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Basel Guidance Reinforces the Need to Fully Document FX Transactions

On 15 February 2013, the Basel Committee on Banking Supervision (BCBS), part of the Bank for International Settlements (BIS) published finalised supervisory guidance for managing risk associated with the settlement of foreign exchange (FX) transactions.  The guidance, which replaces similar rules published in September 2000[1], is to be implemented by banks and national supervisors, taking into consideration the size, nature, complexity and risk profile of the bank’s FX activities.  From 2015, the BCBS will begin monitoring progress made on implementation.

The guidance relates to FX transactions that consist of two settlement payment legs, including FX spot transactions, FX forwards, FX swaps, deliverable FX options and currency swaps involving exchange of principal. It does not apply to FX instruments that involve one-way settlement payments, such as non-deliverable forwards, non-deliverable options and contracts for difference.

The paper focuses on the reduction of risks arising from FX settlement through the use of payment-versus-payment arrangements.  However, there is also a discussion of documentation requirements.  The BCBS recommends that, when documenting FX transactions, a bank should use legally enforceable bilateral netting agreements and master netting agreements, such as the ISDA Master Agreement, with all counterparties (where practicable).  This should be supported by legally enforceable collateral arrangements (such as the ISDA Credit Support Annex) which specifically address issues such as collateral eligibility, haircuts, timing and frequency of margin calls, substitution rights, thresholds and valuations.

The guidance recommends that banks should both receive and deliver variation margin in an amount necessary to fully collateralise the mark-to-market exposure on physically settled FX swaps and forwards with counterparties that are financial institutions and systemically important non-financial entities. Variation margin should be exchanged with “sufficient frequency” (taken to mean ‘daily’) and a low minimum transfer amount should be agreed.  All non-cash collateral assets should be “highly liquid”.  Margin exchange is not mandatory for FX transactions executed with sovereigns, central banks, multilateral development banks or the BIS.  The collateralisation of intra-group transactions will be a matter for national legislators.

This guidance is consistent, and should be read in conjunction, with the BCBS/IOSCO margin requirements for non-centrally cleared derivatives (See our previous blogpost on this topic).  In many ways, the BCBS/IOSCO requirements actually further (for example, in requiring the use of thresholds calculated on a consolidated group basis).  Nonetheless, the supervisory guidance relating to the settlement of FX transactions reinforces the fact that firms need to be thinking about:

  • what arrangements (if any) they have in place with counterparties for the documentation of FX transactions;
  • internal policies and guidelines with respect to repapering where documentation gaps have been identified;
  • the resourcing of additional negotiation requirements; and
  • the changes (in terms of eligible collateral, thresholds, call frequency, minimum transfer amounts, two-way postings and applicable interest rates) that may be necessary in order to ensure that existing CSA portfolios become compliant.

[1] Supervisory guidance for managing settlement risk in foreign exchange transactions

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