There is no let-up in policy makers’ activities as we near the holidays. Here’s a look at the recent moves to revise EMIR variation margin rules, and the FCA once more showing policy leadership.
Recently, there has been murmuring from within the asset management community that the EU is considering repealing a key part of the European Markets Infrastructure Regulation (EMIR). The key element of this repeal will have a significant impact on a large sector of the industry: the exchange of variation margins on physically settled forward rate contracts.
If these rules are amended in this manner, it would be welcome relief to those who vocally contested their benefit and pointed out their potential unintended consequences to the industry. Further, the clear misalignment with international standards has added further credence to these arguments given that the EU is the only jurisdiction to require the mandatory exchange of margin with respect to physical FX forwards. Regulatory global interconnectedness is the not just the dish du jour. The coordination efforts point towards international cooperation which has recently been demonstrated with the research unbundling and swap rules compliance relief issued by the SEC and CFTC, respectively.
Has Christmas Come Early?
Physically settled FX forwards are due to come within the scope of the variation margin exchange rules on January 3, the date the second Markets in Financial Instruments Directive (MiFID 2) comes into effect. This brings FX forwards in line with other uncleared over-the-counter (OTC) derivative contracts, for which the rules started to apply on a phased-in basis since February 4, 2017.
The regulation has created an extensive pipeline of additional work for managers with focus on updating, upgrading, and negotiating OTC documentation, sourcing liquidity, and establishing or enhancing collateral management arrangements. The European Commission’s proposal to amend EMIR invoked a strong industry response. We have heard calls from the industry to extend the implementation deadline to allow the market more time to comply, which although has not fallen on deaf regulatory ears, cannot ease the concern of managers without a formal statement from authorities. Talk of abolishing them altogether would be a much different story, but timing is everything.
As we hurtle towards year-end, the publication of the European Council’s Presidency Compromise text on November 15, 2017, highlighted the intention to carve out physical FX forwards from the mandatory variation margin exchange with application limited to the most systemic counterparties. Soon after, the Joint Committee of the European Supervisory Authorities (ESAs) threw their support behind the industry challenges by issuing a statement which made clear they did not have any formal power to repeal existing regulations, but that a review was underway aiming to create an internationally convergent draft amendment to the existing RTS on risk mitigation techniques for OTC derivatives not cleared by a central counterparty. A draft amendment is expected by Christmas Eve.
Confusingly, the text was deleted in a subsequent compromise proposal issued on 28 November. The proposal said the mandatory exchange of variation margins on forwards should be restricted to transactions between the most systemic counterparties “in order to limit the build-up of systemic risk and to avoid international regulatory divergence.” This could suggest the Council wants to think further about the issue while leaving the door open to change. It also demonstrates that the European legislators are increasingly considering feedback from industry stakeholders in their decision-making process. It also appears the Council has taken Brexit into account in relation to its supervisory responsibilities with respect to central counterparties, along with what is soon to be a key requirement: equivalence.
So, What’s Next?
The second proposal text retained the importance of international regulatory convergence, but deleted the language that sought to exempt all but credit institutions authorized under the Capital Requirements Directive from variation margin for FX forwards. There appears to be consensus among European legislators and supervisory authorities.
Given the well-established and formulaic process of amending EU regulations, the industry will not benefit from formal amendments in time for the January 3 implementation date. As suggested by the ESAs, national competent authorities were urged to utilize their “risk-based supervisory powers” which we have seen the Financial Conduct Authority (FCA) leverage. Acting as a frontrunner, on December 7, the FCA issued a statement applying the carve out to the exchange of variation margin proposed by the ESAs. Proposals for strengthening European regulatory powers, including the ability to issue “no action” relief similar to US regulators, is in the pipeline and in future could provide the key to the comfort required in such times of rapid change.
We anticipate the next couple of weeks will see a flurry of activity from other regulators who may similarly utilize their own powers to enable a consistent approach on this matter across Europe.