EMIR (European Market Infrastructure Regulation No. 648/2012) requires that certain counterparties (please see below) to OTC derivative transactions not cleared through a central counterparty (non-cleared OTC transactions) put in place risk management procedures for “the timely, accurate and appropriately segregated exchange of collateral” in order to reduce counterparty credit risk. This requirement is commonly referred to as “margining” and applies to counterparties classified as (i) financial counterparties (FCs); or (ii) non-financial counterparties over the clearing threshold (as specified in Art. 11 of Regulation No. 149/2013) (NFC+s, and together with FCs, the FC/NFC+counterparties).
On 14 April 2014, the European Supervisory Authorities (ESAs) published common draft regulatory technical standards (RTS) setting out details of the proposed regulatory framework on margining. The consultation period with respect to these RTS ended on 14 July 2014. It is expected that the ESAs will submit the final draft RTS to the European Commission by the end of 2014 with the intention that the majority of the margining arrangements will enter into force as of 1 December 2015.
The arrangements proposed under the RTS include (i) implementing risk management procedures which include the collection of collateral; (ii) various opt-outs from the requirement to exchange collateral; (iii) minimum eligibility criteria for collateral; and (iv) robust operational procedures for the exchange of collateral. This note discusses each of these arrangements in turn.
Collection of collateral
To prevent the build-up of uncollateralised exposures, FC/NFC+ counterparties will be required to collect collateral in the form of initial margin and variation margin. This will apply whether or not their counterparty is established in the EU, subject to the opt-outs outlined in section “Opt-out options” below.
Initial margin will be collected “gross” (i.e., as a two-way payment without the possibility of netting initial margin amounts against each other) within the business day following the entry into a non-cleared OTC transaction. The idea is for initial margin to cover the potential future exposure of an FC/NFC+ counterparty due to its counterparty’s default. Consequently, initial margin will need to be recalculated following a change to the portfolio of non-cleared OTC transactions between the counterparties (e.g., due to the termination of any non-cleared OTC transaction) and otherwise every 10th business day, in each case to reflect movements in counterparties’ risk positions.
The RTS require that initial margin is segregated from proprietary assets of any third party custodian and that the compliance by an FC/NFC+ counterparty with the requirements under the RTS on segregation is supported by legal opinion(s) to be obtained at least annually. In addition, the RTS require that initial margin is not subject to any rehypothecation or other reuse by a collecting FC/NFC+ counterparty.
Variation margin will be collected “net” on a daily basis to reflect current exposures resulting from actual changes in market price calculated in accordance with the daily valuation requirement under Art. 11(2) of EMIR.
Various exceptions to the requirement to collect margin (initial margin, variation margin or both) will be available.
These exceptions are broadly as follows:
- An FC/NFC+ counterparty may agree:
not to collect initial margin with respect to (i) physically-settled FX forwards; (ii) physically-settled FX swaps; or (iii) the exchange of principal of a currency swap;
not to collect initial margin if it or its counterparty belongs to a consolidated group whose aggregate month-end average notional amount of non-cleared OTC transactions for June, July and August of the relevant year is below a certain threshold. The applicable threshold amounts are as follows:
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- < >not to collect initial and variation margin with respect to non-cleared OTC transactions with (i) non-financial counterparties below the clearing threshold; and/or (ii) counterparties exempt from EMIR (as specified in Art. 1(4) and (5) of EMIR); andnot to collect initial and variation margin if the total amount of margin to be exchanged in relation to all non-cleared OTC transactions between it and its counterparty is equal to or lower than €500,000.
- In addition, an FC may agree not to collect initial margin where the total initial margin calculated to be exchanged for all non-cleared OTC transactions between counterparties at group level is equal to or lower than €50 million.
Eligibility of collateral
A wide range of asset classes will be eligible as collateral, including cash, gold, various types of debt securities and equities. Most asset classes will be subject to further conditions, such as credit quality assessments (using an approved internal rating based approach or external ratings), haircuts and concentration limits (of 50%, 10% and 40% respectively, depending upon the asset class) to ensure sufficient diversity of collateral pools.
A variety of operational requirements will be imposed on FC/NFC+ counterparties to ensure that the margining arrangements are implemented in a manner which minimises any potential operational risks. Among other things, the RTS highlight the need for (i) detailed policy documentation with regards to the exchange of collateral; (ii) transparent senior management reporting of material exceptions; (iii) escalation procedures (both internally and between the respective counterparties); (iv) processes to verify the liquidity of collateral; and (v) annual testing of operational procedures for the exchange of collateral.