The ABI s response to the European Commission s Consultation Document on Foreign Exchange Financial Instruments

The ABI s response to the European Commission s Consultation Document on Foreign Exchange Financial Instruments The ABI The UK Insurance Industry The UK insurance industry is the third largest in the world and the largest in Europe. It is a vital part of the UK economy, managing investments amounting to 26% of the UK s total net worth and contributing 10.4 billion in taxes to the Government. Employing over 290,000 people in the UK alone, the insurance industry is also one of this country s major exporters, with 28% of its net premium income coming from overseas business. The ABI The ABI is the voice of insurance, representing the general insurance, protection, investment and long-term savings industry. It was formed in 1985 to represent the whole of the industry and today has over 300 members, accounting for some 90% of premiums in the UK. With some 1,800 billion of funds under management held in a variety of asset classes and UK equity holdings equivalent to almost 20% of the capitalisation of the UK stock market, ABI members represent one of the largest collective bodies of institutional investors in the UK. Introduction The ABI welcomes the opportunity to comment on the European Commission s ( the Commission ) Consultation Document on Foreign Exchange (FX) financial instruments. The definition of FX spot contracts has important implications not only in relation to authorisation requirements under MiFID, but also in relation to the scope of application of other pieces of EU financial regulation, including EMIR, CRD IV and MAR. Our members have a strong interest in ensuring that the regulation of FX activity is implemented on a consistent basis across the EU and, in particular, what types of FX activity should constitute derivative transactions. Member states across the EU have varying definitions of what FX financial instruments constitute a derivative, which in turn has made EMIR scoping and implementation in relation to FX transactions extremely challenging for our members. Given the cross-border nature of the derivatives marketplace, it is frequently unclear which member state s implementation should prevail. Further, there is the risk of regulatory arbitrage across the differing regimes. Overall, we propose an absolute exemption for any FX forwards up to and including T+7, an exemption for FX forwards when they only have the equivalent of T+7 maturity remaining, and an exemption for FX forwards for hedging purposes. For the purpose of determining hedging purposes a representation from the client (as per the NFC clearing obligation) should be sufficient, given it will be difficult for dealers to determine what is or what is not hedging. 1

Our response below is structured in line with the Commission s questionnaire. Question 1: Do you agree that a clarification of the definition of an FX spot contract is necessary? Yes. Providing a clear and simple definition of an FX spot contract will reduce the cost of bilateral negotiation and agreement for, collateral calculations, amongst other issues. As noted in the consultation document, the risks relating to FX spots and FX forwards are quite different and will be managed by market participants through distinct policies and processes. Clarification of the spot definition will enable participants to operate the most efficient and effective risk policies for these trades. This will ensure resources are targeted to the appropriate risks; and authorities can be more certain that regulatory frameworks are fit for purpose. We want to avoid a definition of an FX spot contract that ties this into other transactions and creates operational and system complexities in general, whatever definition is determined by the Commission for an FX spot contract, the remaining FX trades which are deemed to be financial instruments, should be outside the scope of clearing under EMIR, to be consistent with the USA. Physically settled foreign exchange contracts, for which the economic outcome is known with certainty at inception, by their nature do not take the form of a derivative as the parties to the contract are not exposed to fluctuations in the underlying currencies. If the FX forward contract is transacted in order to hedge the currency exposures of the underlying investment holdings or benchmark, any valuation gains or losses on the FX contracts are offset by FX translation gains or losses on the underlying holdings. For this reason, we believe that FX for hedging purposes should be exempt. If these contracts are kept in scope, we recommend a minimum maturity threshold of three to six months. Question 2: What are the main uses for and users of the FX spot market? How does use affect considerations of whether a contract should be considered a financial instrument? The spot market is used by almost all market participants, whether passive or active, as a means of payment. It is extremely rare, outside of liquidity providers, for the spot market to be used for speculative purposes. For example, insurance companies and asset managers use FX spots to invest GBP receipts from policyholders into overseas assets, to convert income and capital on overseas assets into GBP to meet policyholder claims, and to settle invoices raised by third party service providers which are not denominated in GBP. In each case, the objective is to complete the transaction promptly without taking any view on short term movements in FX spot rates. Such transactions are driven by a commercial purpose and not as part of an investment hedging strategy. Day trading activity in FX is a very small part of total trading. The definition of a means of payment should encompass, but not be limited to, paying for / receiving proceeds from investment transactions; financing of and repatriating foreign dividends and income; non-base currency expenses/receipts; net exports and imports; private international/property transactions; possibly holiday and business cash; and other sundry currency requirements. 2

It is important to avoid the risk of discouraging genuine hedging activity (through increased costs or regulatory burden). It makes no sense to bring in additional measures which have the effect of increasing the market s overall systemic risk through increases in the scale of unhedged currency positions. Further, FX trades (whether near dated transactions or otherwise) that are primarily designed to cover known liabilities or expected receipts should not be classed in the same way as a true financial instrument. There is a middle category where the expected receipt or payment is relatively long dated e.g. for dividend hedging. The term element adds an element of uncertainty to the economic outcome, e.g. next year s dividend may be smaller or larger than expected or indeed may not be paid/received at all. However, these transactions are carried out to reduce risk and therefore we believe that these FX spots and forwards should not be described as financial instruments or bear additional regulatory burden. We support the implementation of appropriate regulation for long dated FX forwards (at a term greater than one year). Question 3: What settlement period should be used to delineate between spots contracts? Is it better to use one single cut-off period or apply different periods for different currencies? If so, what should those settlement periods be and for which currencies? A single settlement period should be used for all currencies to delineate between spot and forward FX contracts. We also believe there should be a common threshold applied within the EU. This simple approach will maximise the clarity of understanding of market participants and regulators (for example, assisting in completion of legal agreements, collateral agreements and other practical issues) and minimise inconsistency in reporting under EMIR. A period of T+7 currently covers approximately 85% of all FX transactions. We therefore believe that a common spot definition should be in the form of T+7 business days across all currency pairs. A settlement of 7 business days will take account of spot trades that do go out beyond two days; will accommodate public holidays that do not line up across jurisdictions; and will take into account any need to settle certain FX spot transactions through an intermediate leg (for example, USD). Further, we believe that a single settlement period of 7 days for delineation purposes would not discourage the industry from settling FX spot transactions as promptly as possible, given that this is imperative to minimising counterparty risk. We support the following definitions: FX Spots trades that settle up to and including seven business days. Short dated FX forwards trades that settle beyond seven business days but not greater than one year. Long dated FX forwards trades that settle beyond one year. 3

Question 4: Do you agree that non-deliverable forwards be considered financial instruments regardless of their settlement period? The use of a non-deliverable approach, generally signifies that the forward is being used for financial hedging purposes. As noted in our response to Question 2, it is important to avoid the risk of discouraging genuine hedging activity (through increased costs or regulatory burden). When non-deliverable forwards are being used for financial hedging purposes and have a settlement period of less than a year, they should not be considered as financial instruments. Question 5: What have been the main developments in the FX market since the implementation of MiFID? The development of MiFID has highlighted the importance of best execution and assisted in the development of electronic multi-bank solutions, advanced reporting functionality and the drive for transaction cost analysis (TCA) in FX markets. These, in turn, have increased transparency, reduced costs, and reduced operational risk by allowing greater opportunity for straight through processing (STP) across FX dealing processes. At the same time, the increased use of Continuous Linked Settlement (CLS) and FX netting should reduce the need for a wholesale shift to clearing. There is a risk that the need for central clearing could discourage hedging activity which would have a detrimental effect on overall system risk management. Question 6: What other risks do FX instruments pose and how should this help determine the boundary of a spot contract? The main risks of FX are settlement risk and market risk with the latter being the main contributor to counterparty exposure risk. Operational risk is also relevant, especially with respect to netting agreements and/or collateral management. Collateral management timescales for T+3 trades (Spot +1) are quite tight so setting a longer spot definition (of T+7, as per our response to Question 3, above) would be useful in this regard. Given that settlement risk can be reduced by netting and/or CLS and market risk is quite limited over shorter time periods, it would be possible to improve the operational risk/cost ratio through an extension of the spot boundary. If short-dated FX contracts are classified as non-cleared derivatives, and in due course considered in scope for variation margin, the operation practicalities of implementing margining for short-dated forward FX contracts may post material risks to the effective operation of CLS. Further, collateralisation of short dated FX will not necessarily reduce credit risk. This is because collateral can take T+2 or more to deliver or return after an exposure increase or decrease. Assuming the collateral takes T+2 to deliver, it could mean that a T+4 FX trade is collateralised for 2 days, but then over-collateralised for 2 days, creating credit risk on the collateralised party. In addition, provision of margin collateral is likely to result in funds having to maintain relatively higher levels of cash / near-cash equivalents which results in low returns for investors assets. As noted in our answer to Question 3, FX forwards for T+7 or under should be exempt from the definition of a financial instrument, and this exemption should be extended to FX forwards of greater scheduled duration once there is only 7 or fewer days to settlement. 4

Question 7: Do you think a transition period is necessary for the implementation of harmonised standards? We believe transitional periods are necessary and we would encourage global regulators and lawmakers to work together to provide greater consistency in approach and practice. Publishing an implementation timeline would allow for required changes to systems to be implemented in a timely manner and minimises uncertainty for market participants. A suitable lead time of at least six months should be given, which should also give weight to feedback from the major banks which lead FX spot trading. As our members operate globally, dealing with a variety of separate regulatory regimes brings additional costs and operational risk. It is vital to consolidate the regulatory framework as far as possible as this will strengthen international standards and mitigate the risk of destabilising, cross-border arbitrage opportunities. Question 8: What is the approach to this issue in other jurisdictions outside the EU? Where there are divergent approaches, what problems do these create? In the UK, under Article 84 of the Regulated Activities Order 2001 ( RAO ), if a forward has a settlement period of up to T+7, the UK s Financial Conduct Authority (FCA) will regard it as being done for 'commercial purposes' and it will not be caught by the RAO (and would therefore not be subject to EMIR). There is a question as to whether this commercial purposes test is available under MiFID (as in the UK). There is a commercial purpose test in Article 38 of the MiFID Implementing Regulation; however this is stated to relate to categories (7) and (10) of Annex 1, Section C of MiFID, which appear to relate to commodities only. As noted in the consultation document, there is no clear position across EU Member States as to whether forwards used for commercial purposes are within or outside the scope of the definition of 'financial instruments' under MiFID. Therefore, whether an FX forward constitutes a 'derivative' for the purposes of EMIR could potentially vary between Member States. This creates uncertainty in the application of EMIR to FX forwards. Looking beyond the EU, a key difference is the exemption of FX forwards by the US Department of Treasury. This and the EU differences in regulatory approaches outlined above, add to industry costs through the necessity of multiple operating models for clients in these jurisdictions. We also note our banking counterparts are creating distinctive responses to their own regulatory regimes, which in turn creates additional dealing complexity, costly legal effort and the risk of subsequent reviews and changes as jurisdictions catch up or create scenarios not compatible with current operating models. Question 9: Are there additional implications to those set out above of the delineation of a spot FX contract for these and other applicable legislation? We support the objective to reduce risk in financial markets and to ensure that any changes to definitions and regulation will deliver this objective. However, any additional costs that may arise, either through the need for central clearing, or other regulatory burdens should not unintentionally reduce the incentive for currency hedging to reduce currency risk. 5

Question 10: Are there any additional issues in relation to the definition of FX as financial instruments that should be considered? A list of additional issues that should be considered is outlined below: We support the approach of aligning across Member States, a position along the lines of that reached in the UK, so that: o o FX forwards used for commercial purposes or hedging purposes are outside the scope of the definition of financial instrument under MIFID on a standardised basis and therefore outside the scope of EMIR; and as noted above, not only FX forwards for T+7 or under are exempt from the definition of a financial instrument, but also FX forwards of greater scheduled duration once there is only 7 or fewer days to settlement. Without this exemption of risk-reducing hedging activity, mainstream investment products such as hedged share classes could be impractical to implement. This is because the monies for collateralisation would need to come out of the funds therefore diluting returns for all investors. A hedging exemption would address this. As noted above, the US Department of Treasury has exempted certain FX forwards and swaps from mandatory derivative requirements of the Dodd-Frank Act. It is important there is a global alignment of regulatory guidelines on this issue. For further information contact: Catherine Phillips Policy Adviser, Investment Affairs 020 7216 7319 Catherine.Phillips@abi.org.uk 6