Download Uncleared margin rules: Currency investors brace for change

Uncleared margin rules
Currency investors brace for change
The currency market is one of the largest and most liquid financial market with an
average daily volume of $5.1 trillion.1 Participants in this market include corporations,
pension funds, financial institutions, central banks and many others. Historically, most
pension funds and certain pooled funds, which are referred to as “real money”
accounts, have not been required to collateralize currency forwards used as part of
their hedging programs. This is in sharp contrast to many other derivative instruments
where margin has been required.
Joe Hoffman, CFA
Director, Global Head
of Currency
There are two types of regulatory margin being introduced: initial and variation. Initial
margin is calculated based on a percentage of the derivative notional value, which must
be posted upfront. Initial margin is exchanged by both parties, without netting of
amounts collected by each party (i.e., on a gross basis), and is held in a third-party
segregated account so it’s fully protected in the event that a party defaults. Variation
margin is collateral that is exchanged between counterparties based on the profit and
loss of the underlying instrument in order to mitigate counterparty credit risk.
In light of the Global Financial Crisis, at the 2009 G20 summit in Pittsburgh, leaders
agreed to issue new rules and regulations with the primary goal of reducing systemic
risk across the financial markets. One of the most impactful and far-reaching
requirements issued by regulators was finalized in March 2015, when the Basel
Committee on Banking Supervision and the Board of International Organization of
Securities Commission (BCBS/IOSCO) published the final framework for margin rules
The currency market is the
largest and most liquid
financial market. Requiring
market participants to
exchange margin (i.e.,
collateral) would reduce the
credit risk to market
participants during a crisis
situation.
for non-cleared derivatives, which includes currency forwards and swaps.
Requiring market participants to exchange margin (i.e., collateral) would
reduce the credit risk to market participants during a crisis situation because the
collateral would help cover a party’s obligations in the event of a default.
Margin rules across the globe
Each jurisdiction’s own regulator has been
responsible for drafting rules specific to its
region. Many of the margin rules have been
finalized, but others are still in a proposed
state. Unfortunately, in many cases, the
margin rules for FX forwards and FX swaps
are inconsistent across jurisdictions,
resulting in confusion and uncertainty. It’s
important to become familiar with the
different rules across
jurisdictions since the rules may apply if at
least one party (e.g., a pension plan or
bank counterparty) is domiciled in the
regulated jurisdiction.
Many regulators across the globe have
issued rules or are in the process of
finalizing their rules. However, we will
describe the differences in the margin
rules for foreign exchange for Australia,
Canada, Europe and the United States
because most bank counterparties are
domiciled in these regions.
Russell Investments // Uncleared margin rules: Currency investors brace for change
DECEMBER 2016
In the United States, the Prudential Regulators2 and the
CFTC3 have finalized their margin requirements. FX nondeliverable forwards (NDFs) are categorized as a swap,
which means that financial end users of this instrument that
are facing a regulated entity will need to post and collect
variation margin as of March 1, 2017. Based on the volume
of trading for most pension plans and investment pools,
regulatory initial margin will not be required until September
1, 2020 if, at that time, these entities have swap exposure
that exceeds $8 billion.4 U.S. regulators have excluded
physically-settled currency forwards from both initial and
variation margin requirements. However, the Federal
Reserve issued guidance5 encouraging entities subject to
its oversight to exchange variation margin for inter-affiliate,
physically-settled currency forwards and swaps with
Financial Institutions and Systemically Important NonFinancial Institutions. As a result, the dealer community is
uncertain whether variation margin for physically-settled FX
forwards will be compulsory or not. SIFMA and GFMA6, two
industry groups, are attempting to clarify the conflicts
between supervisory guidance and the rules.
In Canada, the Office of the Superintendent of Financial
Institutions (OSFI) released their final margin rules on
February 29, 2016. Similar to the United States and
Europe, variation margin and initial margin will be phased in
over a number of years in Canada. OFSI stated in their
rules that the requirement of initial margin and variation
margin applies to all non-cleared derivatives with the
exception of physically-settled currency forwards and
swaps.
In Europe, the European Commission adopted a final draft
of the margin rules on October 4, 2016. Under these rules,
users of non-cleared, OTC FX forwards, FX swaps and
cross-currency swaps (FX derivatives) will be required to
exchange variation margin as of March 1, 2017, although
this deadline is extended in respect of physically-settled FX
forwards.7 There are no initial margin requirements for
physically-settled FX forwards and FX swaps, nor for the
exchange of principal cross-currency swaps. Other FX
derivatives, such as FX NDFs, will be subject to initial
margin requirements. The start date for the initial margining
requirements is determined on an entity basis, dependent
on the non-cleared OTC derivative exposure of the entity.
Based on the volume of trading for most pension plans and
investment pools, initial margin will not be required for FX
derivatives until September 1, 2020 if, at that time, these
entities have an aggregate average notional amount of noncentrally cleared derivatives above €8 billion.
The U.S. and European rules include an 8% haircut for noncash collateral posted as variation margin in a currency
other than the currency of settlement of the swap. For initial
margin, the 8% haircut would apply to cash and non-cash
collateral in a currency other than the currency of
settlement of the swap or the specified termination currency
payable to the non-posting party.
Russell Investments expects physically-settled FX forwards
to come into scope on January 3, 2018. However, when the
regulators exempted physically-settled FX forwards until
2018, they neglected to include currency swaps. As such,
currency swaps will be subject to the variation margin
requirements as of March 1, 2017.
Eligible collateral
Under U.S. rules for financial end users, eligible collateral
for variation margin and initial margin includes cash; debt
securities issued by the U.S. government, agencies and the
European Central Bank; certain sovereign debt; certain
corporate debt securities; certain publicly traded debt and
listed equities; and gold.
In Europe, eligible collateral includes cash, government
debt, gold, certain corporate bonds, certain equities and
certain UCITS or shares in UCITS funds.
Although the regulators have listed many types of eligible
collateral, bank counterparties strongly indicate they would
prefer to receive cash. This is because non-cash collateral
negatively impacts a bank’s leverage ratio under the new
Basel rules.8 The settlement timing for variation margin and
initial margin under the new rules in the United States is
same day, assuming the call for collateral is made by the
notification time agreed to between the parties. In Europe,
the posting party has to provide both variation and initial
margin within the same business day as the calculation.
This short settlement cycle could prove problematic for
certain types of collateral (such as those described earlier)
given that many global custodians have strict cut-off times
for transferring cash and securities.
In Australia, on October 17, 2016, the Australian Prudential
Regulation Authority (APRA) responded to submission
surrounding margining and risk mitigation for non-centrally
cleared derivatives. APRA excluded physically-settled
currency forwards and swaps from variation margin
requirements. APRA stated they could revisit this exclusion
depending on changes in the global regulatory
environment. The primary reason for the exclusion is that it
would minimize the burden on institutions that use currency
forwards for hedging purposes.
Russell Investments // Uncleared margin rules: Currency investors brace for change
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Next steps
We would recommend that clients prepare for a March 1,
20179 effective date for posting collateral for physicallysettled forwards and swaps to all financial counterparties.
Russell Investments has continued to build and invest in a
robust collateral process, including systems, vendors and a
dedicated collateral team. We have clients that post both
cash and non-cash collateral as variation margin and initial
margin, providing us with experience and familiarity with the
challenges faced by investors in developing an efficient
process across multiple bank counterparties and global
custodians.
For clients that previously haven’t exchanged variation
margin, this can be a disconcerting time. As your
investment manager, we can help guide you through the
process as well as provide solutions to limit the impact
these rule changes will have on your organization. We can
analyze your existing currency forward holdings and
suggest an amount to be set aside for variation margin. For
clients who are unable to post eligible non-cash collateral,
Russell Investments can offer a derivative overlay solution
on the cash pool to avoid cash drag on your portfolio. We
welcome the opportunity to discuss your options and
develop a plan to comply with these new rules.
SIFMA – Securities Industry and Financial Markets Association;
GFMA – Global Financial Markets Association.
1
Bank of International Settlements 2016 triennial survey, September
2016.
6
2
7
The Prudential Regulators include the Office of the Comptroller of the
Currency, the Board of Governors of the Federal Reserve System, the
Federal Deposit Insurance Corporation, the Farm Credit Administration
and the Federal Housing Finance Agency.
3
U.S. Commodity Futures Trading Commission.
4
This threshold is determined by calculating the average daily
aggregate notional amount of uncleared swaps and uncleared securitybased swaps, FX swaps and FX forwards for each business day in
June, July and August of the previous year.
5
Supervisory Guidance for Managing Risks Associated with the
Settlement of Foreign Exchange Transactions, February 2013;
https://www.federalreserve.gov/bankinforeg/srletters/sr1324.htm.
Variation margin will have to be exchanged in respect of physicallysettled FX forwards by the earlier of (i) December 31, 2018 and (ii) the
later of (x), the date on which MiFID II is to be applied by member
states (currently expected to be January 3, 2018) and (y) the phase-in
date for variation margin.
8
The Bank for International Settlements describes Basel III as a
comprehensive set of reform measures, which was developed by the
Basel Committee on Banking Supervision to strengthen the regulation,
supervision and risk management of the banking sector.
9
In respect to the European rules, it is possible that the start date
could be delayed if implementation of the RTS is delayed until
February 2017 (in which case the variation margin obligations would
apply one month after the implementation of the RTS); however, such
a delay is not expected.
Russell Investments // Uncleared margin rules: Currency investors brace for change
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Appendix
UNITED STATES PRUDENTIAL REGULATORS AND
CFTC RULES
EUROPE MARGIN RULES
Products
 Variation margin and initial margin are required on
NDFs.
 FX swaps and physically-settled FX forwards are out of
scope. However, there is uncertainty regarding the
Federal Reserve Supervisory Guidance.
 Variation margin will be required on FX forwards
(including non-deliverable forwards), FX swaps and
cross-currency swaps.
 Initial margin will not be required for physically-settled
FX forwards, FX swaps or the exchange of principal in
currency swaps.
 Variation margin has been exempt on physically-settled
FX forwards until January 2018.
Variation Margin & Initial
Margin Compliance
Dates
March, 1 2017 – Variation margin applies to all entities.
Sept 1, 2017 – Initial margin applies if a counterparty,
combined with all its affiliates, has an average daily
aggregate notional amount (AANA) of non-cleared
swaps, non-cleared security-based swaps, foreign
exchange forwards and foreign exchange swaps for
March, April and May 2017 that exceeds $2.25 trillion.
Sept 1, 2018 – Initial margin applies if AANA for March,
April and May 2018 exceeds $1.5 trillion.
Sept 1, 2019 – Initial margin applies if AANA for March,
April and May 2019 exceeds $0.75 trillion.
Sept 1, 2020 – Initial margin applies if AANA for June,
July and August 2019 exceeds $8 billion.
January 2017 – Initial and variation margin applies if
AANA for March, April and May 2017 exceeds €3 trillion.
AANA is calculated across a group and recorded on the
last business day for March, April and May of the relevant
year.
March 1, 2017 – Variation margin applies to all in-scope
entities (excluding physically settled FX forwards).
January 1, 2018 – Variation margin applies to physicallysettled FX forwards.
Sept 1, 2018 – Initial margin applies if AANA for March,
April and May 2018 exceeds €1.5 trillion.
Sept 1, 2019 – Initial margin applies if AANA for March,
April and May 2019 exceeds €0.75 trillion.
Sept 1, 2020 – Initial margin applies if AANA for March,
April and May 2020 exceeds €8 billion.
Eligible Collateral
Cash, debt securities issued by the U.S. government,
agencies, the European Central Bank, certain sovereign
debt, certain corporate debt securities, certain publiclytraded debt and list equities and gold.
Cash, government debt, gold, certain bank corporate
bonds, certain equities and certain UCITS.
Haircuts
8%, with respect to variation margin, applies on collateral
where the settlement and collateral currencies differ
except for cash in US dollars or another major currency.
Haircuts to be applied to all non-cash initial margin and
variation margin that reflect the market and credit risk.
A further 8% currency mismatch haircut applies to noncash variation margin denominated in a currency other
than the settlement currency.
A further 8% currency mismatch haircut applies to initial
margin denominated in a currency other than the
termination currency.
Thresholds
Zero threshold on variation margin.
Zero threshold on variation margin.
Minimum Transfer
Amount
USD 500,000
EUR 500,000
FOR MORE INFORMATION:
Call Russell Investments at 800-426-8506 or visit russellinvestments.com/institutional
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First used: November 2016
Russell Investments // Uncleared margin rules: Currency investors brace for change
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