A touch of the surreal has descended upon the market for foreign exchange swaps in recent weeks, as participants ponder whether the instrument ever truly existed.
This existential angst stems from the incoming derivatives margin rules. In Europe, most counterparties will have to pay variation margin on forex swap positions from March 1. Many buy-side users, however, book the instrument as a forward – and these are being margined from the start of 2018.
A lack of guidance from regulators has led to confusion as market participants try to figure out for the first time whether the product is in fact a swap or a forward, which will determine when it must be margined. Many dealers and advisers are said to be giving conflicting advice.
“The treatment of currency forwards as forwards or swaps is a point on which there isn’t absolute clarity. Firms have been left to develop their own policies on that in conjunction with their own counsel,” says Georgia Bullitt, a partner in the asset management group at law firm Willkie Farr & Gallagher in New York.
The treatment of currency forwards as forwards or swaps is a point on which there isn’t absolute clarity. Firms have been left to develop their own policies on thatGeorgia Bullitt, Willkie Farr & Gallagher
The US rules aren’t clear-cut either. Under the US margin regime, forex swaps are exempt from variation margining, but some fear cash-settled and so-called window forwards, where a settlement date is not specified, may nevertheless be caught from March 1, which would impact market participants such as mutual funds.
For users of forex swaps, the treatment is crucial as many want to avoid the extra costs that come with margining their trades. This means they are likely to move their business to banks in a jurisdiction where margining of forex swaps or forwards won’t be required, which could split liquidity in a similar way to when US swap execution facility rules were introduced in 2014.
“This divergence could mean asset managers might want to make a distinction between US and EU banks, and therefore fragment the market,” says David Beatrix, product specialist, collateral and valuation services at BNP Paribas in Paris. “These are serious considerations.”
The confusion has also muddied the waters for banks rushing to get buy-side counterparties to sign new regulatory-compliant derivatives collateral agreements, known as credit support annexes (CSAs), before March 1.
Not all firms can easily move to another dealer, however, which could discourage them from using the instruments at all. A recent survey by buy-side advisory firm Chatham Financial found that around 14% of respondents simply might not hedge if forced to post variation margin on some products.
Anatomy of a trade
Forex swaps allow a party to borrow in one currency and simultaneously lend in another at the spot rate, with the repayment being fixed at the forward rate as of the start of the contract (see figure 1). Banks and corporates can use them for forex risk-free borrowing or lending, collateralised by the reciprocal repayment obligations, while others, such as asset managers, use them as a hedge – in particular, to roll forward positions they already have on.
For example, if an asset manager wants one million euro/US dollar one-month forward exposure, three separate transactions are completed. First, the asset manager would buy euros at spot. It would then execute a forex swap where it sells euros at spot and buys euros forward. The price of this trade is simply the difference between the spot and forward prices. The advantage of executing in this way is that an asset manager can negotiate the two components of the trade – the spot price and the forward price – separately. If it asked for one blended price that combines spot and forward, there would be a lack of flexibility to trade with whichever dealer has the best price for each component.
This leaves the asset manager with three trades: buy euros at spot; sell euros at spot; and buy euros forward. If the two spot trades are done with the same counterparty they net to zero, so there is no need to book them, leaving behind the forward trade.
Technically, this would result in the transaction registering as just one forward, and most asset managers would book it accordingly. But dealers have tended to book the forex swaps as an instrument in their own right. This hasn’t been a problem until regulators introduced different margin treatments for forex swaps and forwards under the non-cleared margin rules. James Binny, head of currency for Europe, the Middle East and Africa at State Street Global Advisors (SSGA) in London, says market participants can make equally strong arguments that the instrument is a swap or a forward.
“On the surface, it’s a very grey area. If you have a forward then you obviously have to roll it to maintain the hedge at maturity, and you’re rolling it with something many people would call a swap, although it’s really not a swap – it’s two forwards, or a spot and a forward. So it is absolutely correct to say they’re forwards and therefore out of scope and also correct that people call it a swap,” says Binny.
“We have checked and we enter our rolls into FX Connect as two transactions, we confirm as two transactions, we settle as two transactions and we report to the DTCC [Depository Trust & Clearing Corporation] as two transactions, so we are happy that it is two transactions,” he adds.
Joe Hoffman, global head of currency at Russell Investments in Seattle, says the regulatory definition of a forex swap doesn’t really align with how the product is traded in practice. “When you execute a trade, it is booked, confirmed, sent to the custodian and reported as two separate trades,” he says.
The distinction is important. From March 1, non-financial counterparties in Europe, Canada, Japan and the US will be required to post variation margin on new non-cleared over-the-counter derivatives instruments. The rules on most OTC products align across jurisdictions, but some fall between the cracks. Forex swaps and forwards, for example, are required to be margined in Europe but not in the US.
In Europe, both swaps and forwards were initially meant to be margined from March 1, but an amendment on July 28 to the European Commission’s regulatory technical standards detailing the margin requirements clarified the start date for forwards as being the application of the relevant delegated act in the revised Markets in Financial Instruments Directive, or December 31, 2018, whichever is sooner. With the directive being applied from January 3, 2018, this is the date from which forwards need to be margined.
On the face of it, this put the matter to rest until next year. But things have been made all the more complicated by the fact that variation margin implementation for forex swaps is still set to go ahead from March 1, despite the fact that the product can be defined as either a swap or a forward.
“A lot depends on how you look at the forex swap product,” says a senior figure at an industry working group in London. “If you look at the way it is confirmed and operationally treated, you could argue it is two forwards. If you look at it [in terms of] what it was you were actually trading, it was a forex swap. There are different ways of interpreting that, and I’m aware that people are looking at this in different ways.”
We’ve taken the stance that whenever we’re doing a forex swap, we’ll have to treat it as such and not requalify it as a spot and a forward, even if the economic sense will be the sameDavid Beatrix, BNP Paribas
In the absence of any clarification from European regulators on the subject, SSGA’s Binny says his firm has been reliant on legal advice from its own counsel and advice from banks. But lawyers say dealers and their clients have been forced to reach their own conclusions on the subject, and these can differ.
BNP Paribas’ Beatrix says that if a trade was intended as a swap, it must be booked as such. “If the initial intention was to trade a swap then they must book it as such and therefore collateralise it on March 1. This wasn’t in black and white in the margin rules. It is something that has come out from analysis we’ve conducted on our side, because there could be a very thin difference between the two. We’ve taken the stance that whenever we’re doing a forex swap, we’ll have to treat it as such and not requalify it as a spot and a forward, even if the economic sense will be the same,” he says.
Not everyone takes this view. Some asset managers feel that since the start of this year there has been a change in guidance from banks. Before then, many of SSGA’s dealers were unwilling to make a decision on whether these trades would require margining, but nearly all have now said these roll trades will not need to be margined, says Binny.
“There’s been a huge debate going on and getting consensus has been difficult. We have $40 billion worth of currency hedging in Europe, the Middle East and Africa, so every month we’re rolling a fairly significant amount of forwards. Speaking to a lot of the banks, no one was coming off the fence. But as the New Year came round, of the 14 banks we have on our panel, 13 have confirmed we don’t need to collateralise until 2018,” he says.
Eyeing US dealers
Timing aside, buy-side sources say Europe’s margining requirement for forex swaps and forwards will lead them to trade with banks in the US, where the regime doesn’t have the same requirement.
“This difference between the jurisdictions will definitely introduce some competitive distortions,” says James Wood-Collins, chief executive of Record Currency Management in Windsor, near London. “EU banks will lose business from non-EU clients that don’t want to be caught under the third-country rules, and they will lose it to US institutions that aren’t required to margin forex forwards.”
Chris Bender, director of regulatory advisory on Chatham Financial’s global regulatory solutions team in Pennsylvania, agrees: “We have a number of clients that have decided they will be prioritising US dealers when transacting deliverable forex forwards,” he says.
But US banks don’t have it so easy themselves. While forex swaps are exempt from variation margining, some market participants fear the Commodity Futures Trading Commission (CFTC) could treat forwards as non-deliverable forwards (NDFs), which are caught by the incoming regime.
“I’ve heard from more than one lawyer that even though the currency is fully deliverable, the CFTC would consider the trade to be like an NDF because there is no physical settlement. The only forwards that would be exempt are [those] where you have no intention of continuing the trade and you intend to take delivery of the currency. Asset managers tend to be conservative when it comes to regulatory issues, so I think everyone will post variation margin on all forwards just to avoid any possible alternative interpretation,” says the head of trading at one US-based asset manager.
Other problems have emerged for more specific products. Registered US funds under the 1940 Investment Company Act have, for the past several years, settled deliverable forwards as cash-settled instruments. This is thanks to an interpretation given by the Securities and Exchange Commission regarding leverage rules under the act. Investment firms that trade cash-settled contracts only have to segregate their liquid assets against the mark-to-market value rather than the full notional amount, as would be the case if they traded physically settled derivatives.
This quirk has made cash-settled forwards a popular instrument for US mutual funds. But as the trades are cash settled, Willkie Farr’s Bullitt says they could meet the definition of a swap under the Dodd-Frank Act, and therefore clients may be forced to post variation margin if trading with a US bank.
“I have concerns that instruments which are documented as forwards but intended as cash settled might be recharacterised as swaps and therefore be subject to variation margin. The law is not clear and there is room for different interpretations,” says Bullitt.
In addition, window forwards are being interpreted by one lawyer as variation margin-applicable contracts, absent any clarification from the CFTC. “Window forwards appear not to be a deliverable forward under the law, because the definition requires an exchange of currency on a specific future date agreed upon at the inception of the contract, which is not the case in terms of window forwards. While the CFTC has not issued definitive guidance on the matter, most market participants are treating them as swaps subject to Dodd-Frank,” says Julian Hammar, a lawyer at Morrison & Foerster.
The confusion among market participants could not come at a worse time for the industry. Only a month remains until the March 1 deadline, and asset managers have completed only a tenth of the paperwork required to begin collateralising swaps, according to a recent survey conducted by the asset management arm of the Securities Industry and Financial Markets Association and the Investment Adviser Association, which represents advisory firms.
Among the numerous difficulties facing their members that they outlined in a letter to global regulators, arguably the biggest is establishing CSAs between counterparties that have never previously had to sign them, which is particularly pertinent for clients that trade forex. Those that do exchange margin today are typically prime brokerage clients such as hedge funds, but there are exceptions.
“Even in a one-month period, you can build up a pretty significant exposure to your counterparty. So we do it just as prudent risk management. There are a fair number of managers that don’t move variation margin on forwards and I’ve never understood why. It’s also easier for mutual funds because we’re not sending cash to banks but rather to a global custodian,” says the head of trading at the US-based asset manager.
Will there be some clients that have no dealer relationships set up by March 1? That’s certainly possibleNew York-based lawyer familiar with the matter
This has created an additional headache for the International Swaps and Derivatives Association, which published a supplement to its variation margin protocol on January 26 to help make it easier for mutual funds that have not been margining forex derivatives to set up agreements with banks and custodians, as they are required to legally segregate these funds under the 1940 Investment Company Act – something that wasn’t taken into account in the original protocol.
Despite the last-minute help, other industry groups appear less than enthused about rushing through documents before the deadline and have called on regulators for a six-month reprieve, like the one offered in Australia, Hong Kong and Singapore.
“Isda continues to evolve the protocol and what it covers, but it’s in the hands of individual asset managers to decide whether that model works for them,” says a New York-based lawyer familiar with the matter. “Will there be some clients that have no dealer relationships set up by March 1? That’s certainly possible.”
In a more extreme scenario, this could lead to some clients not hedging, particularly those smaller pension funds caught by the more prescriptive EU rules.
“European pension funds find it illogical that they are treated as though they are a major bank. This may discourage some of them from hedging in the first place, so I wouldn’t be surprised if some investors said they were not going to hedge anymore. This would introduce event risk. If a Swiss pension fund had chosen not to hedge its euro assets, for example, it would have suffered very severe mark-to-market losses in January 2015 when the Swiss National Bank dropped the cap on the value of the Swiss franc,” says Record Currency Management’s Wood-Collins.
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