European Margin Rules for Non-cleared OTC Derivatives – The Margin Big Bang
After a six-month delay, the rules governing the mandatory posting of collateral for uncleared derivatives entered into force on 4 January 2017. By 1 March 2017, all in-scope counterparties will be obliged to post variation margin with a phased-in implementation for initial margin from 1 September 2017 through to 1 September 2020. In this issue, we review the amendments made in the final draft and consider how the rules operate extra-territorially (including Brexit which will impact the analysis for UK based entities).
As we reported in our September 2016 issue of the Delta Report, the European Commission (the "EC") has been working towards an early 2017 phase-in commencement in respect of the rules for margining of OTC non-cleared derivatives (the "Margin Rules"). This has left Europe behind schedule as compared with the agreed phase-in timetable set out in the supranational BCBS-IOSCO framework and contrasts with the United States where the phase-in timetable for the rules of the Commodities Futures Trading Commission (the "CFTC") commenced on 1 September 2016 (as did regimes in Canada and Japan). On 4 October 2016, the EC adopted the draft regulatory standards submitted by the European Supervisory Authorities (the "ESAs") (the "Final RTS"). The Final RTS were adopted with several amendments as compared with the draft submitted to the EC by the ESAs (the "ESAs Draft RTS"), (being the draft we commented on in our September issue of the Delta Report). The Final RTS have now been published in the Official Journal of the European Union and entered into force on 4 January 2017. From 4 February 2017, counterparties who each have a group aggregate average notional amount of EUR 3 trillion for non-cleared OTC derivatives will have to begin posting both initial margin ("IM") and variation margin ("VM") (with a phase-in then commencing on such date through to 1 September 2020). From 1 March 2017, there will be a market "big bang" bringing all FC's and NFC+'s within scope of the obligation to post VM in accordance with the Margin Rules. In this edition of the Delta Report, we look to summarise the changes made between the Final RTS and the ESAs Draft RTS, provide a snapshot of which market participants will need to comply with the rules and when and, finally, outline the tools and documentation available to market participants to comply with the new requirements.
The Final RTS and the ESAs Draft RTS
The Final RTS adopted by the EC departed from the ESAs Draft RTS in a number of ways despite the ESAs preparing an opinion in September 2016 arguing against such changes being made. As such, the position is now settled that:
(a) pension funds will be exempt from the "concentration limits" that apply to the posting of IM when the IM posted exceeds EUR 1 billion. The EC's rationale for disapplying the diversification requirements to pension funds was that such funds would resort to using multiple counterparties which generated additional credit and foreign exchange risk for them. It was considered a disproportionate requirement considering the limited impact it would have in reducing systemic risk;
(b) the obligation to collect VM within the same business day has been amended to an obligation to post VM on the same business day. The EC has commented that this change is consistent with the terminology used in the Financial Collateral Directive and has been adopted in recognition of the fact that intra-day posting of margin simply isn't possible for a large number of market participants. It has also been stated by the EC that this clarifies the intention that margin can be deemed to be provided when the posting counterparty instructs their custodian (as opposed to when such margin arrives in the relevant custodial account for posting to their counterparty);
(c) the 2.5% threshold in Article 31(2)(c) that applies where a counterparty faces an entity in a "non-netting" jurisdiction will only apply (a) where it is not possible to collect margin on a gross basis and (b) to contracts entered into after the entry into force of the Final RTS. This is a significant departure from previous drafts of the Margin Rules which subjected all contracts concluded with counterparties in non-netting jurisdictions to the 2.5% limit (irrespective of whether margin could be collected on a gross basis) and appeared to imply that all contracts concluded prior to entry into force of the Final RTS would also be brought within scope;
(d) it is now clear that a counterparty looking to ascertain whether they exceed the threshold to post IM in 2017 will have to "look back" to 2016 (which was unclear in the ESAs Draft RTS);
(e) counterparties who belong to the same group will not have to exchange margin until their application for the exemption (the "Intra-Group Exemption") of such contracts has been decided upon by the relevant competent authorities. The derogation (for both IM and VM) in respect of contracts that could potentially fall within the Intra-Group Exemption had been removed in the previous draft but this has now been restored. The effect of this is to confirm that the obligation to post IM and VM will now apply to such contracts either in accordance with the relevant phase-in timetable (or 1 March 2017 in respect of VM) or 4 July 2017, whichever is the later; and
(f) that counterparties will not be required to exchange collateral with either NFC-s established in the EU or entities that would be NFC-s were they established in the EU (i.e. they are a third country entity that would be below the clearing threshold). This has been clarified in the Final RTS after removal in a prior draft.
Snapshot – The Margin Rules
Who is affected?
Article 11(3) of EMIR requires FCs and 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.
Will the Margin Rules apply to third-country entities ("TCEs")?
Yes. Under Article 11(12) of EMIR, the collateral exchange requirements also apply to OTC derivative contracts entered into between TCEs that would be subject to the requirements of the Margin Rules if they were established in the EU where the contract has a direct, substantial and foreseeable effect within the EU or such obligation is necessary or appropriate to prevent the evasion of any provision of EMIR. The Final RTS will only apply if neither counterparty to an OTC derivative contract is established in a third country whose legal supervisory and enforcement regime has been declared equivalent to EMIR. In any case, there is expected to be pressure from an EU firm on a non-EU counterparty to post margin (even if the Margin Rules do not apply to them) to facilitate such EU firm's own compliance. This is illustrated in the following PDF.
Click here to download the following tables (PDF):
EMIR: Cross-Border – Equivalence
EMIR: Cross-Border – Non-Equivalence
How will Brexit change this analysis for UK firms?
Following a British exit from the EU, UK entities who would be FCs or NFC+s transacting with either EU counterparties (if such counterparties are subject to the Margin Rules) or non-EU counterparties (if both parties are directly subject to the Margin Rules as described above for TCEs) would still be required to comply. If the UK were to become a TCE following a British exit from the EU, an equivalence decision under Article 13 of EMIR would be required in order to prevent counterparties to OTC derivative transactions from having to comply with two sets of rules (which may eventually not be consistent depending on how such legislation subsequently applies in the UK).
How do counterparties calculation margin with third country entities?
Where a counterparty is domiciled in a third country, the rules provide that counterparties may calculate margins for a netting set that includes (a) non-centrally cleared OTC derivatives subject to margin requirements under EMIR and (b) contracts that are both identified as non-centrally cleared OTC derivatives by the regulatory regime applicable to the TCE and subject to margin rules in the regulatory regime applicable to the TCE. The cap mentioned above in relation to counterparties in non-netting jurisdictions that applies where it is not possible to collect margin, even on a gross basis, should also be noted.
Are there any exemptions?
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. Exemptions also apply for:
(a) hedging in covered bond issues (subject to certain conditions);
(b) intra-group transactions;
(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);
(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) the application of the rules to equity options has been delayed indefinitely to avoid regulatory arbitrage.
When will I have to comply?
As mentioned in the introduction, the "Phase 1" effective date is 4 February 2017. The "VM for all counterparties" effective date will be 1 March 2017. The following phase-in will then apply in respect of the IM requirements of the Margin Rules:
Phase 2 September 2017
IM: If aggregate month-end notional amount in March, April and May 2017 is greater than €2.25* trillion
Phase 3 September 2018
IM: If aggregate month-end notional amount in March, April and May 2018 is greater than €1.5* trillion
Phase 4 September 2019
IM: If aggregate month-end notional amount in March, April and May 2019 is greater than €0.75* trillion
Phase 5 September 2020
IM: If aggregate month-end notional amount in March, April and May 2020 is greater than €8* billion.
End of phase-in.
* All thresholds are on a group, consolidated basis
How will I know if the rules apply to me?
The ISDA WGMR has worked to produce the ISDA Regulatory Margin Self-Disclosure Letter (the "SDL") which allows parties entering into trading documentation to identify and classify each counterparty to determine if and when the relevant margin regulations will be applicable to that trading relationship. The SDL will allow market participants to disclose the following information to each other:
(a) General information – e.g. LEI, legal name;
(b) entity status – Under applicable margin rules (e.g. "swap dealer" (CFTC rules) / "NFC+" etc.) and whether any exemptions are available;
(c) cross-border status – Under the applicable margin rules (e.g. "US Person", "Third-country entity (TCE)" etc.);
(d) notional thresholds – Whether relevant notional thresholds have been crossed in a particular year for the purposes of determining when the phase-in will apply to that trading relationship; and
(e) threshold tracking is required to be carried out on a group/ affiliate basis due to the aggregation requirements. Firms will therefore also need to provide information about their group structure (including provision of their ultimate parent's identifier).
The SDL is now available on ISDA Amend providing a central repository of information to determine if, and when, transactions will become subject to regulatory margin requirements.
ISDA 2016 Variation Margin Protocol
Has ISDA published a protocol to assist market participants with compliance?
The ISDA WGMR has also produced the ISDA 2016 Variation Margin Protocol (the "Protocol"). The Protocol provides for three different "methods" for creating new documentation (or amending existing documentation) and allows different versions of each method to be applied depending upon the applicable regime. The Protocol is a "questionnaire style" protocol and requires a party to submit an adherence letter to ISDA and exchange questionnaires to put into effect the substantive protocol terms as between the two adhering parties. Adherence constitutes a binding agreement between the parties to amend the agreements covered by the Protocol.
The Protocol has been designed to cover NY-law CSAs (security interest), English-law CSAs (title transfer) and Japanese law CSAs (all versions) along with both versions of the ISDA Master Agreement and non-ISDA Master Agreement framework agreements that attach an ISDA CSA. It currently covers regulatory regimes in the EU, United States, Switzerland, Canada and Japan.
The three "methods" by which parties may amend their existing credit support documentation to bring it into line with local regulatory requirements are as follows:
(a) Amend Method. Terms in existing CSAs are amended as necessary to comply with the regulatory requirements of the relevant jurisdictions. It requires an existing CSA(s) to be in place. Both legacy trades and new trades are covered under the amended CSA.
(b) Replicate-and-Amend. Little difference to the Amend Method other than the new CSA that is created does not cover legacy trades. For this Method though, the existing CSA remains in place but a second CSA (based on the terms of that existing CSA) is created and then amended to comply with the regulatory requirements of the relevant jurisdictions. It also requires an existing CSA(s) to be in place.
(c) New CSA. Parties enter into a new CSA with standard terms and certain optional terms that are generated through the Questionnaire. This method can also be used to put in place an ISDA where no existing ISDA has been entered into. This is also useful for where parties do not have an existing CSA in place.
Utility of the Protocol
The Protocol has sought to provide a go-to method for counterparties to comply with margin regulations on a cross-border basis. However, the many compromises in the ISDA WGMR over (i) what needed to be a "Condition Precedent" to use of the Protocol; (ii) the scope of the "New CSA" method; and (iii) the scope of the Protocol itself have resulted in a product that may be challenging to implement.
The Protocol nevertheless does provide an administratively efficient method of making the necessary amendments to margining documentation. In the EU, with the rules just having been finalised, it is an effective "back-up" due to the time constraints.
It will likewise be useful for straightforward cash/ non-cash collateral CSAs where the Amend-and-Replicate Method can readily be used and there are limited product types being added to a netting set. Furthermore, for situations where the original CSA is non-bespoke, there is only one CSA under a Master Agreement and there is likely to be agreement over the "Method" to be used between counterparties (e.g. it is acknowledged that legacy transactions will remain under an existing CSA), there are few limitations in using the Protocol.
However, certain drawbacks are clear, namely:
(a) In situations where IM will need to be provided in any case (as there is no Protocol for IM), it is likely that simultaneous bilateral discussions will take place. As such, it may be more efficient to simply agree the documentation outside of the Protocol.
(b) Those adopting the VM Protocol will have to read three documents together (the original document, the exchanged questionnaires and the relevant exhibit) in order to make sense of the commercial agreement.
(c) No final document is produced via Protocol (although ISDA is working on this functionality being available in ISDA Amend).
(d) While 349 market participants have adhered as of the date of publication, it may be the case for some that this is to ensure a fall-back is in place if bilateral do not complete by the deadline.
(e) Parties will have to familiarise themselves not only with collateral documentation but the Protocol operation – such complexity has never been tested via the Protocol method.
(f) The Protocol cannot be used by counterparties with more than one CSA under a Master Agreement.
(g) Where using the Amend/ Amend-and-Replicate Method:
(i) Parties wishing to deviate from the regulatory minimums (e.g. to impose larger haircuts/ credit assessment provisions) are unable to do so.
(ii) The Independent Amount (e.g. where no IM) is automatically set to zero by default if not "matched" correctly.
(h) Where using the New CSA Method:
(i) It is restrictive in terms of what types of collateral can be posted (for example it does not allow asset-backed securities, some of which are permitted under the EU Rules).
(ii) EU counterparties cannot post cash that is not in a "Major Currency".
(iii) The overlay with existing Protocols. Where parties have previously agreed to apply negative interest rate provisions (either directly in their documentation or through adherence to the ISDA 2014 Collateral Negative Interest Protocol) then the "Negative Interest" election within the New CSA created via the Protocol will be applicable.
(iv) Any election of the parties to add additional currencies or sovereign debt securities is only effective if the "Collateral Expansion Condition" is satisfied i.e. if the answers of both parties to the question "Consent to Substitution Required?" are the same.
(v) The underlying ISDA Master Agreement must be considered (e.g. under the "New CSA" Method, the Base Currency will be the Termination Currency under the accompanying master agreement but subject to a raft of conditions including a "Matching" exercise).
New standard form documentation
Assuming use of the Protocol is not practical, 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.
Both standard form VM and IM documentation has been developed by ISDA through the WGMR. The general approach to this new documentation has been to update existing documentation for compliance with global margin rules in key jurisdictions. Given the time constraints, the documentation does, however, remain in similar form to precedents with adjustments only made for the Margin Rules. The new documentation includes:
(a) 2016 New York Law VM CSA and English Law VM CSA (each with recommended provisions for Japanese counterparties);
(b) 2016 New York Law VM CSA and English Law VM CSA with allowance for an Independent Amount (i.e. unregulated IM);
(c) 2016 Japanese law VM CSA;
(d) 2016 New York Law "Phase One" IM CSA (and recommended provisions for Japanese collateral);
(e) 2016 English Law "Phase One" IM CSD;
(f) 2016 Japanese Law "Phase One" IM CSA and Trust Scheme Addendum to the Japanese Law IM CSA;
(g) Euroclear Security Agreement and Collateral Transfer Agreement (and recommended provisions for Japanese collateral); and
(h) Clearstream Security Agreement and Collateral Transfer Agreement.
Will I need to bring existing transactions under my new margin documentation?
The Margin Rules only apply to new contracts entered into after the relevant phase-in dates, although this will catch new transactions under a pre-existing master netting set. Parties may choose to include legacy transactions as "Covered Transactions" all under one VM CSA or run this CSA side-by-side with an existing CSA. This will depend on a counterparty's view of whether it is economic and/or operationally practical to move the transactions over. However, there can be no "cherry-picking" of transactions; it is an all or nothing approach in that once one legacy transaction moves over, all existing transactions move over. As described above, the Protocol provides different optionality for parties in this respect depending on whether counterparties wish to retain their existing collateral documentation terms for legacy transactions or, bring them all under one.
The Margin Rules represent the final plank of the post-crisis regulatory framework for derivatives. Although a number of market participants had existing collateral documentation in place, the mandatory requirements and minimum standards agreed at supranational level in 2011 indicated that this would represent a huge deviation from the then current market practice. With the deadline of 1 March 2017 now under three months away, market participants should carefully examine whether they fall within the scope of the Margin Rules (both in Europe and in other applicable jurisdictions) and ascertain the documentation and/or amendments to existing documentation that will be required for compliance.
THE DELTA REPORT
 Calculated on the basis of (a) the average of total gross notional amount recorded as of the last business day of each testing month then an average of the 3 numbers is taken (b) including all entities that consolidate accounts (c) including all non-centrally cleared OTC derivative contracts of that group (including intra-group but counted only once) and (d) assessed on an annual basis in March, April and May with requirements applied the same year.
 As defined in the Regulation No 648/2012 of the European Parliament and of the Council ("EMIR").
 Such date is also applicable for the purposes of the CFTC in the United States.
 The concentration limits are contained in Article 8(1) Final RTS and provide that certain collateral from a counterparty issued by a single issuer or a single group may not exceed the greater of 15% of the total collateral collected or €10 million. A 40% / €10 million requirement applies to securitisation tranches, convertible debt and equities.
 Article 8(4) Final RTS provides that such entities must still establish procedures to monitor concentration risk with respect to the collateral types set out in (c) to (l) of Article 4(1) and take steps to diversify the pool if necessary.
 Article 12(1) Final RTS.
 Comments by ECON Members on the ESAs' Opinion of 8 September 2016 on the amended draft RTS on risk- mitigation techniques for non-cleared derivatives of 28 July 2016.
 Article 31 Final RTS. It is presently unclear when such situation would arise. This would seem to indicate something over and above not being able to obtain a clean netting and/or collateral opinion (perhaps the entity itself is restricted from posting collateral).
 Article 38(2) Final RTS.
 As defined in EMIR.
 Article 24 Final RTS.
 As defined in EMIR.
 "Direct, substantial and foreseeable effect" means those contracts where at least one of the counterparties benefits from a guarantee provided by an FC where such guarantee exceeds an aggregate notional amount of €8 billion and is at least equal to 5% of the sum of current exposures of the FC established in the EU issuing the guarantee or where the two counterparties contract via their branches in the EU and would qualify as FCs if established in the EU.
 Article 13 of EMIR provides that the EC may adopt "equivalence" decisions which declare that the arrangements of a third country (e.g. in respect of margining) are equivalent to those of the EU.
 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.
 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".
 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. This is because the scope of what constitutes an FX forward is due to be defined in the amended Markets in Financial Instruments Directive and Regulation (MiFID II).
 Recital (5) Final RTS.
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