Financial institutions, corporates, governments and investment and pension funds take note. The eagerly awaited draft Regulatory Technical Standards on risk-management procedures for non-centrally cleared over- the-counter (OTC) derivatives (“draft RTS”) have been published by the European Supervisory Authorities (“ESAs”). Once adopted, these draft RTS will have significant implications for in-scope counterparties to non- centrally cleared OTC derivative transactions; mandatory collateralisation is seen by many as one of the most significant challenges for derivatives counterparties, second only to mandatory clearing. It is proposed that the draft RTS will become binding on certain counterparties with effect from 1 September 2016 and will be phased in for certain other counterparties after that date.
As set out in our previous briefing (available here), EMIR1 requires financial counterparties and non-financial counterparties that are above the clearing threshold to use risk mitigation techniques for non-centrally cleared OTC derivatives transactions. EMIR also mandates the ESAs to develop RTS on three main topics, namely:
- the risk-mitigation procedures (“RMP”) for the timely, accurate and appropriately segregated exchange of collateral;
- the procedures concerning the application of intragroup exemptions; and
- the criteria for the identification of practical or legal impediments to the prompt transfer of own funds and repayment of liabilities between counterparties belonging to the same group.
The ESAs consulted twice on the draft RTS, in 2014 and 2015. In order to avoid regulatory arbitrage, they also sought to align the draft RTS with the margin framework for non-centrally cleared OTC derivatives issued by the Basel
Committee on Banking Supervision and the International Organization of Securities Commission in September 2013 (the “BCBS/ IOSCO Framework”).
Overview of the Draft RTS
The draft RTS are split into three chapters. The first chapter deals with RMP and covers a number of topics, such as in-scope counterparties’ RMP, margin calculation, eligibility and the treatment of collateral, operational procedures and documentation. The last two chapters address the procedures for in-scope counterparties and competent authorities when applying exemptions for intragroup OTC derivative contracts.
Risk Mitigation Procedures (RMP)
Requirement to Collect Collateral
Under the draft RTS, in-scope counterparties must put in place RMP that provide for the collection of both initial and variation margins and an up- front agreement between them on a list of eligible collateral that satisfies criteria prescribed by the draft RTS. For this purpose, a counterparty established outside the EEA is treated as “in-scope” where it would be subject to the draft RTS if it was established within the EEA and transacts with a counterparty established in the EEA.
Initial margins are intended to cover current and potential future exposures during the period between the last pre-default exchange of collateral and replacement of the derivative, or rehedge of the risk, on default. Variation margins are to protect counterparties against exposures related to the current market value of their OTC derivative contracts.
Exemptions from the Requirement to Collect Collateral
The draft RTS provide for three categories of potential exemptions from the RMP requirements relating to:
- the collection of collateral;
- the calculation of levels of initial margin; and
- the posting or collection of initial or variation margin,
Potential exemptions from the collection of collateral: the RMP may provide that no collateral is exchanged where one counterparty is a non-financial counterparty that is below the clearing threshold or a non-EEA entity that would be such a non-financial counterparty if established in the EEA. The RMP may also provide that collateral need not be collected from a counterparty where the amount that would otherwise require to be collected is equal to or lower than a minimum transfer amount agreed by the counterparties, which does not exceed EUR 500,000 or its equivalent.
Potential exemptions from the calculation of levels of initial margin: the RMP may provide that initial margins need not be collected with respect to:
- certain foreign exchange contracts; or
- new contracts from January in each calendar year, where one of the counterparties has an aggregate month- end average notional amount (calculated as provided in the draft RTS) below EUR 8 billion (at either entity or group level) for the months of March, April and May of the preceding year.
The requirement to collect initial margin may also be disapplied where the sum of initial margins to be collected does not exceed a specified threshold. That threshold, and the initial margins by reference to which it is calculated, varies (depending on whether either counterparty belongs to a group and, if so, the same group) between EUR 10 million and EUR 50 million.
Potential exemptions from the collection of initial or variation margins: the RMP may, subject to certain conditions, exempt a covered bond issuer or cover pool from posting or collecting initial margin and/ or posting variation margin in respect of cover bond-related interest rate or currency derivatives transacted for hedging purposes. Cover bond issuers/pools must collect cash variation margin for such derivatives. Exemptions also apply where a counterparty is in a non-EEA jurisdiction where legal enforceability of the netting arrangements or collateral protection may not be ensured.
The variation margin must be calculated at least daily. The draft RTS also prescribe the time frame for the calculation of the initial margin; at least every 10 business days and in certain other specified circumstances.
The amount of variation margin to be collected by a counterparty is the difference between the aggregated value of all contracts in the netting set calculated on a mark to market basis and the value of all variation margin previously posted, collected or settled.
For the purpose of calculating initial margin requirements, the draft RTS allow counterparties to choose between the standardised approach and initial margin models. The standardised approach involves two steps. Firstly, derivative notional amounts are multiplied by add-on factors that depend on the asset class and the maturity, resulting in a gross requirement. Secondly, the gross requirement is reduced to take into account potential offsetting benefits to the netting set (net-to-gross ratio). The initial margin model may be developed by one or both counterparties or a third party and must comply with the specified criteria set out in the draft RTS. The International Swaps and Derivatives Association, Inc is developing an initial margin model intended to comply with the BCBS/IOSCO Framework on which the draft RTS are based. This is expressed to be a work in progress.2
Eligibility and Treatment of Collateral
The draft RTS set out a list of classes of eligible collateral, eligibility criteria, including criteria designed to avoid wrong way risk, and requirements for credit assessments. They also include requirements regarding the calculation and application of haircuts, concentration limits and collateral-management procedures.
Counterparties are required to implement robust RMP in order to ensure the timely exchange of collateral for non-centrally cleared OTC derivative contracts. These RMP must include clear senior management reporting, escalation procedures and requirements to ensure sufficient liquidity of the collateral. Counterparties are also expected to conduct tests on procedures, at least on an annual basis. Initial margin collected is required to be segregated, so as to be protected from the default or insolvency of the collecting counterparty. Requirements are imposed regarding documentation and independent legal reviews of the enforceability of netting arrangements.
Procedures Concerning Intragroup Derivative Contracts
EMIR exempts intragroup transactions from the requirement to exchange collateral if certain requirements regarding RMP are met and there are no practical or legal impediments to the transferability of own funds and the repayment of liabilities. Depending on the type of counterparties and where they are established, there is either an approval or a notification process.
The draft RTS specify a number of key elements including the amount of time that competent authorities have to grant an approval or to object, the information to be provided to the applicant and a number of obligations imposed on the counterparties. They also further clarify which requirements regarding RMP have to be met and specify the practical or legal impediments to the prompt transfer of own funds and the repayment of liabilities.
As indicated above, the draft RTS provide that they will enter into force on 1 September 2016, however different phase-in periods apply including for the initial and variation margin requirements.
Specifically, in-scope counterparties that have (on a group basis) an aggregate month-end average notional amount, calculated as provided in the draft RTS, of non-centrally cleared derivatives exceeding EUR 3 trillion will be subject to the initial margin requirements from the outset. The draft RTS gradually extend the requirements to smaller amounts until, by 1 September 2020, they apply to any in-scope counterparty belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives exceeds EUR 8 billion, calculated as provided in the draft RTS.
The requirements for the implementation of variation margin will be binding on all major market participants from September 2016, and for all other in-scope counterparties by 1 March 2017.