THE DELTA REPORT
On 8 March 2016, the European supervisory authorities (the "ESAs") adopted the long-awaited final draft RTS on margin requirements for non-cleared derivatives (the "Margin Rules"). The Margin Rules constitute the risk mitigation techniques related to the exchange of collateral to cover exposures arising from non-centrally cleared OTC derivatives and are a key block of the EMIR27 regulatory framework. The Margin Rules include a number of helpful changes and clarifications from previous drafts28 although the implementation timeline remains unchanged. The phase-in period will begin on 1 September 2016, after which the largest firms will have to comply with initial margin ("IM") and variation margin ("VM") requirements. Thereafter, until 2020, IM and VM requirements will be phased-in based on the notional volume of market participants' non-cleared derivatives books. Furthermore, concerns remain around settlement timings, the treatment of counterparties in non-netting jurisdictions and segregation requirements.
The Initial Consultations (see footnote 28 below) set out a framework of rules for the exchange of collateral for non-centrally cleared OTC derivatives in Europe. Such framework can be summarised as follows:
(a) all non-cleared, OTC derivatives would be covered except for indirectly cleared transactions, physically settled FX transactions and covered bond swap transactions;
(b) it would be recognised in the rules that intragroup transactions do not raise the same systemic and counterparty risks as transactions with third parties and, therefore, there would be an exemption applicable for such transactions, subject to certain criteria being met;
(c) both FCs and NFC+s29 would be required to comply with the obligations under the rules and this would also apply (a) whether or not the facing entity was established in the European Union ("EU") (assuming it would be subject to the rules were it based in the EU) and (b) to a situation where both entities were established outside of the EU but the transactions would have a direct, substantial and foreseeable effect within the EU or application of the rules was necessary to prevent the evasion of any provision of EMIR;
(d) the rules would include mandated methods of calculating IM (either by way of a standard method or an approved model);
(e) collateral posted subject to the rules would be subject to certain minimum requirements as to eligibility, mandated valuation percentages, FX haircuts and concentration limits;
(f) operational processes would need to be revised to comply with mandated settlement timings, documentation requirements and periodic reviews of legal enforceability of netting and segregation arrangements; and
(g) any IM collected would need to be segregated from proprietary assets and immediately available following a default by the collateral taker.
The Margin Rules have built on this initial framework following extensive consultation between industry groups, market participants and the ESAs. A number of the key concerns raised with the ESAs have been addressed, principally in the areas of eligibility requirements, segregation, the use of cash as collateral and the workings of the key intragroup exemption. This article seeks to summarise these important changes and also highlight the areas in which further clarification is required.
Intragroup Transactions Exemption
The Initial Consultations provided for an exemption for all intra-group transactions, provided that:
(a) the conditions for the clearing exemption had been met;
(b) there was no "practical or legal impediment" to the transfer of funds or repayment of liabilities;
(c) if an entity was not established in the European Union, that it was established in an "equivalent jurisdiction"30; and
(d) a notification/ approval regime was complied with dependent on whether the counterparty was an FC or NFC+.
It was hoped that the ESAs may introduce a general exemption for intragroup transactions from the IM requirements. While this has not been included in the Margin Rules, intragroup trades involving group entities in non-EU jurisdictions are now waived from margin requirements for three years following the relevant effective date.31 This is intended to allow time for the necessary equivalence decisions to be adopted by the ESAs. Likewise, the ESAs have also clarified how the thresholds determining when parties are required to comply with the Margin Rules will operate regarding intragroup transactions by stating that each notional amount need only be accounted for once.32
Calculations and Thresholds
Useful clarifications have been made around when margin is required to be posted. The "Minimum Transfer Amount" provided that where the total margin to be exchanged between the counterparties is equal to or lower than EUR 500,000, no margin (IM or VM) needs to be exchanged. The Margin Rules clarify that separate Minimum Transfer Amounts can be agreed for IM and VM provided that they do not exceed the EUR 500,000 total.33
The calculation of the Threshold Amount34 (which will apply at the end of the phase-in period) has also been amended as follows (a) the aggregate month-end notional amounts shall now be based on those for March, April and May of the previous year (as opposed to June, July and August) and (b) it is confirmed the calculation of the Threshold Amount at group level will include all intragroup non-centrally cleared OTC derivatives (accounted for once).
Treatment of Physically-settled FX Swaps and Forwards and Options
It is confirmed in the Margin Rules that physically settled FX forwards and swaps (including those associated with the exchange of principal of cross-currency swaps) will be excluded from IM requirements. Furthermore, there is a new derogation35 included delaying application of VM requirements to FX forwards (although not swaps) until 31 December 2018 (or earlier in the event separate delegated legislation is brought into force).
The Initial Consultations also left unclear the treatment of derivatives that present credit risk for only one of the two counterparties (i.e. options). It has been clarified that where a netting set consists solely of option positions, the option seller may choose not to collect additional IM or VM for such derivatives, whereas the option buyer should collect both IM and VM as long as the option seller is not exposed to any credit risk.36
Eligibility of Collateral
This section of the Margin Rules contains the most important changes from the Initial Consultations and is an area where the feedback from industry participants has most clearly been adopted.
Avoidance of wrong-way risk ensures that the collateral collected is sufficiently diversified and not subject to the risk that exposure increases with the increased risk of counterparty default. Previously, a range of collateral types from sovereign linked public sector entity debt to equities and corporate bonds were all subject to the requirement that they were not issued by the same posting counterparty (nor issued by entities in the same group) and also that they did not have "close links". This was concerning given "close-links" could mean as little as 20 per cent. common ownership. This requirement has now been removed.37
In the Initial Consultations, concentration limits in relation to the collateral posted were included as applicable to all in-scope counterparties with percentage limits varying from 10 to 50 per cent. (of the collateral collected) depending on the type of collateral posted and the entities posting such collateral38. While it was accepted by industry participants that such limits were workable in the IM context, there were concerns the application of such limits to VM would lead to liquidity issues. The applicability of the concentration limits has now been removed for VM under the Margin Rules.
The method of calculating the concentration limits has also been amended in two key ways. Firstly, the concentration limit applicable to (among other types of collateral) corporate bonds, gold, debt securities issued by regional governments of sovereigns and senior securitisation tranches was previously 10 per cent. and is now 15 per cent39. Secondly, it was thought that the concentration limits may result in required transfers of small amounts of collateral. To avoid non-material transfers, the Margin Rules now include a requirement that the amount of collateral posted must be greater than EUR 10 million before the concentration limits apply.40
Two helpful derogations from the concentration limits have also now been included. Firstly, such limits are required to be assessed on the basis of the standard frequencies for calculating IM41 (e.g. each time a new contract is added or expires in a netting set), which at a minimum would mean every 10 business days. In recognition that compliance at such a frequency may represent a burden on certain organisations, a derogation for pension scheme arrangements42 is included in the Margin Rules, provided that the total amount of collateral collected for such entities is below EUR 800 million.43
Secondly, Article 28(6) of the Margin Rules also provides that any collateral collected that is in the form of an asset class that is the same as the underlying asset class of the OTC derivative (for example, an equity option), the collecting counterparty need not apply the concentration limits. A key reason for including this change arose from market participants noting that risks in certain derivatives (e.g. equity derivatives) are often best mitigated by collateral in the form of the relevant underlying asset. It was thought concentration limits in such instances would increase risk rather than reduce it.
A number of important clarifications have been made to the requirements for FX haircuts applicable to IM and VM, which were previously of major concern to market participants. First, it has been confirmed that for VM, collateral posted in cash will not be subject to any FX haircut and non-cash collateral will only be subject to an FX haircut (of 8 per cent.) if it is posted in a currency that has not been previously agreed between the parties44. The latter requirement can easily be resolved by specifying any currencies the parties wish to exchange in the relevant credit support document.
In respect of FX haircuts applicable to IM, both non-cash and cash collateral that are posted will only be subject to an FX haircut (of 8 per cent.) where the assets posted by a party are in a currency that is different from the "termination currency" applicable to that party.45 The Margin Rules also confirm that each party may have a separate termination currency. These clarifications are a significant improvement on the previous provisions, which were much broader.
Provision has also been made for currencies that may differ, for example, from the termination currency, but are pegged to such currency. Article 29(2) of the Margin Rules provides that counterparties may disregard positions in currencies which are subject to a legally binding intergovernmental agreement to limit the variance between them.
Amendments have also been made in this section regarding the independent legal review that parties are required to undertake of the legal enforceability of netting and segregation arrangements. Previously, this was required to be conducted by an independent organisation on a yearly basis. Noting the administrative and cost burdens of this exercise, it has now been confirmed that such review need only take place on entry into the trade, with policies put in place to ensure ongoing compliance46. The review may be carried out by an internal independent unit as opposed to requiring external organisations to undertake such reviews. Furthermore, there is also a new overlap with CRD IV; Article 32(3) provides that any reviews conducted for the purposes of obtaining the relevant regulatory capital relief under CRD IV shall be recognised for the purposes of compliance with the Margin Rules. However, issues remain in the context of non-netting jurisdictions (see further below).
Important changes have likewise been made regarding the requirement to segregate IM once collected. Most importantly, the de facto ban on using cash collateral for IM has been removed. This effective ban arose from the requirement that cash be protected via segregation from the default or insolvency of the third party holder or custodian (which is not possible as a custodian acts as banker and not trustee). Article 34 now confirms that although the collecting counterparty may not re-hypothecate, re-pledge or re-use collateral collected as IM, this requirement shall be deemed satisfied where a third party holder or custodian reinvests IM received in cash47. However, issues remain with this approach linked to the assessments the counterparty collecting the collateral must make as to the third party holder or custodian's creditworthiness. These requirements are set out in Article 23 of the Margin Rules; (d)(ii) of which requires that they are authorised in accordance with CRD IV. This would imply that the third party holder or custodian not only must be separate from the group of the collecting and posting counterparties, but that they are also established in the EU. Alongside the separate concentration limit applicable to G-SIIs and O-SIIs, these requirements still mean there are difficulties for counterparties seeking to use cash IM.
Practical Considerations and Outstanding Issues
In summary, while a number of helpful changes and clarifications have been made in the Margin Rules, issues remain outstanding with interpretation and their workability. These are likely to be raised with the ESAs prior to final publication by the European Commission (which has three months to review them) but some issues, particularly surrounding settlement timings are likely to remain logistically difficult for market participants.
(a) Article 11. Treatment of Counterparties in non-netting jurisdictions. The Margin Rules have sought to reflect (in part) a request from market participants that there be a blanket exemption from margin requirements when dealing with counterparties in a non-netting jurisdiction, provided that such dealings did not exceed a certain percentage of the relevant counterparty's OTC derivatives portfolio. Article 11(3) provides for this although does include a requirement that no more than 2.5 per cent. of the total notional amounts of OTC derivatives contracts for a counterparty's group are made up of such transactions. However, it is not clear from Article 11 what the difference is between this requirement and that in Article 11(1) which simply states that if netting enforceability comfort cannot be obtained, exchange of IM and VM is not required. It is unclear whether this would mean trading is prohibited, collateral should be collected on a gross basis or trading may take place without collection of margins even if this was potentially possible (despite not being able to obtain the appropriate netting enforceability comfort). This would also seem to contradict the recitals of the Margin Rules which state that collateral should be collected wherever possible. Clarification on the interaction between Article 11(1) and (2) will hopefully be forthcoming to explain this discrepancy.
(b) Settlement Timings for IM and VM. Market participants have repeatedly raised concerns around calculation and settlement timings and had requested that the requirements for both IM and VM reflect the standard settlement cycles in the market (according to asset type). The Margin Rules provide that, for IM, calculation is still required the day after an OTC derivative is entered into or executed, matures, triggers a payment or delivery (other than the posting of margins) and, by way of fallback, where no calculation has been performed in the preceding 10 business days, with collection to follow on the next business day48 and, for VM, that collateral is also collected within 1 business day of calculation (or two if there is no requirement to collect IM)49. To address concerns market participants raised over time-zone differences presenting issues with collateral collection, the concept of a "calculation date" has also been included in Article 1250. This is predicated on where a counterparty is "located". It is unclear what "located" means in this context and it is likely industry groups will need to work to find a common approach, subject to further clarification from the ESAs. Furthermore, notwithstanding the addition of the "calculation date" and clarifications around collection date requirements, the Margin Rules do not fully address the concerns market participants have raised. Should the Margin Rules be published in their current form, it may imply prohibitively increased costs to enable compliance on an ongoing basis.
(c) Segregation of IM cash. As mentioned above, it remains unclear whether third party holders or the custodian holding cash IM need to be based in the EU (i.e. authorised in accordance with CRD IV) and whether there are currently sufficient numbers of suitable organisations in the market (given the third party holder or custodian may also not be part of the same group of either party).
(d) Phase-in timetable. Despite the Margin Rules only being released in final form this month, in September 2016, the largest market participants will be required to begin compliance with both the IM and VM requirements and from March 2017, all counterparties within the scope of the Margin Rules will be required to comply with the VM requirements. Market participants should ensure that their counterparties are made aware of these highly significant changes, particularly those based in third country jurisdictions who may not be aware that such requirements will apply to them by the end of the year. Market participants should also note that The International Swaps and Derivatives Association Inc. ("ISDA") has set up a working group to facilitate the implementation of these rules from a documentation perspective. Release of this documentation and the subsequent adoption of it in the market will be the next major development this year in the implementation of these requirements.
27 Regulation No 648/2012 of the European Parliament and of the Council.
28 Joint Consultation on draft RTS on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP (JC/CP/2014/03), issued by the EBA, EIOPA and ESMA on 14 April 2014 and Second Joint Consultation on draft RTS on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP (EBA/JC/CP/2015/002) (together the "Initial Consultations").
29 Each as defined under EMIR.
30 As defined by reference to the equivalence regime under EMIR.
31 See Article 39(9) of the Margin Rules.
32 See Article 8(1) of the Margin Rules.
33 See Article 4(3) of the Margin Rules.
34 This provides that IM is not required where one of the two counterparties has (or belongs to a group that has) an aggregate-month-end average notional amount of non-centrally cleared OTC derivatives below EUR 8 billion.
35 See Article 39(6) of the Margin Rules.
36 See Recital (6) of the Margin Rules.
37 See Article 27 of the Margin Rules.
38 Two categories of concentration limits are applicable across the various types of eligible collateral depending on the entities posting that collateral. For "Category A" entities (i.e. any entity that is within the scope of the Margin Rules), the concentration limits have limited applicability and do not exceed 10 (now 15) per cent. (except in relation to senior securitisation tranches, equities and certain other types of collateral where the sum of collateral collected may not exceed 40 per cent. of a single issuer). For "Category B" entities (those for where the collateral collected exceeds EUR 1 billion and both counterparties are G-SIIs or O-IIs (as defined by reference to Regulation (EU) No 575/2013 "CRD IV")), additional limits apply to assets such as debt securities issued by central governments and regional governments and debt securities issued by credit institutions where a 50 per cent.(of the total collateral collected) limit has been imposed.
39 See Article 28 of the Margin Rules.
40 See Article 28 of the Margin Rules.
41 See Article 14(3) of the Margin Rules.
42 As defined by reference to Article 2(1) of EMIR.
43 See Article 28(7) of the Margin Rules.
44 See Annex II of the Margin Rules.
45 See Annex II of the Margin Rules.
46 See Articles 32 and 33(5) of the Margin Rules.
47 However, it should be noted that this provision is subject to a separate concentration limit, which provides that G-SII's and O-SII's must ensure that where they collect IM from a counterparty that is also a G-SII or O-SII, not more than 20 per cent. of such IM is held in cash by a single third party custodian (See Article 28(5) of the Margin Rules).
48 See Article 14(5) of the Margin Rules.
49 See Article 13(3) of the Margin Rules.
50 Article 12(2) provides that for the purposes of setting dates for IM and VM calculation, (a) for counterparties located in the same time zone, the calculation shall be based on the netting set existing as of the previous business day and (b) for counterparties not located in the same time zone, the calculation shall be based on the netting set of transactions existing and entered into before 16:00 hours of the previous business day in the time zone where it is first 16:00 hours.
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