European banks are being cut from counterparty lists for some foreign clients, a result of rules that would force the dealers to collect variation margin (VM) on currency forwards. Banks in other jurisdictions will be able to continue trading the products without margin after the rules take effect in the European Union in January next year.
“What we are doing now is taking EU banks off the bank panel for our non-EU clients unless those clients want to collateralise,” says James Wood-Collins, chief executive of Record Currency Management, a company that manages currency for pension funds, charities, foundations and endowments.
Two other currency management firms say they are considering taking similar steps. One side-effect could be a diminution of London’s status as the world’s biggest currency trading hub.
At State Street Global Advisors, US derivatives users that have opted to execute their trades via its London team may now relocate that activity to the US, says James Binny, the firm’s head of currency for Europe, the Middle East and Africa.
“London has historically been the highest volume centre for forex, so for that reason it has always just made sense to have those clients here. What we could do is just transfer those clients to be managed by one of the teams in the other jurisdictions. That is something we are looking at,” he says.
The problem stems from the EU’s version of global margining rules for non-cleared derivatives. Uniquely among the key jurisdictions, the EU regime applies to physically settled currency forwards, with implementation due from January 3, 2018. The EU and other jurisdictions agree non-deliverable forwards (NDFs) are in scope of the rules, and VM requirements for NDFs came into effect globally on March 1.
The expansion of the European regime next year will bring into scope a new array of hedgers and other end-users, some of which have no prior experience of collateralising derivatives trades. Third-party specialists that manage forex risks for pension funds and others say the cost of making cash and other securities available to post as margin on a daily basis could be prohibitive for their clients.
What we are doing now is taking EU banks off the bank panel for our non-EU clients unless those clients want to collateraliseJames Wood-Collins, Record Currency Management
“The majority of our clients have historically preferred to trade on credit lines, and therefore would not have been collateralising before,” says Record Currency Management’s Wood-Collins. “Now they are going to have to keep sufficient liquid assets free to pay and receive VM, and that is going to affect their asset allocation, how they run their portfolio and, in a world where cash yields are effectively zero, inevitably impact returns.”
If the firm in question is not regulated in the EU, it would face these costs only when trading with an EU dealer. As stipulated in Europe’s rules, variation margin must be exchanged in both directions when a third-country entity that would otherwise be in scope enters into a derivatives trade with an EU-regulated entity.
“That’s a big – and, in my view, financially sound – reason to exclude some of those EU banks,” says Alex Dunegan, chief executive of Lumint, an independent provider of outsourced currency management. “Doing it so you don’t have to post VM makes a lot of sense. When you look at pension funds or the asset management firms we focus on, they are using these derivatives purely for risk management purposes – and they are going to be penalised for it.”
In addition to the funding and collateral management costs involved, firms that have not previously collateralised their trades also face a documentation hurdle. Derivatives margining is governed by a contract known as a credit support annex (CSA), which needs to be negotiated and signed with each counterparty.
“It’s not quick or pain free,” says Wood-Collins. “We do that centrally with each bank counterparty, so our role as agent can make it easier for our clients. But there is still a significant body of documentation to go through and a number of banks have said to us that if you’ve not started the process by the end of the third quarter then it is not going to happen.”
For their part, banks are still working through a documentation backlog from the original March VM deadline, with US banks especially hurried due to the expiration of the Fed’s forbearance in September. A risk manager at one US bank says there will be little progress on CSAs for forex forwards users until then.
“I don’t think people have really started, I think they’re probably focusing on September 1,” the risk manager says. “We’ll go through the same thing – our clients will probably tell us they don’t understand this, and so on. It’s going to be the same exercise all over again.”
Industry readiness for the January 3 deadline is being monitored by the International Swaps and Derivatives Association.
“We’ve been talking about that with firms – it’s their next big focus,” says Tara Kruse, head of Isda’s non-cleared margin implementation effort. “In some cases, these are counterparties that sometimes only trade forex, who don’t necessarily look at themselves as entities that regularly trade derivatives, and they may not have an existing CSA even if they have an existing master agreement. So the process and the regulations are less familiar to them and that seems to be something that makes this population a bit more challenging.”
The lack of harmony across jurisdictions is troubling because you end up with inefficiencies and potential problems for asset managers that trade globallyA source at one trade association
Banks have lobbied European regulatory authorities for foreign exchange to be treated in a fashion consistent with other jurisdictions. They have pointed, in particular, to the internationally agreed version of the rules, issued by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (BCBS-Iosco), which calls for a “globally harmonised and territorially complementary approach”.
The BCBS-Iosco standards do in fact recommend VM should be exchanged for physically settled forex products. However, it was left to the discretion of national regulators to decide whether supervisory guidance or regulation should be the mechanism for achieving this objective. Most jurisdictions opted for the former, while the EU chose the latter.
A source at one trade association worries the difference between jurisdictions will make foreign exchange derivatives a less efficient way for firms to hedge and invest.
“The lack of harmony across jurisdictions is troubling because you end up with inefficiencies and potential problems for asset managers that trade globally and for a global client base,” says the source.