A futures exchange needs a high level of trust to operate effectively, because every contract is guaranteed by all those permitted to transact there. The exchange uses a deposit and margining system to ensure performance under a futures contract. Every time a contract is entered into, a deposit is placed with the exchange, and every movement in value of the contract involves either the depositing of further money (if contract value declines) or the ability to withdraw money (if contract value increases). This mechanism was seized on by advocates of mark-to-market as an opportunity to tax parties to the contracts consistent with the flows of cash and with the way exchanges conducted business.
Opponents claimed that mandatory mark-to-market for futures contracts gave off-exchange contracts an unfair advantage. Schapiro, representing the NYSBA, thought this was the correct result because ‘‘executory
contracts… don’t involve daily transfers of cash. They are not a sum zero system.
Congress need not have worried about an immediate constitutional challenge (although it did come later). Sixty-forty was such a winning formula that as soon as mark-to-market was enacted for futures contracts, representatives of the banking industry implored policymakers to include their contracts also. Acting with uncharacteristic alacrity, in 1982 Congress enacted mark-to-market for ‘‘foreign currency contracts.’’ The legislative history recognizes that there is no equivalent to the margining mechanism in the over-the-counter market, but Congress was no longer concerned with the realization principle. It sought to tax FX contracts off exchanges equivalently to those on exchanges. Congress delineated the extension of mark-to-market in crisp language:
Section 1256(g)(2) FOREIGN CURRENCY CONTRACT DEFINED. — The term ‘‘foreign currency contract’’ means a contract —
(A)(i) which requires the delivery of, or the settlement of which depends on the value of, a foreign currency which is a currency in which positions are also traded through regulated futures contracts,
(A)(ii) which is traded on the inter-bank market,
(A)(iii) which is entered into at arm’s length at a price determined by reference to the price in the inter-bank market.
Although the law refers to FX contracts, the legislative history talks about ‘‘bank forward contracts’’ only. No good explanation has been given for the discrepancy between the language in the law and in the history. Practitioners who were present when the law was being delivered insist that the term ‘‘foreign currency contracts’’ was intended to include only FX forwards. They offer as proof the requirement that the contracts be traded
on and priced by reference to, the interbank market. Those who read the code as a free-standing document find no such intent to limit the term to FX forwards. The term ‘‘foreign currency contracts’’ could conceivably include forwards, options, and swaps. All these can be traded and priced by reference to the interbank market
The IRS has given taxpayers little help in solving the conundrum, although it has been asked to do so several times. The question in LTR 881801044 was whether FX swaps were FX contracts under section 1256(g)(2). The ruling states that ‘‘Congress intended to include within the definition of foreign currency contract bank forward contracts in currencies traded through regulated futures contracts because they are economically comparable and
used interchangeably with regulated futures contracts.’’ The ruling concludes that because ‘‘currency swap contracts typically account for interest rate differentials through a present and continuing exchange of notional interest payments over the life of the contracts while bank forward contracts account for such difference upon maturity,’’ and because there is no intention in the legislative history to include swaps under section 1256(g)(2), swaps do not come within that code section. The ruling does not attempt to interpret the plain language of the statute.