The EC kicked off the consultation on April 9, after concerns were raised about the dissension between European Union member states on where the boundary lies between what is a spot FX contract and what is a derivative. The consultation aims to clarify this definition and settle the matter.
Banks and trade bodies are mounting a response to convince the EC to soften its tough stance on the definition of derivatives. They believe FX transactions with a settlement period of up to seven days should still be classified as spot contracts and not forwards, which are considered to be derivatives.
Stéphane Malrait, chair of the Financial Markets Association’s (ACI) Forex Committee, says it is important to have a definition of spot from a settlement perspective, as there is market practice but no law on this point.
“FX is a global market, so we have to be careful when implementing regulation,” he says. “It has to be uniform in Europe.
“Clarity is important because of the impact of hedging requirements for commercial purposes. People are not necessarily aware of the impact, which will force some change on the buy and sell side.”
A concrete definition is vital, says Bill Stenning, head of clearing, regulatory and strategic affairs at Société Générale. Europe has moved to an environment where rules are introduced in the form of regulations that are applied across all member states, as opposed to directives that are applied in local legislation.
“If rules are applied across Europe, then key terms should be well defined,” he says.
ACI’s Malrait says FX trades settled before seven days should be considered spot and anything settled after should fall under the definition of a derivative, as is the case in the fixed-income world.
Spot transactions remain unregulated, but firms that trade above a certain threshold of FX derivatives are legally bound to clear trades and report them to trade repositories, such as the DTCC, under the European Market Infrastructure Regulation (EMIR). The requirements were introduced to increase transparency in the derivative market and prevent another financial crisis by reducing counterparty, operational and systemic risk.
However, some countries’ regulators have rejected the hard and fast rule when it comes to FX. The UK’s Financial Conduct Authority has deemed that FX transactions with a settlement period of up to seven days, or entered into for commercial purposes, are not derivatives contracts and are exempt from EMIR.
Luxembourg’s Commission de Surveillance du Secteur Financier has also stated FX forwards are not derivatives contracts, under Mifid definitions. Market participants suggest Italy is also following a similar line of thinking.
The European Securities and Markets Authority urged the EC in February to clarify the definition of a derivative, hence the current consultation.
Niklas Karlsson, global head of FX spot at Danske Bank, agrees that seven days is the most practical cut-off for spot, considering there can sometimes be delays to settle some currencies.
“It is hard to determine, but seven days is reasonable [from a] risk and operations [perspective],” he says.
The European Association of Corporate Treasures (EACT) is compiling a response to the consultation, according to its chairman Richard Raeburn. The EACT wants the EC to recognize that the way spot transactions are settled differs between markets.
“We do not want the burden of compliance already created by EMIR to be increased unless there is clear evidence that this truly helps reduce systemic risk,” he says.
“And we hope that the forthcoming review of EMIR – EMIR 2 – will allow a more extensive challenge to some of the flaws in EMIR.”
The UK’s Association of Corporate Treasurers wants the EC to go a step further, and is lobbying to exempt corporates that use FX instruments from reporting requirements altogether, says Martin O’Donovan, deputy policy and technical director at the ACT.
“The authorities legislated that hedging transactions don’t need to be cleared,” he says. “If that is the case, why report them? What is the benefit [to regulators] in terms of financial risk mitigation compared to the burden imposed on non-financial companies?”
The ACT believes many millions of companies across Europe could, and should, escape the burden of trade reporting, were the EC to carve out an exemption for commercial FX hedges.
Market participants have until May 9 to register their thoughts with the EC.