Industry poised for FX margin decision

David Wigan
Published on:

Final rules on margin requirements for non-centrally cleared derivatives are expected in the coming days and are likely to include an exemption for foreign exchange swaps and forwards, analysts say. However, lobbying efforts are likely to swiftly move on to whether FX derivatives should be mandated for clearing.

After more than year of consultation, the working group on margining requirements – a joint working group of the Basel Committee on Banking Supervision and the International Organization of Securities Commissions – is expected to concur with industry claims that the risk of physically settled foreign exchange swaps and forwards does not lie in potential changes in valuations.

James Kemp, FX division MD at GFMA
“We don’t think margin is the right approach as what you risk doing is tying up huge amounts of collateral, increasing end-user costs and expending large amounts of energy on operational challenges when the market is well risk-managed already,” says James Kemp, FX division managing director at the Global Financial Markets Association (GFMA).

In its consultations, the Basel Committee sought comment on initial and variation margins for physically settled foreign exchange swaps and forwards, and in particular whether contracts with different maturities should be subject to distinct treatments. The industry response was overwhelmingly that all FX swaps and forwards, which comprise around 57% of the $4 trillion daily FX market turnover, should be exempt.

The basis for the industry stance was that the replacement costs associated with margin requirements are already adequately covered in FX.

“Replacement cost is already appropriately mitigated in the large majority of cases by the use of credit support annexes (CSAs), and the trend of using CSAs is rising,” says Kemp. “Settlement risk is the main source of systemic risk for the FX market and should remain the key area of focus for market participants and regulators.”

Settlement risk in the context of the foreign exchange market is the risk of loss of principal – paying out sold currency without receiving the purchased currency in return. According to a study by Oliver Wyman, settlement risk comprises 94% of the maximum loss exposure in a trade for foreign exchange instruments with maturity of less than one year, and 89% for instruments with maturity of greater than a year.

Steve Grob, director of group strategy at Fidessa
The reason settlement risk is so much higher than counterparty risk in FX swaps is the relatively short tenor of contracts, says Steve Grob, director of group strategy at trading technology vendor Fidessa.

“The life of the contract is much shorter than in rates or credit and that makes a huge difference in terms of the potential exposures,” he says. Some 75% of FX swaps mature in less than a week, with more than 97% maturing in less than six months. Some 96% of forwards mature in less than six months.

In any event, the industry argues that settlement risk has been dramatically reduced by the development and use of CLS, a private-sector initiative that settles payments for deliverable foreign spot, forward and swap transactions only once it has received money from both sides to the trade.

CLS settlement accounts for around two-thirds of all transactions, industry sources estimate, and the firm is working on adding more currencies to its service to reflect the increased focus among corporates and investors on markets such as Russia and Brazil.

In addition, the GFMA argues, FX swaps and forwards are derivatives more in name than nature. For instance, unlike most derivatives, which are cash settled, FX derivatives are physically settled, meaning the physical exchange of two currencies between transacting parties. The only “derivative” characteristic that distinguishes them from spot transactions is a matter of duration.

That perspective was recognised by US regulators late last year when the Department of the Treasury determined that FX swaps and forwards should not be regulated under the Commodity Exchange Act and therefore should be exempted from the definition of swap.

“The FX swaps and forwards market is markedly different from other derivatives markets,” the Treasury says. “While central clearing requirements will strengthen the rest of the derivatives market, the potential benefit is reduced in the FX swaps and forwards market because existing practices already help limit risk and also ensure that the market functions effective.”

While US policymakers exempted FX swaps and forwards from clearing and margining, they retained reporting requirements, and excluded from the exemption FX options, currency swaps and non-deliverable forwards.

In Europe, meanwhile, while an exemption is expected for margin requirements, FX swap and forward clearing is yet to be decided. In a consultation published in July, the European Securities and Markets Authority (ESMA) said a clearing requirement for individual products might depend on notional currency, settlement method or maturity.

Kemp says: “Our point again is that this is a global market and we do not want to see bifurcation around cleared and uncleared or around margin treatment.”

ESMA can expect its post bag to be full in coming weeks.