On 24 November 2017, the European Supervisory Authorities ("ESAs") issued a statement28 on the variation margin requirements in respect of physically settled FX forwards under Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 with regard to risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty29 (the "Margin Rules" and, as the Margin Rules apply to physically settled FX forwards, the "FX VM Requirements"). The ESAs acknowledged that: (i) the globally agreed framework (i.e. the framework developed by the Basel Committee on Banking Supervision ("BCBS") and the International Organisation of Securities Commissions ("IOSCO")) for the margining of physically-settled FX forwards had been applied on a more limited basis in other key jurisdictions (such as the United States, Japan, Singapore and Canada); and (ii) the FX VM Requirements had created challenging obligations for certain end-users.
As a result, the ESAs announced that they were undertaking a review of the Margin Rules in order to align the FX VM Requirements with the margin requirements of other key jurisdictions. The ESAs stated that they expected competent authorities to generally apply "their risk-based supervisory powers in their day-to-day enforcement of applicable legislation in a proportionate manner." Prior to this statement, financial counterparties, non-financial counterparties above the clearing threshold and equivalent non-European Union ("EU") entities had expected the FX VM Requirements to apply from 3 January 2018.
On 7 December 2017, the Financial Conduct Authority ("FCA") issued a statement confirming that it supported the ESAs’s statement30. Whilst the FCA noted that the proposed amendments to the Margin Rules were not clear, the proposals outlined in the ESAs’s statement could be used by firms as an indication of what the amended requirements may look like. The FCA therefore confirmed that they would not require firms whose physically settled FX forwards are likely to be outside the scope of the amended requirements to continue putting processes in place to exchange variation margin.
Draft amendment to the Margin Rules
On 18 December 2017, the ESAs published draft regulatory technical standards to amend the existing Margin Rules (the "Draft RTS")31. They acknowledged that:
- the EU is the only jurisdiction to directly include physically settled FX forwards within the scope of its variation margin requirements;
- if the FX VM Requirements were not amended, there was a risk that EU market participants might accept the negative consequences of leaving their currency risk unhedged;
- this risk was particularly true for smaller clients for which the amount of variation margin exchanged would be small, but the cost of implementing margining systems and procedures would be disproportionately high; and
- clients outside the EU may decide to trade away from EU banks to avoid the FX VM Requirements.
The ESAs considered that a full exemption from the FX VM Requirements for all counterparties would "contradict the BCBS and IOSCO guidance that encourages the exchange of variation margin" and concluded that their preferred option would be to restrict the FX VM Requirements to transaction between "institutions", as described below. Accordingly, they have proposed to amend the Margin Rules by adding in the following provision:
"Article 31a Treatment of physically settled foreign exchange forward derivatives
By way of derogation from Article 2(2), counterparties may provide in their risk management procedures that variation margins are not required to be posted or collected for physically settled foreign exchange forward contracts in any of the following cases:
(a) where one of the counterparties is a counterparty other than an ‘institution’ in the sense of point (3) of Article 4(1) of Regulation (EU) No 575/2013;
(b) where one of the counterparties is established in a third country and would not meet the definition of ‘institution’ in the sense of that Article, if it were established in the Union."
An "institution" is a "credit institution or an investment firm" as defined in the Capital Requirements Regulation32.
Implementation in the EU
In the Draft RTS, the ESAs acknowledged that the amendments to the Margin Rules would only take effect after 3 January 2018 (the date on which the FX VM Requirements would be in force). The ESAs therefore stated that "for institution-to-non-institution transactions, the competent authorities should apply the EU framework in a risk-based and proportionate manner until the [Draft] RTS enter into force". The "Summary of responses to the stakeholder group consultation and the ESAs’ analysis" in the Draft RTS clarifies that this "risk-based and proportionate" approach will only apply in the period between 3 January 2018 and the date on which the Margin Rules are amended.
Given the urgency with which it is necessary to amend the Margin Rules, the Draft RTS states that it will come into force "on the day following that of its publication" in the Official Journal of the European Union (not the usual 20 days).
European Parliament’s Economic and Monetary Affairs Committee ("ECON Committee") — Draft report
The European Parliament’s ECON Committee has published a draft report dated 26 January 2018 (the "ECON Draft Report")33 on the proposal to amend Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories ("EMIR"). It may be worth noting that the ECON Draft Report agrees that "the mandatory exchange of variation margins (VM) for physically-settled FX forwards should be limited to certain counterparties (banks and investment firms), via a modification of the [Margin Rules]." In addition, it recommends that in order to achieve a perfect alignment with other international jurisdictions, the ESAs’s proposal should be extended to physically settled FX swaps. For a detailed analysis of the proposed amendments to EMIR, please see Eduardo Barrachina’s article in this issue of the Delta Report.
Whilst the exact timing of the implementation of the Draft RTS is not clear and the FX VM Requirements have technically been in force since 3 January 2018, the statements from the ESAs and the FCA and the move to restrict the FX VM Requirements to "institutions" will come as welcome relief to many in the market. The Draft RTS, if implemented in its current form, should level the playing field as against other jurisdictions (such as the United States).
THE DELTA REPORT
28 — Variation Margin exchange for physically-settled FX forwards under EMIR, 24 November 2017. Available on this link: https://esas-joint-committee.europa.eu/Pages/News/Variation-margin-exchange-for-physically-settled-FX-forwards-under-EMIR-.aspx
29 — Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards for risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty). For more background on margining under Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories, please see "European Margin Rules for Non-cleared OTC Derivatives—The Margin Big Bang", Nathaniel Crowley, Delta Report, 24 January 2017. Available on this link: https://www.whitecase.com/publications/article/european-margin-rules-non-cleared-otc-derivatives-margin-big-bang
30 — For more information, please see: https://www.fca.org.uk/markets/emir
31 — Draft regulatory technical standards on amending Delegated Regulation (EU) 2016/2251 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on risk-mitigation techniques for OTC derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012 with regard to physically settled foreign exchange forwards. Available here: https://esas-joint-committee.europa.eu/Publications/Technical%20Standards/Joint%20Draft%20RTS%20on%20margin%20requirements%20for%20non-centrally%20cleared%20OTC%20derivatives%20(JC-2017-79).pdf
32 — Point (3) of Article 4(1) of Regulation (EU) No 575/2013 of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012.
33 — For more information, please see: europarl.europa.eu/sides/getDoc.do?type=COMPARL&reference=PE-616.810&format=PDF&language=EN&secondRef=01
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