On 1 March 2017, EU rules governing the mandatory posting of collateral for uncleared derivatives came into effect. From that date all in-scope counterparties are required to exchange variation margin. A phased implementation for initial margin requirements will start on 1 September 2017 and continue to September 2020. However, the largest counterparties in OTC derivatives markets were required to exchange both initial and variation margins with effect from 4 February 2017.
The financial industry has been concerned about its ability to meet the 1 March deadline for posting variation margin (VM). On 23 February 2017 the European Supervisory Authorities - ESMA, the EBA and EIOPA (the ESAs) - issued a statement on the implementation date for the exchange of VM, aimed mainly at smaller firms who might not have been able to comply fully with the requirement from 1 March and what they expect should be the approach to these firms by national competent authorities (NCAs). At the same time, the UK’s NCA, the Financial Conduct Authority (the FCA), published a statement on its approach to firms who have not met the 1 March deadline.
In this article we examine the rules in respect of exchanging VM and initial margin (IM). We update you on the recent statements made by the ESAs and the FCA and consider what this means for counterparties who were subject to the requirement to exchange VM from 1 March 2017.
What requirements apply, to whom and from when?
The 2012 European Market Infrastructure Regulation (EMIR) requires both IM and VM to be exchanged in respect of uncleared over the counter (OTC) derivatives transactions by financial counterparties (FCs) and NFCs - non-financial counterparties whose average positions, calculated in accordance with EMIR, exceed specified clearing thresholds. The margin requirements apply to transactions entered into by counterparties each of which has, or belong to groups that have, uncleared OTC derivatives with an aggregate average notional amount exceeding the threshold specified for a phase-in date that has been reached. However, where the margin requirements also apply to existing outstanding transactions if new transactions are documented under the same master agreement or other netting arrangement.
The table below summarises the thresholds and phase-in dates:
Note that these requirements will apply only to new transactions entered into after the relevant phase-in dates and transactions under existing master agreement or other netting arrangement.
The European Commission set these requirements based on international agreement on terms for collateralising uncleared derivatives. In addition to setting deadlines, EMIR itself and the Commission’s regulation cover a range of details, such as other phase-in periods, exemptions, trades with non-EU counterparties, margin calculation, acceptance of non-cash collateral, and segregation of IM.
What if my firm can’t meet the 1 March deadline?
On 23 February 2017 the ESAs issued a statement on the implementation date for the exchange of VM, acknowledging that some mainly smaller firms were experiencing “operational challenges” in meeting the 1 March deadline. While stating that there could be no “general forbearance” or extension of the deadline, as neither the ESAs nor NCAs possess any formal powers to disapply directly applicable EU legislation, the ESAs expect NCAs (such as the FCA) to “generally apply their risk-based supervisory powers in their day-to-day enforcement of applicable legislation”. The ESAs envisaged that this would entail NCAs taking into account:
The size of the exposure to the counterparty plus its default risk. The steps taken by the market participant towards full compliance, including alternative arrangements to ensure that the risk of non-compliance is contained, such as using existing collateral documents (for example, Credit Support Annexes) to exchange VM.
However, the ESAs also emphasised that they expect difficulties faced by counterparties not fully compliant by 1 March to be solved “in the coming few months”.
The FCA welcomed the ESAs’ statement and announced its approach to firms not in a position to comply with VM requirements by 1 March. The FCA plans to take a risk-based approach to these firms and to “use judgement as to the adequacy of progress, taking into account the position of particular firms and the credibility of the plans they have made”.
These statements do not have the effect of excusing firms from being fully compliant with the requirement to exchange variation margin from 1 March 2017. There is no formal extension to the deadline and transactions concluded on or after 1 March 2017 remain subject to the obligation to exchange variation margin.
While these statements should reassure firms who have made best efforts to comply, counterparties should note that the FCA, and perhaps other NCAs, may at any time request to see detailed and realistic plans to achieve compliance in as short a time as practicable.
Given that there is no extension to the deadline to start exchanging variation margin, and the statements made by the ESAs and FCA, it is more important than ever that counterparties act now to achieve compliance. Generally, in-scope counterparties must enter into new credit support/collateral documentation, or amend existing documentation, and procure an independent legal review of the enforceability of that documentation, including associated master or netting agreements.
Counterparties who were not fully compliant by 1 March 2017 should consider what other arrangements they can put in place to mitigate the risks of non-compliance.