How Will EMIR Impact Foreign Exchange
Welcome to part 1 of 4 in our EMIR series. This follows our white paper on the topic EMIR: A Practical Guide
EMIR requires that over-the-counter derivatives (Different to exchange-listed derivatives, an OTC derivative is a private contract between two parties) including interest rate derivatives, credit derivatives, fixed income derivatives, and foreign exchange derivative transactions, including forward contracts, options and swaps, must comply with its regulatory processes. According to ESMA, the EU body overseeing EMIR, regarding the foreign exchange market, “the contracts for which settlement risk is the predominant risk are FX forwards and FX swaps contracts executed on a deliverable basis.”
There are 3 main components to EMIR:
- Reporting to an approved trade repository.
It includes both financial and non-financial entities. Financial entities include banks, building societies and pension funds whereas non-financial entities refer to any businesses that use derivatives under EMIR’s remit, regardless of their sector. Both main parties must comply with the protocol conditions required on each derivative transaction.
EMIR’s main impact on entities trading FX derivatives is the significant costs and time that they will have to spend on implementation and continual compliance with EMIR. Moreover, another considerable hurdle is in understanding what exactly is needed for each type of FX derivative transaction, as there has been much ambiguity in EMIR’s requirements. There is a likelihood that entities will waste resources on essentially figuring out what is required for each FX transaction or if particular transactions are even affected by EMIR at all.
Crucially for many FX derivative users, ESMA has confirmed that spot transactions are to be exempted from EMIR’s remit. Spots are generally seen to be trades settled within two days of the transaction. The Central Bank of Ireland understand that “all FX transactions with settlement beyond the spot date are to be considered Forward contracts and therefore fall within the definition of a derivative as provided for under EMIR and will be subject to the reporting obligation.” The spot date is the day when a transaction is settled; when all funds involved in a transaction are transferred.
FX swaps and forward derivatives
Swaps must go through the EMIR mandatory reporting stage. A swap is a contract between two parties, where an agreement for a series of specified future cash exchanges, or cash “swaps”, on specified dates is agreed. There is still, however, considerable confusion over forward contracts. A forward contract is where two parties agree to a future trade of an asset at an agreed price to be transacted on a future date. The main difference between a swap and a forward is that a forward is one transaction on one agreed future date, whereas a swap is a sequence of agreed transactions on various agreed future dates. Forwards must comply with the EMIR reporting obligation as confirmed by ESMA. Though it is likely that a settlement that takes longer than T+2 is to be considered an FX forward, this is yet to be clarified. On February 14, 2014, ESMA sent a letter to the European Commission asking for clarification on the definition of a forward contract, and in particular, on FX forward contracts. Therefore, the definition of an FX forward contract may change for EMIR once the European Commission answer is published.
UK and EU conflict status over EMIR FX forwards
In the UK, due to a loophole as to how the national regulator, the Financial Conduct Authority, interprets the EU definition of “derivative”, there has been some uncertainty that foreign exchange forwards would be exempt from EMIR in the UK. However, it is expected by many industry figures that the UK will eventually relent and follow suit. Nevertheless, the dispute remains to be resolved. As the EU class FX forwards as a “predominant risk” it is unlikely that they will back down.
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