|Foreign exchange (FX) forward|
|European Union Electricity Market Glossary|
'Foreign exchange (FX) forward' is a derivative contract that solely involves the exchange of two different currencies on a specific future date at a fixed rate agreed at the inception of the contract covering the exchange.
The total OTC foreign exchange daily turnover amounts globally to USD 5.067 billion of notional.
Of those, only 14% (USD 700 billion) are the ‘outright forwards’, the category that most closely approximates the EU definition of FX forwards.
Outright forwards are transactions involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery (cash settlement) at some time in the future (more than two business days later).
The category of ‘outright forwards’ also includes forward foreign exchange agreement transactions (FXAs), non-deliverable forwards (NDFs) and other forward contracts for differences.
Outright forwards are generally not traded on organised exchanges and their contractual terms are not standardised (ESMA, EBA, EIOPA, JC/2017/79, 18.12.2017, p. 14).
Physically-settled OTC foreign exchange contracts are preferentially treated in the risk management procedures under the EMIR and BCBS-IOSCO legal frameworks for collateral.
For the said types of contracts it is sufficient the exchange of variation margin without initial margin (See Article 27 and Recitals 16 and 42 of the 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).
However, the EU is the only jurisdiction which includes within the scope of its variation margin requirements physically settled FX swaps and forwards (International Swaps and Derivatives Association (ISDA) comments on the ‘EMIR Refit’ proposal, 18 July 2017, p. 2).
According to ISDA, jurisdictions such as the US, Japan and Hong Kong exclude these products.
ISDA argues that "this will impact the ability of firms to hedge, broader FX market liquidity and EU banks’ global competitiveness".
The reflection of the above concerns is the Statement of European Supervisory Authorities (ESAs) of 24 November 2017 on the variation margin exchange for physically-settled FX forwards under EMIR, which reads:
“the Boards of the ESAs are currently undertaking a review of the Regulatory Technical Standards on risk mitigation techniques for OTC derivatives not cleared by a central counterparty (RTS) and develop draft amendments to these RTS that align the treatment of variation margin for physically-settled FX forwards with the supervisory guidance applicable in other key jurisdictions.
Specifically, the amendment of the RTS and their subsequent implementation would reiterate our commitment to apply the international standards, and require the exchange of variation margin for physically-settled FX forwards in a risk based and proportionate manner.
In particular, this would most likely imply that the scope should cover transactions between institutions (credit institutions and investment firms).
In addition for some institution-to-non-institution transactions the competent authorities should consider the actual risk that the exchange of variation margins would mitigate and whether non-institutions might face additional risks related to the daily exchange of variation margin.”
UK FCA supported the above ESAs’ statement.
The legislative follow-up to the above considerations was the ESAs’ document of 18 December 2017 - “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” (JC/2017/79) where the ESAs propose that the requirement to exchange variation margin for physically settled FX forwards target only transactions between institutions (credit institutions and investment firms).
ESAs underlined that although the requirement to exchange variation margin for physically settled FX forwards is part of a globally agreed BCBS-IOSCO margin framework, after the application of the said Delegated Regulation (EU) 2016/2251, the ESAs have been made aware of challenges for certain counterparties to comply.
The aforementioned ESAs’ document of 18 December 2017 reads:
„Based on the material presented to the ESAs, it has become apparent that the adoption of the international standards in other jurisdictions via supervisory guidance has led to an international scope of application that is more limited than the scope the ESAs have proposed.
Whereas the requirement remains relevant for transactions between institutions, the implementation appears to pose a challenge regarding transactions between institutions and end-users.”
Moreover, in the said document of 18 December 2017 ESAs confirmed that the EU is the only jurisdiction to directly include physically settled FX forwards within the scope of its variation margin requirements.
ESAs referred to the fact that all other jurisdictions – such as the USA, Japan, Singapore and Canada – have not included physically settled FX forwards, leaving it to the discretion of national banking supervisors to decide to develop variation margin requirements for such derivatives.
ESAs also mentioned. as an example, the letter of the US Federal Reserve issued in December 2013, which ‘encourages’ large financial institutions supervised by the Federal Reserve (companies with consolidated assets of USD 50 billion) to exchange variation margins for physically settled FX forwards.
The solution put forward by the ESAs in aforementioned ESAs’ document of 18 December 2017 therefore limits the requirement to collect variation margin for physically settled FX forwards to only transactions concluded between ‘institutions’, within the meaning of the Capital Requirements Regulation (CRR), i.e. credit institutions and investment firms, or with an equivalent entity located in a third country that would meet the definition of ‘institution’ if located in the EU.
Moreover, the ESAs expressed the view 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.
Reporting FX forwards to trade repositories under EMIR
In accordance with Article 3a of the Commission Implementing Regulation (EU) No 1247/2012 in case of FX forwards, the counterparty receiving the currency which is first when sorted alphabetically by ISO 4217 standard is to be identified as the buyer.
The same rule applies to FX futures (EMIR ESMA’s Q&As, answer to the TR Question 24).
As regards the Underlying identification field (Table 2, Field 8) ESMA referring to the question:
“How to populate Table 2 Field 8 (Underlying identification) for FX derivative contracts that are not based on an index or a basket? For example when the underlying is a currency (foreign exchange rate)?”
provided the following answer:
“In the absence of an endorsed UPI, the underlying currency must be indicated under the notional currency fields 9 and 10 and populating the relevant section 2g. The Underlying field (Table 2 Field 8) cannot be completed in this case and should be populated with an ‘NA’ value” (TR Question 28, version applying from 1 November 2017).
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, JC/2017/79, 18.12.2017 (the requirement to exchange variation margin for physically settled FX forwards target only transactions between institutions (credit institutions and investment firms)
Commission Implementing Regulation No 1247/2012 of 19 December 2012 laying down implementing technical standards with regard to the format and frequency of trade reports to trade repositories, Article 3a(6)
Commission Implementing Regulation (EU) 2017/105 of 19 October 2016 amending Implementing Regulation (EU) No 1247/2012 laying down implementing technical standards with regard to the format and frequency of trade reports to trade repositories according to Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories
|Last Updated on Sunday, 07 January 2018 23:52|