On October 19, 2015, the Office of the Superintendent of Financial Institutions (OSFI) published for public consultation a draft of Guideline E-22 — Margin Requirements for Non-Centrally Cleared Derivatives. The purpose of the draft Guideline is to provide clear and comprehensive guidance to all federally-regulated financial institutions1 (FRFIs) on the variation and initial margin requirements that will take effect starting September 1, 2016. As presently drafted, the draft Guideline requires the exchange of margin to secure the performance of non-centrally cleared derivatives (NCCD) transactions, which are derivative transactions that are not cleared through a central counterparty, between Covered Entities (as defined in the draft Guideline). The draft Guideline is available.
As recognized by OSFI in its Guideline Impact Analysis Statement, NCCDs contribute significantly to systemic risk in the financial sector. By requiring that collateral be available to offset losses caused by the default of a derivatives counterparty, margin can mitigate this systemic risk and offer heightened protection against counterparty credit risk. In addition, OSFI expects that implementing margin requirements will promote central clearing of derivatives where practicable.
Parallel U.S. Action
Coincidentally, following closely after the publication of the draft Guideline, on October 22, 2015, the major U.S. prudential bank regulatory agencies approved a joint final rule under Title VII of the Dodd-Frank Act. Like the draft Guideline, this final rule addresses minimum requirements for the exchange of initial margin and variation margin collateral between banks and their counterparties in connection with NCCDs. This final rule is available. The focus of this alert, however, is on the Canadian requirements as set forth in the draft Guideline.
In September 2013, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) released an initial draft of a framework setting out the minimum standards for margin requirements for NCCDs. Canada, as a member of BCBS, participated in the development of this framework. Revised in March 2015, this framework now requires the mandatory exchange of initial and variation margin for NCCDs beginning on September 1, 2016.
The draft Guideline is based on the BCBS/IOSCO framework. According to OSFI, the draft Guideline is both consistent with the provisions of the BCBS/IOSCO framework, and supports the BCBS' financial stability objectives, while “giving due recognition to the constraints imposed by Canada's place in the global market.” Given the cross-border nature of the derivatives market, OSFI notes that the draft Guideline may also support “equivalency or comparability assessments of Canadian derivatives regulatory requirements by other jurisdictions.”
Who is Covered?
The Guideline applies to all FRFIs and their non-FRFI counterparties that meet the definition of a Covered Entity. Prior to entering into a transaction, FRFIs are expected to self-declare themselves as Covered Entities (assuming they meet the requirements) and are responsible for confirming whether their counterparties are Covered Entities as well. Of particular note is that certain entities are excluded from the definition of a Covered Entity. In particular, OSFI has provided an exemption to small and medium sized entities that would only face a low degree of risk in virtue of their non-material exposure to NCCDs. Significantly, in this connection OSFI has provided that investment funds that are managed by an investment advisor are considered distinct entities that are treated separately when applying the monetary threshold for determining whether it is a Covered Entity as long as the funds are distinct legal entities that are not collateralised by or are otherwise guaranteed or supported by other investment funds or the investment advisor in the event of fund insolvency or bankruptcy. In addition, sovereigns, public sector entities, multilateral development banks eligible for a zero risk weight in the Capital Adequacy Requirements (CAR) Guideline, the Bank for International Settlements and qualifying central counterparties are excluded from the definition of a Covered Entity. OSFI has also addressed situations where the FRFI and the counterparty are located in different jurisdictions and has stated that the rules of the counterparty's home jurisdiction can be deferred to in certain situations for purposes of determining whether the counterparty is a Covered Entity.
What Type of Transactions are Covered?
In general, the margin requirements outlined in the draft Guideline apply to all NCCDs with the exception of physically settled foreign exchange (FX) forwards and FX swaps. However, NCCDs between a FRFI that is a Covered Entity and its affiliates (i.e. intra-group trades) are not subject to the margin requirements of the draft Guideline.
What type of Collateral is Permitted?
The following types of collateral are eligible to satisfy both variation and initial margin requirements: (a) cash (in the form of money credited to an account or similar claims for the repayment of money, such as certificates of deposit or comparable instruments issued by a Covered Entity); (b) gold; (c) debt securities rated by a rating agency that meet certain defined threshold rating levels; (d) debt securities not rated by a rating agency if they are issued by a bank, listed on a recognized exchange, classified as senior debt, all rated issues of the same seniority by the issuing bank meet certain defined threshold rating levels, the institution holding the securities as collateral has no information to suggest that the issue justifies a rating below such rating and OSFI is sufficiently confident about the market liquidity of the security; (e) equities (including convertible bonds) that are included in a main index; (f) equities (including convertible bonds) which are not included in a main index but which are listed on a recognized exchange; and (g) Undertakings for Collective Investments in Transferable Securities (UCITS) and mutual funds if a price for the units is publicly quoted daily and the UCITS/mutual fund is limited to investing in the instruments listed above. Securities issues by the posting counterparty are not eligible collateral.
Any margin posted, other than cash in the same currency, must be subject to a haircut to account for potential changes in the value of the collateral. Haircuts may be computed using an internal model if the internal model meets the requirements set out in the draft Guideline. Variation margin is not subject to the additional haircut when the currency of the asset differs from the currency of collateral. Otherwise, standard supervisory haircuts are mandated as described in the draft Guideline.
How is Margin Posted?
Collateral must be posted for both variation margin and initial margin. The draft Guideline contains a number of requirements in this connection, including the required amount to be exchanged, how and when margin should be calculated and called as well as the manner in which margin should be exchanged. For both variation margin and initial margin, parties must have “rigorous and robust” dispute resolution procedures in place with their counterparty before entering into a NCCD transaction.
For initial margin requirements, the required amount may be calculated by reference either to (i) an internal quantitative portfolio margin model; or (ii) a standardized margin schedule. The specific method and parameters used by each party must be agreed upon prior to a transaction, and this choice should be consistent for all transactions within the same asset class. Moreover, a party may only use the internal model if it meets certain criteria set out by OSFI in the draft Guideline, such as the establishment of internal governance and validation processes, modeling and documentation requirements, and mandatory periodic reviews and escalation procedures.
With respect to variation margin, OSFI has stated that the full amount necessary to fully collateralize the mark-to-market exposure of the NCCDs must be exchanged. In addition, to reduce adverse liquidity shocks and in order to effectively mitigate counterparty credit risk, OSFI has required that variation margin should be calculated and exchanged for NCCDs subject to a single, legally enforceable netting agreement, which would include an ISDA Master Agreement.
The amount of variation margin required must be calculated and called on a daily basis and it must be exchanged (posted/received) on or before the business day following the calculation of variation margin amount.
When are the Requirements in Effect?
The requirement to exchange variation margin will be phased-in for certain FRFIs from September 1, 2016 to February 28, 2017. On a permanent basis thereafter, all Covered FRFIs will be subject to the requirements when transacting with another Covered Entity.
The requirement to exchange two-way initial margin with a threshold of up to $75 million will be phased-in from September 1, 2016 to August 31, 2020. On a permanent basis thereafter, all Covered FRFIs (subject to certain exceptions) will be subject to the initial margin requirements when transacting with another Covered Entity.
Initial margin and variation margin requirements will apply to all new contracts entered into during the phase-in periods. In this connection, genuine amendments to existing derivatives contracts will not qualify as a new derivatives contract. However, OSFI has stated that any amendment that is intended to extend an existing derivatives contract for the purpose of avoiding margin requirements will be considered a new derivatives contract. Applying the initial margin and variation margin requirements to existing derivatives contracts is not required. Of course, a Covered FRFI may choose to do so as long as this is bilaterally agreed upon with the counterparty. A Covered FRFI cannot alternate between applying the margin requirements to all NCCDs and only apply them to new NCCDs to reduce margin requirements. OSFI has stated that this choice should be made consistently over time on a counterparty by counterparty basis.
With the issuance of the draft Guideline, OSFI is opening its proposed framework for public consultation. In particular, it is requesting opinions on the two possible ways in which margin requirements can be regulated in the context of NCCD transactions in Canada: either OSFI opts to create its own guideline that would provide domestic margin requirements, or it relies on the BSBS/IOSCO framework to communicate these requirements. OSFI's stated preference is for the former, opining that a comprehensive domestic margin requirements guideline is the most appropriate option for ensuring that institutions correctly understand and apply the international framework. Indeed, according to OSFI, “the BSBS publication includes multiple areas of national discretion where institutions would not have any guidance if OSFI were not to develop its own requirements.” In addition, OSFI is asking for comments on whether credit intermediation swaps, which are used by participants in the Canada Mortgage Bond (CMB) program that are not eligible to enter into a swap agreement with Canada Housing Trust directly in order to manage prepayment risk related to the CMB program, should be included in the scope of instruments covered by the draft Guideline.
Comments on the draft Guideline will be accepted until November 27, 2015. Once the public consultation is complete, OSFI will take the submitted comments into consideration when developing its final version of the Guideline, which will take effect on September 1, 2016.