The final draft regulatory technical standards (RTS) for margining uncleared OTC derivatives under EMIR have now been published. Those of you who came to our recent seminar on this subject will know that the derivatives industry has been hoping that this final draft would resolve many areas of uncertainty arising from previous drafts of the RTS. There has been some welcome clarification but there are perhaps as many new questions raised by the new text.
A comparison of the final draft RTS and the previous draft can be viewed on this version.
In this alerter, we highlight key changes and clarifications made in the final draft RTS.
- Collateral haircuts for currency mismatch . It is now clear that in valuing any cash variation margin, an FX haircut need not be applied when it is collected in a currency other than the currency agreed in the relevant master agreement or CSA. The final draft RTS are, unfortunately, not totally clear where such a currency mismatch would arise: they only refer to currencies other than those agreed in an individual derivatives agreement, the relevant master netting agreement or the relevant credit support annex. This should allow "silo" CSAs, with different variation margin requirements for transactions denominated in different currencies, but it is unclear how much wider the scope of agreed currencies should be. The previous draft of the RTS referred merely to the transfer currency. All initial margin, cash and non-cash, attracts an 8% haircut where it is denominated in a different currency from the currency agreed for termination payments under the relevant master agreement or CSA.
- Forward FX . The inclusion of physically-settled FX forward transactions both in the universe of transactions for which variation margin is to be calculated and collected and for calculation of threshold notional amounts is likely to be the most significant change that the RTS will impose on institutional buy-side participants. This was a thorny issue given that variances across the EU in the way physically-settled FX forward contracts are currently defined have meant that there is no harmonised approach across the EU as to whether FX forwards fall within the definition of an OTC derivative. As there will in due course be EU-wide clarification on what is an FX forward, which will be set out in Level 2 measures under MiFID II, the inclusion of physically-settled FX forwards for variation margin purposes is deferred until these Level 2 measures are in force or 31 December 2018, if earlier.
- Assessing Notional Amounts . The final draft RTS have now clarified how entities should calculate their group-wide aggregate notional amount of uncleared OTC derivatives for the purposes of various thresholds in the RTS. It is now clear that intra-group OTC derivatives are included only once (in other words, each end of an OTC derivative is not counted separately). However, as physical FX forwards still need to be taken into account when calculating the aggregate threshold notional amount, the differing interpretation of what amounts to a physical FX forward remains, until the MiFID II Level 2 measures on the point are issued.
- Timing of Delivery of Variation Margin . In the previous draft RTS, variation margin had to be collected on a T+1 basis, with parties who were providing initial margin under the RTS being able to extend to T+3 if the mandatory initial margin requirement was adjusted to allow for such longer period of risk. In the final draft RTS, T+1 remains but this can be extended to T+2 if the risk period for the initial margin requirement is adjusted (as per the previous draft RTS) or, where the parties are not subject to mandatory initial margin, variation margin previously collected has been calculated in the same way as initial margin, but only based on a risk period of the number of days between calculation and collection of the variation margin. Increased variation margin resulting from T+2 collection will, of course, create credit risk, not reduce it.
- Intra-group Initial Margin Thresholds . Where mandatory initial margin applies to a trade with a group entity, initial margin need not be collected from such entity up to an amount of EUR 10 million. Initial margin above this amount will have to be collected.
- Counterparties in Non-Netting Jurisdictions . If a non-EU counterparty is domiciled in a jurisdiction where netting arrangements are not enforceable, there is no requirement to post either initial or variation margin to that counterparty. A covered entity is also not required to collect initial or variation margin if the aggregate notional of trades with such non-EU counterparties is less than 2.5% of the gross notional of all its trades (excluding intra-group trades).
- Segregation of Initial Margin . The final draft RTS acknowledges that margin held in custody cannot be insulated from custodian credit risk. The insolvency-remoteness requirement is therefore now limited to protection from insolvency of the collecting counterparty rather than also that of the custodian. Where collateral is provided by title transfer, the collecting counterparty would still have to segregate such collateral from its other assets. Where this is the case, insolvency-remoteness of the segregated margin could require a "charge-back" or similar structure in favour of the posting counterparty. Further, cash initial margin cannot be held by a custodian that is within the same group as either party. For non-cash collateral, there is no express prohibition on custodians to be part of the same group as either party, although query whether the use of affiliated custodians would meet the requirements of the final draft RTS in relation to timely return of collateral, for example.
- Custodian Liens . As with the previous draft, the final draft RTS make it clear that custodian liens on segregated non-cash initial margin must be limited to fees and expenses incurred in providing the custodial accounts or otherwise be a routine type of lien imposed on securities held in clearing systems. Custodians who require a lien for other amounts due to them may therefore need to be secured in other ways.
- Equity Options . There is a 3-year delay before single-stock and equity index options are to be taken into account in the calculation of initial margin and variation margin requirements. This reflects the lack of any international standards for margining these types of trades. Again, in this 3-year period, such options are still to be included when determining the aggregate threshold notional amounts of uncleared OTC derivatives.
- Legal Review . The final draft RTS retain the requirement that all covered entities carry out an independent legal review of the enforceability of their bilateral netting agreements and of their initial margin segregation requirements. Legal review need only be continuously assessed upon request rather than be refreshed annually as was prescribed in the previous draft RTS.