Article 11 of EMIR requires in scope entities (including UCITS and AIFs) entering into non-centrally cleared OTC derivative contracts to put in place procedures and arrangements to measure, monitor and mitigate associated operational and counterparty credit risks.

Specifically, such entities must:

  1. Obtain timely electronic confirmations of the terms of OTC derivative contracts
  2. Put in place a formal risk management process for such OTC derivative contracts
  3. Have an agreed dispute resolution process with counterparties
  4. Value all OTC derivative contracts daily on a mark-to-market basis (unless market conditions require marking to model)
  5. Exchange collateral to cover exposures (i.e. receive and post initial* and variation margin).

*Physically settled forward foreign exchange contracts ("FX Forwards") have been specifically exempt from initial margin requirements pursuant to an express derogation in the Commission Delegated Regulation (EU) 2016/2251.

These obligations are being introduced on a phased basis and are scheduled to apply to FX Forwards from 3 January 2018.

Industry has been increasingly concerned with the implications of introducing variation margin requirements for FX Forwards. In a funds context, this was particularly the case for hedged share classes (where the class typically does not represent a separate pool of assets, thus presenting distinct operational and risk challenges for the posting of collateral).

On 3 October 2017, EFAMA issued a letter to the European authorities highlighting its concerns around the requirement for funds to post variation margin for FX Forwards. The letter requested a deferral of the introduction of these requirements and a reconsideration of their scope.

On 15 November 2017, an updated version of a proposed EMIR Amending Regulation was published by the Council of the European Union (available here). It proposes to amend Article 11 of EMIR so as to confine the requirement to exchange variation margin on FX Forwards to transactions concluded between EU authorised credit institutions. If this progresses, UCITS and AIFs using FX Forwards will not be required to exchange variation margin (or initial margin). However, the risk mitigation measures listed at 1 to 4 above will still apply.

In terms of timing, it is very unlikely that the EMIR Amending Regulation will come into effect prior to 3 January 2018 – it still needs to be finalised and will then only come into effect 20 days after it is published in the EU's Official Journal. It will therefore remain a legal obligation to exchange variation margin from this date. However, ESMA and national competent authorities could potentially follow an EMIR based precedent and apply a "risk-based approach" to the supervision of the adequacy of processes adopted by entities.

We will need to track how any such regulatory flexibility develops in order to assess whether funds may have the option to simply disregard the obligation to exchange variation margin on Day 1 or whether compliance will still be required pending the EMIR Amending Regulation being finalised and entering into force.