On June 10, the European Supervisory Authorities (ESA) published a second consultation paper on draft Regulatory Technical Standards (RTS) to implement the European Market Infrastructure Regulation (EMIR) requirement that persons classified under EMIR as “financial counterparties” (FCs) or “non-financial counterparties” (NFCs) who surpass certain specified clearing thresholds (referred to as NFC+s) collect and post initial and variation margin for their non-cleared over-the-counter (OTC) derivatives (the Revised Margin RTS). The Revised Margin RTS reflects changes and clarifications to the draft RTS that was issued by the ESA in April 2014 on the same topic (the 2014 Margin RTS). The changes made to the 2014 Margin RTS by the Revised Margin RTS are based on the ESA’s review of comments and suggestions from industry stakeholders and other authorities in response to its consultation paper on the 2014 Margin RTS.
The second consultation paper solicits comments on those aspects of the Revised Draft RTS that differ from the 2014 Margin RTS. Comments in response to the second consultation paper must be submitted by July 10, 2015.
Summarized below are certain key aspects of the Revised Margin RTS relevant to end-users of OTC derivatives that may be subject to the Revised Margin RTS directly or by virtue of having OTC derivatives counterparties that are subject to the Revised Margin RTS=.1
1. Application of Margin Requirements to Third-Country Entities (TCEs)
Persons outside of the European Economic Area (EEA) are considered TCEs for purposes of EMIR. Under the 2014 Margin RTS, FCs and NFC+s would have been required to collect initial and variation margin from all of their TCE counterparties, regardless of how they would be categorized under EMIR if they were located within the EEA. The Revised Margin RTS recognizes that requiring all TCEs to post initial and variation margin may result in such TCEs choosing not to trade with EU entities and thus, could place EU entities at a competitive disadvantage in the market. To prevent jurisdictional arbitrage, the Revised Margin RTS stipulates that, when facing EU entities, TCEs will be subject to the margin requirements only if they would be classified as FCs or NFC+s under EMIR if they were located in the EEA. This change in the Revised Margin RTS is notable because under the proposed U.S. rules for margin relating to OTC derivatives, non-financial end-users are not required, by regulation, to post or collect margin but would have had to do so with their EEA counterparties.
2. Trading Documentation Requirements
The 2014 Margin RTS required that market participants enter into written agreements to govern the operational processes for the exchange of collateral, even with counterparties that would not be subject to margin requirements. This requirement had the potential to result in an excessive operational burden with limited risk-reduction benefits. To balance the need for proper trading documentation and the risk of creating unnecessary burdens on market participants, the Revised Margin RTS requires such trading documentation only for relationships where the exchange of margin is mandated by the Revised Margin RTS. Such documentation must address all material terms governing the trading relationship between the counterparties.
3. Cash Collateral as Initial Margin
The 2014 Margin RTS would have imposed strict segregation requirements and restrictions on the re-use of collateral posted as initial margin. Such requirements and restrictions were criticized for resulting in a de-facto ban on the use of cash as eligible collateral for initial margin. The Revised Margin RTS relaxes the restrictions on the re-use of collateral so that cash collateral posted as initial margin may be reinvested to protect against the exposure that the counterparty collecting the collateral faces with respect to the posting counterparty. Notwithstanding the foregoing, securities obtained via the reinvestment of cash collateral still must be segregated and may not be re-used.
4. Timing of Variation Margin Exchanges
The 2014 Margin RTS required collection of margin within one business day following execution of an OTC derivatives transaction, which many market participants complained did not account for unavoidable operational delays such as time zone differences and margin call reconciliations. The Revised Margin RTS still requires that variation margin be calculated daily but now may be collected within three business days of the calculation date.
5. Timing for Implementation
The 2014 Margin RTS called for the variation margin requirement to enter into force beginning in December 2015 and the initial margin requirement to be subject to a staggered implementation period between December 2015 and December 2019, depending on the counterparties’ aggregate month-end average notional amount of OTC derivatives not subject to clearing.
The Revised Margin RTS modifies the proposed implementation dates to be in line with international standards recommended by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions. Pursuant to the Revised Margin RTS:
- The variation margin requirement would be implemented via a phase-in schedule beginning on September 1, 2016 if both counterparties have an aggregate average notional amount of non-centrally cleared derivatives above three trillion Euros. All other contracts would be subject to the variation margin requirement beginning on March 1, 2017.
- The initial margin requirement still would be implemented via a staggered phase-in schedule based on the counterparties’ aggregate month-end average notional amount of OTC derivatives not subject to clearing, but such schedule would begin on September 1, 2016 and run through September 2020 instead of December 2015 through December 2019.