9 May 2014
1 To: Unit G3 – Securities Markets
DG Internal Market and Services European Commission
Via e-mail to MARKT-G3@ec.europa.eu
Re: Consultation Document – FX Financial Instruments
Dear Sir, Dear Madam,
The undersigned represent global asset management firms assets on behalf of savers around the world. Our clients range from retail savers to institutional investors such as governments and pension funds.
FX instruments play an important part in achieving and protecting our clients’ investment objectives, in particular as tools for the hedging against currency risks. A harmonised definition of FX financial instruments is key as it would provide needed clarity around the scope and applicability of the new European derivatives rules and more generally given the importance of FX financial instruments for the well-functioning of financial markets and for the broader economy. We therefore welcome the opportunity to comment on this important initiative.
Please find below our responses to the questions raised in the consultation document.
Question 1: Do you agree that a clarification of the definition of an FX spot contract is necessary?
Yes. We strongly support clarification of the definition of FX spot contracts as it will provide necessary guidance for firms and end-users to determine their regulatory requirements and obligations. The definition affects existing requirements under EMIR such as trade reporting, and may also affect other EMIR obligations in the future. In addition, clarification will facilitate consistency in the EU, and will be a welcome step towards global harmonization of derivatives regulation.
We also refer to page 6 of the ESMA 2014 work program where convergence is mentioned as one of ESMA’s key objective. In this regard, ESMA’s objective is also to enhance its international engagement with non-EU regulators and supervisors to further improve the international consistency of regulation and effective co-operation between EU and non-EU supervisors.
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 buy-side market participants, whether passive or active, as a means of payment for securities and other investments. It is extremely rare, outside of banks and other liquidity providers, for the spot market to be used for speculative purposes.
In our view, the use of FX instruments should be a key criterion in considering the definition of financial instruments. However, as noted in our response to question 3, this should be done
2 in a manner which does not impose an unmanageable operational and technological burden on market participants. One example is so-called securities conversion FX transactions. As set out in our response to question 3, we are of the view that given the purpose of these transactions, they should be treated as spot FX transactions.
Forward FX transactions executed for the purpose of hedging the FX risk of the securities denominated in a foreign currency are simply the forward leg of such a FX spot security conversion transaction. In these cases, the purpose of entering into FX forwards is to minimize/reduce the currency exchange risk that would otherwise exist in connection with investing in securities denominated in a foreign currency or in receiving amounts in a foreign currency by way of dividend etc. as a result of holding securities. The objective of entering into such FX forward transactions is therefore to reduce currency risk. In most cases, such FX forwards will settle physically.
Moreover, other than in relation to trade reporting, we believe that EMIR regulatory requirements such as central clearing (including collateralization and the provision of margin) as well as risk mitigation techniques should not apply to any FX forward transactions.
Otherwise, we are concerned that, suboptimal risk/ return characteristics and hedging levels will result.
We note that this approach is consistent with the intent and text of EMIR. The specific nature of FX transactions and the need to treat them differently has explicitly been recognized in recital 19 of EMIR:
“(19) In determining which classes of OTC derivative contracts are to be subject to the clearing obligation, due account should be taken of the specific nature of the relevant classes of OTC derivative contracts. The predominant risk for transactions in some classes of OTC derivative contracts may relate to settlement risk, which is addressed through separate infrastructure arrangements, and may distinguish certain classes of OTC derivative contracts (such as foreign exchange) from other classes. CCP clearing specifically addresses counterparty credit risk, and may not be the optimal solution for dealing with settlement risk. The regime for such contracts should rely, in particular, on preliminary international convergence and mutual recognition of the relevant infrastructure.” [Emphasis added.]
This was also recognized by the US Department of the Treasury when taking the decision to exempt FX forwards from the clearing and execution obligations under the Dodd–Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). We encourage the Commission to specifically consider the treatment of these transactions when finalizing the definition of FX financial instruments and to ensure international consistency in the regulation of these transactions to avoid market fragmentation and regulatory arbitrage.
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 cut-off period of T+7 should be used to delineate between spot and forward contracts. Applying different periods across currencies will give rise to uncertainty and would be problematic to implement and track for many market participants. This would increase
3 disparities and errors (reducing the effectiveness of trade reporting information for longer dated transactions).
Setting a single cut-off at this level ensures that security conversion transactions are treated as spot FX trades without imposing operationally burdensome requirements which will be difficult, if not impossible, for market participants to achieve.
In line with the letter sent by the Global FX Division of the GFMA to the Commission and to ESMA on 25 March 2014, as well as the approach taken in US, we would urge the Commission to ensure security conversion trades are not considered financial instruments.
These are typically very short dated trades aimed at reducing risk under one of the following categories:
1. FX trades related to the settlement of a securities transaction, i.e. the purchase, sale or exchange of a foreign currency between two parties for the sole purpose of effecting a purchase or sale of a security in a particular currency; and
2. FX trades related to the conversion of amounts received by the holder(s) of securities by way of dividends, coupons or other corporate actions such as rights offerings and class action settlements, from the currency in which they are originally paid into another currency required by such holder(s).
These FX transactions are an integral part of the settlement process. Typically, the settlement cycle for most non-EUR denominated securities is T+3. Accordingly, the counterparties would generally enter into an FX transaction on a T+3 basis as well. In some securities markets, for example in South Africa, the settlement cycle however can take up to seven days.
More importantly, as mentioned above, these transactions are effected for the sole purpose of reducing the currency exchange risk that would otherwise exist in connection with investing in securities denominated in a foreign currency or in receiving amounts in a foreign currency by way of dividend etc. as a result of holding securities. By definition, they are not entered into, and cannot be entered into, for speculative purposes in order to profit from changes in FX rates and they are not intended in any way to be derivatives, and subjecting them to EMIR requirements such as reporting would be misleading. Also, we believe that to subject these transactions to the requirements of EMIR would expose parties trading in securities to unnecessary credit and other risks in respect of such transactions, and would not provide meaningful protection to such parties.
Although the vast majority of short dated FX trades are security conversion transactions, in practice, it would be extremely difficult to validate this on a trade by trade basis. A single FX conversion trade could relate to the settlement of multiple security transactions, could involve some degree of rounding up or down and could take into account existing cash balances which will result in an inexact and unclear matching process. Additionally most market participants systems will not currently support a link between an FX transaction and an underlying security transaction / dividend payment, making verification for both the buy and sell side financially and operationally burdensome.
Setting a single cut-off at T+7 would also accommodate public holidays and the need to settle certain FX spot transactions through an intermediate leg (normally USD).
4 It is extremely rare for FX trades of T+7 or less to be used for anything other than as a means of payment (function 1 under section III of the consultation) outside of liquidity providers. As such, we believe this represents the best and most practical method to delineate between spot and forward transactions without creating uncertainty or reducing the effectiveness of regulatory oversight.
Question 4: Do you agree that non-deliverable forwards be considered financial instruments regardless of their settlement period?
No. Given the global nature of the non-deliverable forwards (“NDFs”) market, we generally recommend ensuring international consistency in the regulatory treatment of these transactions to achieve a harmonized regulatory approach and to avoid fragmentation of the global FX market as well as regulatory arbitrage. In the US, an exemption was granted to FX forwards so that they are not regulated as swaps, but this exemption was not extended to FX NDFs. Notwithstanding our general desire for international coordination, this in our view is unfortunate as there are no compelling reasons for a discrepancy of treatment of FX NDFs and other FX forwards given how functionally similar NDFs and other forwards are. We therefore believe that FX NDFs should benefit from the same exemption as FX forwards.
Should however the decision be taken to subject NDFs to regulatory requirements such as mandatory central clearing, a transition period should be granted to avoid any disruption in markets and the use of these instruments.
In the context of NDFs, we would also ask you to confirm that multiple deliverable forward FX transactions that settle on a net basis so that only a net payment may be delivered are not treated as non-deliverable forward transactions, also consistent with the US regulatory interpretation.
Question 5: What have been the main developments in the FX market since the implementation of MiFID?
Market developments following the Markets in Financial Instruments Directive (“MiFID”) have highlighted the importance of best execution and assisted in the development of electronic multi-bank solutions, advanced reporting functionality and transaction cost analysis (“TCA”) in FX markets. These, in turn, have increased transparency, and reduced costs and 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.
On the other hand, there is certainly a risk that a clearing requirement could discourage hedging activity which would have a detrimental effect on overall risk management.
Question 6: What other risks do FX instruments pose and how should this help determine the boundary of a spot contract?
We are not aware of any other relevant risks and, in any case, do not believe this will assist in determining the boundary between spot and forward contracts. The key risk in FX markets is settlement risk which has been successfully addressed by the introduction of the Continuous
5 Linked Settlement (“CLS”) in 2002 which provides settlement services to its members in the FX markets.
Furthermore, it is important to emphasize that FX instruments, and FX forwards in particular, are used by market participants to hedge against currency risks. We believe their use is therefore in the best interest of end-investors.
Question 7: Do you think a transition period is necessary for the implementation of harmonised standards?
Yes. Independent of the final definition of FX financial instruments, we agree that a transition period will be required as any changes to the current definition will lead to changes in current business practices and are likely to require new systems builds, changes in documentation and reporting, etc. In addition, FX markets are global in nature. By allowing for a transition period, market distortions will be avoided and will also provide for sufficient time to make relevant changes to national regulatory regimes necessary to reflect the harmonized definition.
Lastly, in light of the significant number of regulatory changes in response to the financial crisis, the harmonized definition of FX instruments needs to be closely coordinated with the implementation of new regulatory initiatives such as the review of MiFID, and the Central Securities Depositories Regulation.
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?
Most importantly, in the US, the US Department of the Treasury on 16 November 2012 took the decision to exempt FX forwards from central clearing and electronic execution, as provided for in the Dodd–Frank Act. In addition, as mentioned in our response to Question 3, the US CFTC and SEC have determined that security conversion transactions should be treated as spot FX transactions and hence exempt from the relevant regulatory requirements.
Given the global nature of the FX market, divergence in the treatment of FX transactions has to be avoided as it would lead to the fragmentation of the market. Furthermore, divergent regulatory regimes would result in complexity, increased operational risk in managing to inconsistent definitions and possible regulatory arbitrage, especially as this applies to pre- trade, execution methods, post-trade, clearing, confirmation and reporting, as well as other legislation that relies on the definition of financial instruments.
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?
There is a risk of unintended consequences if the harmonized definition of FX financial instruments is not carefully calibrated. Such consequences could include that certain FX transactions could be in scope for the planned EU11 Financial Transaction Tax which would make these transactions uneconomic or that these transactions would be in scope of the margin and collateral requirements under EMIR.
In addition, the potential implications under the Undertakings for Collective Investment in Transferable Securities (“UCITS”) Directive and the Alternative Investment Fund Managers
6 Directive (“AIFMD”) if transactions currently treated as spot would be treated as forward transactions need to be taken into account. UCITS which currently do not invest in financial derivative instruments could find that they are holding instruments considered to be derivatives which the UCITS previously only considered to be spot FX transactions. The UCITS would then need to amend its fund documentation and risk management process documents to capture the use of forwards – this would also mean that the UCITS calculation of its global exposure and OTC counterparty exposure will need to be recalibrated to take these ’derivatives’ into account.
Under the AIFMD, spot FX transactions would need to be considered as part of the commitment calculation and the depositary may need to include this asset class in its ownership verification procedures for ‘other assets’.
Question 10: Are there any additional issues in relation to the definition of FX as financial instruments that should be considered?
In addition to securities conversion FX transactions which, for the reasons stated above, we believe should be treated as spot FX transactions, we would like to encourage the Commission to consider in particular the treatment of physically-settled FX transactions. If such transactions were subject to the full set of EMIR requirements, suboptimal risk/return characteristics and hedging ratios would be the result. We therefore encourage the Commission to consider exempting such transactions from both the clearing obligation and the risk mitigation requirements under EMIR and would welcome the opportunity to discuss this with the Commission in more detail. Moreover, as per our response to Question 4 and for the same reasons just enunciated in relation to deliverable forwards, we further believe that FX NDFs should also be exempt from the clearing and risk mitigation requirements of EMIR.
However, we do support that such transactions (but not, for the avoidance of doubt, securities conversion FX transactions) be reported to trade repositories to ensure that regulators’
objective of having comprehensive overview of activities in the derivatives markets is being achieved. Such treatment of FX forwards would not only ensure consistency with their treatment under US rules but would also align with recital 19 of EMIR emphasizing that a different approach and above-all international consistency will be required.
Allianz Global Investors APG Asset Management BlackRock
Fidelity Worldwide Investment
Shell Asset Management Company B.V.
State Street Global Advisors UBS Global Asset Management