On January 3, 2018, physically settled foreign exchange forward transactions (FX Forwards) are scheduled to become subject to the variation margin requirements set out in Commission Delegated Regulation (EU) 2016/2251 of October 4, 2016 (EU Margin Regulation) that apply generally to OTC derivatives.

On November 24, the European Supervisory Authorities (ESAs), however, threw the scope of FX Forwards variation margin obligations into some doubt. The ESAs announced an urgent review of whether the variation margin regulatory technical standards on risk mitigation techniques for OTC derivatives not cleared by a central counterparty (RTS) should apply to all counterparties entering into FX Forwards from the scheduled date. In their announcement, the ESAs explained that they intend to propose amendments to the RTS to harmonize the European Union’s (EU’s) variation margin rules (VM rules) under the European Market Infrastructure Regulation (EMIR) for FX Forwards with equivalent rules in other jurisdictions. The announcement indicates that the ESAs believe that VM rules should primarily apply to FX Forwards between “institutions,” defined by the ESAs as credit institutions and investment firms. The ESAs, however, indicated that for some non-institution-to-non-institution transactions, the daily exchange of variation margin could lead to such non-institutions facing additional risks.

The ESAs stated a review was necessary because, although the VM rules form part of a globally agreed framework, some jurisdictions have a lower scope of application, and generally exempt all counterparties from FX Forward variation margin requirements.

The ESAs’ announcement will create some compliance challenges for FX Forward counterparties on January 3 because neither the ESAs nor the national competent authorities have any power to disapply directly applicable EU law. As a result, any amendments to the VM rules proposed by the ESAs will only become effective when they are implemented through EU legislation. Given that the announcement indicates that the proposed amendments may not even be submitted to the European Commission before December 24, there is no doubt that any approved changes will not come into effect until substantially after January 3.

Indications in the market suggest that some counterparties that are not institutions, and that are not currently margining all their derivatives, expect that their 2018 FX Forwards will not be subject to the VM rules on the assumption that a permanent exemption will be forthcoming based on the ESAs’ announcement, and that it is therefore unnecessary to comply with the law in the interim. The ESAs, at the end of their announcement, give some support to this view, stating that “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.“ Institutions, however, should continue to prepare to exchange variation margin for FX Forwards with credit institutions and investment firms from January 3, 2018, since there is no reason to expect that the changes proposed by the ESAs will exempt those trades.

 The ESAs’ announcement is available here.