EMIR is the centrepiece of the EU post financial crisis reform of derivatives markets and seeks to address perceived issues with counterparty credit risk and transparency. After a long and difficult consultation period, and some way behind other similar global initiatives, the next major piece of the EMIR framework will soon come into effect--the requirement for eligible counterparties to post margin on OTC derivative transactions.
These new requirements will affect financial counterparties (which include EU banks, insurers, asset managers and pension funds) and non-financial counterparties with derivative portfolios above the EMIR thresholds. The requirement will result in major changes for eligible counterparties' derivative trading activities, as well as imposing significant liquidity and operational burdens on those counterparties.
The upcoming 1 March 2017 deadline will be of immediate concern to all affected counterparties, as from this date, all new uncleared OTC derivative transactions will be subject to the requirement to post variation margin in accordance with the new rules. This will be a "bigbang" moment in the market and affected clients should begin taking immediate steps to ensure compliance in advance of the deadline.
The European Market Infrastructure Regulation1 ("EMIR") is the key piece of post financial crisis derivative regulatory reform in the EU. It is aimed at reducing systemic risk in derivatives markets by addressing perceived issues with counterparty credit risk and transparency. One of the main requirements EMIR imposes to achieve that aim is for EU financial counterparties ("FCs") (broadly defined to include banks, asset managers, alternative investment trusts, UCITS, insurers and pension funds) and non-financial counterparties (defined as entities which are not FCs) with derivative portfolios above the thresholds specified in EMIR ("NFC+s") to exchange margin on uncleared OTC derivative transactions, including initial margin ("IM") and variation margin ("VM"). This obligation applies where an EU FC or NFC+ trades with another EU FC or NFC+, or where an EU FC or NFC+ trades with a non-EU entity which would be subject to the requirements if it was established in the EU. The EMIR margin requirements reflect similar reforms enacted in other major jurisdictions, including the US, Japan and Canada.
Article 11(15) of EMIR mandated the European Supervisory Authorities ("ESAs") to develop common draft regulatory standards ("RTS") to implement the margin requirement. After a long and difficult consultation period, the
1 Regulation (EU) No. 648/2012.
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European Commission adopted the RTS on 4 October 2016, and the RTS was published in the Official Journal on 15 December 2016.
It is clear that EMIR has brought about widespread reforms to derivative markets, from adjustments to operational processes to accelerating the trend towards central clearing. As described below, it is likely that the requirement for eligible counterparties to exchange margin in accordance with the requirements of the RTS will bring about further profound reform of derivative markets, and will impose significant liquidity and operational requirements on eligible counterparties. Clients should particularly note the upcoming 1 March 2017 deadline for eligible counterparties to commence exchanging VM (as described below), which will be a "big-bang" moment. We would recommend that clients begin taking preparatory steps (including reviewing existing collateral documentation, engaging with counterparties to make necessary amendments and confirming internal operational processes meet the RTS requirements) as soon as possible to meet this deadline.
2. Margin Rules
The two key requirements which the RTS imposes on eligible counterparties are the obligations to exchange VM and IM.
The requirement to exchange VM will commence for most eligible counterparties on 1 March 2017 and applies to OTC derivative transactions entered into after that date. VM is defined in the RTS as "collateral collected to reflect the results of the daily marking-to-market of outstanding contracts referred to in [EMIR]". VM is therefore exchanged in order to reduce the current market risk for the parties of the OTC derivative contracts contained under the relevant netting set. The RTS requires the daily exchange of VM between counterparties, with postings to occur on the same day as valuations. Collateral posting on a T+2 basis is permitted, but only where the counterparties have posted sufficient initial margin to cover the extended posting period.
IM is defined in the RTS as "collateral collected by a counterparty to cover its current and potential future exposure in the interval between the last margin exchange and the liquidation of positions following a default of the other counterparty". In simple terms, IM is therefore exchanged to cover the "gap risk" of changes in the market value of a transaction in the period between a default occurring and the transaction terminating (usually estimated at a minimum period of 5 business days). Unlike the VM obligation, the requirement for eligible counterparties to exchange IM has a staggered implementation timeline, which depends on the size of the counterparties' portfolio (the "portfolio") of uncleared OTC derivative transactions; measured as the average aggregate notional amount of such transactions at group level ("AANA"), as follows:
Both counterparties have a portfolio in excess of EUR3 trillion
Both counterparties have a portfolio in excess of EUR2.25 trillion
Both counterparties have a portfolio in excess of EUR1.5 trillion
Both counterparties have a portfolio in excess of EUR0.75 trillion
Both counterparties have a portfolio in excess of EUR8 billion
IM Commencement Date February 2017 September 2017 September 2018 September 2019 September 2020
The RTS requires that IM is calculated using either (i) a model which meets the detailed requirements of the RTS (including a confidence level of 99% with a risk horizon of at least 10 days, using data from a historical period of at
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least three years, including at least 25% of the overall data set from a period of stress) or (ii) the standardised approach set out in the RTS (which, in simple terms, applies a specified percentage to the notional amount of the transaction to produce a gross requirement, which is then reduced to take into account potential offsetting benefits in the netting set). The RTS permits a threshold of EUR50 million, or EUR10 million if both parties are part of the same group, before IM must be collected.
Counterparties are required to recalculate IM on certain specified events, including the addition of a new transaction, payment under a transaction or termination of a transaction, with a minimum IM recalculation period of 10 days.
The RTS recognises that a requirement for both counterparties to post IM to each other would result in significant credit exposures between the parties. The RTS therefore requires that any IM is segregated from the assets of both parties. In practice, unless one of the parties is able to offer a custodial type arrangement, this is likely to require the parties to use a third party custodian.
Eligibility, Haircuts and MTA
The RTS contains significant detail on the types of collateral which can be exchanged. A full list is included in the RTS, which includes cash, gold, sovereign and quasi-sovereign bonds, supranational bonds, corporate bonds, senior tranches of eligible securitisations, equities included in main indices, convertibles and UCITS shares. Any such collateral must meet minimum rating criteria (either internal IRB ascribed or as provided by an approved external credit rating agency), and a process must be included for the removal of such collateral which fails to meet those ratings requirements but avoiding a "cliff-edge" immediate sale. Concentration limits are applied, with further restrictions on wrong way risk and own issued securities.
The RTS also contains haircuts which must be applied to the collateral, which depend on credit quality and maturity. A further 8% haircut is applied where collateral is posted in a currency other than that specified in the relevant transaction, netting agreement or exchange of collateral agreement. The RTS also states that the minimum transfer amount (or "MTA") may be a maximum of EUR500,000, which may be split between VM and IM.
The RTS requires that the parties have adequate operational processes which support the requirements to exchange collateral. These include clear senior management reporting, escalation procedures (internally and with counterparties), processes to ensure sufficient liquidity and eligibility of the collateral, collateral management and (where applicable) segregation processes, and collateral valuation mechanisms. Counterparties are required to conduct tests on these operational procedures at least on an annual basis, and are required to be able to produce documentation which supports these operational procedures on request by a regulator.
In addition to the operational processes described above, the RTS also contains specific requirements for the legal agreements the counterparties must have in place for the exchange of collateral. These include that such agreements contain terms covering payment obligations, netting arrangements (both payment and default netting), events of default, calculation methods, segregation arrangements (where applicable) and governing law. The RTS requires that an independent legal review of the enforceability of those agreements (including netting arrangements) is conducted when they are entered into and on a continuous basis. Such review may be conducted externally or internally, and reliance on opinions obtained under Article 296 of the Capital Requirements Regulation2 is permitted.
3. Exemptions and Thresholds
The RTS contains several exemptions from both the VM and IM requirements.
2 Regulation (EU) No. 575/2013
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Physicallysettled foreign exchange ("FX") forwards and FX swaps and the principal in cross-currency swaps are excluded from the IM requirements. Due to ongoing uncertainty over the definition of FX forwards in the EU there is also a temporary exemption from the VM requirements for FX forwards until the earlier of (i) 31 December 2018 and (ii) the date on which the delegated regulation defining FX forwards is issued under MiFID II3, together with a three year exemption from the VM and IM requirements for single stock equity options and index options. Transactions with central counterparties are also exempt from VM and there are also exemptions for covered bond issuers.
An exemption from the margin requirements for intra-group transactions is contained in EMIR itself. The extent of the exemption, and the process by which it can be obtained, depends on the location of the two entities. EMIR provides that, for the intra-group exemption to be available for most cases, the parties must have adequate operational and risk management procedures in place and there must be no practical or legal impediment on the transferability of own funds and the repayment of liabilities. The second requirement is defined in the RTS to include the existence of exchange controls or minority interests which would prevent transfers, insufficient availability of unencumbered or liquid assets to the relevant counterparty and operational obstacles for such transfers or repayments when due. As of 3 January 2017, the FCA has started accepting applications for intragroup exemptions, and the FCA has three months to assess each application.
As it will take some time for national regulators to process and approve applications for intra-group exemptions, the RTS contains a temporary exemption for intra-group transactions from the margin requirements until July 2017. Similarly, due to delays in granting equivalence status for non-EU jurisdiction, the RTS contains a temporary exemption for intra-group transactions with entities in jurisdictions where no equivalence decision has been granted until the earlier of (i) three years after the entry into force of the RTS and (ii) when the equivalence decision for that jurisdiction is granted.
The RTS also contains an exemption for transactions with entities in jurisdictions where the legal review does not confirm that netting arrangements can be legally enforced and/or the enforceability of segregation arrangements. Therefore, unless alternative processes are found, the RTS requirement is that there is no need for an EU counterparty to post VM or IM, and must collect from its non-EU counterparty on a gross basis. Additionally, there is no need for the EU counterparty to collect or post VM or IM if the legal review confirms collecting on a gross basis is not enforceable and the ratio of the notional amount of group OTC transactions for which no margin is collected in such jurisdictions to the total notional of all group OTC transactions is less than 2.5%. The result is that, if that ratio is exceeded, the EU entity will be unable to trade with counterparties in those jurisdictions.
It is clear that the VM and IM requirements will impose significant commercial, legal and operational requirements on eligible counterparties. The upcoming 1 March 2017 deadline should be of immediate concern to all eligible counterparties as from this date all new uncleared OTC derivative transactions will be subject to the VM requirement and also subject to a RTS compliant collateral agreement. If affected clients have not started already, affected clients should review as soon as possible existing collateral arrangements and commence the necessary amendments.
As usual, ISDA has been very active in publishing revised versions of existing market standard collateral agreements (including the 1995 English law Credit Support Annex) which comply with the RTS, together with a protocol for market participants to adhere to in order to effect multilateral amendments to existing collateral agreements with other protocol adhering parties. Notwithstanding these publications, affected clients should seek to begin work as soon as possible and with a detailed understanding of the RTS requirements to take the necessary steps in advance of the relevant regulatory deadlines.
3 Directive 2014/65/EU
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