LONDON, Sept 14 (Reuters) - New European Union regulations on foreign exchange trading will make it harder and more expensive to manage currency risk, traders said, especially for large financial counterparties such as hedge funds and insurance companies.
The regulations will impose “variation margins” on banks, companies and funds that use currency forwards and other derivatives to hedge exposure to currency swings. That means they will need to put up cash to back their trades every day.
Market participants say the rules will make it harder for investors to invest in financial markets, because they will have to set aside a greater chunk of their capital.
“The whole European regulation on the increased collateral requirements for currency forwards is a shock to the system, and the impact of this will be particularly felt by the investor community at large,” said James Binny, head of currencies at EMEA at State Street in London.
Others say that’s the point: the rules will curtail the kind of reckless trading that culminated in the global financial crisis in 2008 by ensuring some these large players meet daily requirements to track swings in foreign exchange.
“The idea behind this is to prevent the next Lehman Brothers and AIGs of the world,” said Phung Pham at Baker & McKenzie’s London derivatives practice, referring to the two giant U.S. financial firms who were trapped in the 2008 crisis.
The regulations take effect in January 2018, and counterparties will have to get the necessary documentation in place by then. They will also need to exchange margins on a daily basis and calculate the hedges they need in real time, a tough job for users who have been used to doing this over several days or even weeks.
Consequently, traders say, they will not be able to fully exploit market opportunities, posing a fresh challenge when they are already battling outflows. Some industry participants say the new rules will make European cities less attractive as currency-trading hubs.
Rules in the United States are much looser. Physically deliverable foreign exchange forwards and foreign exchange swaps are not subject to variation margin under the Dodd-Frank reform of Wall Street, according to a briefing note by law firm Macfarlanes LLP.
For analysts scratching their head on what the broad market impact will be, separate EU requirements for non-deliverable currency forwards (NDFs) that came into effect earlier this year offer some clues.
A global chief operating officer for currencies at a European bank in London said a large chunk of non-deliverable forward transactions are now settled on currency exchanges amid a broader decline in trading volumes.
Unlike cash or spot transactions, forwards and other derivatives require a higher capital charge because they are settled at future dates. Investment banks generally offer clients a few days to provide extra capital if currency markets go against them. The new regulations eliminate that cushion.
“On a single transaction, the capital is small, but it all adds up, and that limits the firepower available for funds to invest in markets,” said a trader at a hedge fund.
SSGA’s Binny said about 35 people were working around the clock in his team to meet the new requirements before the deadline.
The rules are set to strengthen risk-management practices at large hedge funds and pension companies. They take a trading view of markets each day, so they are intensive users of derivatives, compared with companies who can show their use is linked to hedging requirements.
Even though Britain has voted to leave the EU, law firms say it will adopt the new rules when they go into force next year. Depending on how Brexit negotiations turn out, policymakers may tweak rules in the coming years.
That matters, because London is the world’s biggest foreign exchange centre, trading more than $2.4 trillion each day. Cash transactions make up a third of that; the rest are derivatives.
Trading in currency forwards and derivatives has grown exponentially in recent years. Companies are buying them to guard against sharp swings in currency markets, such as last October’s sterling flash crash or the euro’s 14 percent surge against the dollar this year.
The greater capital requirements may lead some small companies not to hedge their currency exposure at all.
“For a lot of small companies, moving into a world where they have to collateralize foreign exchange risk, this is a huge step. It is expensive in terms of technology, internal reporting or compliance and so on,” said David Clark, chairman of the Wholesale Markets Brokers’ Association, an industry body.
“The worst thing is people would end up saying `I won’t cover my risk.’ ”
Some analysts say the new regulations will drive foreign institutions out of London, leading them to route their trades through other centres such as New York or even Singapore, which are mounting a charm offensive to capture more market share
“Large banks will gravitate towards centres where there are not onerous requirements for posting collateral,” said Nick Bradbury, partner at Allen & Overy in London. (Additional reporting by Huw Jones; Reporting by Saikat Chatterjee; Editing by Larry King)