The Office of the Superintendent of Financial Institutions (OSFI), Canada’s federal regulator of financial institutions, recently issued Guideline E-22 – Margin Requirements for Non-Centrally Cleared Derivatives (Guideline). The Guideline requires the mandatory exchange of margin for non-centrally cleared derivatives transactions (NCCDs). A draft of the Guideline was published by OSFI on October 19, 2015, and the final Guideline reflects many of the comments submitted during the comment period. Blakes represented the International Swaps and Derivatives Association, Inc. in commenting on the draft Guideline.
The Guideline requires the exchange of margin for NCCDs between “Covered Entities” where at least one of the parties to the NCCD is a federally-regulated financial institution (FRFIs). The Guideline is based on the margin framework for NCCDs established by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) entitled “Margin requirements for non-centrally cleared derivatives”. In specified circumstances, the requirements of the Guideline may be satisfied by following comparable foreign rules that are based on the BCBS-IOSCO framework.
While the broad terms of the Guideline will look familiar to market participants who have experience with the BCBS-IOSCO framework, it does contain a number of features specific to Canada. This bulletin discusses the Guideline and some of the implementation issues that market participants will face.
WHO IS SUBJECT TO THE GUIDELINE?
Subject to certain exceptions, the Guideline is applicable to NCCDs between a FRFI and a financial entity (or a transaction between two FRFIs) where both parties to the transaction qualify as “Covered Entities”.
- FRFIs include OSFI-regulated banks, foreign bank branches, bank holding companies, trust and loan companies, cooperative credit associations, life insurance companies, property and casualty insurance companies and insurance holding companies.
- Financial entity refers to a legal entity whose main business includes the management of financial assets, lending, factoring, leasing, provision of credit enhancements, securitisation, investments, financial custody, proprietary trading and other financial services activities. OSFI has noted that the definition of financial entity includes (but is not limited to) deposit-taking institutions, insurance companies, pension funds, hedge funds and asset managers.
The Guideline defines a Covered Entity as a financial entity (which would include a FRFI) that belongs to a consolidated group whose aggregate month-end average notional amount of NCCDs for March, April and May (Aggregate Average Notional Amount) in 2016 or any year thereafter exceeds C$12-billion. For purposes of calculating the Aggregate Average Notional Amount, inter-affiliate trades are excluded but physically-settled foreign exchange (FX) forwards and swaps must be included as NCCDs. A consolidated group is a group of entities for which consolidated financial statements are prepared. Investment funds managed by an investment adviser are considered distinct entities that are treated separately when calculating the Aggregate Average Notional Amount so long as the funds are distinct legal entities that are not collateralised by or otherwise guaranteed or supported by other investments funds or the investment adviser in the event of fund insolvency or bankruptcy. FRFIs that qualify as Covered Entities are referred to in the Guideline as Covered FRFIs.
Certain entities are excluded from the definition of Covered Entity under the Guideline and NCCDs with these entities will not be subject to the new margin requirements. These excluded entities include sovereigns, public sector entities (including entities directly or wholly-owned by a government, school boards, hospitals, universities and certain social service programs, as well as municipalities), certain multilateral development banks, treasury affiliates that undertake risk management activities on behalf of affiliates within a corporate group, certain special purpose entities (SPEs) (including certain SPEs used in connection with securitizations, investment funds and real estate holding, in each case that meets prescribed requirements) and central counterparties.
Where an FRFI transacts with a foreign entity that is incorporated or formed under non-Canadian laws, the Guideline permits the FRFI to defer to the margin rules of the foreign entity’s jurisdiction to determine whether the counterparty is a Covered Entity provided that certain conditions are met (as further explained below).
OSFI expects FRFIs to self-declare their Covered Entity status to their counterparties prior to entering into NCCDs. They are also responsible for verifying whether or not their counterparties are Covered Entities prior to entering into NCCDs. A Covered FRFI may determine the Covered Entity status of its counterparty by relying on a declaration of the counterparty unless the Covered FRFI has reason to believe the declaration is inaccurate. We expect a standard industry template will be developed to allow parties to disclose their Covered Entity status.
Covered FRFIs must exchange applicable margin with counterparties that are Covered Entities. Margin posting obligations apply to transactions entered into starting September 1 of the year in which the entity becomes a Covered Entity (as determined by applying the Aggregate Average Notional Amount test described above). However, if a party’s Covered Entity status changes such that it ceases to be a Covered Entity, no transactions (regardless of when they were entered into) between the parties are thereafter subject to the Guideline’s margin requirements.
WHAT TYPES OF TRANSACTIONS ARE SUBJECT TO THE GUIDELINE?
NCCDs include all derivatives not cleared by a central counterparty, other than inter-affiliate derivatives and physically-settled FX forwards and swaps. Derivatives are defined broadly in the Guideline as a financial contract the value of which depends on, or is derived from, the value of one or more underlying reference assets. The term includes forwards, futures, swaps and options, but excludes physically-settled commodity transactions.
As noted above, for the purposes of calculating the Aggregate Average Notional Amount, inter-affiliate transactions are excluded. However, a consolidated group’s physically-settled FX forwards and FX swaps must be included even though they are not otherwise in scope for the margin requirements.
If the margin requirements apply to NCCDs between a pair of counterparties, then the counterparties must exchange both initial margin and variation margin bilaterally, in the amount and subject to the terms set out in the Guideline.
The requirement to exchange initial margin applies as follows:
Determination of Amount – The required amount of initial margin may be determined by reference to either (i) an internal quantitative portfolio margin model; or (ii) the standardized margin schedule set out in the Guideline. The choice between model-based and schedule-based initial margin calculations should be consistent over time for transactions within the same asset class; the Guideline provides that a counterparty may not “cherry-pick” between the two methods. The Guideline sets out rules and minimum standards for the governance, control and design of models.
Collection – Initial margin must be collected on a gross basis, subject to any agreed upon posting threshold not to exceed C$75-million. The threshold is applied at the consolidated group level, based on all NCCDs between the two consolidated groups. For transactions involving a foreign Covered Entity, the parties are able in certain circumstances to apply the initial margin threshold applicable under foreign margin rules in the jurisdiction of the foreign Covered Entity (in lieu of the C$75-million threshold contemplated in the Guideline). In the case of cross-currency swaps, special rules apply to remove the FX portion of the NCCDs for the purposes of determining the amount of required initial margin.
Timing of Call and Exchange – Initial margin must be calculated and called within two business days of the execution of a trade, and thereafter, on a daily basis. Initial margin must be exchanged on or before the second business day following each call for initial margin.
Holding – Initial margin must be held in such a way as to ensure that: (i) it is immediately available to the collecting party in the event of the counterparty’s default; and (ii) it is subject to arrangements that protect the posting party in the event that the collecting party enters bankruptcy.
Use – Initial margin cannot be re-hypothecated, although initial margin that is cash may be held in a general deposit account with a custodian in the name of the posting counterparty.
The requirement to exchange variation margin applies as follows:
Amount – The required variation margin amount is the amount necessary to fully collateralise the mark-to-market exposure of the NCCDs entered into between the Covered Entities.
Collection on a Net Exposure Basis – Variation margin should be calculated and exchanged subject to a single, legally enforceable netting agreement in respect of all NCCDs between the parties. A netting agreement is deemed legally enforceable where:
- the counterparties have executed a written bilateral netting contract the result of which is a single legal obligation or claim for payment based on the net sum of the mark-to-market values of all netted transactions in the event of a counterparty default
- the Covered FRFI has conducted a sufficient legal review of the laws of all relevant jurisdictions and has a well-founded legal basis to verify that the netting contract and the determination of a net amount would be upheld in the event of a legal challenge
- the Covered FRFI has procedures in place to ensure the continuing enforceability of the netting arrangements in light of possible changes in relevant law
- the netting agreement does not contain a walkaway clause and
- the Covered FRFI maintains all required documentation
Where a Covered FRFI enters into a netting agreement with a Covered Entity that is not legally enforceable, the Covered FRFI must collect variation margin amounts on a gross basis, but may post variation margin in accordance with the netting agreement.
Timing of Calls and Exchanges – Variation margin generally must be calculated and called within two business days of the execution of a trade, and thereafter, on a daily basis. Variation margin must be exchanged on or before the second business day following each call for variation margin.
A Covered FRFI must have dispute resolution procedures in place with a Covered Entity before entering into NCCDs to address potential disagreements in the calculation of initial and variation margin.
Minimum Transfer Amount of Margin
Margin transfers (combined initial and variation margin) may be subject to a minimum transfer amount not to exceed C$750,000. For transactions involving a foreign Covered Entity, the parties are able in certain circumstances to apply the minimum transfer amount applicable under foreign margin rules in the jurisdiction of the foreign Covered Entity (in lieu of the C$750,000 minimum contemplated in the Guideline).
The following types of collateral are eligible to satisfy the initial and variation margin requirements:
- Debt securities rated at least:
- BB- when issued by sovereigns or public sector entities that are treated as sovereigns by the national supervisor
- BBB- when issued by other entities (including banks and securities firms)
- A-3/P-3 for short-term debt instruments
- Unrated bank debt securities listed on a recognized exchange and classified as senior debt where:
- All rated issues of the same seniority by the issuing bank are rated at least BBB- or A-3/P-3 by a recognized rating agency
- The institution holding the securities as collateral has no information to suggest that the issue justifies a rating below BBB- or A-3/P-3 (as applicable)
- Equities (including convertible bonds) that are included in a main index or are listed on a recognized exchange
- Investments in mutual funds and undertakings for collective investments in transferable securities (UCITS) where:
- A price for the units is publicly quoted daily
- The UCITS/mutual fund is limited to investing in the instruments listed above
Securities issued by the posting counterparty are not eligible collateral.
Haircuts must be applied when valuing margin to account for potential changes in the value of the collateral. Counterparties may compute the haircuts using either an internal model or the standard supervisory haircuts set out in the Guideline. When relying on an internal model, the Guideline provides Covered FRFIs with rules pertaining to the governance and design of their models that must be met.
DEFERENCE TO FOREIGN LAW AND SUBSTITUTED COMPLIANCE
Where a Covered FRFI transacts with a foreign counterparty, the Guideline permits the Covered FRFI to defer to the rules of the foreign counterparty’s jurisdiction to determine whether the counterparty is a Covered Entity if (i) the foreign counterparty is not regulated by OSFI and (ii) the Covered FRFI has obtained documentary evidence that the foreign counterparty’s jurisdiction has implemented the BCBS-IOSCO margin requirements for NCCDs through published laws, rules or regulations that include the following:
- the margin requirements in the foreign jurisdiction require the exchange of initial and variation margin for NCCDs between covered entities
- the phase-in of the margin requirements in the foreign jurisdiction is not any longer than the phase-in under the Guideline and
- the exchange of margin is subject to minimum transfer amounts and initial margin thresholds that are similar to or more conservative than those under the Guideline
The Guideline permits substituted compliance for a Covered FRFI trading with a foreign Covered
Entity where the Covered FRFI:
- is required to comply with, and has complied with, the margin requirements imposed on the foreign Covered Entity by a foreign jurisdiction that have been implemented through published laws, rules or regulation and
- has documentary evidence that the margin requirements of the foreign jurisdiction are comparable to the BCBS-IOSCO margin requirements for NCCDs
The Guideline also permits substituted compliance for the Canadian branch of a bank or insurance company established under the laws of a foreign jurisdiction (Branch) where the Branch:
- is required to comply with, and has complied with, the margin requirements of the foreign jurisdiction under whose laws the relevant foreign bank or insurance company is established that have been implemented through published laws, rules or regulation and
- has documentary evidence that the margin requirements of that foreign jurisdiction are comparable to the BCBS-IOSCO margin requirements for NCCDs
We would note that substituted compliance for a Branch appears to be available regardless of whether the Branch is trading with a domestic or foreign Covered Entity (provided the conditions noted above are met). In contrast, substituted compliance is available to Covered FRFIs more generally only where they are trading with a foreign Covered Entity.
PHASE-IN OF MARGIN REQUIREMENTS
The Guideline sets out separate phase-in timelines for the initial margin and variation margin requirements based on the Aggregate Average Notional Amount of both counterparties. As detailed below, the variation margin requirement will be completely phased in by March 1, 2017, and the initial margin requirement will be completely phased in by September 1, 2020. As noted above, for the purposes of calculating the Aggregate Average Notional Amount, inter-affiliate trades are excluded but physically-settled FX forwards and swaps must be included as NCCDs.
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The initial and variation margin requirement will apply to all new NCCDs entered into after the phase-in dates referred to above. The margin requirements will not apply to existing (grandfathered) NCCDs, novated grandfathered NCCDs or NCCDs that result from portfolio compression of grandfathered trades.
ANTICIPATED RULE-MAKING BY PROVINCIAL SECURITIES REGULATORS
We understand that provincial securities regulators are working on similar margin rules also based on the framework established by BCBS and IOSCO. While the exact scope of those rules remains to be seen, our hope is that substituted compliance with the Guideline will satisfy the requirements of the provincial rules to the extent the Guideline is applicable. For transactions where substituted compliance with the Guideline is not available, including in particular when Canadian non-FRFIs face non-Canadian banks and swap dealers, the approach in the provincial rules to substituted compliance will be of critical importance.