EMIR finalisation does not close door on FX derivatives regulatory arbitrage: opinion
legislators last week, the FX industry needs to turn some of its attention away from the clearing of options and NDFs to the margining of non-cleared forwards and swaps.
As market participants await the final text of the European Market Infrastructure Regulation (EMIR) agreed on by European At a conference last week in London, Steven Maijoor, chair of the European Securities and Markets Authority (ESMA), said there still existed differences between how non-cleared FX derivatives, otherwise known as margins for contracts, will be treated under Dodd-Frank and EMIR. Simply put, in Europe, banks must post a margin on non-cleared forwards and swaps – referred to as bilateral collateralization – whereas in the US they do not.
This might lead one to conclude that this could be a new area of concern for regulatory arbitrage. The ESMA chair seemed to suggest this last week. “The problem of international inconsistency and regulatory arbitrage is much more serious on margins for contracts that are not centrally cleared than on the clearing obligation,” Maijoor told delegates.
As things stand, a bank can make its own decision on how it decides to collateralise FX trades. In foreign exchange markets, this can be quite dynamic. For instance, bank A might provide a credit line up to a designated amount that it feels confident about on counterparty B’s credit – without the need to put in place a credit support annex – which collateralizes the trade up to a certain level.
What EMIR now requires, under Article VI, is that such collateralization would need to be hard coded and, thus, a bank would no longer be able to grant a credit line up to a certain limit, without that line being collateralized. In other words, everything would need to be collateralized.
The difference between the cost of the dynamic approach, or status quo in the US, and the European approach is further clouded by the fact it is also entwined with prudential capital regulation that is being implemented in tandem.
So, in practice, the charges could potentially be identical between the US jurisdiction and the European jurisdiction – for example, if the prudential capital charges in the US were ramped higher to offset the margins for contract charges in Europe.
Maijoor reiterated the ultimate goal of the regulation in his speech last week, saying: “Whilst different approaches cannot always be aligned, we absolutely need to ensure this does not end up in a higher risk for the entire financial system.”
To further complicate this again, those charges will depend on the individual credit quality of each counterparty. Regulatory specialists say, in Europe, there is a strong interplay between EMIR margining and the prudential regulation.
That then produces a blended number, and so the actual result depends on the bank itself. As a result, it is difficult to come up with a standardized industry-wide calibration.
It is this issue that the industry plans to work with ESMA in the coming months to form some sort of consensus on creating a market standard.
“It’s our understanding that ESMA will be working through and finalising how the bilateral collateral requirements are set – another consideration is that there is likely to be an interplay between these collateral needs and capital requirements under CRD4,” says James Kemp, managing director of GFMA’s global FX division. “That may mean the final numbers could differ on a bank-by-bank basis. We look forward to working with ESMA to better understand any impact on foreign exchange.”
Regulatory consultants suggest that standard will centre around whether or not there should be some calibration of that new hard-wired formula that reflects on the residual risk – excluding settlement risk, which is taken out by CLS – and the size of that residual risk.
Given that residual risk in FX contracts is small – at about 6 % – the industry wants to know whether there should be some sort of formula that allows for the fact it might not be at the same level or complexity of risk that might exist in another area of the market.
As a result of this element of bank-by-bank difference, and the interplay between this bilateral collateralization and between the prudential capital charges, it is difficult to know at the moment whether the end result is the same across all jurisdictions.
This discussion on forwards and swaps will continue to roll and roll.
A final ruling on FX forwards and swaps under EMIR?
Amongst all of this discussion, the issue of the exempting of forwards and swaps from the definition of swaps hasn’t received much attention. Given that the final text is yet to be published, sources close to Brussels expect that the FX recital (12b) should continue to include:
“The regime for such contracts should rely notably on preliminary international convergence and mutual recognition of the relevant infrastructure.”
In effect, this clears the way for an exemption for FX forwards and swaps under EMIR.