BCBS and IOSCO Released Second Consultative Document
The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) released a second consultative document (the Second Paper) that presented “the near-final policy framework that establishes minimum standards for margin requirements” for non-centrally cleared (NCC) derivatives. The BCBS and IOSCO indicate that the proposed framework in the Second Paper reflects their consideration of the responses to their first consultative document issued in July 2012 (the First Paper) and the results of the quantitative impact study (QIS) conducted by the BCBS and IOSCO. A copy of BLG’s Derivatives Alert on the First Paper can be found [here]. Over 80 entities, including a number of global or international industry associations such as the International Swaps and Derivatives Association (ISDA), provided their feedback and comments on the framework proposed in the Second Paper.
To date, the Canadian Securities Administrators (CSA) have issued very little guidance on the issue of collateral requirements for over-the-counter (OTC) derivatives. In their consultation paper of segregation and portability in OTC derivatives clearing, the CSA stated that parties to an uncleared trade should be free to negotiate the level of segregation required for collateral, but that dealers should be required to offer arrangements for collateral to be held with a third-party custodian for uncleared trades. The Second Paper provides a much more detailed discussion of the issue.
UPDATES MADE TO THE PROPOSED FRAMEWORK IN THE SECOND PAPER
The First Paper divided the framework into seven elements:
- instruments subject to the requirements;
- scope of applicability;
- baseline minimum amounts and methodologies for initial and variation margin;
- eligible collateral for margin;
- treatment of provided margin;
- treatment of transactions with affiliates; and
- interaction of national regimes in cross-border transactions.
Each element encompassed a key principle and related proposed requirements.
In the Second Paper, the seven elements remain the same; however, under the principle relating to the treatment of transactions with affiliates, initial and variation margin requirements between affiliates are now deferred to local regulators. The BCBS and IOSCO also update some of the requirements relating to instruments that are subject to the margin requirements and the scope of applicability of the margin requirements. In addition, an eighth element (and its corresponding key principle), dealing with the phasing-in of margin requirements, is added.
Instruments Subject to the Requirements
In the First Paper, the BCBS and IOSCO did not settle on any particular criteria that could be used to determine whether a NCC derivative should be exempt from margin requirements. In the Second Paper, the BCBS and IOSCO propose that the margin requirements should apply to all NCC derivatives other than physically-settled FX forwards and swaps, and sought comment on whether there should be different margin requirements for physically-settled FX swaps and forwards with differing maturities.
In its comment letter, ISDA agrees that physicallysettled FX swaps and forwards should be exempt from the margin requirements. It also argues that cross-currency swaps involving the exchange of two currencies, which are similar to physically-settled FX swaps, should also be exempt from margin requirements. ISDA does not support the proposal to impose different margin requirements for physically-settled FX swaps and forwards with differing maturities, as it believes that this would bifurcate the FX market and reduce liquidity for FX derivatives broadly.
Scope of Applicability
In the First Paper, the BCBS and IOSCO proposed that firms that are subject to margin requirements (“covered entities”, which include financial firms and systemically-important non-financial entities) should exchange both initial and variation margin. Recognizing that this requirement would add liquidity costs, the BCBS and IOSCO indicated that they would further consider options that would help mitigate the costs associated with the full bilateral exchange of margin.
In the Second Paper, the BCBS and IOSCO propose the following parameters for the exchange of margin:
- all covered entities must exchange initial margin with a threshold not to exceed €50 million. The threshold is applied at the level of the consolidated group to which the threshold is being extended and is based on all NCC derivatives between the two consolidated groups
- all margin transfers may be subject to a minimum transfer amount not to exceed €100,000
- initial margin requirements will be phased-in and, at the end of the phase-in period, covered entities with NCC derivatives activity of at least €8 billion of gross notional outstanding amount will be subject to the initial margin requirements.
In its comment letter, ISDA notes that the level of initial margin proposed by the Second Paper is extremely high and that such requirements would have a significant impact on the overall market, both in the ordinary course and during times of market stress. ISDA expresses concerns regarding the €50 million threshold and the requirement that the threshold be applied on a consolidated basis. It believes the mandated €50 million threshold is too low. ISDA suggests that the BCBS and IOSCO consider permitting covered entities to determine initial margin on an individual legal entity basis, or to at least provide more flexibility on threshold calculations. It also requests that the BCBS and IOSCO confirm that investment funds managed by the same manager would not be consolidated for this purpose. In addition, ISDA believes the €8 billion trigger for the initial margin requirements is excessively low and that a simple threshold does not accurately reflect the volume of risk for any given entity. In its view, if a threshold method is used, the threshold should exclude, at the very least, instruments used for hedging purposes and any physically-settled swaps and forwards.
Treatment of Transaction with Affiliates
In the First Paper, the BCBS and IOSCO proposed that NCC derivatives between affiliated entities be subject to variation margin requirements, but initial margin requirements would be left to the discretion of the applicable regulatory authority. In the Second Paper, recognizing that the exchange of initial or variation margin by affiliates for NCC derivatives is not customary and that the specific legal and regulatory environment in which such transactions are regulated varies considerably across jurisdictions, the BCBS and IOSCO propose that transactions between a firm and its affiliates should be subject to appropriate 3 regulation in a manner consistent with each jurisdiction’s legal and regulatory framework. Local regulators should impose initial and variation margin requirements for transactions between affiliates, as appropriate. ISDA supports the BCBS’ and IOSCO’s proposals in this regard.
Phase-in of Requirements
The Second Paper articulated Key Principle # 8 as follows:
The requirements described [in the Second Paper] should be phased-in in a manner that appropriately trades off the systemic risk and incentive benefits with the liquidity, operational and transition costs associated with implementing the requirements. In addition, the requirements should be reviewed on a regular basis so as to evaluate their efficacy, soundness and relationship to other existing and related regulatory initiatives.
The BCBS and IOSCO propose that the requirement to exchange variation margin become effective on January 1, 2015 and that the requirement to exchange two-way initial margin with a threshold of up to €50 million be phased in between 2015 to 2019, based on the month-end average notional amount of NCC derivatives for the last three months of the previous calendar year of the corporate group to which a covered entity belongs, starting with €3 trillion in 2015 to €0.75 trillion in 2018. In 2019 and beyond, any covered entity belonging to a group whose aggregate month-end average notional amount of NCC derivatives for the last three months of the preceding year is more than €8 billion will be subject to the initial margin requirements.
ISDA expresses concerns that the phase-in arrangements proposed in the Second Paper impose too short a timeframe. There is no assurance that most jurisdictions will have implemented margin rules by 2015. ISDA suggests that the phase-in dates begin three years after all of the G-7 regulators have promulgated margin rules. In addition, ISDA opposes the requirement that the €8 billion notional amount be calculated at the end of the final three months of the calendar year – there is no reason that the notional amount be measured exclusively over the last three months of the year while disregarding the previous nine months. As ISDA points out, it would be very difficult for a market participant to determine its notional amount as of the last three months of the previous calendar year and, if the €8 billion threshold is triggered, to then be in a position to acquire and post collateral by January 1 to meet the margin requirements.
HOW WILL THE PROPOSALS PLAY OUT IN CANADA?
ISDA’s comments illustrate some of the issues that market participants have with the proposals in the Second Paper. Of course, not all market participants share the same views. One of the challenges for regulators will be to find a solution that works for the various stakeholders, while achieving the objectives of reducing systemic risk and promoting central clearing of OTC derivatives. Other issues raised by the Second Paper on which ISDA and other market participants commented on include the requirements relating to the adoption of an initial margin model, eligible collateral and the applicable haircut, rehypothecation of posted collateral, issues relating to extra-territoriality and, overall, how the margin requirements will dovetail with capital requirements Given the response to the Second Paper, there are a number of issues that the CSA will need to grapple with in designing a solution that is appropriate for market participants in Canada, while seeking to be consistent with international standards. Although the Second Paper proposes that the margin requirements should be effective as of January 1, 2015, given the many issues relating to margin requirements that still need to be worked out, it is not certain that Canada will have margin rules for NCC derivatives in place by that time.
A full copy of the Second Paper is [available here].