The big debate: The margining of FX swaps

Published on:

The FX market is on Friday presenting its arguments to regulators as to why it thinks new proposed rules on imposing margins on uncleared FX swaps and forwards is out of proportion with the risks the products pose to the wider market.

Friday is the deadline for industry comments on a final consultative document published by the Basel Committee on Banking Supervision (BCBS) titled Supervisory Guidance for Managing Risks Associated with the Settlement of Foreign Exchange Transactions.

Those Basel proposals could be finalized in November. Arguments against parts of the proposals from the FX industry via its trade group, the Global Financial Markets Association (GFMA), are expected to be released on the group’s website next week. At the heart of industry debate around this issue is recommendations made by the BCBS, published in August, that all uncleared derivatives under the EU’s European Market Infrastructure Regulation (EMIR) be subject to mandatory variable margin (VM) and initial margin (IM) across all product types, including foreign exchange. FX participants are concerned about how these requirements will be applied globally and consistently to enable a level playing field across jurisdictions, primarily between the US and EU. The current state of affairs As things stand in the US, there is the expectation that FX swaps will be exempted from clearing and therefore a common margin rule will not apply. The exemption is yet to be officially approved by the US Treasury Department, but expectations are that it will receive final approval. The US Treasury indicated in the last couple of days that it is likely to announce its decision on the exemption for FX products in early 2013. However, in the EU, no such exemption exists, and it is not anticipated, according to FX industry trade groups, whose members trading in the EU will be subject to mandatory clearing for some currencies products, and margin requirements for others. From the industry’s point of view, there is something of a contradiction here. On the one hand, industry officials in Europe point out that US regulators are saying that FX over-the-counter (OTC) futures and swaps, at least from a US treasury perspective, should be exempt from being cleared through a clearing house because they are deemed “not systemically risky”. At the same time, EU regulators through the BCBS process will be able to charge market participants with a potential 6% margin for trades on several classes of OTC FX products, say industry officials. While the industry accepts it has not dealt with every part of risk in the FX market, recent studies conducted by GFMA found that regulators should examine the risk of leaving OTC FX forwards and swaps unregulated as a whole for the good of the FX market. GFMA argues that the majority of the structural risk associated with these products is settlement risk and that, via CLS and other settlement methods, the risk is reduced by 94% – with just 6% left in the form of mark-to-market risk. This 6% of mark-to-market risk is managed by credit support annex (CSAs) agreements, says GFMA. GFMA response In an interview with EuromoneyFXNews, GFMA global FX division managing director James Kemp says it is important for regulators to realize that the key risk in foreign exchange is settlement risk, which his group says comprises 94% of estimated maximum loss exposure in a trade for FX instruments with a maturity of six months. The FX industry has moved to manage this settlement risk in a number of ways, including the build out and usage of the CLS settlement system.
 James Kemp:
"It would be
costly. Many
may simply
choose not
to hedge
their FX risk."
“The 6% of risk that is left is replacement risk and the industry manages this extremely well through an increasing use of CSAs, which are highly effective for the FX market due to the short-term nature and highly transparent pricing of the products,” says Kemp. “Having covered the key systemic risks, it is important to allow banks to take on well-managed risk to extend credit to fund economic growth.” The August BCBS paper suggests the potential need to manage this replacement risk through a mandatory VM and IM regime. Kemp says he does not believe this use of a mandatory regime – introducing cost – is the right solution for the markets. Kemp cites FX industry efforts to reduce settlement risk and usage of CSAs as evidence of GFMA’s concerns. “It’s not a zero-sum game, so even if there is a pension or corporate exemption for OTC FX from clearing and margin requirements [under EMIR], there will still be costs that will be incurred in the corresponding dealer trades, which will have to be passed on to end-users,” says Kemp. “That, in turn, could distract from industry efforts to concentrate further reduction of the main risk – settlement risk.” Kemp says those conclusions were reflected in many of GFMA’s comments to regulators in the past, including within the BCBS paper on Friday. “It does seem slightly incongruous that once regulators have proposed to exempt a product from mandatory clearing on the basis that it does not pose a systemic risk, that they then come along, call it an uncleared derivative, and potentially start to apply what could be seen as punitive margins,” says Kemp. UBS managing director and COO for global FX Huw Evans adds that the cost of implementing the BCBS’ proposed margining regime would create an entry barrier to the FX market for some participants who simply need to “change currency in order to get on with their business”. While many large banks like UBS, hedge funds or other big financial institutions have the technical capability to receive margin from counterparties, many participants do not. “If the proposed BCBS regime is approved, some people in the market would have to find ways to be able to accept margin in FX forwards trades and segregate and deal with it,” says Evans. “That is a lot of operational infrastructure to put into place, and it would be costly. Many may simply choose not to hedge their FX risk.” EU might not match US FX exemption In a speech in London in February, ESMA chairman Steven Maijoor warned that the US Treasury exemption would not be matched by a similar exemption for FX derivatives in the EU. However, more than the regulatory arbitrage risk between the Dodd-Frank Act and EMIR posed by a US Treasury exemption for the products in the US, the “real issue” would be the need for bilateral collateralization of trades in the products in the EU, says Maijoor.

Steven Maijoor:
"Real issue
 the need for
 in the EU"

According to Kemp, this is the argument why US and EU regulators – and others globally – would choose to exempt FX forwards and swaps from a clearing mandate in Dodd-Frank and EMIR and their own derivatives legislation: the products do not pose a substantial risk to the stability of the global financial system and subjecting them to clearing might increase the risks in the market. Kemp says bilaterally OTC-traded FX forwards and swaps fit those criteria. However, Maijoor’s comments in February suggested that, while ESMA might match the US clearing exemption for FX forwards and swaps by not requiring a mandatory regime in Europe, he then went on to suggest they would look to apply margining requirements instead for uncleared products. This position might now be under review, as the European consultation on margin for uncleared derivatives was recently put on hold pending the finalization of the August BCBS paper in an effort to reach regulatory convergence. FX products are a specific focus of attention in that consultation. If EU officials take a different stance from the US on exempting the products, then Kemp says it might undo good faith placed by the US treasury – and other central banks – in identifying the most effective tools to manage the risk in the FX market. Kemp says the proposed US treasury exemption clearly lays out how settlement risk is the key risk in FX and, as such, is already effectively managed. “The proposed treasury exemption states that FX forwards and swaps pose significantly less counterparty credit risk to the financial system,” says Kemp. “European policymakers have indicated they are also unlikely to mandate clearing for FX forwards and swaps, although there is a possibility of a mandatory margin regime being incorporated – this is being discussed as part of the BCBS consultation process.” Where next? Now the FX market anxiously awaits US Treasury Secretary Timothy Geithner’s decision on whether the CFTC can ignore oversight of all OTC FX derivatives from its oversight of the wider currency market.

According to Stanford University professor Darrell Duffie, the black and white, go/no-go potential of the treasury exemption means the FX market has it all to play for.

Darrell Duffie:
"We shouldn't
expect anything
to happen close
to the elections."

In the EU, even if EMIR regulators eventually decide not to mandate the posting of margins on uncleared, OTC FX forwards and swaps, they could still require minimum bilateral collateral requirements, says Duffie. However, in the US, Congress has given the Treasury an either/or option on the breadth of the exemption for FX products, he says. “There was very substantial industry lobbying in the US to have the FX space exempted because it is a deliverable as opposed to a non-deliverable [product],” says Duffie. “The banks were successful in getting Congress to say it is up to the Treasury to decide.” “Everyone I talk to now says it’s getting close to the US elections and we shouldn’t expect anything to happen close to the elections,” says Duffie. “Maybe the Treasury exemption will come through by the end of the year when the Volcker Rule [in Dodd-Frank] is expected to be finalized.” GFMA’s Kemp says his group is still expecting the US Treasury to move forward with the exemption from clearing and execution requirements for FX forwards and swaps.

“We have heard nothing that differs from the proposed determination in April 2011, so we believe the exemption will still stand,” says Kemp.