ESAs Review on Variation Margin Challenges for FX Forwards

The European Supervisory Authorities (ESAs) today released a statement acknowledging challenges for certain counterparties to exchange variation margin for physically settled FX forwards under EMIR by January 3, 2018.

Based on the material presented to the ESAs, it notes the implementation appears to mainly pose a challenge regarding transactions with certain end users.

The requirement to exchange variation margin for physically settled FX forwards is part of a globally agreed framework that aims to ensure safer derivatives markets by limiting the counterparty risk from derivatives trading partners, notes ESAs. The international standards state that variation margining of physically settled FX forwards is both an established practice among significant market participants and that it is a prudent risk management tool that limits the build-up of systemic risk, and thus that variation margining should apply to physically settled FX forwards. 

“The international standards recommend implementing this requirement by way of national regulation or supervisory guidance. The ESAs followed the option of implementing these international standards by way of regulation applicable to transactions in the scope of EMIR. However, it became apparent that the adoption of the international standards in other jurisdictions via supervisory guidance has led to a scope of application that is more limited than the scope the ESAs have proposed,” the statement says.

“From a legal perspective, neither the ESAs nor competent authorities (CAs) possess any formal power to disapply directly applicable EU legal text. Therefore, any changes to the application of the EU rules would formally need to be implemented through EU legislation.  

“In light of this, the Boards of the ESAs are currently undertaking a review of the Regulatory Technical Standards on risk mitigation techniques for OTC derivatives not cleared by a central counterparty (RTS) and develop draft amendments to these RTS that align the treatment of variation margin for physically settled FX forwards with the supervisory guidance applicable in other key jurisdictions.

“Specifically, the amendment of the RTS and their subsequent implementation would reiterate our commitment to apply the international standards, and require the exchange of variation margin for physically settled FX forwards in a risk-based and proportionate manner. In particular, this would most likely imply that the scope should cover transactions between institutions (credit institutions and investment firms). In addition, for some institution-to-non-institution transactions, the competent authorities should consider the actual risk that the exchange of variation margins would mitigate and whether non-institutions might face additional risks related to the daily exchange of variation margin,” the statement continues.

Once the Boards of the ESAs have finalised its current review, and assuming a solution is reached, then these draft amendments will be submitted to the European Commission within one month from this communication, ESAs says.

“Accordingly, as regards difficulties that in particular certain end users are facing, the ESAs expect competent authorities to generally apply their risk-based supervisory powers in their day-to-day enforcement of applicable legislation in a proportionate manner,” it concludes.

Commenting on the ESAs’ announcement, James Kemp, managing director of the GFMA Global FX Division, says, “This is a very welcome announcement and helps build towards a more globally harmonised environment for end users of FX markets, ensuring that they have cost effective access to products that allow them to hedge their currency risk. 

 “Clearly, with deadlines looming, both sight of the final text combined with confirmation from each EU country, as soon as possible, regarding the amended scope and timing expectations will help to further clarify the position,” he adds.

Julie Ros

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