Ahead of the March 1, 2017, implementation date of a new variation margin requirement regime in the U.S., which will affect most financial end-users, the International Swaps and Derivatives Association, Inc. (“ISDA”) recently released both an informational self-disclosure letter and a protocol intended to assist market participants with compliance.
The ISDA 2016 Variation Margin Protocol (the “VM Protocol”) adopts a structure similar to prior ISDA protocols relating to derivatives regulation, and is designed to allow market participants to more efficiently establish new, or to amend existing, credit support documentation with each of its non-cleared derivatives counterparties in order to implement the rules of various regulatory regimes for the exchange of margin for those derivatives. However, unlike past protocols, a number of elections will be required to be “matched” by the parties in order to amend current, or enter into new, documentation as described below.
Non-cleared Swaps Margin Rules Generally
Based on the Basel Committee on Banking Supervision and the International Organization of Securities Commissions’ joint framework, these rules have been proposed or adopted in the U.S., Australia, Canada, the EU, Japan and Switzerland. A more detailed explanation of the margin requirements in the U.S. and related considerations can be found in our previous client alert. At a high-level, as of September 2016, financial firms in the U.S. with the largest derivatives portfolios commenced exchanging initial and variation margin on non-cleared derivatives trades. Based on the new regulations, for other financial entities, initial margin requirements will be phased in over a four-year period based on whether those entities have material swaps exposure at specified levels.
In addition, financial end-users trading non-cleared derivatives with covered swap entities that do not trade exclusively uncovered products (e.g., cleared swaps or non-cleared physically settled FX forwards) will be required to post and receive variation margin commencing March 1, 2017. However, the margin rules exclude non-cleared derivatives for certain nonfinancial and corporate end-users that otherwise have an exemption or exception from the clearing requirements and non-cleared derivatives entered into between financial end-users and non-covered swap dealers (e.g., certain regional banks).
ISDA Regulatory Margin Self-Disclosure Letter
Related to the global non-cleared swaps margin rules, ISDA also recently published the Regulatory Margin Self-Disclosure Letter (the “Letter”), intended to be a standard form for sharing information regarding an entity’s status under each applicable regime with that entity’s non-cleared swaps trading counterparties. Although market participants are not required to complete and deliver a Letter to any of their non-cleared swaps counterparties in connection with the VM Protocol, the information disclosed in the Letter will likely be necessary to determine if and when the rules under a particular margin regime will apply to a trading relationship and the elections to be made in the related questionnaires exchanged between the parties for purposes of matching responses under the VM Protocol. In that respect, swap dealers expecting to receive a Letter from their financial end-user counterparties have begun sending the Letter or a proprietary version thereof to those counterparties. A more detailed explanation of the self-disclosure letter can be found in our previous client alert.
ISDA 2016 Variation Margin Protocol
Adherence and Matching Questionnaires
Once parties to a non-cleared derivatives trade have exchanged Letters in order to determine the impact of the regulations on their trading relationship, the parties will likely need to amend their existing credit support documentation or enter into new credit support documentation in order to be compliant with the relevant rules. While the parties could elect to do this on a bilateral negotiation basis, market participants may find it most efficient to adhere to the VM Protocol and exchange standardized questionnaires with each of their in-scope counterparties in order to effect such amendments or new documentation. Like past protocols, there is a one-time fee (in this case, $1,000) in connection with the delivery of an adherence letter to ISDA on ISDA’s website. After delivering an adherence letter, the financial end-user that is party to the related swaps documentation (or the investment manager acting on its behalf if the investment manager signed that swaps documentation on behalf of the financial end-user) can populate one or more questionnaires for delivery to each of the financial end-user’s in-scope counterparties. The questionnaires specify a number of elections, some of which are detailed below. If parties exchange questionnaires and those questionnaires match on certain of those elections, the parties will automatically create new, or amend existing, credit support documentation that is compliant with the new rules, as specified by exhibits generated by the parties’ responses in the questionnaires. If the parties do not match on any required elections, the parties may amend the questionnaires and redeliver them until those questionnaires match on such elections. Questionnaires can be completed either on ISDA Amend on Markit’s website or by exchanging paper or email versions of the forms. Unlike past protocols, it is contemplated that parties will be able to exchange draft forms of questionnaires on ISDA Amend prior to submitting final versions. The VM Protocol questionnaires are expected to be available for matching on ISDA Amend in late November/early December of this year.
Certain Elections Under VM Protocol
When exchanging questionnaires, there are several considerations to weigh. Most importantly, financial end-users must determine whether to: (1) amend existing credit support annexes or “CSAs” with the amendments necessary to comply with the margin rules relevant to a particular relationship; (2) replicate and amend existing documentation such that the then-current CSA would remain in place unmodified for trades in effect prior to the implementation date, and a new CSA would come into effect replicating the existing CSA terms but including the amendments necessary to comply with the margin rules relevant to that relationship for trades entered into on or after the implementation date; or (3) enter into a new CSA based on the new form of ISDA 2016 Credit Support Annex for Variation Margin (VM). Additionally, financial end-users must make some or all of the following determinations (depending on whether the parties have agreed to enter into a new CSA or to amend an existing CSA):
- whether any covered margin regimes apply to the principal delivering the questionnaire (but not their counterparty);
- the latest time for delivery of notice for the demand of a same-day margin transfer;
- a minimum transfer amount to apply to transfers between the parties (not to exceed US$500,000);
- eligible forms of currency and securities to be delivered as collateral between the parties;
- the date of effectiveness of the new or amended documentation (not to be later than March 1, 2017, in the U.S.); and
- whether the new or amended documentation should cover all transactions between the parties or only in-scope transactions.
With respect to the selection of a covered margin regime, financial end-users should note that it is likely that no covered margin regime applies given that the rules in the U.S. impose obligations directly on covered registered swap dealers and only indirectly on end-users.
Given that it is expected that even the largest financial end-users will not be required to exchange initial margin pursuant to the non-cleared swaps margin rules until September 2020, the VM Protocol largely does not address initial margin. However, the new or amended CSAs relating to variation margin may impact the documentation in place between the parties related to initial margin. Accordingly, parties to non-cleared swaps adhering to the VM Protocol should also consider whether they need to revisit their credit support documentation related to initial margin. ISDA is also working on documentation in that respect. Given the volume of counterparties with which covered swap dealers must enter into regulatory-compliant documentation, financial end-users would be wise to start this process to avoid having a limited dealer universe with which to trade, or other trading disruptions when the rules become effective.