Uncorrelated – August 2017

Year-End Milestones for Fund Managers Trading OTC Derivatives

Earlier this year, the EU regulatory technical standards under EMIR (Margin RTS) which implement variation margin (VM) and initial margin (IM) requirements in relation to uncleared OTC derivatives, entered into force.  Taking into account the phased implementation of the Margin RTS, the industry pushback on the Margin RTS deadline date for VM requirements and the current shift of market focus to MiFID II, fund managers trading OTC derivatives should note the implementation of VM requirements and the clarification of which foreign exchange (FX) transactions are in-scope of EMIR, as we approach the final quarter of the year.

Implementation of Variation Margin Requirements – 1 September 2017

VM requirements in relation to large volume trading counterparties were implemented earlier in the year. In relation to lower volume trading counterparties (those with under €3trn of uncleared OTC derivatives transactions) such as fund managers, the implementation date was 1 March 2017 (IM requirements will be phased-in to all counterparties by 1 September 2020).  As the deadline approached, industry members, who were engaged in updating large numbers of collateral terms in an effort to achieve compliance, became concerned that the deadline would not be met. Several regulators and central banks were approached through a joint association letter requesting a forbearance until 1 September 2017.

In the US, the CFTC issued a no-action letter stating that no enforcement will be taken until 1 September 2017. In the EU, the European Supervisory Authorities did not grant a forbearance. Instead, they encouraged the adoption of a risk-based approach by competent authorities within the member states when applying and enforcing the rules. In the UK, the FCA stated that it expects firms to demonstrate that they have made best efforts in order to achieve full compliance, and that they should be ready to explain how they would achieve compliance in as short a time as practicable. This standard should therefore be noted by fund managers who have not been able to update their OTC derivatives collateral documentation yet.

Fund managers should note that the VM margin requirements apply to EMIR financial counterparties (FC) (including, for example, AIFs with an authorised AIFM and UCITS) and to EMIR non-financial counterparties exceeding the EMIR clearing threshold (NFC+). Additionally, two third country entities (i.e. non-EU entities) which would fall into one of these categories had they been established in the EU may be required to exchange VM when trading with each other if acting through an EU branch or if guaranteed by an FC. When such entities trade with an FC or NFC+, they may be affected by their counterparty’s VM requirements.

Examples of VM margin rules which have an impact on fund managers include:

  • VM must be provided on the same business day that the call for margin is made. This potentially represents an operational challenge for parties, particularly those posting VM across multiple time zones. At present, the industry has interpreted the provision to mean that the posting of VM must be initiated on the same day but this may be subject to further interpretation.
  • VM must be calculated and exchanged by the parties on each business day.  A daily calculation is widely practiced however, where this is not the case, documentation will need to be updated to comply with the new requirement.
  • The minimum transfer amount (MTA) in collateral documentation is limited by the Margin RTS to €500,000. Collateral arrangements which specify a higher MTA will need to be revised.
  • The Margin RTS sets out a number of collateral types that can be posted as margin, in addition to cash collateral. Cash VM is not subject to a haircut, however, non-cash VM is subject to applicable haircuts and to eligibility criteria.
  • Additionally, the Margin RTS introduces collateral management requirements such as the requirement on counterparties to conduct an independent legal review (by a third party or an in-house unit) of exchange of collateral and netting arrangements and annual reviews of the risk management procedures.

MiFID II – New Rules on In-Scope Derivatives Take Effect – 3 January 2018

EMIR defines the categories of derivative which may be subject to the reporting and margin requirements noted above by reference to MiFID.  However, as the European Securities and Markets Authority (ESMA), noted in a letter to the Commission in 2014, the inconsistent implementation of MiFID across the EU has meant that there is no single, commonly accepted definition of ‘derivative’ or ‘derivative contract’, thus preventing the convergent application of EMIR.

The inconsistency is most obviously demonstrated in the context of FX contracts where questions arise as to:

  • the circumstances in which an FX contract is a ‘spot’ or a ‘forward’; and
  • the circumstances in which certain FX forwards will not be treated as derivatives

With the MiFID II reforms (and in particular, the MiFID “Org” Regulation), which enter into force on 3 January 2018, European legislators have sought to clarify the position.

Spot Contracts

Spot contracts are not derivatives for the purposes of MiFID II and are not subject to EMIR margin and reporting requirements (see Article 10(1)(a) of the MiFID Org Regulation).

For these purposes, a spot contract is a contract for the exchange of one currency against another, under the terms of which delivery is scheduled as follows:

Contract relates to: Delivery period
A pair of major currencies Within two trading days
Any pair of currencies where at least one currency is not a major currency Within the longer of: (i) two trading days; or (ii) the period generally accepted in the market for that currency pair as the standard delivery period
Contract for the exchange of those currencies is used for the main purpose of the sale or purchase of a transferable security or a unit in a collective investment undertaking Within the shorter of: (i) the period generally accepted in the market for the settlement of that transferable security or a unit in a collective investment undertaking as the standard delivery period or (ii) five trading days


Accordingly, any trade which settles after the delivery periods noted above will be deemed to be an FX forward and potentially subject to the EMIR margin and reporting requirements.

FX Forwards

Certain FX forward contracts are also excluded from the scope of MiFID II and, thereby, the EMIR margin and reporting requirements.

Broadly, such contracts will be a “means of payment” which is settled physically (although non-physical settlement is permissible by reason of a default or other termination event) and is effected to facilitate payment for goods, services or direct investment (see Article 10(1)(b) of the MiFID Org Regulation). All other FX forwards will be in scope.

In the UK, the FCA will issue amended guidance in its perimeter guidance manual (PERG) to help firms understand the contours of this exclusion.

The reforms to be ushered in by MiFID II in the context of FX contracts represent a significant change in the scope of UK domestic regulation. Previously, the FCA took the view that all FX forwards with a commercial purpose are outside the scope of MiFID and, therefore, of EMIR. However, this position will fundamentally change in the New Year and fund managers should be prepared for it.

Uncorrelated is produced by MJ Hudson’s Hedge Fund team. We advise on all aspects of structuring, launching, and investing in hedge funds across all EU and non EU jurisdictions (including Cayman, Luxembourg, Ireland and US). We will find the ideal structure and jurisdiction for your needs.

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