1 | Introduction
The foreign exchange (FX) market is one of the largest financial markets in the world. Transactions in FX are performed to fulfil a number of functions including as a means of payment in the real economy for goods or services, hedging foreign currency risk for financial assets or commercial contracts or investment or speculation in foreign currency. A variety of financial instruments are used to perform FX transactions such as swaps, options, forwards and spots.
The regulation of FX markets has come onto the regulatory radar this summer at both an EU and UK level. In this briefing we provide an update of the key issues that have come to light.
2 | The relevant articles
Article 2(5) of the European Markets Infrastructure Regulation (EMIR) provides that ‘derivative’ or ‘derivative contract’ means a financial instrument as set out in points (4) to (10) of Section C of Annex I to the Markets in Financial Instruments Directive (MiFID) as implemented by articles 38 and 39 of the MiFID implementing Regulation.
Point (4) of Section C of Annex I to MiFID refers to: “Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash.” The Commission Q&A on MiFID states, at ID 191, that spot FX contracts are not considered to be financial instruments for the purposes of MiFID.
The obligations in Title II of EMIR and the related Commission Delegated Regulations apply to derivatives or over-the-counter (OTC) derivatives. In addition certain requirements for central counterparties only apply to OTC derivative contracts.
3 | The definition problem
The transposition of MiFID has given rise, for certain types of instruments or contracts, to different definitions on what constitutes a financial instrument and what should be classified as a derivative contract. The use of different definitions may lead to an inconsistent application of MiFID, EMIR and potentially other EU legislation that rely on the MIFID definition of financial instruments.
Differences have arisen, in particular in relation to FX forwards, depending on the settlement delivery date (the frontier between an FX spot and an FX derivative). Analysis carried out by the European Securities and Markets Authority (ESMA) has found that it is not controversial that contracts that settle within two trading days are considered spot contracts and that contracts that settle after seven trading days are FX forwards. In some countries contracts that settle up to 7 days are not deemed to be derivatives. For contracts with a settlement date between 3 and 7 trading days there are different laws in some Member States determining whether or not they are a derivative.
4 | ESMA and Commission letters
On February 14, 2014 ESMA sent a letter to Michel Barnier, the EU Commissioner for the Internal Market and Services, drawing attention to the fact that there is no commonly adopted definition of derivative or derivative contract across the EU which, in particular, was preventing convergent application of EMIR. ESMA invited the Commission as a matter of urgency to adopt measures that would clarify the position, in particular in relation to FX forwards and physically settled commodity forwards. The Commission was also asked to clarify:
- the definition of currency derivatives in relation to (i) the frontier between spot and forward; and (ii) their conclusion for commercial purposes; and
- the definition of commodity forwards that can be physically settled.
The Commission responded on February 26, 2014 agreeing that it was essential that there is a fully consistent transposition throughout the EU of the relevant MiFID provisions defining derivatives contracts. In particular the Commission stated that DG MARKT would urgently assess the options for action and provided preliminary views which included:
- the delineation between derivative and spot contracts needed to be clarified. To help with this ESMA was asked to provide the Commission with details of how point (4) of Section C of Annex I to MiFID and the definition of an FX forward had been transposed by Member States. ESMA was also asked to provide details of the commonly accepted delivery period for currencies in Member States and the developments in the FX markets since MiFID’s implementation;
- agreed with the ESMA suggestion that as the notion of “the commercial purpose” of the conclusion of a derivative contract is only foreseen as a criterion for physically settled commodity derivative contracts in point (7) of Section C of Annex I to MIFID, it cannot be introduced for the purposes of point (4) of Section C of Annex I to MiFID; and
- argued that the definition of commodity forwards that can be physically settled was discussed in the MiFID II negotiations and would be the subject of delegated acts. ESMA was asked as part of its work in advising the Commission on the MiFID II implementing measures to assess the status of physically settled commodity forwards and consider issuing guidelines.
5 | Industry associations letter
After the Commission’s letter to ESMA four industry associations (the GFMA, AFME, ASIFMA and SIFMA) published a joint letter asking that the Commission also consider FX security conversions.
The industry associations argued that an FX transaction that is entered into solely to effect the purchase or sale of a foreign security (commonly referred to as FX security conversions) is a bona fide spot transaction in situations where the settlement period is greater than two days. The industry associations asked the Commission and national competent authorities in Member States to confirm that FX security conversions are not financial instruments under Section C4 of Annex I of MiFID. The Commission has so far not responded.
Interestingly, the industry associations’ letter noted that regulatory authorities in the US and Canada have previously defined transactions used solely to fund the purchase or sale of a foreign security where the settlement period is greater than T+2 days as a spot transaction and therefore outside the scope of derivatives regulation within those jurisdictions.
6 | The Commission consultation
On April 10, 2014 the Commission published a fairly short consultation on FX financial instruments. The deadline for comments on the consultation was May 9, 2014. The consultation covered a variety of issues including the key themes of settlement and delivery, FX risks and regulatory implications of classifying an FX contract as a financial instrument.
Noticeably the Commission mentioned that the means of settlement may differ. For a spot or ‘outright’ forward, the Commission noted that settlement is by way of exchange of the relevant currencies but for non-deliverable forwards there is in fact no physical settlement but instead, based on the price movement of two currencies, a net cash settlement is made by one party to the other. This netting process may mean that they cannot be used for payment. One of the questions asked by the Commission was whether non-deliverable forwards should be considered as financial instruments regardless of their settlement period?
7 | The legislative route to change
Once the Commission has decided on what changes it will make the question arises how these will be implemented particularly as MiFID II will not be applicable in Member States until the beginning of 2017. However, article 4(2) of MiFID allows the Commission to issue implementing Regulations to clarify definitions in order to take into account developments on financial markets, and to ensure the uniform application of MiFID. The procedure which is further set out in article 64 of MiFID and Council Decision 1999/468/EC provides for a three month review period (by the European Parliament and the Council) of any proposed changes although this can be reduced in exceptional circumstances.
8 | Market manipulation
Allegations of manipulation in the FX markets have been widely reported with some in the industry stating that it is painfully reminiscent of the early days of the Libor scandal in 2012. In October 2013 the Swiss regulator, Finma, announced that it was investigating FX market manipulation but this was quickly followed by the FCA and other regulators. The investigations are expected to continue for some time as the regulators have to sift through thousands of emails, records and taped phone calls. It has been reported in the media that the FCA does not expect to reach its final conclusions until next year at the earliest.
However, the Government is not standing still. In his Mansion House speech of June 12, 2014 the Chancellor, George Osborne MP, stated that HM Treasury, the Bank of England (BoE) and the FCA will be conducting a “comprehensive” review of standards in the fixed income, currency and commodity markets. The review will publish a report next year. In the meantime the Government will also be extending the new powers that it put into place to regulate Libor to cover further benchmarks across FX, commodity and fixed income markets. A full list of benchmarks will be consulted on this autumn with the new regime in place by the end of the year.
9 | Bank of England review of market manipulation
On March 5, 2014 the BoE issued a press release concerning an internal review into allegations that its officials condoned or were informed of manipulation in the FX markets or the sharing of confidential client information.
The BoE stated that its review had found no evidence that its staff had colluded in any way in manipulating the FX market or in sharing confidential client information. However, whilst stating that it requires its staff to follow rigorous internal control processes the BoE had in fact suspended a member of staff, pending further investigation into compliance with those processes.
The BoE also stated that the Oversight Committee of its Court of Directors would lead an investigation to assess whether any of its officials were:
- either: (i) involved in attempted or actual manipulation of the FX market (including the WMR FX benchmark); or (ii) aware of attempted or actual manipulation of the foreign exchange market; or (iii) aware of the potential for such manipulation; or (iv) colluded with mark participants in relation to any such manipulation or aware of any such collusion between participants;
- either: (i) involved in the sharing of confidential client information; or (ii) aware of the sharing of such information between participants for the purposes of transacting business in the foreign exchange market; or
- involved in, or aware of, any other unlawful or improper behaviour or practices in the foreign exchange market.
The results of this review are so far not public.
10 | Renminbi
Finally, it is also worth noting that in the Mansion House speech the Chancellor also mentioned that two thirds of all Renminbi payments outside of China and Hong Kong now take place in London. Chinese bonds are also being issued in London and a Chinese clearing bank has also recently been appointed here.