Deliverable Forward (NDF) (A Swap under the CEA)
An NDF is similar to a foreign exchange forward, in that it is an obligation to buy or sell a specific currency on a future settlement date at a fixed price set on the trade date, except that at maturity, an NDF does not require physical delivery of currencies. Rather, the contract typically is settled in a reserve currency, such as U.S. dollars. This is because one of the currencies involved in the transaction, usually an emerging-market currency, may be subject to capital controls or similar restrictions and is therefore "non-deliverable."
2 The addendum, if adopted, would apply only to (1) foreign exchange forwards and foreign exchange swaps that, by their terms, are physically settled, have a stated maturity of one year or less, and where each currency is among the following currencies: U.S. dollar, euro, Japanese yen, pound sterling, Australian dollar, Swiss franc, Canadian dollar, Hong Kong dollar, Swedish krona, New Zealand dollar, Singapore dollar, Norwegian krone, and Mexican peso (the "BIS 13 Currencies"); or (2) a vanilla foreign exchange option that, by its terms, is physically settled, where each currency is one included among the BIS 13 Currencies, and where the option has a stated maturity of six months or less.