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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 2 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 3 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 Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management. Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand. Copyright © 2016. Russell Investments Group, LLC. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. First used: November 2016 Russell Investments // Uncleared margin rules: Currency investors brace for change RIIS-3038 (11/19) 4