The Canadian Securities Administrators (CSA) recently published for comment Consultation Paper 95-401 – proposing a framework for minimum margin requirements for non-centrally cleared derivatives.
This framework is another development in an ongoing reform by the CSA and other regulators intended to make the Canadian over-the-counter (OTC) derivatives market more secure and transparent. For more information about the other aspects of the reform, see our previous articles concerning the revised mandatory clearing rules for OTC derivatives and the customer clearing rule published by the CSA and the final margin requirements for non-centrally cleared derivatives transactions published by the Office of the Superintendent of Financial Institutions (OSFI).
The proposed framework is largely consistent with the standards developed by the Basel Committee on Banking Supervision and the International Organization for Securities Commissions (BCBS-IOSCO Standards) that were published in March 2015 and the Guideline E-22 on Margin Requirement for Non-Centrally Cleared Derivatives (OSFI Guideline)applicable to federally regulated financial institutions (FRFIs) and includes the key elements outlined below. The proposed framework does not apply to FRFIs.
- Scope of OTC Derivatives and Entities Subject to Margin Requirements
With some exceptions relating, for example, to physically settled foreign exchange transactions (for initial margin), physically settled commodity transactions and other instruments excluded under local product determination rules, the proposed margin requirements apply to all OTC derivatives that are not cleared through a central counterparty, provided that both counterparties to such derivatives are “covered entities.” A covered entity is defined as “a financial entity whose aggregate month-end average notional amount outstanding in non-centrally cleared derivatives, calculated on a corporate group basis and excluding intragroup transactions, exceeds $12 billion.”1 The term “financial entity” covers a wide range of market participants such as cooperative credit associations, central cooperative credit societies, banks, loan corporations, loan companies, trust companies, insurance companies, treasury branches, any person or company subject to registration or exempt from it under securities legislation of a Canadian province as a result of trading in derivatives.
Covered entities that are not FRFIs satisfy the proposed margin rules if they enter into a derivative with a FRFI subject to and complying with the OSFI Guideline.
- Margin Requirements
Initial and Variation Margins: Covered entities are obliged to exchange initial margin and deliver variation margin in relation to non-centrally cleared derivatives where both of the counterparties are covered entities. Initial margin is intended to protect the non-defaulting party from potential future exposure arising from the default of its counterparty. Variation margin is intended to prevent the accumulation of current losses due to changes in the value of the underlying asset and prevent the erosion of initial margin.
Margin Calculation: Initial margin is calculated by using either the standardized schedule proposed by the CSA or quantitative margining models developed by covered entities or third parties. The standardized schedule defines initial margin as a percentage of notional exposure, setting the range of initial margin from 1% to 15% depending on the asset class. The standardized schedule is a straight-forward method of calculation; however, it is not fully sensitive to risks associated with a derivatives portfolio. Market participants preferring the initial margin calculation to be tailored to the risks arising under a particular class of derivatives could use quantitative margining models, a more sophisticated, yet more costly and less transparent, method of margin calculation. To strike a balance between flexibility and transparency, quantitative margining models used by covered entities must comply with certain standards (such as certification by an independent auditor) prescribed by the CSA. Furthermore, although covered entities may choose the method of calculation, they may not switch between the use of the standardized schedule and quantitative margining models to obtain favourable margin outcomes. As for variation margin, covered entities are expected to calculate it using the mark-to-market method. They could use alternative calculation methods only if prices for a mark-to-market method are unavailable, untimely or unreliable.
Thresholds: The requirement to exchange initial margin will be triggered only when the total amount of initial margin under all outstanding non-centrally cleared derivatives, determined on a consolidated group basis, exceeds $75 million. Covered entities will be required to exchange the initial margin in excess of this threshold (subject to a minimum transfer amount). The proposed minimum transfer amount for the delivery of initial and variation margin on a combined basis is $750,000. If this threshold is reached, the covered entity will be required to deliver the entire amount of margin payable.
Rehypothecation: Initial margin may not be re-hypothecated, re-used or re-pledged, except on a one time basis in order to fund a back-to-back hedge of the derivative position of the posting counterparty. The CSA is silent as to whether variation margin may be re-hypothecated but such re-hypothecation is permitted under the OSFI Guideline and the BCBS-IOSCO Standards.
- Eligible Collateral
To ensure the efficiency of the margin requirements, the assets exchanged as margin should be highly liquid and, after accounting for an appropriate haircut, they should be able to hold their value in a time of financial stress. Moreover, these assets should not be heavily dependent upon the creditworthiness of the counterparty providing the collateral or upon the value of the derivatives in relation to which the collateral is exchanged. Furthermore, their quoted prices, if any, should be reasonably accessible to public to allow counterparties to value them. The non-exhaustive list of eligible collateral proposed by the CSA includes: cash; gold; debt securities issued by or guaranteed by the Government of Canada or the Bank of Canada or the government of a province or territory of Canada; debt securities issued and fully guaranteed by the Bank for International Settlements, the International Monetary Fund or a multilateral development bank with a rating of at least BB-; debt securities issued by foreign governments with a rating of at least BB-; debt securities issued by corporate entities with a rating of at least BBB-; equities included in major Canadian stock indices; and some types of mutual funds.
The CSA are cognizant of the fact that the proposed margin requirements may impact the availability, price and liquidity of high-quality collateral. However, the CSA believe that the risk of such impact will be mitigated by limiting the reach of the margin requirements to transactions where both counterparties to a derivative are covered entities and by setting the threshold for initial margin exchange.
- Phase-in Approach
The CSA will adopt a phase-in timeline to allow for a gradual implementation of margin requirements and to mitigate their impact on relatively small market participants.