The long-awaited new Australian laws which allow Australian banks, funds, insurers, superannuation entities and other Australian market participants to access the increasingly regulated international risk-management marketplace have been made. In addition, new internationally compliant margining documents have been published. For Australians that were unable to use some offshore clearing markets, and those subject to the looming international margining deadlines, this will be of great relief.
No longer on the margins – new Australian law
The Australian Government has now passed the Financial System Legislation Amendment (Resilience and Collateral Protection) Act 2016 and has now made the Financial System Legislation Amendment (Resilience and Collateral Protection) Regulation 2016. This new law represents a fundamental change to the application of Australia’s security and insolvency laws to financial markets. The Act creates a completely new regime for enforcing security relating to derivatives and the Regulation ensures that trustees of regulated superannuation entities and life companies can now grant the security needed to access certain international clearing houses and offshore liquidity. The Act has received royal assent and will commence on 1 June 2016. The Regulation has been made and will commence immediately after the Act, and apply to charges given on or after, but not before, commencement.
The protections, safeguards and conditions are critical, and sometimes complex. Financial market participants should dedicate some time and energy to consider what must be done to ensure that the potential business impact is understood and unlocked. Our explanation of some of the key issues addressed in the new laws can be found here and here.
What’s in the margins? - Background on margin obligations
Post-financial crisis, international regulation requires that significant market participants who enter into OTC derivatives that are not cleared through a central clearing house exchange margin to cover their exposures. These margin requirements are intended to promote the use of central clearing and reduce systemic risk by ensuring collateral is available to meet losses caused by the default of a derivatives counterparty. Market participants that are subject to the margin requirements may be required to provide both initial margin and variation margin. Initial margin is provided to cover potential future exposures (in other words, exposures that may arise in the future). Variation margin is provided to cover changes in current exposure.
The margin requirements are being implemented locally by many G20 countries (for instance, more on the margin requirements under EMIR is here). In Australia, margin requirements are to be implemented by APRA and APRA’s draft prudential standards for margining (‘Prudential Standard CPS 226 Margining and risk mitigation for non-centrally cleared derivatives’) are currently available for consultation. These draft standards provide for APRA regulated entities (eg ADIs including foreign ADIs, general insurers, life companies including eligible foreign life insurance companies, registrable superannuation entities are certain holding companies) that meet certain qualifying thresholds to be subject to the margin requirements. APRA has proposed phase-in periods for the variation margin requirements (September 2016, March 2017, September 2017 and onwards) and initial margin requirements (September 2016 to September 2020 and onwards). The Australian Council of Financial Regulators is expected to consider the approach for non-APRA regulated institutions later this year.
One of the many challenges to compliance with these requirements was the legal impediments to entities granting the security needed, particularly for initial margin. The new Australian laws address these issues in Australia. Another challenge is the new documentation needed to make it happen.
Collateral on Variation Margin – new collateral documents
The International Swaps and Derivatives Association (ISDA) has been working for some time on new collateral documents intended to help market participants comply with the upcoming margin requirements. These include templates for variation margin. The most recent of these is the 2016 Credit Support Annex for Variation Margin (VM), which is to be used for variation margin which is provided by way of absolute transfer. It complements the New York law Credit Support Annex for the posting of variation margin by way of security interest, which had already been published by ISDA. Under the international margining rules, variation margin can be provided either by way of absolute transfer or security interest which is why two different forms of document are available. In Australia, the use of absolute transfer is most consistent with existing practice so this new document should be of particular interest to participants in the Australian marketplace.
Some new features of the 2016 credit support annex include:
- Covered transactions and multiple CSAs. It covers the transfer of variation margin in respect of the types of ‘Covered Transactions’ specified by the parties (which are intended to be transactions that are subject to variation margin requirements). The transfer of any margin in respect of other types of transactions, and initial margin in respect of Covered Transactions, is intended to be covered by other separate Credit Support Annexes between the parties under the same ISDA Master Agreement (it even includes provisions which offset of delivery obligations between different CSAs). This will be a new step for some market participants who are used to having only a single Credit Support Annex with an ISDA Master Agreement.
- credit support eligibility. It provides for specified credit support eligibility conditions to address regulatory or other limitations on the type of collateral that may be posted. Also, it allows for the application of legally ineligible credit support provisions, which give the recipient of collateral the right to identify collateral (or a specified amount of it) that ceases to meet the margin eligibility requirements under any law applicable to it. These provisions are intended to provide flexibility around margin eligibility issues, including in the event that margin requirements change. They could be used to address requirements related to issues such as wrong-way risk, concentration limits and credit quality assessment, so that parties do not have to set out such requirements in the CSA itself.
- daily margining. The timing for margin requirements is hard-wired into the document as being each business day. Previous documents allowed flexibility in this regard, although parties often agree to daily transfers.
- valuation haircuts. It provides for more complex calculations of valuation haircuts, including their specification by reference from margin requirements.
- interest transfers and adjustments. It provides more flexibility for interest amounts. Parties may elect whether interest amounts are required to be transferred (‘interest transfer’) or satisfied through the adjustment of the amount of cash in the base currency comprised in the credit support balance (‘interest adjustment’).
Crossing the margin – what next?
This is only the beginning of the forthcoming barrage of documents and disclosure which will confront market participants as the imminent commencement of margin requirements draws closer. ISDA is expected to publish further collateral documents over the coming months, including in relation to the posting of initial margin. All of this is critically important and necessary to achieve compliance with the last (and the largest) of the post-GFC global derivative reforms.
The Australian laws needed have been passed but there is still much to do.