Risk-mitigation techniques for non-centrally cleared over-the-counter (“OTC”) derivative contracts are once more the focus of attention. On 10 June 2015 the European Supervisory Authorities (“ESAs”) published their second consultation on these techniques under Regulation 648/2012 on OTC derivatives, central counterparties and trade repositories (“EMIR”). This Second Consultation contains amended draft Regulatory Technical Standards (“Second Draft RTS”) which address several of the concerns raised by industry following the ESAs’ first consultation on risk-mitigation techniques for non-centrally cleared OTC- derivative contracts (“First Draft RTS”) in Spring 2014.
One of EMIR’s key objectives is to encourage the central clearing of standardised OTC derivatives. However, not all derivatives are considered appropriate for central clearing. Consequently, EMIR imposes risk mitigation requirements on parties to transactions in OTC derivatives that are not cleared by a central counterparty (“CCP”). The requirements affect (to a varying extent) all types of counterparties to non-centrally cleared OTC derivative contracts, irrespective of whether they are otherwise regulated or unregulated. EMIR also mandates the ESAs to develop common draft regulatory technical standards (“RTS”) that outline the concrete details of the requirements.
EMIR reflects G20 commitments on OTC derivatives markets following the financial crisis, which highlighted the risks associated with those markets. The G20 commitments include the imposition of margin requirements on non-centrally cleared derivatives and, in September 2013, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions, published minimum standards on margin requirements for non-centrally cleared derivatives (“Minimum Standards”).
The ESAs issued the consultation on their First Draft RTS on 14 April 2014. In their responses, a number of respondents raised several concerns regarding the ESAs’ proposals, including that they were more restrictive than the Minimum Standards in certain respects. Some of these concerns are reflected in the changes introduced in the Second Draft RTS including those relating to:
- the treatment of non-EU entities;
- initial margin (“IM”) models;
- concentration limits;
- documentation requirements;
- segregation; and
- phase-in requirements.
Treatment of Non-EU Entities
Under the First Draft RTS, all EU entities subject to EMIR margin rules were required to collect variation margin (“VM”) and IM from all non-EU entities, regardless of size or status. Respondents were concerned that this would place EU entities which are active in non-EU jurisdictions at a major competitive disadvantage as counterparties would instead opt to transact with non- EU entities that would not be required to collect margin from small corporates. They also pointed out that the proposed approach was inconsistent with the Minimum Standards.
In the Second Draft RTS, NFCs domiciled outside the EU are treated in the same way as NFCs domiciled within the EU1. In other words, EU entities subject to EMIR margin rules have a discretion as to whether or not to collect collateral from counterparties that are below the clearing threshold and established in a third country.
The First Draft RTS provided that IM models must assign each derivative contract to an underlying class (interest rates/currency/gold; equity; credit; and commodity/other) for the purposes of calculating IM and accounting for diversification, hedging and risk offsets. Respondents argued that this approach was more restrictive than that provided for under the Minimum Standards, that it would imply a substantial increase of the IM requirements and would necessitate a change in operational processes.
The approach taken in the Second Draft RTS seeks to allow more flexibility in the modelling phase. In particular, IM models are no longer required to assign each derivative contract to an underlying class. However, IM models may only account for diversification, hedging and risk offsets within the same underlying asset class and not across such classes. There are some changes to the asset classes listed, as compared with the First Draft RTS.
The First Draft RTS imposed specific percentage concentration limits on both IM and VM. While some respondents objected to the percentage limits themselves, respondents also argued that sovereign debt should be exempted from those limits. In this respect it was argued that sovereign debt does not generally raise the same credit issues as corporate debt and therefore should not be subject to the same concentration limits.
While the Second Draft RTS retain specific percentage concentration limits, the diversification requirements in respect of government debt securities now only apply where each of the counterparties is a systemically important institution, as described in those draft RTS.
The First Draft RTS required counterparties to agree several specific matters in writing. Respondents claimed that the number of required written agreements was excessive and had the potential to impose a significant operational burden on counterparties, with limited risk-reduction benefits. The ESAs have responded to these concerns by introducing a more general requirement covering all the aspects relating to trading documentation: when entering one or multiple OTC derivative contracts, counterparties must put in place robust risk management procedures in order to ensure that written trading documentation is executed by them prior to or contemporaneously with entering into non-centrally cleared derivative transactions. The documentation must comprise all material terms governing the trading relationship between the counterparties, including a number of terms specified in the Second Draft RTS.
The First Draft RTS required legal opinions to be obtained, and refreshed at least annually, on the effectiveness of the segregation arrangements. Recognising that such requirements would result in an excessively cumbersome process, the Second Draft RTS has replaced them with the following requirements:
- to perform an independent legal review at least annually of whether applicable segregation requirements are met; and
- to be in a position to provide the documentation specifying the legal basis for such compliance.
Further, whereas cash provided as IM must still be segregated individually, the Second Draft RTS expressly permits the re-investment of such cash where: that use is for the purpose of protecting the party providing it and subject to an agreement between the counterparties; and the re-invested collateral is treated in accordance with applicable segregation and eligibility requirements.
Respondents to the First Draft RTS widely agreed that counterparties would need a longer period of time in which to prepare for and implement the new requirements than that provided for in those RTS. The Second Draft RTS provide for a staggered implementation of the IM requirements and a different staggered implementation for the VM requirements. In so providing, the ESAs are seeking to give more time to market participants to adapt legal documentation, develop internal and bilateral processes and implement operational changes, to give effect to the new requirements.
As a result, the new VM requirements will take effect from 1 September 2016 for the largest financial institutions, with other firms following suit from 1 March 2017. IM posting will be phased in from 1 September 2016 to 1 September 2020, depending on the notional amount of non-centrally cleared derivatives traded by the group to which each party belongs.
Comment and Next Steps
It is clear from the substantial differences between the related provisions of each of the First and Second Draft RTS that the ESAs have taken on board a number of observations made during the first consultation process. As a result, the consultation on the Second Draft RTS focuses on a narrow range of issues and is open for a relatively short one month period, closing on 10 July 2015. The ESAs plan to hold a public hearing on the draft RTS in London on 18 June 2015. Comments on the Second Draft RTS may be submitted to the ESAs here.