FX forwards and regulatory IM

There are multiple discussions about bilateral IM for FX forwards and FX options, specially with category 5 coming into play next September. See for example the recent Risk article Margin rules snare FX options user (subscription required).

Personally, I never understood why deliverable FX spot and FX forward were excluded from the framework, except perhaps that they had better lobbyists. I don't understand the "spirit" behind that rule.

One propose workaround proposed to include some deliverable FX forwards is to use zero collar options to hedge the delta risk, in a way similar to what is done for IR swaps.

There is another method that, to my knowledge, has not been publicly discussed before and which is to my taste nicer. And it does not involve options.

Instead of a physically settled forward, one can trade a pair of forwards with

  • one non-deliverable forward at the same date and rate
  • one physically settled forward, the strike of which is set on the non-deliverable fixing date at the benchmark rate

Both are subject to the IM regulation. The first one because it is non deliverable, the second one because the rate is not agreed on the trade date. The exact wording of the EU regulation (Article 27 (a) ) is

initial margins are not collected with respect to: (a)  physically settled OTC derivative contracts that solely involve the exchange of two different currencies on a specific future date at a fixed rate agreed on the trade date of the contract covering the exchange (‘foreign exchange forwards’);
The cash flows of such transaction are the following:

  • Suppose you want to create a forward transaction with amount x in currency X and amount y in currency Y paid on date t.
  • NDF has Y amount of y and X amount x fixing in u for delivery in t (u is usually t-2). A benchmark rate for exchange from Y to X fixing at u is fx. The actual payment in currency X is x - fx . y
  • A physical delivery swap with strike fx set in u on amount y in currency Y and payment in t. The payment is y in Y and fx.y in X
  • The total cash flows are y in Y and x - fx.y + fx.y = x in X.


Et voila!

Perfect physically settled cash flows, only forwards are used and all of them enter into the IM netting set.

Don't thanks me for that, it is always my pleasure to explain how to fully respect the letter and the spirit of the rules. Even if I confess I don't understand the spirit of this rule.

In dubio contra fiscum.

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