THE DELTA REPORT
As we reported in our June 2016 issue of the Delta Report, in March 201688 the European supervisory authorities (the "ESAs") adopted a long-awaited draft of the final RTS on margining for non-cleared derivatives (the "Margin Rules") appearing to put Europe on track to meet the implementation schedule set out in the BCBS-IOSCO framework (the "BCBS-IOSCO Framework"), a major G20 initiative. However, shortly after we went to press, the EU Commission informed the market that it would not have completed its review in time for the phase-in commencement date of 1 September 2016. It would now appear that the EU Commission is working towards approval for the end of 2016 with an envisaged phase-in commencement date of March 2017.89 At the same time, the Commodities Futures Trading Commission (the "CFTC") confirmed there would be no delay in the US and the phase-in would go ahead as planned in September 2016. While the delay in Europe has been welcomed by market participants as the industry struggles with the weight of operational changes and updates to existing, standardised legal documentation, the timing differences are likely to present further challenges to derivatives users trading cross-border.
Developments Since the Final Draft RTS
This article intends to provide readers with an overview of the Margin Rules in Europe following our previous article on the updates contained in the Final Draft RTS. However, in a letter from the EU Commission90 in July 2016, it was also confirmed that some further changes from that draft would be proposed including:
(a) a new recital justifying the delay of the phase-in of margin requirements for equity options (essentially to prevent arbitrage as neither the US prudential supervisory nor the CFTC rules cover these products);
(b )addressing the concern we highlighted in our June 2016 issue of the Delta Report that for the purposes of cash IM segregation, a custodian in a non-EU jurisdiction may be used provided such custodian is equivalent to those in the EU who are regulated under the Capital Requirement Directive ("CRD")91 (the Final Draft RTS had appeared to limit participants to using custodians established in the EU);
(c) clarification that the intra-group transaction exemption can be applied for at any time following entry into force of the Margin Rules;
(d) the removal of concentration limits for pension funds (recognising that liabilities to retirees are usually denominated in a single currency meaning such funds would be required to enter into foreign exchange transactions, introducing costs and a new layer of risks to such funds); and
(e) stating that variation margin ("VM") requirements will apply to in-scope physically settled FX forwards from entry into application of the MiFID Delegated Act92 which is intended to clarify MiFID's scope including for FX forwards (which we understand to be 3 January 2018), or, if the relevant delegated act does not apply by then, by 31 December 2018.
Despite the concerns raised by market participants, no changes have yet been suggested to settlement timing for initial margin ("IM") and VM, which for practical purposes continues to be on a T+1 basis. Likewise, no changes have been made to address the treatment of counterparties in non-netting jurisdictions despite some confusion over how these provisions are intended to operate.
The Margin Rules
Who is affected?
Article 11(3) of EMIR93 requires financial counterparties ("FCs") and non-financial counterparties which exceed the clearing thresholds set out in EMIR ("NFC+s") to exchange collateral for uncleared OTC derivatives. Entities in those categories will be required to collect margin from one another, subject to the phase-in thresholds outlined below. The obligation extends to third country entities ("TCEs") that would be FCs or NFC+s were they established in the EU.
Are there any exemptions?
Crucially, the Margin Rules do not apply to non-financial counterparties who are below the clearing threshold ("NFC-s"). The requirement to post and collect IM will only apply to transactions between two FCs or NFC+s that both (or whose groups both) exceed the relevant thresholds during the phase-in period.94 Exemptions also apply for:
(a) hedging in covered bond issues (subject to certain conditions);
(b) intra-group transactions;95
(c) IM transfer threshold and minimum transfer amounts (see further below);
(d) CCPs entering into derivative contracts to hedge the portfolio of an insolvent clearing member;
(e) IM posting for physically settled FX forwards and swaps or for the exchange of principal and interest in currency swaps (note there is no such flexibility for interest rate swaps or other types of derivatives);96
(f) contracts where the premium is paid upfront (although this is only contained in the recitals rather than in substantive provisions of the Margin Rules and will only apply where the portfolio under a netting set consists solely of such contracts); and
(g) as mentioned above, the application of the rules to equity options has been delayed indefinitely to avoid regulatory arbitrage.
Based on the latest comments from the European Commission, the existing timetable is expected to remain in place with the exception being a delay of six months to the first phase-in for IM and VM. The Phase 1 (see below) effective date is envisaged as being February/March 2017. The actual date would be 1 month after entry into force of the Margin Rules (which itself would be 20 days after their publication in the EU's Official Journal).
The "VM for all counterparties" effective date would be the later of 1 March 2017 (so this is aligned with other jurisdictions) or 1 month after entry into force of the Margin Rules. Thus, if the Phase 1 effective date is 1 March 2017 or later (as seems likely), the Phase 1 IM and "VM for all counterparties" requirements should be implemented simultaneously.
- Phase 1 - March 2017
Initial Margin requirements commence where aggregate month-end notional amount exceeds EUR 3 trillion
Variation Margin requirements commence for all counterparties
- Phase 2 - September 2017
Initial Margin requirements where aggregate month-end notional amount exceeds EUR 2.25 trillion
- Phase 3 - September 2018
Initial Margin requirements where aggregate month-end notional amount exceeds EUR 1.5 trillion
- Phase 4 - September 2019
Initial Margin requirements where aggregate month-end notional amount exceeds EUR 0.75 trillion
- Phase 5 -September 2020
Initial Margin requirements where aggregate month-end notional amount exceeds EUR 8 billion
End of phase-in.
How much IM is required?
The IM calculation is designed to cover current and future potential exposure in the interval between the last exchange of margin and (a) the liquidation of positions following the default of a counterparty and (b) the hedging of that exposure (known as the margin period of risk or MOPR). The Margin Rules provide a standardised method for calculating IM which is based on the BCBS-IOSCO Framework standard tables and also allow for an IM model developed with a third party. However, to achieve consistency and limit potential disputes, the industry has been working on a model – "ISDA SIMM" – tailored to meet the one-tailed 99% confidence internal over a 10-day horizon set by regulators on a uniform basis for market participants. The third party approach/industry designed model is more flexible and produces less onerous margin requirements than the standard tables (by some estimates the standard tables would increase the amount of margin posted by a factor of 10 to 15 when compared with ISDA SIMM).97 ISDA SIMM has, however, yet to be approved by regulators.
How often will this need to be collected?
IM must be calculated within 1 business day of certain events including the entry into a new uncleared OTC derivative, the expiry/removal of such a derivative from the netting set, a payment or delivery (excluding margin) and, in any case, with a backstop of every 10 local business days. Any additional IM would then need to be collected within 1 BD of that calculation being made.
If a party to a transaction has (or its group has) an aggregate month end notional below EUR 8 billion (calculated in accordance with the Threshold Calculation Method) as of the end of the phase-in period, the IM requirements will not apply. The Margin Rules also permit the parties to agree that if the IM requirements between them (and their groups) are below EUR 50 million, then IM need not be collected from a counterparty at group level.
The parties also have the option of agreeing to a minimum transfer amount which is subject to a maximum of EUR 500,000 (or its equivalent in another currency, subject to appropriate recalibration to ensure the level of protection is maintained despite currency fluctuations). Parties may specify separate minimum transfer amounts for IM and VM provided the aggregate does not exceed this figure.
The Margin Rules provide that IM must be segregated to protect it from the default or insolvency of the collecting party. As noted in our previous report, 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). The Margin Rules now confirm 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 cash.98 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. The segregation requirements also mandate that IM is available to the posting counterparty in a "timely manner" on a default.
How much VM is required?
VM should reflect the full amount necessary to collateralise the mark-to-market exposure for all non-centrally cleared derivatives in the relevant netting set. Calculating whether that target has been achieved (compared with the collateral already held to cover such exposure) should be done on a daily basis. Where two entities are located in the same time zone, the determination is made as of the previous business day. Where two entities are not located in the same time zone, the determination is made at 4pm as of the previous business day in the earlier time zone.
As mentioned above, the parties can agree to a maximum EUR 500,000 minimum transfer amount to be apportioned between IM and VM. Unlike for IM, there is no threshold for VM so once the minimum transfer amount is exceeded; the full amount will need to be posted.
How often will this need to be collected?
The rules require collection on a T+1 basis. Although there is an option for counterparties to settle VM requirements on a T+2 basis of the calculation in certain circumstances (essentially amounting to a pre-funding of IM), the conditions associated with this option make it rather narrow and onerous meaning market participants are likely, in practice, to be subject to a T+1 deadline.
Restrictions on the type of collateral that may be posted
Eligible Assets (IM and VM)
Assets eligible for use as collateral include cash (or similar, such as money-market deposits), gold, debt securities issued by sovereign and certain public sector entities, equities included on a main index (including related convertibles) and units in UCITS. These classes are subject to certain credit quality and wrong-way risk (i.e. a positive correlation with the creditworthiness of the posting counterparty) tests – see further below. The Margin Rules confirm that IM may be collected in cash as long as it is held in accounts with a Central Bank or a credit institution that is not affiliated with the collateral provider.
Haircuts (IM and VM)
Non-cash collateral is also subject to haircuts, either on the basis of the standardised amounts set out in tables in the Margin Rules or by counterparties own estimates (subject to certain predefined criteria that such estimates must comply with). The standard haircuts range from 0.5% for highly rated sovereign debt to 24% for securitisation positions with a 5 year residual maturity and a rating of between A+ and BBB-.
The standard methodology also includes haircuts of 8% on non-cash collateral posted as VM where it is denominated in a currency other than those agreed in the applicable documents. There is no requirement for any haircut on cash VM but both cash and non-cash IM will be subject to the same 8% haircut where posted in a currency other than the termination currency specified in the trading documentation.
Concentration Limits (IM)
Applying only to IM, these limits restrict the proportion of different categories of collateral in order to reduce risk via what is effectively a diversified portfolio strategy. As highlighted in our June 2016 issue of the Delta Report, the concentration limit rules have been significantly simplified from initial drafts of the Margin Rules. The 10% limit on IM from an individual counterparty constituted by corporate bonds or equities of the same issuer or group has been relaxed to the greater of 15% and EUR 10 million (or its equivalent in another currency) although the limit now also applies to securities issued by investment firms and credit institutions (which were previously omitted).
There remains a limit of 40% (but now subject to a limit of EUR 10 million, or its equivalent in another currency) on, cumulatively, certain (a) equities and convertibles issued by institutions subject to CRR99 (i.e. credit institutions) and (b) securitisation positions, in each case including where those assets are held in UCITS.
Restrictions on certain sovereign debt100 apply more expansively where both counterparties are (a) considered systemically important by regulators (e.g. G-SIIs or O-SIIs) or (b) counterparties for which the total IM to be collected from an individual counterparty exceeds EUR 1 billion. In such a scenario, a 50% single issuer concentration limit applies. G-SIIs and O-SIIs are also subject, in certain circumstances, to requirements to limit the amount of cash IM collected when transacting with each other and, in the case of G-SIIs and O-SISs only, to obligations to diversity cash IM across more than one custodian. As noted above, proposals are currently being agreed to limit the operational burden of compliance with these concentration limits for pension funds.
As a practical matter, one of the key points to address for market participants will be the amendment of existing credit support documentation to bring it into line with the new requirements on eligible collateral, collateral haircuts, timing of calculation and dispute resolution provisions.
The ISDA WGMR has been working to finalise a number of new standard form documents that will comply with the Margin Rules requirements including:
(a) a new English law Credit Support Deed ("CSD") for IM (as it is thought there will be a move away from title transfer arrangements given the level of collateral that will need to be set aside – estimated at EUR 200 billion by the ESAs);101
(b) a new English law Credit Support Annex ("CSA") for VM;
(c) a self-disclosure form that will be available through the recently launched "ISDA AMEND 2.0" (allowing counterparties to determine when they will be required to comply with the margin requirements and make various elections as to what collateral they may provide); and
(d) a Protocol which will update Credit Support Annexes to comply with the requirements in relation to VM.
Market participants should note that although existing transactions are not directly affected by the Margin Rules (in that they are not retrospectively subject to their requirements), where existing collateral documentation is amended and used to collect IM or VM for new OTC derivative transactions, in order that any existing transactions and the new transactions can form a single netting set, existing transactions will be brought within the scope of the rules for both IM and VM purposes, assuming the rules would apply to the relevant counterparties and product types being traded.
A significant improvement in the Final Draft RTS was to address the concern over counterparties located in non-netting jurisdictions.102 A counterparty will not be required to post any VM or IM for OTC derivatives with counterparties domiciled in such jurisdictions but should still be required to collect margin from those counterparties. Further, there will be no requirement for a counterparty to collect or post VM or IM if the OTC derivatives in a counterparties portfolio do not exceed 2.5% of the total from counterparties in non-netting jurisdictions. However, as we highlighted in our June 2016 issue of the Delta Report, the interpretation and application of these provisions remains unclear and further guidance is awaited.
The Final Draft RTS state that they are fully aligned with the standards set out in the BCBS-IOSCO Framework. However, it is clear the devil is very much in the detail of the rules both in Europe, the US and in other key jurisdictions. The substituted compliance/equivalence regimes that have been built into the post-crisis rulebooks were intended to enable market participants to apply comparable foreign rules when trading across borders. This will be particularly important given the CFTC's margin rules could end up applying to a large number of dealers that are also subject to separate overseas requirements http://www.whitecase.com/publications/alert/cftc-issues-final-rules-cross-border-uncleared-swap-margin-requirements?s=margin The implementation delay in Europe means a substituted compliance determination is unlikely in the near future. Taking the Europe/US arrangements as an example, according to ISDA, "it seems likely that trades between two phase-one European banks (including those that are non-US CSEs but don't have a US guarantee and aren't classed as foreign subsidiaries under the CFTC margin rules) will now not be required to meet IM and VM requirements until sometime in 2017, when the EU rules come into force".103 This could create arbitrage opportunities although it will ultimately depend on the status of each entity and the identity of their counterparties.
The industry has been working hard to ready themselves for the entry into force of this final plank of the post-crisis legislation for derivatives and the finish line is in sight. New standardised documentation in the form of title-transfer and security interest annexes/supplements to the ISDA Master Agreement, protocols, disclosure regimes and Euroclear collateral documentation are all either approaching final form or have already been published. The build-out of ISDA Amend 2.0 and ISDA SIMM should ease the operational and logistical burdens that will inevitably fall on market participants. In the US and other key markets, the rules should be going into action from 1 September. However, although in sight, the finish line will only truly be reached when there is more clarification on the Margin Rules themselves in terms of how they will work in practice (particularly on a cross-border basis) and on how they will impact market liquidity where significant bifurcation in European and US trading has already been observed.
88 the "Final Draft RTS"
89EU Collateral Rules Lag U.S. in $493 Trillion Swap Market
91 Directive 2013/36/EU
92MiFID (II) and MiFIR
93 Regulation No 648/2012 of the European Parliament and of the Council.
94 Following the end of the phase-in period, IM will only apply where counterparties have an average total gross notional amount of all uncleared derivatives in excess of EUR 8 billion. This figure (the "Threshold Calculation Method") is calculated across a counterparties group and is as recorded on the last business day of the months of March, April and May of the relevant year.
95 Numerous conditions apply to this carve-out. Broadly, the counterparties must have adequate risk management procedures and there must be "no current or foreseen practical or legal impediment to the prompt transfer of own funds or repayment of liabilities between counterparties".
96 Although there is a carve-out for IM, counterparties are still required to post VM under the Margin Rules. However, as in the EU there is no consistent definition of physically settled FX forwards, the Final Draft RTS provides for a delayed implementation date in respect of such contracts that will be between January 2018 and 31 December 2018.
97 ISDA Quarterly "The ISDA SIMM"
98 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).
99 Regulation 575/2013 of the European Parliament and of the Council.
100 See Article 28 in the Final Draft RTS of the Margin Rules. This refers to central government debt, certain other public sector debt and the debt securities of certain multinational development banks and other international organisations (although the carve-out that other public sector debt must be guaranteed in order to fall within the carve out has been removed).
101 European supervisory authorities, final draft regulatory technical standards on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012, page 93,
102 Jurisdictions in which the legal enforceability of a netting agreement in a third-country cannot at all times be confirmed and/or where the legal review concludes that the effective segregation of IM as per the requirements in the Margin Rules cannot be provided for.
103 ISDA Quarterly "Cross-Border Challenges"
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