For the first time in the history of derivatives, regulators in leading markets will require assets to collateralize many derivatives which are not settled in a regulated clearinghouse.
It is not possible to overstate the significance of this global regulatory development, which began to take effect in the United States on September 1, 2016, and will continue to apply in 2017 in several industries domestically and across national borders.
Employee benefit plans, foundations, certain entities used in real estate financings, funds, financial services firms, banks and even non-financial companies may be subject to new law and regulation, depending on their use of derivatives and their counterparties.
The next compliance date is March 1, 2017, for many companies using over-the-counter or OTC derivatives; market participants in multiple jurisdictions will be required to comply with new collateral regulations.
On November 28, 2016, compliance tools were made available to the market through a partnership between a leading international trade association and a service provider.
This introductory summary is the first in a series of briefings which provides background and brings into sharper focus compliance tools, requirements, action items as well as timing and consequences for non-compliance.
Industry-specific and technical issues are the subject of later briefings. A framework for understanding the law, which to some may appear like a game of three-dimensional chess, is provided in this introductory briefing.
This important development necessitates coordinated action in operational, documentation, negotiation and trading spheres well before March 1, 2017, and teams of compliance, legal, treasury, tax, asset managers and others have begun to collaborate to meet myriad challenges before March 1, 2017, at the risk of losing access to these important financial instruments.
Similar in many respects to insurance policies, derivatives manage risks which are inherent in business enterprises and charitable pursuits. Domestic and multinational corporations execute derivatives to manage fluctuations in currencies and interest rates (which will likely rise), as well as price fluctuations in consumer products such as milk and eggs to other commodities, from cardstock to oil, gas and other resources.
Derivatives are executed in connection with the financing of commercial and residential real estate developments and these ubiquitous financial tools also manage outputs from oil, gas, the sun and wind. Investment managers, banks, energy and transportation companies use derivatives extensively. Local water, electricity and other utilities and governmental entities have derivatives in place. Sovereign funds protect assets with derivatives. The World Bank has for years used derivatives to lessen the adverse financial and human impacts of severe droughts in countries such as Malawi and derivatives are also used in connection with climate change initiatives.
Derivatives are not new; archeologists discovered cuneiform tablets indicating their use in some form since 2800 BC (the history of their regulation is included in the author’s text, The Post-Reform Guide to Derivatives and Futures (John Wiley & Sons, 2012), hereinafter the “Guide to Derivatives”).
Today the global OTC derivatives market has been reported to be in excess of USD 500 trillion in aggregate notional value. Over USD 300 trillion of that value is traded in the United States, an amount that is greater than 23 times the gross domestic product of the US.
Unless derivatives are settled by a regulated clearinghouse or an exemption applies, derivatives used in many industries (and even many charitable undertakings) have been, and will continue to be subject to an elaborate set of collateral rules promulgated by regulators, generally in a coordinated way, globally, from September 1, 2016, and thereafter on March 1, 2017.
These rules arose out of the Great Recession of 2008 and were released across multiple time zones and jurisdictions. The next phase of implementation affecting most OTC derivatives after February 2017 was triggered by final rules issued by U.S., European, Canadian, Japanese and other regulators. Swap dealers and others within the jurisdiction of these regulators will indirectly impose collateral rules on the parties facing banks and dealers on trades.
Practical Framework for Understanding Obligations
There are several practical recommendations in approaching derivatives compliance initiatives as well as pitfalls to avoid in this time-sensitive undertaking.
The first practical recommendation for complying with derivatives law and regulation is from the author’s Guide to Derivativesi: inventory your firm’s existing use of derivatives based on the “3 P’s,” that is, the platform on which your derivatives are executed and settled, or “cleared,” the product that is traded, and the participants in the transaction.ii
A clear understanding of the participants in the transaction will help provide the correct regulatory map identifying the rules that apply. OTC derivatives are executed in most regulatory jurisdictions throughout the world. The rules are new and have not been completely harmonized.
If, for example, a participant to a derivative is a bank regulated by a U.S. prudential regulator, that bank is authorized by express regulation to impose certain margin requirements, under certain circumstances, on non-financial companies (such as energy and many real estate companies, for example) facing the bank in a covered transaction. Without initially understanding each participant to a trade and the applicable set of regulations, time and resources may be wasted or margin may be imposed with regulatory authority in an unanticipated way.
So, to avoid surprises and to continue trading, parties to derivatives need to properly identify themselves to each other and confirm the correct application of law. To facilitate identification, the leading trade association for OTC derivatives (International Swaps and Derivatives Association, Inc.) published on June 30, 2016 the ISDA Regulatory Margin Self-Disclosure Letter (SDL) to be exchanged between the two parties to an OTC derivative. The SDL includes representations enabling each party to reach conclusions, such as which law would properly apply to their trading.
The SDL may be exchanged in hardcopy form or electronically after November 18, 2016 on the IHS Markit Counterparty Manager electronic platform. Dealers providing derivatives to their counterparties will not continue and do so unless those dealers obtain requisite information prior to derivative execution, either by the SDL or otherwise.
Participants are characterized in the SDL in several important ways, including, for purposes of U.S. law, whether the participant is a “financial end user,” a deceptively broad term that pulls into that category an expansive list of various entities including, but not limited to, foundations, employee benefit plans, funds, banks, financial services firms and even certain vehicles used in real estate and other financings.
Parties who face U.S. dealers or banks need to understand which sets of rules to follow: either swap rules promulgated by the U.S. Commodity Futures Trading Commission (regulator of Swap Dealers, et al.) or rules put into final form by U.S. prudential regulators (regulators of banks that are not Swap Dealers). These rules from multiple regulators are not the same and present challenged reading.
Even those companies which are outside of the scope of the term “financial end user” may be subject to collateral requirements triggered by recently finalized and effective rules on collateral. For example, an energy company that is not engaged in investment may enter into a derivative that is subject to U.S. prudential regulator margin rules, which authorize (but do not require by regulatory mandate) a U.S. bank to impose margin requirements on that energy company, for example.
Once the participants to a covered transaction are clear as to the legal and regulatory regime that applies (and the way each participant is properly characterized and thereby regulated), the next practical step is to understand the application of the law to the financial product that is subject to their transaction.
Requirements within these rules also turn on the type of OTC derivative executed and settled by the participants to the transaction. Certain currency derivatives are subject to mandatory margin rules in the European Union—but not in the United States, where the vast majority of OTC derivatives except certain currency derivatives were subject to September 1, 2016 rules and will also be subject to March 1, 2017 collateral rules (September 1, 2016 and March 1, 2017 U.S. collateral rules, together, the “U.S. Collateral Rules”).
After confirming the application of the law to properly-characterized market participants and the products, the final step in the analysis involves the platform on which the derivatives trade. The U.S. Collateral Rules do not apply if a platform referred to as a clearinghouse is used to settle the trades. Derivatives that are executed bilaterally (between two parties but not on a regulated exchange) and then “given-up” for settlement or clearing at a regulated clearinghouse are not subject to the U.S. Collateral Rules. Futures and other exchange-traded derivatives are outside of the U.S. Collateral Rules.
Understanding the Collateral Requirements and Timing
Using a framework along the lines of what is described above is important for a few reasons; new and far-reaching collateral requirements may appear like three-dimensional chess. A framework that addresses derivative collateral requirements based on the parties to the trade (and their regulators), the financial product traded and the platform on which they trade is important. This is because not all rules apply simultaneously and many rules are phased-in.
If the party to a trade is a U.S. Swap Dealer or Major Swap Participant, then the margin rules imposed by the Commodity Futures Trading Commission, or CFTC, apply. If the party to the trade is a bank or other financial services entity regulated by U.S. prudential regulators (PRs), then the collateral rules of the PRs apply. CFTC and PR rules are substantially harmonized but the other leading U.S. regulator of derivatives (the Securities and Exchange Commission or SEC), including put and call options on most equities, has yet to publish final rules on the collateralization of financial products under SEC jurisdiction. PRs in the U.S. published a final and interim rule for most derivatives executed and settled over-the-counter (OTC) on November 30, 2015, while the CFTC published its OTC margin rules on December 15, 2015. The CFTC and PR rules are not the same.
PR rules for collateral are phased in over a five-year period, in a manner that is consistent with international banking regulators and supervisors, the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions (Basel/IOSCO).
New collateral rules address two forms of collateral: initial margin and variation margin. Variation margin protects parties to a derivative from daily fluctuations of values in the market for the derivative. Initial margin is designed to protect a party against losses that may occur anytime (including during a single trading day) prior to the maturity or termination of the derivative.
Whereas in the United States, initial margin requirements have been in place since September 1, 2016 for trading between many of the largest market participants in derivatives (e.g., Swap Dealers and Major Swap Participants as well as banks and other financial services entities regulated by the PRs in the U.S.), CFTC variation margin requirements will, for the first time, be imposed on and after March 1, 2017 for many of those trading with counterparties under the jurisdiction of U.S. and other regulators in leading markets.
The March 1, 2017 variation margin requirements affect a wider universe of entities trading in the global derivatives market than the September 1, 2016 initial margin requirements.
Initial margin requirements imposed by PR regulators in the U.S. were phased-in starting on September 1, 2016 and continuing through September 1, 2020. The timing and application of rules depends on the average daily aggregate notional amount of OTC swaps and foreign exchange forwards and swaps.
September 1, 2016 was the effective date for PR requirements to collect and post variation margin supporting swaps executed and settled over-the-counter for market participants with USD3 trillion of average, daily aggregate notional value (with affiliates).
Tools to Comply by March 1, 2017
Of the wide range of tasks which need to be attended to in light of collateral rules, perhaps none is more important from a legal standpoint than ensuring that the proper documentation is in place before March 1, 2017. On November 28, 2016, the International Swaps and Derivatives Association, Inc. (“ISDA”), working in tandem with IHS Markit (“Markit”), announced the launch of an electronic platform to create and amend derivatives documentation in a manner that may bring about compliance with applicable statutory law and regulation through a protocol published by ISDA. This will be the subject of subsequent briefings.
The primary challenge is understanding the legal (and resulting operational) mandates (and operational adjustments) that need to take place no later than March 1, 2017 for most market participants.
Documentation which has already been executed may be amended by two parties which have a “meeting of the minds” through a process called “adhering” or joining a protocol on Markit with written terms which, after adherence, are incorporated into existing documentation. New ISDA variation margin documentation is available either from ISDA (www.isda.org) or from the author.
As this briefing is meant to provide both a foundation and a framework for understanding new collateral rules, additional guidance on an industry-by-industry basis will be provided shortly in subsequent briefings.
Readers seeking additional background are encouraged to contact the author of this briefing and consult the Guide to Derivatives which discusses collateral, trading, documentation and Title VII of Dodd Frank, as well as the basis of the rules which are introduced in this briefing. Excerpts from, or limited copies of the Guide to Derivatives may be available from the author at no cost and questions concerning these far-reaching rules are welcome.