The Council of the European Union (EU) has proposed an amendment to the European Market Infrastructure Regulation (EMIR)1 that eliminates mandatory initial margin requirements for physically settled foreign exchange (FX) forwards and mandatory variation margin requirements for physically settled FX forwards between financial entities other than “credit institutions”2 as defined under the European Capital Requirements.3
Under EMIR, non-cleared swaps and forwards originated after March 1, 2017, are subject to mandatory margin requirements. However, the margin requirement for physically settled FX forwards was delayed until the effective date of the Markets in Financial Instruments Directive (MiFID II), because, until such date, the definition of physically settled FX forwards varies among EU member states. MiFID II becomes effective on January 3, 2018.
Unlike European regulators, regulators in other jurisdictions that enacted mandatory margin requirements for non-cleared swaps and forwards exempted physically settled FX forwards from such mandatory margin requirements because of the specific risk profiles of the entities that use physically settled FX forwards.4 As a result, if the Council’s proposal is adopted, regulated entities would benefit from a harmonized, cross-border exemption for margin requirements on physically settled forwards.
One complication is the fast-approaching effective date of MiFID II. The Council’s proposal is not expected to be adopted until after January 3, 2018, so entities will need to look to the enforcement authority of their jurisdiction for guidance regarding the initial and variation margin requirements for physically settled FX forwards. In this regard, the Joint Committee of the European Supervisory Authorities (the European Banking Authority, the European Insurance and Occupational Pensions Authority, and the European Securities and Markets Authority) published a statement indicating that they expect local authorities to “generally apply their risk-based supervisory powers in their day-to-day enforcement of applicable legislation in a proportionate manner” while the European Supervisory Authorities undertake a review of the Council’s proposed amendment.5 This statement indicates that there likely will be an exemption from posting margin for physically settled FX forward transactions other than transactions between credit institutions and investment firms.
For months, firms have been preparing for the January 3, 2018, compliance date by implementing EMIR’s compliance requirements, including its margin requirements, into their trading documentation. As a result, if such trading documentation already includes agreed-upon provisions for the exchange of initial and variation margin, the proposed relief may cause some issues. Specifically, to the extent margining was to be required for physically settled FX forwards under EU law,6 the question, from a contractual perspective, is whether, and how, physically settled FX forward transactions should be carved out of the margining requirements until the Council’s proposal becomes final. To provide a temporary solution until the relief becomes effective, market participants are drafting model language, to be used in conjunction with such trading documentation, to exclude physically settled FX forwards from applicable margining provisions included in such trading documentation. If you receive a proposal not to margin physically settled FX forward transactions from one of your European counterparties, you may want to consult with your legal counsel to determine whether or not you are able to benefit from the Council’s relief, if implemented.
1European Market Infrastructure Regulation (EU) No 648/2012.
2 Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012.
3See Council of the European Union, Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the Clearing Obligation, the Suspension of the Clearing Obligation, the Reporting Requirements, the Risk-mitigation Techniques for OTC Derivatives Contracts not Cleared by a Central Counterparty, the Registration and Supervision of Trade Repositories and the Requirements for Trade Repositories, Brussels, 15 November 2017 (the “Proposal”), available at http://data.consilium.europa.eu/doc/document/ST-14372-2017-INIT/en/pdf.
4E.g., in the United States. Proposal at p.11.
5 European Supervisory Authorities, Variation Margin Exchange for Physically-settled FX Forwards under EMIR (November 24, 2017), available at https://esas-joint-committee.europa.eu/Pages/News/Variation-margin-exchange-for-physically-settled-FX-forwards-under-EMIR-.aspx.
6 To the extent counterparties have agreed to exchange margin for FX forward transactions that was not keyed to the requirements under EU law, they may continue to do so.
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