knowledge 20 December 2017 |

Variation Margin Exchange for Physically-settled FFX Forwards – Last Minute Reprieve?

Background

EMIR sets out requirements for the clearing of over-the-counter (“OTC”) derivatives through authorised central counterparties, collateral exchange and risk mitigation requirements for non-cleared derivatives, as well as post-trade reporting requirements for all OTC derivatives.

The risk management procedures include the requirement to collect variation margin in respect of OTC derivative transactions that are not centrally cleared. This requirement is set out in Commission Delegated Regulation 2016/2251, which is based on regulatory technical standards (“RTS”) adopted by the ESAs, and which started to apply on a phased-in basis from 4 February 2017. The requirement will apply to FFX contracts from 3 January 2018, the date the revised Markets in Financial Instruments Directive enters into effect. For further information see our earlier briefing (here).

On 24 November 2017 the ESA’s published a press release (here) stating that the ESAs were reviewing the RTS with a view to amending them so as to align the treatment of variation margin for FFX with the supervisory guidance applicable in other key jurisdictions.  In the press release, the ESAs also stated that pending the adoption of the Amending RTS, they expected national competent authorities to exercise regulatory forbearance in the enforcement of the RTS.

The Amending RTS

The Amending RTS provide for a derogation from the requirement to exchange variation margin, permitting in-scope counterparties to provide in their risk management procedures that variation margins are not required to be posted or collected for FFX contracts where one counterparty is not, or if it were established in the EU would not be, an institution (effectively, credit institutions and certain investment firms). 

According to the recitals to the Amending RTS this approach is consistent with the approach adopted in other major jurisdictions and would continue to ensure the reduction of any systemic risks arising from FFX contracts.

The recitals also state that counterparties involved in a transaction that is, as a result of these amendments, outside the scope of the requirement to exchange variation margin should employ prudent risk mitigation measures to properly identify, measure, monitor and control risks arising from these transactions until their settlement has been confirmed and reconciled in a way consistent with the requirements of the RTS as amended by the Amending RTS.

In their Final Report, the ESAs acknowledge that the amendments are likely to enter into force after 3 January 2018, and state that “for institution to non-institution transactions, the competent authorities should apply the EU framework in a risk-based and proportionate manner until the amended RTS enter into force”.

The Central Bank of Ireland’s Statement

On 19 December 2017 the Central Bank of Ireland published a statement on the variation margin requirements (here), confirming that it intends to “apply its risk-based supervisory powers in the day-to-day enforcement of applicable legislation in a risk-based and proportionate manner until the amended RTS enter into force.”

Relevance for counterparties to physically settled FX forward transactions

We anticipate that many counterparties to FFX transactions that are in scope for the Amending RTS’s derogation will, in light of the above developments, wish to reconsider whether EMIR-compliant variation margin arrangements should be implemented (or, if they have already been implemented, whether they should be maintained) in respect of those transactions.  In light of the recitals to the Amending RTS, counterparties should ensure that any determination in this regard is consistent with the more general requirement to employ prudent risk mitigation measures to properly identify, measure, monitor and control risks arising from the transactions.

Next Steps

The amending RTS must now be considered by the Commission, and then by the Parliament and the Council.  They will enter into force the day after their publication in the EU’s Official Journal.