FX: The missing piece in the margin puzzle
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Foreign Exchange

FX: The missing piece in the margin puzzle

European banking authorities have diluted ‘currency mismatch’ haircut rules in forthcoming non-cleared derivatives legislation – but the bigger issue remains that traders still don’t know if they will have to post collateral on their uncleared FX derivative trades.

New global rules will come into force from September, requiring the world’s biggest financial players to start posting initial and variation margin on their uncleared derivatives trades.

The rules will initially impact the largest dealers, but over time will also affect smaller banks and buy-side institutions such as pension funds.


Roger Cogan, Isda

Regulators want to push as many derivatives trades as possible through clearing houses, in a bid to mitigate counterparty risk, but this cookie-cutter approach does not work for all derivatives, hence the new margin rules.

The theory is that posting collateral against these trades, such as cash or bonds, will prevent another Lehman-style collapse, if a counterparty to a trade goes bust.

The US Commodity Futures Trading Commission finalized its minimum margin requirements at the end of last year, which fall under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

European Union (EU) regulators released the final draft of their equivalent rules in March, which form part of the European Market Infrastructure Regulation (EMIR). These are expected to be finalized by mid-July.

Currency mismatch haircut

The EU’s final draft has provided clarity on the rules and offers dealers some relief with regards to its ‘currency mismatch’ rules. Variation margin that is posted in cash but is denominated in a different currency than that agreed under the master agreement will no longer face an 8% haircut.

Roger Cogan, head of European public policy at the International Swaps and Derivatives Association (Isda), which represents the world’s largest derivatives dealers, welcomed the concession.

“We welcome the improvements made to the RTS [regulatory technical standards] in respect of the currency mismatch haircut, which make the calculation more proportionate and – importantly – ensure that the calculation does not itself increase counterparty credit risk.”

Dealers will still face an 8% haircut on initial margin – cash and non-cash – where there is a currency mismatch, and also on non-cash variation margin, such as bonds.

EU vs US

The EU and Hong Kong have adopted the same approach regarding cash variation margin; Singapore’s rules have yet to be finalized.


Michael Beaton, DRS

US rules are comparatively more restrictive, though, imposing the haircut where the variation margin collateral is denominated in a different currency to the one of settlement or is not cash-denominated in a G10 currency.

In particular, this would hit Asian financial counterparties that trade with US counterparties, because their local currencies are not G10 currencies, says Michael Beaton, managing partner at specialist risk consultancy Derivatives Risk Solutions (DRS).

The impact to Asian banks should be minimal, though in terms of getting access to the relevant currencies, believes John Ball, managing director of the FX division in Asia-Pacific at banking lobby forum Global Financial Markets Association.

“This [access] should already be happening on a daily basis through the funding of their currency assets and liabilities in the interbank market to meet settlement obligations,” he says.

Regulatory divergence

Haircuts are part and parcel of margining, though. The bigger problem is how regulators treat FX derivatives.

Non-cleared physically settled currency forwards fall outside of the scope of US rules, meaning dealers do not have to post collateral on these trades.


William Winterton,
Clifford Chance

It remains to be seen whether US banks will seek to margin those trades anyway, either of their own volition or as a result of prudential encouragement, says William Winterton, senior associate in banking and finance at law firm Clifford Chance. 

EU regulators have, however, taken a radically different approach, deeming them in scope.

“This is the key headline difference between the EU and US margin rules on uncleared derivatives,” says Winterton.

However, the problem remains there is no EU-wide definition of an FX forward and, as such, consensus on whether it is even a derivative. The final draft rules provided some clarity on the issue, largely by kicking the can down the road.

An EU-wide definition of an FX forward is expected under forthcoming regulation the Markets in Financial Instruments Directive II (Mifid II). EU banking regulators have therefore decided to defer imposing variation margin on physically settled FX forwards until Mifid II is in force or December 21, 2018, whichever date come first.

If it is decided these commonly traded instruments are in fact derivatives, then this could make it is more expensive to trade them in the EU than in the US.

Isda’s Cogan says: “Our members want the rules to be as harmonized as possible to make them practically workable.”

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