In response to the 2008 financial crisis, the United States passed the Dodd-Frank Act in 2010. One of the reforms suggested by the Dodd-Frank Act was to require the exchange of margin in relation to non-centrally cleared derivatives. The initiative to impose margin requirements bore fruit at the international level in September 2013, when the Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) jointly published a final policy framework that establishes minimum standards for margin requirements for non-centrally cleared derivatives. Through a series of modifications to address public comments, US regulators finalized their own margin rules in 2015, and the BCBS-IOSCO standards have been adopted by EU regulators in EMIR via supplementing rules called Regulatory Technical Standards (RTS), and by other national regulators.
Amidst global regulatory framework changes in relation to non-centrally cleared derivatives, on 27 February 2017 the Financial Supervisory Service (FSS) of Korea published its final “Guidelines on Margin Requirements for Non-Centrally Cleared OTC Derivatives Transactions” (the “Guidelines”), which came into effect on 1 March 2017. The Guidelines form part of a global effort to reduce systemic risk relating to OTC derivatives transactions and are aimed at implementing the FSS’s “Margin Requirements for Non-Centrally Cleared Derivatives” (the “Recommendations”) published in March 2015.
The Recommendations and, by extension, the Guidelines, seek to reduce systemic risks inherent in OTC derivatives which are not centrally cleared through a central counterparty (“CCP”) by requiring all financial institutions and systemically important non-financial institutions to receive and deliver additional margin in respect of such transactions.
The Guidelines apply to all OTC derivatives transactions which are not cleared through a CCP, other than physically settled FX forwards and swaps, currency swaps, spot transactions, and commodity forward transactions, which are excluded.
Financial institutions such as banks, financial investment companies, and insurance companies, and on/off-shore collective investment schemes trading OTC derivatives with an average balance of nominal transactions greater than or equal to KRW 3 trillion at the end of March, April, and May of each year shall be obliged to comply with the Guidelines. Non-financial corporations, the Bank of Korea, GSEs, and international organizations such as the BIS, are excluded from the scope.
“Aggregate Outstanding Transactions” is the simple average of yearly second quarter month-end notional amounts aggregating all outstanding amounts of the financial group.
Exchange of initial margin shall apply to new contracts executed after each relevant application date.
Cash, gold, government bonds, foreign government bonds, high quality corporate bonds, and listed shares shall be eligible collateral. Shares issued by a party itself will not be treated as eligible collateral. Haircut rates have been published but the Guidelines also allow for parties to use their own internal standards as long as consistent rates are applied for each type of eligible collateral.
(i) Initial margin can be calculated by either the “standard initial margin calculation model” or a quantitative portfolio model developed autonomously by a party or by a third party institution. The two models cannot be used as alternatives depending on which is more favorable under the circumstances. A party must elect one and use it consistently. An entity wishing to use its internal quantitative model approved by a foreign supervisor must report the quantitative model name and the fact of approval to the FSS.
(ii) Variation margin must be calculated in a consistent way in relation to a counterparty and reflect the current exposure related to the portfolio, and it may either be directly calculated by an entity’s internal model or outsourced to a third party. Daily margin calculation is recommended to efficiently manage exposure to market fluctuations.
Threshold is to be applied to the entire financial group but distribution of threshold among each entity within a financial group and by product may be determined through mutual agreement. MTA must be applied for each counterparty, and if the margin to be exchanged is above MTA, the whole margin must be exchanged without deducting the MTA.
Initial margin shall be exchanged on a gross basis whereas variation margin shall be exchanged on a net basis.
Margin must be exchanged based on the Guidelines for transactions within a financial group. However, the Guidelines will not apply to a financial institution which has in place a system to integrally manage the financial group’s risks.
Substituted compliance will be permitted for transactions between “foreign established financial institutions” which comprise (i) foreign financial institutions established outside Korea, (ii) Korean branches of foreign financial institutions, and (iii) subsidiaries of Korean financial institutions established outside Korea. This is conditional on the FSS recognizing the equivalence of the Guidelines and the margin rules of the relevant foreign supervisory bodies.
The entity will need to agree with its counterparty on detailed procedures to detect, record, and monitor disputes concerning confirmation, valuation, and exchange of margin for OTC transactions. In addition, it must prepare dispute resolution procedures.
Overall, IOSCO members have adopted margin requirements that are largely consistent with their peer jurisdictions pursuant to the BCBS-ISOCO framework, and it is worthwhile to compare the Korean margin rules with the US margin rules in particular. The US margin rules have been prepared with reference to the final rule (the “PR Margin Rules”) prepared jointly by the Board of Governors of the Federal Reserve System (the “FRB”), the Office of the Comptroller of the Currency (the “OCC”), the Federal Deposit Insurance Corporation (the “FDIC”), the Farm Credit Administration (the “FCA”) and the Federal Housing Finance Agency (the “FHFA”) (collectively the “Prudential Regulators”), and the final rule (the “CFTC Margin Rules”, together with the PR Margin Rules, the “US Margin Rules”) prepared by the Commodity Futures Trading Commission (the “CFTC”).2 The following summary of US margin rules has been prepared with reference to publicly available sources and legal briefings from other international law firms fully qualified to practice under the relevant laws with expertise in the pertinent issues.3
1 Yulchon LLP is a Korean law firm and is prohibited from rendering any legal advice other than Korean legal advice. We do not advise on US law issues, and this comparison table is summary of US and South Korean margin rules prepared for informational purposes only, and should not be construed as legal advice or legal opinion. If deemed necessary, please seek separate US counsel for legal advice on US margin rules.
2 80 FR 229, November 30, 2015, available at 81 FR 636, January 6, 2016, available at http://www.cftc.gov/LawRegulation/FederalRegister/FinalRules/2015-32320a (note that the CFTC interim final rule is included with the FR release of the CFTC final rule); 81 FR 34818, May 31, 2016, available at http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2016- 12612a.pdf.
3 Latham & Watkins LLP, US vs EU margin rules: comparative summary as of January 4, 2017, January 4, 2017, available at https://www.lw.com/thoughtLeadership/US-EU-margin-rules-reference-guide; Linklaters, The U.S. Margin Requirements: The Impact on Special Purpose Vehicles (SPVs) used in Securitizations, Repackagings and other Structured Products, November 1, 2016, available at http://www.linklaters.com/pdfs/mkt/newyork/Client%20Note_Charts_SPV_PR%20_CFTC%20Margin%20Reqs%20for%20OTC.pdf; Sullivan & Cromwell LLP, Margin Requirements for Uncleared Swaps, January 7, 2016, available at https://sullcrom.com/margin-requirements-for-uncleared-swaps.
4 Fiancial Supervisory Service, March 1, 2017, Guidelines on Margin Requirements for Non-Centrally Cleared OTC Derivatives Transactions.
5 Unclear whether private equity funds and hedge funds are subject to margin rules.
6 Not applicable VM for uncleared OTC transactions with Swap Entity Counterparty as such VM must be posted/collected in cash only.