The Office of the Superintendent of Financial Institutions (“OSFI”) published Guideline E-22 Margin Requirements for Non-Centrally Cleared Derivatives (the “Final Margin Rule”) on February 29, 2016, setting out final margin requirements for non-centrally cleared derivatives transactions between certain financial entities. The Final Margin Rule, which is based on the framework jointly published by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (the “BCBS-IOSCO Framework”), is aimed at mitigating systemic risk in the financial sector and promoting the central clearing of derivatives.
Overview of the Final Margin Rule
Scope – Covered Entities
The margin requirements under the Final Margin Rule apply to non-centrally cleared derivatives transactions between financial entities known as “Covered FRFIs” and “Covered Entities”. The margin requirements do not apply to derivatives transactions cleared through a central counterparty or to derivatives transactions entered into by non-financial entities, both of which present fewer concerns from a systemic risk perspective.
A “Covered FRFI” is defined under the Final Margin Rule as a “federally regulated financial institution” that satisfies the definition of “Covered Entity” described in the following paragraph. The reference to “federally regulated financial institution” is broad and captures banks, foreign bank branches, bank holding companies, trust and loan companies, cooperative credit associations, cooperative retail associations, life insurance companies, property and casualty insurance companies and insurance holding companies.
By comparison, a “Covered Entity” is defined under the Final Margin Rule as a “financial entity” whose non-centrally cleared derivatives transactions exceed a particular notional threshold described in the following paragraph. A “financial entity” is an entity whose main business includes one or more financial services activities, and may include a deposit taking institution, insurance company, pension fund, hedge fund or asset manager. The reference to financial entity in the definition of Covered Entity is broader than the reference to federally regulated financial institution, as the reference does not depend on an entity being regulated by OSFI.
Not every “federally regulated financial institution” or “financial entity” falls under the definition of “Covered Entity”. Specifically, a financial entity belonging to a consolidated group whose aggregate month-end average notional amount of non-centrally cleared derivatives for March, April and May of 2016 and any year thereafter is less than Canadian $12 billion will not be considered a Covered Entity under the Final Margin Rule. The threshold requirement is intended to limit the margin requirements to transactions with the largest and most systemically important financial entities. As the threshold requirement is applied on a consolidated basis, inter-affiliate trades are not included in the calculation of this notional amount. However, all non-centrally cleared derivatives must be included in this calculation, even if the margin requirements do not apply to such derivatives (for example, physically settled foreign exchange (“FX”) transactions, as discussed below).
The Final Margin Rule includes several other exclusions from the definition of “Covered Entity”. Sovereigns, public sector entities (including school boards, hospitals, universities, municipalities and other entities directly or wholly owned by the government), certain international entities (including various multilateral development banks) and certain supranational entities (including the Bank of International Settlements) are all excluded from the definition of Covered Entity. Likewise, centralized treasury affiliates that undertake risk management activities on behalf of a corporate group, and certain special purpose entities (“SPEs”) that are established for the purpose of financing a specific pool of assets are also excluded.
Scope – Exempt Transactions
The Final Margin Rule includes several exemptions for transactions that would otherwise be subject to the margin requirements described above. Significantly, a Covered FRFI is not required to collect or post margin in respect of a transaction with a Covered Entity that is an affiliate of the Covered FRFI (i.e. an intra-group transaction). As noted in the BCBS-IOSCO Framework, although current market practices vary, the exchange of initial margin (“IM”) or variation margin (“VM”) by affiliated parties to non-centrally cleared derivatives transactions is not customary and, accordingly, extending the margin requirements to such transactions would likely create additional liquidity demands.
Similarly, the margin requirements under the Final Margin Rule are not applicable to transactions in certain physically settled derivatives, including physically settled commodity derivatives, and physically settled FX forward and FX swaps. Physically settled commodity derivatives have been exempted for consistency with other regulatory treatment of such derivatives, and also to avoid any potential adverse consequences for Canada’s physical commodity markets. Physically settled FX derivatives have been exempted in accordance with the BCBS-IOSCO Framework.
Finally, the Final Margin Rule provides for limited forms of substitute compliance and does not require margining of transactions by: (i) a Covered FRFI trading with a foreign Covered Entity; or (ii) a foreign bank branch operating in Canada, or a foreign insurance company operating in Canada on a branch basis, that is a Covered Entity; provided that in each case, the relevant counterparty is required to comply with, and has indeed complied with, the margin requirements imposed on such party by a foreign jurisdiction, and such party has documentary evidence that the foreign margin requirements are comparable to those recommended under the BCBS-IOSCO Framework. According to OSFI, the rationale for these exclusions is to avoid duplicative or conflicting margin requirements on a single set of transactions. These exclusions should reduce uncertainty as to which jurisdiction’s rules apply and limit regulatory arbitrage.
Initial and Variation Margin Requirements
The Final Margin Rule provides that Covered FRFIs engaging in non-centrally cleared derivatives transactions with other Covered Entities must exchange IM and VM commensurate with the counterparty risk posed by such transactions.
IM refers to initial collateral that is collected and posted at the outset of a transaction. IM is intended to protect counterparties from potential future exposure that could arise from future changes in the mark-to-market value of a derivative position during the time it takes to close out and replace the position in the event that one or more counterparties default. By contrast, VM refers to additional collateral that is collected and posted over the life of a transaction. It is intended to protect counterparties from the current exposure that has actually been realized by one of the parties from changes in the mark-to-market value of a derivatives position after the transaction has been executed. The amount of VM is determined by reference to current exposure, and since it depends on the mark-to-market value of the derivative position at any given time, it will change from time to time.
With respect to IM, the Final Margin Rule includes two methodologies for calculating the amount of IM that must be exchanged: (i) the internal model methodology, which allows for tailored IM margin amounts that depend on the counterparties’ internal assessments of risk; and (ii) the standardised schedule methodology, which sets out generic IM amounts that depend on the asset class, the notional size of a transaction and in some cases, the remaining time to maturity of the transaction. With respect to VM, the Final Margin Rule is much less prescriptive, and simply requires a counterparty to collect an amount of VM that would fully collateralize such counterparty’s mark-to-market exposure.
The amount of margin that will be exchanged generally corresponds to the amount of a counterparty’s exposure, which in turn depends on various factors such as the volatility of the underlying derivative instrument, and the expected duration of the contract closeout and replacement period. As the determination of exposure is a complex process that may lead to different conclusions, the Final Margin Rule requires that counterparties have a dispute resolution mechanism in place at the outset of a transaction in order to address any valuation uncertainties that may arise.
Under the Final Margin Rule, IM and VM must be calculated and called within two (2) business days of the execution of a non-centrally cleared derivatives transaction. Thereafter, it must be calculated and called on a daily basis. Once a counterparty has made a call for IM or VM, the opposing counterparty will have two (2) additional business days to respond to such call and post the required margin.
The exchange of margin is subject to several conditions, including a threshold amount condition (the “Threshold Amount Condition”), which provides that a counterparty is not required to collect initial margin until the amount of exposure of the counterparty and its affiliates within a consolidated group exceeds a particular threshold, which threshold cannot be greater than $75 million. According to the Threshold Amount Condition, if the exposure of a counterparty and its affiliates within a consolidated group exceeds the threshold, then the counterparty will be required to collect an amount of IM equal to the difference between the exposure and the threshold, subject to the minimum transfer amount condition (the “Minimum Transfer Amount Condition”) discussed below. As a result, counterparties will be subject to uncollateralized exposure in an amount equal to the threshold. The Minimum Transfer Amount Condition states that the amount of IM and VM to be transferred by a counterparty at any time cannot be less than $750,000. The Minimum Transfer Amount Condition is intended to reduce the operational burden of transferring small amounts of margin.
Eligible Margin Collateral and Haircuts
Only certain highly liquid financial instruments, including cash, gold and other high quality securities, are eligible to be posted as collateral in satisfaction of the margin requirements under the Final Margin Rule. Notably, securities issued by the posting counterparty do not constitute eligible collateral. The Final Margin Rule also includes rules for reducing or “haircutting” the value of this collateral to account for potential changes in value. Similar to the determination of IM, haircuts may be calculated using an internal model approach or a standardized schedule approach.
Changes to the Draft Margin Rule
The Final Margin Rule introduced a few important changes to the draft margin rule published by OSFI in October 2015 (the “Draft Margin Rule”), most notably as to the scope of application. Through the refinement of certain definitions and the addition of certain new exclusions, the margin requirements under the Final Margin Rule are narrower than those contemplated under the Draft Margin Rule.
Most significantly, the Final Margin Rule no longer applies to non-centrally cleared derivatives transactions by non-financial entities. Based on OSFI’s report about comments received on the Draft Margin Rule, several commenters requested that non-financial entities be excluded from the definition of “Covered Entity”, suggesting that such entities are typically end users who use derivatives solely for hedging purposes. Commenters also noted that non-financial entities are excluded from the definition of a “Covered Entity” under the margin rules in most foreign jurisdictions. In response to these comments, OSFI agreed that it was appropriate to carve out non-financial entities from the definition of “Covered Entity” in the Final Margin Rule.
Similarly, OSFI’s report indicates that several commenters suggested the definition of “financial entity” under the Draft Margin Rule was overly broad and needed to be clarified. Commenters requested that treasury affiliates of commercial entities and SPEs be exempted from the definition of “Covered Entity”, noting that many SPEs are exempt from the comparable definition in the U.S.. In response to these comments, OSFI revised the Final Margin Rule to include: (i) a non-exhaustive list of financial entities that are intended to be captured by the definition; and (ii) specific exemptions for qualifying central treasury affiliates and qualifying special purpose entities, as discussed above.
In its publication of the Draft Margin Rule, OSFI requested comments on whether credit intermediation swaps entered into in connection with issuances under the Canada Mortgage Bond (“CMB”) program should be subject to margin requirements like other non-centrally cleared derivatives transactions. According to OSFI’s report, many commenters requested that CMB swaps be exempt from the margin requirements, noting that bringing them within the scope of the Draft Margin Rule would raise the cost of funds for participants in the CMB program. Notably, OSFI did not revise the Final Margin Rule to address these comments, suggesting that credit intermediation swaps present the same risks as similar swaps with similar counterparties.
Implementation of the Final Margin Rule
The requirement for Covered FRFIs to collect and post IM for non-centrally cleared derivatives transactions with Covered Entities will be phased in over a four-year period, consistent with BCBS-IOSCO Framework. The first requirement comes into effect in September 2016 for the largest and most systemically important Covered FRFIs whose aggregate month-end average notional amount of non-centrally cleared derivatives for March, April, and May of 2016 exceeds $5 trillion (“Initial Covered FRFIs”). Initial Covered FRFIs will be required to collect and post IM when transacting with Covered Entities that also meet that condition (“Initial Covered Entities”).
The requirement for Covered FRFIs to exchange VM will be phased in over a much shorter one-year period with the first requirement coming into effect in September 2016 for Initial Covered FRFIs who will be required to collect and post VM when transacting with Initial Covered Entities.
The full implementation schedule for IM and VM can be accessed here.