Starting January 3, 2018, physically settled foreign exchange forward transactions (FX Forwards) will be subject to the variation (but not initial) margin requirements set out in Commission Delegated Regulation (EU) 2016/2251 of October 4, 2016 (EU Margin Regulation) that apply generally to OTC derivatives. FX Forwards are defined in Article 27 of the EU Margin Regulation as “physically settled OTC derivative contracts that solely involve the exchange of two different currencies on a specific future date at a fixed rate agreed on the trade date of the contract covering the exchange.”

The EU Margin Regulation permanently exempted FX Forwards and physically settled foreign-exchange swaps (FX Swaps)1 from initial margin requirements, but provided FX Forwards, but not FX Swaps, a transitional exemption from variation margin requirements. This transitional exemption ends on January 3, 2018, at which time any FX Forward that is not a “spot contract” becomes subject to variation margin if one or both of the parties to the FX Forward is a financial counterparty (FC) or a non-financial counterparty above a clearing threshold (NFC+) established in the EU, or a third country entity that would be an FC or NFC+ (if its counterparty is an actual FC or NFC+). A “spot contract” is defined in paragraph 2 of Article 10 of Commission Delegated Regulation (EU) 2017/565 of April 25, 2016 as follows:

A spot contract . . . shall be a contract for the exchange of one currency against another currency, under the terms of which delivery is scheduled to be made within the longer of the following periods:

(a) 2 trading days in respect of any pair of the major currencies set out in paragraph 32;

(b) for any pair of currencies where at least one currency is not a major currency, the longer of 2 trading days or the period generally accepted in the market for that currency pair as the standard delivery period;

(c) where the 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, 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 5 trading days, whichever is shorter.

To address the issue of “rolling spot,” the definition also specifies that “[a] contract shall not be considered a spot contract where, irrespective of its explicit terms, there is an understanding between the parties to the contract that delivery of the currency is to be postponed and not to be performed within the [prescribed] period.”

The change in the margin status of FX Forwards will complicate the recent effort of the US and the EU to harmonize their rules for derivatives since FX Forwards are not swaps for the purposes of the CFTC’s swap margin regulations. In particular, the EU decision concerning the equivalence of the CFTC’s margin rules contains the caveat that “[t]his Decision should therefore only apply to OTC derivatives that are subject to margins under both the Union law and the CFTC Regulations.”

For parties that use International Swaps and Derivatives credit support annexes that already apply to all transactions between the parties without regard to whether the transactions are technically subject to regulatory margin requirements, FX Forwards subject to the EU Margin Regulations should not create any practical issues. Others will have to make decisions about how they trade FX Forwards. In particular, non-EU entities may want to curtail their FX Forward activity with EU counterparties.

The EU Margin Regulation is available here.

The definition of a “spot contract” is available here.

The EU equivalence decision concerning CFTC margin rules is available here.