CLIENT UPDATE 2015 OCTOBER FINANCIAL INSTITUTIONS 1 © Rajah & Tann Singapore LLP MAS Consults on Margin Requirements for Non-Centrally Cleared OTC Derivatives Introduction Pursuant to the G20’s and Financial Stability Board recommendations on over-the-counter (“OTC”) derivative reforms following the crisis in 2008, the International Working Group on Margin Requirements (“WGMR”) published its report setting out margin requirements for non-centrally cleared OTC derivatives (“uncleared derivatives”) in September 2013, and subsequently revised its report in March 2015. The Monetary Authority of Singapore (“MAS”) is now consulting on proposals to implement margin requirements on uncleared derivatives set out by WGMR. The proposals will be effected via new rules, which will be consulted on separately, after taking into account feedback from the present consultation. The consultation will end on 1 November 2015. Scope of Proposed Margin Requirements Product Scope MAS proposes to subject all OTC derivative contracts that are not centrally cleared by a qualifying central counterparty (“QCCP”) (as defined in the BCBS Capital Requirements for Bank Exposures to Central Counterparties) to margin requirements. It is proposed that physically settled foreign exchange forwards and swaps be exempt from such margin requirements. Entity Scope MAS is adopting a phased-in approach to give affected entities time to operationalise the proposed margin requirements. For now, MAS is proposing to apply margin requirements only to the following entities that are conducting regulated activities under the Securities and Futures Act (“SFA”) (collectively referred to as “MAS Covered Entities”): (a) banks licensed under the Banking Act; (b) merchant banks approved as financial institutions under section 28 of the MAS Act; and (c) other licensed financial institutions (including entities under the Finance Companies Act, Insurance Act, SFA, and Trust Companies Act). This will also include fund managers that are legal counterparties to the uncleared derivatives. MAS is considering a limited exemption from these margin requirements for non-bank MAS Covered Entities if the exposure of their uncleared derivatives booked in Singapore fall below a certain threshold, so as not to discourage the use of OTC derivatives for hedging and risk management purposes. MAS is proposing to disapply these margin requirements in respect of counterparties such as sovereigns, central banks, public sector entities, multilateral development banks and the Bank for International Settlements. CLIENT UPDATE 2015 OCTOBER FINANCIAL INSTITUTIONS 2 © Rajah & Tann Singapore LLP MAS is also seeking views on whether investment funds domiciled in Singapore should be subject to margin requirements, and the factors that should be taken into account in formulating the margin requirements for such investment funds. Margin Requirements on MAS Covered Entities Proposed Margin Obligations MAS proposes that an MAS Covered Entity be subject to both initial margin (“IM”) and variation margin (“VM”) requirements when all of the following conditions are met: (a) the MAS Covered Entity is a legal counterparty to the transaction. “Legal counterparty” has been defined by the MAS to mean “an entity who is a signatory to the ISDA master agreement and the collateral service agreement of the transaction”; (b) the transaction is booked in Singapore; and (c) the transaction is entered into with a counterparty which is either an MAS Covered Entity or an overseas regulated financial firm. MAS notes that the WGMR Framework requires an exchange of IM and VM, on a bilateral basis (“postand-collect”). To address certain operational challenges faced by industry participants, MAS is considering an alternative of imposing a collect-only (“collect-only”) requirement on MAS Covered Entities. A collect-only regime would achieve a bilateral exchange of margins if both counterparties are subject to margin requirements prescribed by their regulators. As major jurisdictions like US, Europe and Japan have consulted on and are working towards implementing their margin requirements on uncleared derivatives, a collect-only regime could be a viable alternative to achieving the same outcome of a post-and-collect regime, while minimising the associated operational challenges. For VM obligations, MAS is proposing that MAS Covered Entities calculate their VM obligations at least on a daily basis. The full amount of VM (i.e. a zero threshold) must be exchanged (if MAS adopts a postand-collect regime) or collected (if MAS adopts a collect-only regime) from counterparties within two business days following the execution of a new uncleared derivative contract. For IM obligations, it is proposed that the gross amount of IM obligations (i.e. no netting of IM payments between the two counterparties) be calculated at least on a sufficiently regular basis to reflect changes in risk positions and market conditions. MAS Covered Entities are then required to ensure that the IM is exchanged or collected from their counterparties within two business days following the recalculation of the IM obligations (see section on “Initial Margins” below). Proposed thresholds MAS proposes that the exchange or collection of IM shall only be required if the cumulative IM exposure from the counterparty exceeds S$80 million. The threshold of S$80 million is to be calculated at the group-consolidated level and is based on all uncleared derivatives between the two consolidated groups. MAS recognises that the IM requirements would necessitate significant changes in market practices and could have an impact on market liquidity. Therefore, MAS proposes that IM requirements only apply to transactions between two entities, each belonging to a group whose aggregate gross notional uncleared derivatives exposure, including physically-settled FX forwards and swaps, exceeds the prescribed IM phase-in thresholds outlined in the section “Implementation Timeline” below. After the phase-in period, the minimum level of uncleared derivative activity necessary for MAS Covered Entities to be subject to IM requirements proposed in the consultation shall be set at S$13 billion. If the group aggregate exposure of MAS Covered Entities subsequently falls below the IM phase-in thresholds after entering into the uncleared derivative transaction, the collateral requirements on the IM previously exchanged or collected shall continue to apply until the transaction expires. CLIENT UPDATE 2015 OCTOBER FINANCIAL INSTITUTIONS 3 © Rajah & Tann Singapore LLP To ease the operational burden of transferring small amounts of margin, MAS proposes that all margin transfers be subject to a de minimis minimum transfer amount not higher than S$800,000. Margin Calculations and Methodologies Initial Margin MAS proposes to allow the required amount of IM to be calculated by reference to either a quantitative portfolio margin model or a standardised margin schedule. An MAS Covered Entity may opt for either approach, and not restrict itself to one approach for the entirety of its derivative activities. However, the choice between model- and schedule-based IM calculations should be made consistently over time for all transactions within the same well-defined asset class. Quantitative Portfolio Margin Model: The proposed quantitative portfolio margin model is discussed at length at paragraphs 5.5 – 5.7 of the Consultation Paper (see “Resources” below). Standardised Margin Schedule: The simpler and less risk-sensitive standardised margin schedule is discussed at paragraph 5.8 and Annex B of the Consultation Paper. Variation Margin It is proposed that MAS Covered Entities calculate and post or collect VM requirements on an aggregate net basis across all uncleared derivatives that are executed under a single, legally enforceable netting agreement. In the absence of legally enforceable netting agreements, MAS Covered Entities should calculate and post or collect the VM requirements for each uncleared derivative contract on a gross basis. Eligible Collateral and Haircuts Eligible Collateral MAS recognizes that assets used to meet IM and VM requirements should be highly liquid so as to best ensure that the value of the collateral held as margin can be fully realized in a period of financial stress. However, such an requirement could result in liquidity implications on the financial system. MAS is thus proposing to permit a broader set of eligible collateral to be used, but to address the potential volatility of such assets through appropriate valuation haircuts for margin purposes. MAS proposes to allow the following range of eligible collateral to be used to meet IM and VM requirements: (a) cash; (b) gold; (c) debt securities (AAA to BB- for central government or central bank issuers, AAA to BBB- for other issuers); and (d) equity securities in a main index of a securities exchange in Singapore or a recognised Group A exchange (see footnote  below). MAS proposes to align the standardised schedule-based haircuts for permitted eligible collateral for IM and VM to the standard supervisory haircuts set out for eligible financial collateral recognised under the financial collateral comprehensive approach in MAS’ capital framework for locally incorporated banks. (Please refer to the table below for the schedule of standardised schedule-based haircuts.) CLIENT UPDATE 2015 OCTOBER FINANCIAL INSTITUTIONS 4 © Rajah & Tann Singapore LLP Standardised Haircut Schedule Asset Type1 Haircuts Cash (in the same currency as the settlement currency) 0% Gold 15% Central bank and government issuers Debt securities with credit ratings of AAA to AA- (or equivalent issue credit ratings)2 Residual maturity: 1 year 0.5% Residual maturity: > 1 year, 5 years 2% Residual maturity > 5 years 4% Debt securities with credit ratings of A+ to BBB- (or equivalent issue credit ratings)3 Residual maturity: 1 year 1% Residual maturity: > 1 year, 5 years 3% Residual maturity > 5 years 6% Debt securities with credit ratings of BB+ to BB-(or equivalent issue credit ratings) All maturities 15% Other issuers Debt securities with credit ratings of AAA to AA-(or equivalent credit issue ratings)2 Residual maturity: 1 year 1% Residual maturity: > 1 year, 5 years 4% Residual maturity > 5 years 8% Debt securities with credit ratings of A+ to BBB-(or equivalent issue credit ratings)3 Residual maturity: 1 year 2% Residual maturity: > 1 year, 5 years 6% Residual maturity > 5 years 12% Equity securities in a main index of a securities exchange in Singapore or recognised Group A4 exchanges 15% Haircut for currency mismatch between currency of the collateral and the settlement currency 8% Risk-Sensitive Model-Based Haircuts In addition to schedule-based haircuts, MAS also permits the use of risk-sensitive model-based haircuts, which may be based on models that are internally-developed or provided by a third party, subject to MAS’ approval. The MAS Covered Entity must however ensure that it complies with the requirements for the quantitative portfolio margin model (see paragraph 5.5 of the Consultation Paper), including requirements on appropriate internal governance standards as in the case of the MAS Covered Entity’s use of quantitative portfolio margin models for IM calculation. MAS Covered Entities are required to consistently adopt either the schedule-based or model-based approach for all the collateral assets within the same well-defined asset class. 1 Only external credit ratings from Fitch Ratings, Moody’s Investors Services, and Standard and Poor’s Ratings Services are recognised for the purposes of the standardised haircut schedule. 2 For short-term issues, eligible credit ratings are F-1 / P-1 / A-1 for the respective credit rating agencies. 3 For short-term issues, eligible credit ratings are F-2 and F-3 / P-2 and P-3 / A-2 and A-3 for the respective credit rating agencies. 4 Group A exchanges are securities exchanges in the following countries: Australia, Austria, Belgium, Canada, France, Germany, Hong Kong, Italy, Japan, Malaysia (except Labuan), Netherlands, New Zealand, South Korea, Spain, Sweden, Switzerland, Taiwan, Thailand, United Kingdom, United States. CLIENT UPDATE 2015 OCTOBER FINANCIAL INSTITUTIONS 5 © Rajah & Tann Singapore LLP MAS Covered Entities are expected to establish and document internal policies and controls to ensure that the collateral collected is not overly concentrated in an individual issuer, issuer type or asset type. MAS Covered Entities should ensure that the value of the collateral does not exhibit a significant correlation with the creditworthiness of the counterparty or the value of the underlying uncleared derivatives portfolio so that the effectiveness of the protection offered by the collateral collected to meet the margin requirements is not undermined (i.e. “wrong way risk”). As such, the MAS Covered Entity should not accept securities issued by the counterparty or its related entities as collateral. Haircuts on FX Mismatch As eligible collateral can be denominated in a currency other than the settlement currency of the uncleared derivative transaction, MAS is proposing an FX mismatch haircut of 8% to be applied to the value of eligible collateral, to recognise the inherent FX risk of such transactions. MAS Covered Entities which have been approved by MAS to use risk-sensitive model-based haircuts will have to incorporate the FX risk resulting from the FX mismatch in their model-based estimates of the collateral haircuts for collateral used to meet IM and VM requirements.MAS is seeking feedback on its proposal to apply the same FX mismatch haircut of 8% in the case where the eligible collateral used to meet VM requirements is in the form of cash, and on whether a lower haircut should be applied to any liquid currency. Dispute Resolution MAS expects MAS Covered Entities to have rigorous and robust dispute resolution procedures in place at the onset of a transaction to deal with disputes relating to margin calculations and eligible collateral. At the onset of the transaction, the two counterparties must agree in writing or other equivalent permanent electronic means on the specific margin calculation method and the quantitative model to be used (if applicable). The calibration data and parameters for calculating IM should also be agreed upon and recorded in writing or other equivalent permanent electronic means. In the event that a dispute arises over margins or the value of collateral, any non-disputed amount shall first be exchanged or collected, while all necessary and appropriate efforts, including timely initiation of dispute resolution protocols, should be taken to resolve the dispute. Where relevant, the remaining required amount of margin should be exchanged or collected in a timely fashion. Treatment of Collateral Safe-Keeping To ensure that the collateral is sufficiently protected against the insolvency risk of the collateral collector, MAS proposes that MAS Covered Entities be required to safe-keep the IM collected from counterparties in a manner such as to ensure that: (a) the IM collected is immediately available to the collecting party in the event of the posting party’s default; and (b) the IM collected must be subject to legally enforceable arrangements that protect the posting party to the extent possible under applicable law in the event that the collecting party enters bankruptcy. CLIENT UPDATE 2015 OCTOBER FINANCIAL INSTITUTIONS 6 © Rajah & Tann Singapore LLP Further, IM should be safe-kept in either of the following ways so as to ensure that the IM collateral collected is legally segregated from the collecting party’s proprietary money and assets: (a) IM collateral collected to be held with an independent third party custodian under a trust arrangement to address the insolvency risk of the collecting party; or (b) IM collateral collected to be held under other legally enforceable arrangements to protect the posting party in the event of default of the collecting party. MAS is also proposing that the collateral arrangements used need to be legally enforceable and reviewed periodically with updated legal opinions to confirm that they continue to meet with the safe-keeping requirements as set out above. Re-Hypothecation, Re-Pledge and Re-Use of Collateral The risk of the loss of IM could be further exacerbated if the collecting party re- hypothecates, re-pledges, or re-uses (henceforth “re-hypothecates”) the IM collected, which could result in third parties having legal or beneficial title over the collateral, or a merging or pooling of the collateral with assets belonging to others. This could lead to legal complications which may result in delays or failure to return rehypothecated assets to the posting party in the event the collecting party defaults. To limit such risks, MAS proposes that non-cash IM shall only be re-hypothecated to a third party in accordance with the list of conditions set out in Annex D of the Consultation Paper. Once non-cash IM has been re-hypothecated to a third party in accordance with those conditions, no further rehypothecation of IM by the third party is permitted. Treatment of Intra-Group Transactions It is proposed that MAS Covered Entities may apply for exemption of intra-group transactions from the scope of margin requirements, subject to the condition that the MAS Covered Entity comes under groupwide supervision by MAS or regulators in other jurisdictions. The proposed exemption would be limited to transactions between entities belonging to the same group where the financial statements of these entities are consolidated upon preparation of the group consolidated financial statements, as such transactions do not transfer risks in or out of a corporate group and are best left to such groups to manage their group-wide risks in a manner most appropriate for their corporate structure. Treatment of Cross-Border Transactions To manage the risk of uncleared derivatives exposure building up when transacting with counterparties from jurisdictions that have not implemented margin requirements for all regulated financial firms, have different implementation schedules or have unclear netting laws, MAS is considering the feasibility of imposing a threshold such that an MAS Covered Entity shall be subject to margin requirements only if its total exposure to counterparties from such jurisdictions exceeds a certain threshold. To avoid the application of duplicative or conflicting margins requirements on the same transaction, given the global nature of the OTC derivatives market, MAS proposes to deem MAS Covered Entities to have complied with MAS’ margin rules when: (a) an MAS Covered Entity, established under the laws of, or that has a place of business in, a foreign jurisdiction with comparable margin requirements, is required to comply and has complied with the margin requirements of that relevant foreign jurisdiction; or (b) an MAS Covered Entity, trading with a foreign counterparty, is required to comply with and has complied with comparable home- or host- margin requirements imposed on the foreign counterparty. CLIENT UPDATE 2015 OCTOBER FINANCIAL INSTITUTIONS 7 © Rajah & Tann Singapore LLP MAS further proposes to adopt a comparability assessment that is outcome-based with a focus on whether the margin requirements in the foreign jurisdiction achieve the same regulatory objectives as MAS’ margin requirements. This would not require the regimes to be identical nor constitute a line-byline comparison in determining the regulatory objectives. However, MAS is considering the requirement for MAS Covered Entities to collect the types of eligible collateral and hold them in a manner consistent with MAS’ rules. Implementation Timeline The proposed phased-in implementation schedule to effect the above proposals may be found in the table below. MAS will review the exemption threshold and commencement date for the non-bank MAS Covered Entities at a later stage. Phase-In Implementation Schedule Obligation MAS Covered Entity Belonging to Group Exceeding Phase-in Threshold Commencement Date5 Variation Margin (VM) Requirements Commercial banks6 S$4.8 trillion7 1 Sep 2016 All other commercial banks and merchant banks - 1 Mar 2017 Initial Margin (IM) Requirements Commercial banks S$4.8 trillion5 1 Sep 2016 All other commercial banks and merchant banks S$4.8 trillion5 1 Mar 2017 S$3.6 trillion8 1 Sep 2017 S$2.4 trillion9 1 Sep 2018 S$1.2 trillion10 1 Sep 2019 S$13 billion11 1 Sep 2020 Impact Assessment In addition to preliminary studies already conducted to assess the impact of the proposed margin requirements and liquidity requirements already implemented, MAS will be further engaging the industry to undertake another study of the impact of the proposed margin requirements. Resources 1. Policy Consultation on Margin Requirements for Non-Centrally Cleared OTC Derivatives 5 MAS proposes to provide MAS Covered Entities with a 6-month transition period from the respective VM and IM commencement dates to provide sufficient time for them to be operationally ready for a smooth implementation of the requirements. 6 Refers to any bank licenced under the Banking Act and conducts regulated activities under the Securities and Futures Act. 7 The group’s aggregate month-end average notional amount of uncleared derivatives for March, April and May 2016. 8 The group’s aggregate month-end average notional amount of uncleared derivatives for March, April and May 2017. 9 The group’s aggregate month-end average notional amount of uncleared derivatives for March, April and May 2018. 10 The group’s aggregate month-end average notional amount of uncleared derivatives for March, April and May 2019. 11 The group’s aggregate month-end average notional amount of uncleared derivatives for March, April and May for the given year. 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