Much of the attention has been around derivative trading and on transparency in services. The main themes to most of the regulation can be broken down into 5 areas.
The main area still being addressed by the regulators is in Capital Markets. The impact of this continued drive by the regulators on Forex is fortunately limited. The Forex market should not unduly be concerned with PRIIPS, UCITS for example, which is a big change to other Asset types.
There is one new regulation that will impact Forex outside of Capital Markets: the introduction of AML 5, the fifth directive on Anti Money Laundering due in 2021. We will come to that later.
Returning to Capital markets, much of the regulations are now in place, with the Securities Financial Transaction Regulation (SFTR) being the latest at the end of 2020. The next step taken by the regulators is to clean up the exemptions and anomalies. To that point, the regulators are looking at Central Clearing and specifically Initial Margins.
Finally, while not a regulation for 2021, the conduct of the Forex Market will be under scrutiny as the FX Global code is revised this year.
Since 2008, the regulators have sought to push the market to central clearing, indeed LCH ForexClear cleared approximately $19.1Tn in 2020. That is around 96% of the total cleared Forex activity and is approximately 20% of all Forex derivative activity. The regulatory push will continue through 2021. For a start, the Pension fund exemption from the EMIR refit obligation on clearing will be coming to an end at the end of June 2021. The exemption was provided as it was appreciated that they would “encounter difficulties in meeting variation margin requirements for centrally cleared transactions due to high cost (e.g. lower investment returns or transaction costs), risk of inefficiencies as a result of converting assets into cash” and therefore added cost to the investor as the pension fund would need to divest of some assets to provide the collateral in the form of cash.
This removal of the exemption will mean the Pension Funds will become incumbent to follow the clearing regulation of ESMA and FCA, where the requirements include the need to monitor the value of derivative positions in a range of assets classes, understand where the threshold has been breached and then inform the regulator of the breach, and then commence Central Clearing of the derivative transactions in that asset class (or where the threshold is no longer met, have the option to stop Central clearing). These obligations are already with the eligible Asset Managers.
The impact to FOREX is not just the potential additional cost, the question of efficiency and economies of scale dictate that where the derivatives of other asset classes are already being centrally cleared, it may choose to also clear its Forex derivative business. This of course will also depend on the counterpart also choosing to centrally clear. This could force the market to split, even if only temporarily, into centrally Cleared and Uncleared.
EMIR refit and FX Global code
ESMA have been discussing the possibility of extending the scope of some actions to incorporate Forex trading. To date, only Forwards and Options are captured. However, there is some discussions about the effectiveness of the FX Global code. We are aware that the GFXC (Global Foreign Exchange Committee) are currently reviewing the code, with the aim of updating it this year. One of the main issues is the reluctance of many of the large Buy side to enter into agreement to adhere to the code. The Buy side are unclear of the compliance needs of the code and in some cases have expressed the view that it is simply “regulation in disguise”. Indeed the commitment of the Buy Side has also been exasperated by the perception that it is too Sell side centric.
The extent to which the revision from the GFXC meets these needs and answers these questions will have a bearing on the discussions among the regulators to extend the scope of regulation to incorporate Forex spot trading to a greater or lesser extent.
Discussions with ESMA are related to the MAR review report published in September 2020 that identified that further analysis of the spot market was warranted. Against that view, the market have been at lengths to highlight that any changes to the practices of the Forex spot market would have a knock on effect to not only the Financial service industry at large, but also to the economy.
This issue will not go away with the amended code, but will continue, based on the size and scope of changes, the uptake and the perception of the regulators to the general conduct of the market. Will the Buy side join, based on the changes and pressure of possible future regulation, or continue to live outside the code? This could be a key to the future.
The Fifth Directive of Anti Money Laundering has a set of small but potentially time consuming changes. The main changes impacting Forex are:
- A new list of Politically Exposed Persons must now be maintained by each of the member states (and UK). Going forward, this will be the PEP list to be used.
- Electronic means of identification and verification will now be permitted where they have been approved by the national authorities.
- Finally, easier and free access to information from central registers will be available, and the sharing of information encouraged. However, this means each firm must ensure continued compliance with privacy laws, with secure processes in place should they wish to share the information.
The impact on Forex will be to update their own process around recoding PEP’s, as well as electronic identification and verification. While this is not a significant change, each will require some time consuming changes to systems and processes.
The major regulatory change in 2021 will be the Uncleared Margin Requirement (UMR). This has been around for a few years now, with the roll out starting in phases from 2016 in the USA. The next and final phase will be Phase 6, which was due to go live in September 2021, and will affect smaller insurance/banking groups and asset managers with EU and US thresholds of $8 Billion or less. However, the deadlines were pushed back by 12 months last year, so that phase 5 for firms over the $50bn threshold is only going start in September 2021 and phase 6 will follow in 2022.
The UMR has set out the need for financial derivative exposures/Margins to be covered by collateral. Initially this requirement for Insurance and Asset managers was for Variation margin to be calculated and collateralised. While that went live in 2017, the need for Initial Margin is now becoming a reality.
- Variation Margin, also known as the Mark to Market margin, is used to cover any potential losses due to market movement and can be called daily or even intra daily.
- Initial Margin, as the name suggests, is called at the outset of a transaction being posted. The IM is provided to create additional cover for the position the transaction impacts or creates. The cover could be for unforeseen operational issues, for large swings in the market between VM calls, or even, as in 2008, to cover for the swing in value of the collateral during the period from default to closure and settlement of the default positions.
The impact of the need for IM and VM calls and collateral cannot be underestimated for those firms in Phase 6. The main areas of impact will be in the calculation, choice of asset to provide and the documentation.
For the first part, ISDA have provided a standardised model (SIIM).
Where the transaction is centrally cleared, the CCP will calculate and complete the settlement of the collateral movement automatically, the onus is then to pass that requirement to clients, using the calculation of the CCP.
However, where the transaction is uncleared, the Sell side will usually define the IM aligned to a position. This will then be passed on to the clients to ensure the collateral given and received does not leave a gap in value. The net collateral, from the IM and VM, should then be calculated and agreed with the counterpart before the delta collateral values can be confirmed and settled.
The assets to be delivered as Collateral will differ depending on the Counterpart (including the CCP), the type and asset of the derivative, as well as the form of margin. The pressure on having the right form of asset to provide as collateral could well drive a change in the assets offered and accepted as collateral. The USA already sees a wider range of asset provided that in Europe; even Mortgage Backed Securities are common in the USA, but not in Europe. I am not suggesting MBS be provided, but given the ever widening assets held by the Insurance firms, Pension Funds and Asset managers, the pressure will be on for alternate forms of collateral to be accepted. At the same time, each firm will need to determine what instrument(s) to provide based on the cost of not holding that instrument for the duration of the collateralisation. For example, the opportunity cost of giving a fixed income bond between Dividend dates is zero (providing it is recalled before the ex-dividend date); less than cash, where the interest would be realised on a daily basis. However it is cheaper to deliver cash than a bond due to the CSD transactional charge. In order to manage the collateral provided, constant monitoring of the opportunity cost of interest and CSD/custodian charges, along with the cost of transferring the instrument, is required.
The documentation required is potentially the biggest challenge in advance of the September deadline, the documentation being the transaction confirmation, the Collateral agreement and the Client Service Agreement (CSA).
The collateral details are embedded within the confirmation and must be sent to the counterparty and broker (if used) immediately after the transaction. The form of collateral to be used, the delivery and custody arrangements, the limitation of reuse of collateral, and other legal elements relating to the Margin requirement and collateral, are embedded within the Collateral agreement. The CSA, usually based on the ISDA master agreement, provides more general agreements such as default, netting and legal obligations.
The problem is that the form of confirmation, and the completely new section of the Collateral agreement to cover the IM, will need to be agreed with each counterpart. This may lead to adjustments in the Master Agreement to cover any specific points raised through the agreement of the first two documents. For an Asset manager, pension fund or insurance firm, that could become a very long process given the number of potential clients requiring these documents.
So, 2021 will be a quiet year for new regulation, but the tidying up and the UMR obligation will certainly keep us all busy.
Indeed, after 10 plus years of just keeping pace with regulatory demands, maybe 2021 is the ideal time to look at strategic changes to the operation, streamlining processes, including automation, reorganising the Operational risk, regulatory and compliance teams may also provide some efficiencies and redefinition of the three lines of defence.