The European Market Infrastructure Regulation (EMIR) is targeted at reducing risk in derivative transactions. Forward foreign exchange (FX) transactions and currency swaps fall within its scope and therefore EMIR will have an impact on funds where such hedging tools are used to reduce currency risk.
Investors have access to a wide range of unhedged and hedged funds in the market and depending on their objective or current view will select accordingly. Currency hedging is not new to the market and is widely used by professional investors but EMIR imposes more rigorous requirements. Traditionally passive or active funds with currency exposures, such as global bond funds or those containing equities or other assets denominated in currency other than the fund’s base currency, are hedged using forward contracts or currency swaps.
These typically involve two counterparties agreeing to exchange currencies in a given amount, at an agreed rate, on a value date in the future – perhaps 30, 60 or 90 days hence. Deliverable forwards (DF) are the most commonly used instruments for this purpose. They provide both parties with certainty as to the amount of currency they will receive on the value date. Such transactions have typically been agreed on a bilateral, over-the-counter (OTC) basis. Similar OTC arrangements can be agreed for non-deliverable forwards (NDF), where only the net amount of the trade would be exchanged on the value date.
Impact of EMIREMIR supports the same hedging aims but requires that trades be reported to an authorised trade depository. Such reporting is already implemented. However, FX forward contracts and currency swaps are now becoming subject to collateral requirements.
NDF contracts were impacted as of 1 March 2017. It is likely that the start date for DF collateralisation will be 3 January 2018, to coincide with the implementation of the revised Markets in Financial Instruments Directive (MiFID II), though this has yet to be confirmed.
Collateralising a derivative transaction is designed to provide greater certainty to the counterparties that the (currency) asset will be delivered on the due date. If delivery should fail, the counterparty can have access to the collateral. “Collateral to the value of the unrealised profit or loss on the NDF must be taken,” explains James Binny, head of currency for EMEA at State Street Global Advisors, and this raises the question of what collateral a counterparty – a bank, for example – would find acceptable.
Eligible collateral“EMIR lays out what can be used as collateral,” says James. “A pretty broad list includes equities, bonds and cash. However, counterparties to funds, such as banks, have a much more conservative list of acceptable collateral: essentially, it’s cash and US, UK, German and French government bonds.”
Collateralising a derivative transaction is designed to provide certainty to counterpartiesIf, for example, a global bond fund wants to launch a currency-hedged share class, the fund manager would have to be able to provide collateral for the currency forwards that would be used to hedge out the currency risk. The amount of collateral ready to be transferred must be enough to cover the same day movement in the currency hedged out versus the currency the investment is made in. So, if the fund manager is offering a US Treasury bond fund with a euro base currency, the collateral required would have to be enough to cover movements in euros/US dollars that day. Likewise, a similar fund involving bonds denominated in several currencies would require
a series of hedges back to the euro.
The amount of collateral to be held ready to be transferred would be likely to be 5% of the value of the trade and the bonds in the fund could be held as collateral. Five per cent would be likely to be sufficient to cover any overnight movement between major currencies such as the US dollar, the euro, pound sterling, the yen or the Swiss franc under normal markets.
The collateral is posted with the counterparty and the economic benefit of the bonds remains with the fund, therefore the collateralisation has no impact on the fund’s performance. The same process would be followed each day to cover the intraday currency movements that take place; this is termed providing ‘variation margin’. Of course, depending on which way the exchange rates have moved, the fund could receive, as well as post, collateral.
Non-eligible collateral If, however, the fund is an equity fund – let’s say a FTSE 100 or S&P 500 index tracker – the equities cannot be posted as counterparties do not currently class them as eligible collateral. The way this is addressed is by posting cash. However, to do so means holding cash in the fund or selling holdings to generate the cash. As returns on cash are likely to be lower than on equities, this would result in so-called ‘cash drag’ on the fund. One way of addressing this is to buy a futures contract based upon the index being tracked and this would allow the fund to stay invested but also to generate a cash instrument.
“The further we get from eligible collateral,” says James, “the harder we have to work to deliver a good index tracking return. Fund managers are having to wrestle with this problem as EMIR implementation draws closer.”
ESMA opinionMeanwhile a further regulatory complication for fund managers is contained in an opinion issued in January 2017 by EU regulator the European Securities and Markets Authority (ESMA).
ESMA issued four principles that should govern different share classes within the same fund – funds falling within the scope of Undertakings for Collective Investment in Transferable Securities (UCITS) – that can be sold throughout the single market. They are:
- All share classes within a fund should share the same objective.
- There should be no risk of contagion between different share classes in the same fund if they have differing features or risk profiles.
- All features of a fund should be predetermined before the fund is set up.
- Differences in share classes within a fund should be disclosed to investors.
It is important for investors to understand how the fund manager is coping with these challenges and what steps they’ve taken to ensure non-contagion.
In this context, it is useful to consider the potential effects on unhedged share classes of currency hedging of hedged ones.
Jargon buster
Deliverable forward
Two parties agree to exchange currencies at an agreed rate on an agreed date in the future and both amounts, one in each currency, are paid – or ‘delivered’ – on the value date. Also referred to as a ‘physically settled FX forward’.
Non-deliverable forward
Commonly found in the context of an exchange involving an illiquid (often emerging market) currency where there is a restricted on-shore market in it. Two parties agree to exchange currencies at an agreed date in the future but only a net amount in one currency is paid on the value date.
EMIR (European Market Infrastructure Regulation)
A piece of EU financial services regulation aimed at reducing the risks attached to derivative transactions. It requires that:
– derivatives trades are reported to an authorised trade repository
– derivatives trades above a certain threshold must be cleared
– risks are controlled by periodical reconciliations between counterparties that may involve posting additional collateral.
MiFID (Markets in Financial Instruments Directive)
MiFID II, the second piece of such regulation, is due to take effect on 3 January 2018. It aims to strengthen European financial markets and make trading in financial instruments more transparent, affording greater protection for investors.
First, share classes that are unhedged are exposed to currency risk and may profit or lose from their exposure. Second, the principle of ‘no contagion’, point two of the ESMA opinion, means that the costs of hedging or profits or losses from unhedged share classes must not spill over into other share classes.
A further potential risk to unhedged share classes is that of the exposure of the whole fund to currency derivatives that are taken out at the fund level. However, the principle of non-contagion must apply again. Where investors have concerns that their unhedged share classes could be impacted, they should seek clarification from their fund manager and/or seek a legal opinion on their potential risk position, especially if the fund is a non-UCITS fund not covered by the ESMA opinion.
Investor questionsCurrency hedging reduces currency risk within a fund or portfolio. It is an important aspect of funds where the assets they invest in are denominated in a currency that is different from their base currency.
Investors are unlikely to be experts in currency risk and therefore they should consider asking the following key questions of their investment manager or product provider:
- How is your product or fund provider managing currency hedging? Are they already collateralising under EMIR? If not, when are they planning to?
- How is your product provider managing the collateral? Are they using cash? If so, what is the impact on portfolio performance? Or are they using derivatives and are investors happy with increased derivative risk? Does it fit with the overall ethos of the performance of the portfolio?
- How are they managing the risk of contagion?
- Are the hedging provisions likely to have an impact on performance for the hedged and unhedged share classes? If there is an impact on the return on the fund, an investor might make a different investment decision.
All in all, EMIR and other related regulation has made life more complicated for fund managers who manage currency denominated assets within a fund. However, it should give investors greater security and transparency as to how, and how well, their money is being managed.
This article was originally published in the Q3 2017 print edition of The Review. The print edition is available to all members who opt in to receive it, except student members. All eligible members who would like to receive future editions in the post should log in to MyCISI, click on My Account/Communications and set their preference to 'Yes'.