Introduction

On October 4 2016 the European Commission published the final delegated regulation on the margin requirements for derivative trades not cleared by a central counterparty (CCP). Under the European Market and Infrastructure Regulation (EMIR), certain counterparties will need to exchange both initial and variation margin in respect of derivative trades not cleared by a CCP. These rules will have far-reaching consequences for derivatives documentation.

The rules stem from a requirement for counterparties to protect themselves from the risk of a potential default of the other counterparty. Two types of collateral in the form of margins are viewed as necessary to manage the risks to which counterparties are exposed. Variation margin reflects the daily mark-to-market of outstanding contracts and protects counterparties against exposures related to the current value of their over-the-counter (OTC) derivative contracts. Initial margin is the collateral collected by a counterparty to cover its current and potential future exposure. This protects counterparties against expected losses which could stem from movements in the market value of the derivatives position occurring before the default of a counterparty and the time that the OTC derivative contracts are replaced or the corresponding risk is hedged.

The rules follow the framework established by the international standards set out in the Basel Committee on Banking Supervision and the International Organisation of Securities Commission's final report, which recommended a start date for the margin requirements of September 1 2016.

Publication of the final delegated regulation was significantly delayed, leaving market participants little time to prepare for these requirements, which are expected to start to apply from mid-January 2017 – although they could apply from as early as mid-December 2016.

Having missed the globally agreed start date of September 1 2016, Europe has been racing to catch up with the United States and Japan, which have already implemented their margin rules in accordance with the international timeline. There is currently some uncertainty as to when the first phase of the margin requirements will apply, as the European Council and the European Parliament have a period of 90 days (which can be extended) to provide any objections to the delegated regulation, although they are both widely expected to provide non-objection statements. Once the non-objection statements have been provided, the delegated regulation will come into force 20 days after it is published in the Official Journal of the European Union and will become effective 30 days afterwards. If the non-objection statements are provided at the end of October, the largest dealers will need to comply with the margin requirements from around December 17 2016.

Who must comply?

Broadly, if you are an EU financial counterparty (FC) or a non-financial counterparty above the clearing thresholds laid down by EMIR (NFC+), you will need to consider whether the margin requirements apply to your trades.

Under EMIR, you will be an NFC+ if your aggregate OTC derivative positions of your group on a worldwide basis exceed any of the clearing thresholds set out below.

Type of derivative contract

Clearing threshold (gross notional amount)

OTC credit derivatives

€1 billion

OTC equity derivatives

€1 billion

OTC interest rate derivatives

€3 billion

OTC foreign exchange derivatives

€3 billion

OTC commodity and any other OTC derivatives

€3 billion

However, the initial margin requirements will not apply to all new derivative contracts entered into in a calendar year where one of the counterparties has an aggregate month-end average notional amount of uncleared derivatives for March and April of the preceding year below €8 billion.

Equally, if you are trading with a non-financial entity whose derivatives activity is below the clearing thresholds (NFC-), you do not need to comply with the margin requirements.

What about trade with non-EU entities?
If you are an EU counterparty which is subject to the margin requirements and you are trading with a non-EU counterparty which would be subject to the margin requirements if it were established in the European Union, you will need to exchange initial and variation margin.

The initial and variation margin rules will also apply to a transaction between two non-EU entities if both entities would be subject to the margin rules if they were established in the European Union and the transaction has a direct, substantial and foreseeable effect within the European Union. Generally, this will be the case where the transaction is executed via two EU branches of non-EU entities and where there is a guarantee from an EU FC of a certain amount.

An EU counterparty may not need to post or collect variation or initial margin for trades with a non-EU counterparty located in a jurisdiction where the enforceability of netting agreements or protection of collateral cannot be supported by an independent legal assessment. Certain requirements must be met and the number of such trades is strictly limited.

Are there any exemptions?
Certain entities are exempt from the margin requirements, such as:

  • multilateral development banks;
  • public sector entities that are owned by central government or have government guarantees;
  • the European Financial Stability Fund;
  • the European Stability Mechanism; and
  • the Bank for International Settlements

An exemption also applies for uncleared trades with CCPs and for CCPs where they are managing the portfolio of a defaulted clearing member.

The initial margin requirements do not apply to uncleared foreign exchange (FX) forwards, FX swaps and currency swaps.

Given the inconsistent interpretation of FX derivatives across the European Union, the application of the variation margin requirements to physically settled FX forwards has been delayed until December 31 2018 or the date of entry into force on the delegated act under the Markets in Financial Instruments Directive II, which would provide a common definition of 'FX forwards'.

There is a three-year phase-in of the initial and variation margin requirements for uncleared OTC derivatives on single-stock equity options and index options, and an exemption for OTC derivatives associated to covered bonds subject to certain conditions being met.

What about intra-group transactions?
An exemption can be obtained for intragroup transactions, provided that certain detailed requirements are met and communicated to the relevant competent authority. There is a delayed application of six months for trades with EU counterparties and a delayed application of the initial margin requirement to trades with non-EU counterparties of up to three years.

What about securitisation special purpose vehicles?
There is no preferential treatment for securitisation special purpose vehicles (SPV). Although there is an exemption for covered bonds, the feedback statement notes that an exemption for securitisation (like that for covered bonds) cannot be included in the final rules; it will therefore be necessary to assess whether the margin rules apply to these structures on a case-by-case basis. In any event, many SPV issuers will be an NFC- and therefore should not be caught by the margin requirements.

Initial margin requirements

When do initial margin requirements apply?
Under the final rules, you will need to exchange initial margin from the relevant phase-in date (see below) only if you and your counterparty both have, or belong to groups which have, an aggregate month-end average notional amount of uncleared derivatives that is above €8 billion. This €8 billion threshold does not apply to the requirement to post variation margin, which will apply from March 1 2017 for all FCs and NFC+s.

The requirements to exchange initial margin will be phased in (starting with the largest derivatives market participants) and will apply to new contracts as set out in the table below.

Phase-in date

Uncleared derivatives trades subject to the initial margin rules

One month after the delegated regulation enters into force

If both counterparties have or belong to groups each of which has an aggregate month-end average notional amount of uncleared derivatives for March, April and May 2016 that is above €3 trillion.

September 1 2017

If both counterparties have or belong to groups each of which has an aggregate month-end average notional amount of uncleared derivatives for March, April and May 2017 that is above €2.25 trillion.

September 1 2018

If both counterparties have or belong to groups each of which has an aggregate month-end average notional amount of uncleared derivatives for March, April and May 2018 that is above €1.5 trillion.

September 1 2019

If both counterparties have or belong to groups each of which has an aggregate month-end average notional amount of uncleared derivatives for March, April and May 2019 that is above €750 billion.

September 1 2020

If both counterparties have or belong to groups each of which has an aggregate month-end average notional amount of uncleared derivatives that is above €8 billion.

In order to calculate the group aggregate average notional amount, all of the group's uncleared derivatives – including FX forwards, currency swaps and intra-group transactions – must be included.

Which OTC derivatives will initial margin requirements apply to?
All uncleared OTC derivatives except physically settled FX swaps and forwards and currency swaps are within the scope of the initial margin requirements.

The margin requirements apply throughout the life of all new derivatives contracts entered into after the applicable phase-in dates. Existing contracts will not be affected.

Initial margin thresholds
Where the total initial margin for uncleared derivatives between the counterparties at group level is equal to or lower than €50 million, no initial margin need be exchanged.

How is initial margin calculated?
Initial margin can be calculated using the standardised approach (similar to the mark-to-market approach) or by using initial margin models (which may be developed by one counterparty, both jointly or a third party), or both. Counterparties need to agree on the method that each counterparty uses to determine the initial margin it must collect, but counterparties need not agree on a common methodology. Initial margin should be collected within the business day of calculation.

The International Swaps and Derivatives Association, Inc (ISDA) has developed a standard initial margin methodology for use by market participants globally in order to provide an open, transparent and standard methodology available to all.

What segregation arrangements will need to be established for initial margin?
The collecting counterparty must segregate the initial margin either with a third-party holder or custodian or via other legally binding arrangements so that it is protected from the default or insolvency of the collecting counterparty. Counterparties will need to arrange for initial margin to be provided by way of security rather than title transfer.

Collateral collected as initial margin must be segregated from the other proprietary assets of the collecting counterparty, posting counterparty or third-party holder or custodian, as relevant. The initial margin must be available to the posting entity in a timely manner in case the collecting party defaults. In addition, the collecting counterparty should provide the posting counterparty with the option to segregate its collateral from the assets of the other counterparties.

Counterparties need to conduct an independent legal review (by either by an internal independent unit or external independent third party) confirming that the segregation requirements have been met. In addition, counterparties will need to provide documentation to their competent authority upon request supporting that the segregation arrangements in all relevant jurisdictions meet these requirements, and set up policies to ensure ongoing compliance with these requirements.

Where cash is provided as initial margin, it should be deposited with a third-party holder or custodian that is not part of the same group of either counterparty, or with a central bank.

The collecting counterparty must not re-hypothecate, re-pledge or reuse the collateral collected as initial margin, although variation margin may be re-used by the collecting counterparty.

Variation margin requirements

When do variation margin requirements apply?
The requirement to exchange variation margin will apply to new contracts as set out below.

Phase-in date

Trades subject to initial margin rules

One month after the delegated regulation enters into force

If both counterparties have or belong to groups each of which has an aggregate month-end average notional amount of uncleared derivatives for March, April and May 2016 that is above €3 trillion.

March 1 2017

All other relevant counterparties.

Which OTC derivatives will variation margin requirements apply to?
The variation margin requirements will apply to all uncleared OTC derivatives, including physically settled FX swaps and forwards and currency swaps.

The variation margin requirements apply throughout the life of all new derivatives contracts entered into after the applicable phase-in dates. Existing contracts will not be affected.

How is variation margin calculated?
You will need to calculate variation margin on at least a daily basis and collect it either within one business day of the calculation or, in certain circumstances, within two business days. The amount of variation margin collected should be the outstanding balance between the aggregated value of all contracts in the netting set and the value of all variation margin previously posted, collected or settled. If there is a dispute as to the exact amount of variation margin that should be collected, you should collect at least the part of the variation margin that is not being disputed.

What is the minimum transfer amount for the exchange of initial and variation margin?
Counterparties that are subject to the margin requirements can agree on a minimum transfer amount (not more than €500,000), such that where the full amount due to be collected is lower than this amount, no collateral need be collected. This can be shared with initial and variation margin.

What collateral can be posted?
Only certain collateral that is sufficiently liquid and not exposed to excessive credit, market and FX risk will be eligible for initial and variation margin. The list of eligible collateral includes:

  • cash;
  • allocated gold;
  • debt securities issued by government entities, multilateral development banks, credit institutions or investment firms;
  • certain covered bonds;
  • corporate bonds;
  • the most senior tranche of a securitisation (provided that it is not a re-securitisation); and
  • certain equities.

There are also concentration limits for initial margin to ensure that the collateral is reasonably diversified; and to the extent that the value of collateral is exposed to market and FX risk, risk-sensitive haircuts may need to be applied.

What procedures should be implemented for collateral posting?
You will need to put in place robust operational requirements, including:

  • clear senior management reporting;
  • an escalation procedure in the case of a dispute; and
  • documentation covering the collateral requirements.

The procedures should be tested on a periodic basis and at least annually.

In addition, you will need to ensure that detailed documentation covering all material terms relating to the collateral requirements is executed prior to, or contemporaneously with, any non-cleared derivatives transactions.

What documentation changes should be considered?
You will need to identify the extent to which you will be affected by the rules, as this will determine the exact amendments to existing documentation that may be required.

ISDA has published the 2016 Variation Margin Protocol to help counterparties comply with the new variation margin requirements, either by putting new contractual documentation in place or by making changes to existing documentation to bring it into compliance.

You may need to negotiate revised collateral documentation such as the Credit Support Annex published by ISDA.

ISDA has published a suite of margin-rule compliant documentation, including:

  • the ISDA 2016 Credit Support Annex for Variation Margin (VM) (Security Interest – New York Law);
  • the ISDA 2016 Credit Support Annex for Variation Margin (VM) (Title Transfer – English Law);
  • the ISDA Regulatory Margin Self-Disclosure Letter (June 30 2016);
  • the ISDA 2016 Credit Support Annex for Variation Margin (VM) (Loan – Japanese Law);
  • the 2016 Phase One Initial Margin Credit Support Deed (Security Interest – English Law); and
  • the ISDA 2016 Phase One Credit Support Annex for Initial Margin (IM) (Security Interest – New York Law), although some participants are negotiating bespoke arrangements.

Given that the new rules about trades extend into after the applicable phase-in period, this may lead to the possibility of having separate silos and trades with different collateral requirements, which may lead to operational complexity.

What about equivalent rules published in other jurisdictions?
The US margin rules were effective as of September 1 2016, with staggered compliance dates until September 1 2020. Similarly, Japan has also implemented rules effective as of September 1 2016.

For further information on this topic please contact James Doyle or Isobel Wright at Hogan Lovells International LLP by telephone (+44 20 7296 2000) or email (james.doyle@hoganlovells.com or isobel.wright@hoganlovells.com). The Hogan Lovells International LLP website can be accessed at www.hoganlovells.com.

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