Just weeks until EU variation margin rules come into force for physical FX forwards, regulators have said schemes will probably not have to comply after all. This creates a lot of uncertainty, writes Stephanie Baxter
Pension funds have been getting ready for new rules requiring them to post variation margin (VM) on physically-settled foreign exchange (FX) forwards, which they commonly use to hedge currency risk.
There have been concerns these new rules under the European Markets Infrastructure Regulation (EMIR) that apply from 3 January will make currency hedging more onerous and costly for schemes.
This is because VM, which must be delivered in response to daily market movements, typically has to be in cash. While the EU rules allow banks to accept many different types of assets as collateral for VM, they are penalised for holding anything other than cash under separate bank capital rules.
So while pension funds still enjoy a temporary reprieve from having to centrally clear derivatives, bank capital rules create the same issues for derivatives that do not have to be centrally cleared.
Unlike EU regulators, regulators in other jurisdictions that enacted mandatory margin requirements exempted physically settled FX forwards because of the specific risk profiles of the entities that use them.
After intense lobbying (PP wrote about the issue back in March 2016) and just weeks to go until the deadline, EU regulators have finally sat up and taken notice.
In a joint statement on 25 November, the three European Supervisory Authorities (ESAs) revealed they are reconsidering whether VM rules for FX forwards should be mandatory for buy-side institutions such as pension funds, having been made aware of challenges. They are now seeking changes to align the treatment of physical FX forwards with the supervisory guidance in other jurisdictions.
Macfarlanes partner William Sykes says: "I can only assume the relevant people at the European authorities were finally convinced by the lobbyists' argument that from a cost benefit perspective, the credit risk mitigation benefits of exchanging collateral were outweighed by the hassle factor and cost for the majority of market participants that use this."
While this move will be welcomed by pension funds, it creates a lot of uncertainty ahead of the looming deadline. Any changes would need to be formally implemented through EU legislation, which could take several months.
Pensions and Lifetime Savings Association investment and defined benefit policy Lead Caroline Escott says:
"Forcing the collateralisation of variation margin for FX contracts by pension schemes could undermine schemes' ability to hedge risks and increase the underlying risk levels, which could ultimately have an adverse impact on members' pension savings. We therefore support moves at a European level, such as the ESAs' recent statement, to exempt pension schemes from such a requirement.
"The ESAs' announcement does create uncertainty, with so few working days until the 3 January deadline. We would hope that the European Council would insert a general approach provision into the EMIR Refit proposal, which could provide sufficient grounds for national regulators to provide general forbearance for organisations which do not comply."
Sykes estimates the earliest the rules will be changed at the European level is by the end of February 2018, but says this is pretty optimistic. A more realistic estimation is end of March or beginning of April; however it could take until November.
There should hopefully be more clarity on the situation before Christmas. The ESAs have said once their current review is finalised - assuming a solution is reached - draft amendments will be submitted to the European Commission by 24 December.
How to react
How should schemes react in the meantime? The UK Financial Conduct Authority (FCA) helpfully released a statement on 8 December effectively saying pension funds can stop working towards January's looming margin deadline for physical FX forwards.
This means schemes should be confident they will not be fined by the regulator if they breach the rules from 3 January - although the FCA does say it continues to recognise VM as a "prudent risk management tool".
"Last February, when European regulators acknowledged that participants were not going to be ready for VM and that forbearance would be necessary, the FCA merely said it would take a risk-based approach to their supervision and would expect firms to use their best efforts to achieve full compliance within the next few months," says Sykes.
"This time though they have been far blunter, confirming that firms whose FX forwards were subject to the exemption could cease working towards a 3 January deadline. I think that is probably all they will say on the matter, and so for UK schemes, I would take that as definitive permission to ignore VM on their FX forwards for the purposes of EMIR. Schemes should however check in with their FX counterparties, which are still free, commercially, to request an exchange of VM as a condition of trading."
Schemes that have not gotten everything up and running, and are still making decisions now as to how much money to spend, may decide to ignore the rules if they can.
The other option is to be very cautious and comply for four or five months until the legislation is amended, and then switch off again.
"The downsides of this are it's a drain on your liquidity to exchange margin, and there's a cost involved," says Sykes. "But if you've already spent the money on putting collateral systems in place and paid lawyers and advisers to do the work, some of that money is locked in anyway, so to some extent you might as well do it, given the credit risk reduction that exchanging margin brings."
Record Currency Management chief executive officer James Wood-Collins says there is a risk of creating a very unfortunate outcome whereby entities that have not been prudent to be ready by the deadline will be rewarded.
"Institutions that have been sensible and looked ahead will be effectively penalised by having to do this margin activity and put cash aside, while those that didn't know about the rules or chose to turn a blind eye will be rewarded. It sets a terrible precedent for future changes in regulation.
When deciding what to do ahead of 3 January, pension funds must ensure that what they are trading is indeed a vanilla physically-settled FX forward, as otherwise they might find themselves in trouble.
Also, it is still within the commercial powers of the banks to require exchange of VM if they want to.
"There's a slight suspicion that once the banks have set up and gotten used to receiving margin from a particular party, the inertia in turning it off will mean a lot of people will say ‘we're used to it now and it hasn't been a problem'," adds Sykes.
"That may not be the case for pension funds as they tend to be large, slow moving piles of liquid assets so tend to be quite creditworthy, whereas there's no way banks would do anything with hedge funds unless they exchange collateral.
"However, if a pension fund was doing an FX forward and its FX trading [book] was enormous, a bank might say ‘we don't care what the rules are, we want them to exchange'."
Some schemes may prefer to be very conservative and meet the rules anyway; one of the benefits of exchanging variation margin is it reduces counterparty credit risk.
"One of the biggest private UK pension funds collateralises FX forwards as a matter of policy, because it's very large, has a big derivatives portfolio and is worried about credit risk on these banks," says Sykes.
The costs of variation margin
The incoming variation margin rules for physical FX forwards have presented a huge challenge for pension funds.
"Historically, most of our pension fund clients have chosen to trade on FX credit lines, so they pay or receive when a forward contract matures, but not on a daily basis," explains Record's Wood-Collins.
"When you move to daily margining, someone has to everyday look at mark-to-market positions of the forward contracts with each different bank - and there may be several. You have to be able to value positions on a very standardised valuation model, and compare that updated valuation with the amount of margin historically received to figure out the difference."
"Although the regulations allow other things to be used as variation margin, including equities, bonds, UCITS funds and even gold, the regulators didn't realise when drafting the rules the banks would be much more restrictive in what they would accept. Cash is universally accepted as margin. Some banks are willing to accept government securities like gilts but not all, and often your gilts would be typically used in a liability-driven investment programme."
He estimates a typical scheme would need to keep around 1.25%-2% of the total fund in cash, which is "not trivial" when pension funds are "looking to minimise costs and maximise returns in every possible dimension". It is also not helped by increased demand for transfers since the pension freedoms, he adds.
"Given the volatility in the FX markets, for a client to be reasonably confident and not have to add to cash pot over the course of a 12 month period, that pot should be somewhere between 5%-10% the size of the hedge."
His calculations are based on a portfolio 60/40 split between equities and bonds, estimating a currency hedge to be around 25% of the total pension fund.
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