European Market Infrastructure Regulation (EU) No. 648/2012 (EMIR) requires certain classes of OTC derivatives to be cleared through a central counterparty (a CCP). This is colloquially referred to as the “clearing obligation” or “mandatory clearing”. For further information on the clearing obligation, please see our earlier report here.
EMIR also requires that certain counterparties to OTC derivatives not cleared through a CCP put in place risk management procedures for “the timely, accurate and appropriately segregated” exchange of collateral. This is colloquially referred to as the “margining obligation”.
Once in force, the margining obligation will extend to all EU financial counterparties (FCs) and EU non-financial counterparties over the clearing threshold (as specified in Art. 11 of Regulation No. 149/2013) (NFC+s, and together with FCs, In-scope Counterparties) unless they can benefit from one of the exemptions available under the margin rules. Notably, there will be no specific exemption for pension schemes under the margin rules. As a result, pension schemes should consider whether it will actually be more expensive to transact on an uncleared basis, but comply with the margin requirements (if they apply) than it will be to clear the relevant OTC derivatives.
Where are we?
On 9 March 2016, the Joint Committee of the European Supervisory Authorities (ESAs) published the final draft regulatory technical standards (the RTS) outlining the framework on margining of uncleared OTC derivatives. The RTS reflect the minimum global standards for margin requirements for non-centrally cleared OTC derivatives introduced by the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) in September 2013 (and then revised in March 2015).
In a nutshell, the RTS:
- set out a requirement for In-scope Counterparties to exchange initial and variation margin (unless exempt);
- outline the list of eligible collateral for the exchange of margin, the criteria to ensure the collateral is sufficiently diversified (with concentration limits only applicable to initial margin) and the methods to determine appropriate haircuts; and
- prescribe the operational procedures related to documentation, legal assessments of the enforceability of the relevant arrangements (such as the bilateral netting agreements) and the timing of the collateral exchange.
The final draft must be endorsed by the European Commission and then accepted by the European Parliament and the Council and published in the Official Journal of the EU before it takes effect.
The new margin rules will impact only uncleared OTC derivatives which are entered into between In-scope Counterparties after the relevant phase-in dates. Separate timescales apply with respect to collateral in the form of initial margin and variation margin (in each case, based on In-scope Counterparties’ aggregate month end average notional amount of non-centrally cleared OTC derivatives (AANA)), and are as follows (subject to certain exceptions ):
Click here to view table.
The risk management procedures will apply throughout the life of any OTC derivatives that are subject to the margin rules at their respective inception dates. Collateral arrangements relating to non-centrally cleared OTC derivatives entered into before the relevant phase-in date will remain subject to existing bilateral agreements.
The RTS provide for a number of opt-outs which are broadly in line with the previous proposals. The “new” requirements include, among other things (i) an option for In-scope Counterparties to agree on separate minimum transfer amounts for initial and variation margin; (ii) an obligation to take into account (albeit once only) all intra-group non-centrally cleared OTC derivatives of the group for the purposes of calculating the group AANA (in order to determine if the prescribed threshold for collecting initial margin has been exceeded); (iii) an option for an In-scope Counterparty not to collect initial margin where both counterparties belong to the same group and the sum of all initial margin required to be collected by such In-scope Counterparty is equal to or lower than EUR 10 million; and (iv) an option for an In-scope Counterparty not to post or collect margin for OTC derivatives with counterparties domiciled in the third-country jurisdictions if certain conditions are met(suggesting that legal enforceability of netting agreements or collateral protection may not be guaranteed).
To the extent they have not already done so, In-scope Counterparties that may be subject to the margining obligation should now start to take steps to establish when the relevant requirements will apply to them and what they need to do to comply.
Crucially, existing collateral agreements should be scrutinised. To facilitate the implementation of the new margin rules across jurisdictions, the International Swaps and Derivatives Association, Inc. (ISDA) has set up a WGMR Implementation Program. A documentation initiative has been established as part of this program to develop new industry standard documentation to govern collateral and segregation relationships in line with the new margin requirements.
On 29 April 2016, ISDA published the English law Credit Support Annex (CSA) for variation margin. ISDA is also expected to publish a variation margin protocol early this summer to assist In-scope Counterparties with the creation of new regulatory compliant variation margin CSAs or upgrade of existing CSAs to be regulatory compliant.
It is expected that the protocol will be relatively complex and will present market counterparties with multiple options as to how to create new CSAs or update their existing CSAs. In order to use the protocols, counterparties should have a firm understanding of the CSAs they currently have in place with all of their counterparties. Counterparties will also be free to update their CSA arrangements on a bilateral basis, although if a party has a relatively large number of trading relationships, it is expected that the protocol will offer significant efficiencies.
ISDA is also developing a self-disclosure letter relating to margining that will provide market participants with a standard form for providing counterparties with information to determine whether compliance with initial or variation margin is required and when.
ISDA is also developing a suite of documentation to address requirements for counterparties to post initial margin. These documents represent a greater departure from existing ISDA documentation as EMIR requires that each party separately post initial margin that is not netted off and not delivered on a title transfer basis. Both pools of initial margin will be held by the counterparties in segregated accounts. Because of the phase-in requirements for initial margin, the initial margin requirements will impact far fewer market participants than the variation margin requirements and many counterparties will never be required to post initial margin.
In addition, as part of the program there is an initiative focusing on the creation of a model for the calculation of initial margin (the ISDA Standard Initial Margin Model (the SIMM)). Latest draft documentation relating to the SIMM was published on 21 March 2016. The SIMM aims to provide an open, transparent, standard calculation methodology that will be available to all market participants (and there will be no charge for market participants to use the SIMM to calculate initial margin with respect to their own uncleared OTC derivatives). In-scope Counterparties should be considering the appropriate method for calculating initial margin, as well as overall infrastructure which will be required by then to comply with the new requirements.