Introduction
IM requirements and structures
The Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 has obliged counterparties to non-centrally cleared over-the-counter (OTC) derivative contracts to establish and apply risk management procedures relating to the exchange of collateral.
In this regard, the Delegated Regulation refers to two models for the exchange of collateral between counterparties. These are:
- the "variation margin" (VM), which corresponds to the collateral collected by a counterparty to reflect the results of the daily marking-to-market or marking-to-model of outstanding contracts; and
- the "initial margin" (IM), which is the collateral collected by a counterparty to cover its current exposure and its potential future exposure in the interval between the last collection of the margin and the liquidation of positions or hedging of market risk following a default of the other counterparty.
The VM has already been applied since March 2017, regardless of the average notional amount of the counterparties, and can be applied provided certain requirements are met.
Regarding the timing of the application of the IM rules, the Delegated Regulation establishes six phases of application of those rules, depending on the aggregate average notional amount of non-centrally cleared derivatives of each counterparty. As of 1 September 2022, the sixth phase of application of the IM will occur, with IM requirements applying from that date where counterparties have both, or belong to groups that each have, an average notional amount of non-centrally cleared derivatives exceeding €8 billion.
IM requirements and structures
The counterparties to OTC derivative contracts should therefore assess whether they are subject to the IM exchange obligation and how the rules may apply to them. In this respect, the following steps should be followed.
Establish whether counterparty is covered by IM rules
The entity concerned will be covered by the IM rules if it is:
- a financial counterparty;
- a non-financial counterparty above the clearing threshold; and
- a third country counterparty meeting certain requirements.
Average notional amount of non-centrally cleared derivatives
Where the entity concerned is one of the entities referred to above, for it to be covered by the IM rules, the average notional amount of non-centrally cleared derivatives will need to exceed €8 billion. The average notional amount of non-centrally cleared derivatives must be calculated on the basis of the last business day of March, April and May 2022.
Establish whether counterparty to OTC derivatives is covered by IM rules
The IM rules will only apply if both counterparties in question meet the applicable requirements. For that purpose, the International Swaps and Derivatives Association, Inc (ISDA) has established a template letter – the regulatory initial margin average aggregate notional amount self-disclosure letter (SDL). Entities can use this template letter in the communication they send to their counterparty regarding whether the applicable IM requirements have been fulfilled. In this respect, it is important for each entity to inform its counterparty about whether it has complied with the IM requirements and for each counterparty to check any communication sent by its counterparty using the SDL. If a counterparty has not received any such communication, it should ask its counterparty about it. If neither of the counterparties in question meet the requirements, the IM rules will not apply to their bilateral relationship.
Calculating the margin
Calculation methods
If it is concluded that the IM rules are applicable to a given bilateral relationship, it will be necessary for the parties to calculate the margin that should be made available. There are two methods to do this:
- the standard method, as defined in the Delegated Regulation; or
- the ISDA SIMM, which is a model developed by the ISDA.
Applicable threshold
Under the Delegated Regulation, the parties can agree that the IM should only be exchanged if the amount of the IM exceeds €50 million. Accordingly, only the amount exceeding €50 million will have to be posted as IM.
Excluded transactions
Counterparties to OTC derivatives that are not centrally cleared, and that are traded on or after 1 September 2022, must establish IM exchange procedures if they meet the requirements explained above. However, if the counterparties provide for it in their risk management procedures, initial margins may not be charged in respect of the following transactions:
- foreign exchange (FX) forwards, which involve physical settlement;
- FX swaps, which involve physical settlement;
- exchange of principal on currency swaps, also referred to as principal payments on currency swaps;
- equity options and index options – these are excluded until 4 January 2024;
- covered bonds, if certain conditions are met;
- OTC derivatives linked to securitisations for hedging purposes if certain conditions are met;
- OTC derivatives entered into with counterparties established in a third country if certain conditions are fulfilled;
- intra-group OTC derivatives, if certain conditions are met; and
- certain physically settled forward contracts and commodity options.
Select the appropriate service providers
Under the Delegated Regulation, the IM must be provided in a segregated manner, and the counterparty receiving the IM cannot be reuse it. Therefore, counterparties will need to use a third-party custodian, which will deposit the IM provided by the counterparty.
Typically, these IM deposit or custody services may be provided by credit institutions, as well as by central securities depositories, such as Clearstream and Euroclear. This means there are two types of structures offered by depository institutions:
- triparty custody – a counterparty appoints a depositary institution as its representative. Once both counterparties agree on the amounts of IM that must be provided, the custodian determines which assets of each counterparty best meet the requirements of the IM call and automatically transfers those assets from the counterparty's general deposit account to the segregated IM account; and
- third-party custody – once both counterparties agree on the amounts of IM that should be provided, the providing counterparty gives an order to the custodian to transfer the IM determined by the margin providing counterparty. In this case, the custodian plays no role in determining the margin to be transferred.
Under the Delegated Regulation, counterparties must conduct an independent legal review in order to check that the segregation arrangements comply with the legal requirements.
Documentation
To implement the IM rules, from a contractual point of view, among other things, the parties will have to negotiate and establish certain contractual documents. Assuming that the master agreement (eg, ISDA master agreement) that regulates the OTC derivative transactions entered into between both counterparties is governed by English law – which is common when Portuguese counterparties are involved – the following situations must be distinguished:
- The counterparties have selected depository institutions in different jurisdictions. In this case, the main contractual documents to take into account would be the following:
- an agreement subject to English law governing the mechanical aspects of the margin trading relationship and governed by the same law as the underlying ISDA master agreement. In this regard, ISDA has prepared a contract called the "2019 IM Bank Custodian CTA"; and
- collateral agreement, which will be subject to the law of the jurisdiction where the margin is located, that is, where the deposit accounts are located. For example, if one counterparty selected a depository entity located in Spain and the other counterparty selected an entity located in Portugal, then there should be one collateral agreement subject to Spanish law and one collateral agreement subject to Portuguese law.
- The counterparties have selected depository institutions in the same jurisdiction, namely:
- an agreement subject to English law as above;
- a collateral agreement as above. However, in this case, as their deposit accounts are located in the same jurisdiction, the counterparties will be able to enter into only one collateral agreement; and
- if the jurisdiction of the depository institutions selected by the counterparties is the United Kingdom, as an alternative to the two points referred to above, the parties can enter into the 2018 IM CSD (2018 Credit Support Deed For Initial Margin (IM) (Security Interest – English Law)). This is a contract subject to English law that was developed by ISDA. It regulates the mechanisms for exchanging collateral and the requirements for constituting collateral subject to English law, as would be in the case where both counterparties have deposit accounts located in the United Kingdom.
Besides the documentation referred to above, it is also expected that counterparties will be required to enter into the respective deposit contracts with the depositary institutions. Further, if any of the counterparties use Clearstream or Euroclear to deposit IM, they will also have to enter into membership contracts to access those platforms.
For further information on this topic please contact Luis Miguel Vasconcelos, Gonçalo dos Reis Martins or Raquel Azevedo at PLMJ by telephone (+351 213 197 300) or email ([email protected], [email protected] or [email protected]). The PLMJ website can be accessed at www.plmj.com.