Defining the Margins: Draft EU Standards on Margin Requirements for Non-Cleared OTC Derivatives are Published

Consultation paper setting out draft regulatory technical standards on risk mitigation techniques for OTC derivative contracts not cleared by a central counterparty.

Introduction

On 14 April 2014, the Joint Committee of the European Supervisory Authorities (the European Securities and Markets Authority, the European Banking Authority and the European Insurance and Occupational Pensions Authority) published a consultation paper (the "CP") setting out draft regulatory technical standards ("RTS") on risk mitigation techniques for OTC derivative contracts not cleared by a central counterparty, as required by Article 11(15) of EMIR.  The CP notes that the RTS are in line with the September 2013 BCBS-IOSCO guidelines on "Margin requirements for non-centrally cleared derivatives".  (Click here for our recent alerter and here for the CP.)

The draft RTS

The draft RTS are set out in Section 4 of the CP.  Sections 1 to 3 set out how to respond to the consultation, an executive summary and background and rationale to the RTS; Section 5 includes a draft impact assessment and an overview of questions for consultation.

Taking each of the chapters of the draft RTS in turn:

Chapter 1 – counterparties' risk management procedures

EMIR requires a financial counterparty (a "FC") to have risk management procedures in place that require the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts; and it requires a non-financial institution (a "NFC+") to have similar procedures in place if they are above the clearing threshold.  A non-financial institution below the clearing threshold (a "NFC-") is afforded multiple derogations.  With that in mind, the RTS sets out these broad stipulations:

• an exchange of variation margin ("VM") at least daily, starting on T+1 of each trade

• an exchange of initial margin ("IM"), by T+1 of each trade

• VM may be netted; IM may not be netted

• upfront agreement on eligible collateral

• no IM is required for: physically settled FX forwards; physically settled FX swaps; the exchange of principal under a cross-currency swap

• a FC may agree with its counterparties that, where the amount of IM required to be exchanged at group level is equal to or lower than EUR 50m, no IM need be exchanged but instead capital will be held against the relevant exposures; and, where the EUR 50m threshold applies:

• IM may be reduced by EUR 50m (across the group)

• the group shall determine how to allocate IM received among its membership

• the group shall monitor (at a consolidated level) whether the threshold is exceeded and shall maintain records to record its exposure to consolidated counterparties

• FCs and NFC+s may agree a minimum transfer amount not exceeding EUR 500,000 (but where IM plus VM exceeds that amount, the full amount is to be transferred)

• a FC or a NFC+ trading with a NFC- may agree not to exchange VM or IM

• other exemptions include: covered bond issuers (if certain conditions are met); the ESCB, EU central banks, other supra-national banks and certain public sector entities; and indirectly cleared derivatives transactions (if margin is posted according to the relevant CCP’s rules)

• only new contracts at the time of entry into force of the RTS will be subject to the relevant requirements (but market participants should strive to margin the "widest" set of non-centrally cleared OTC derivatives possible).

In relation solely to IM, the RTS adds the following specific requirements:

• IM is to be calculated/collected using a standardised approach or an IM model

• counterparties are to agree in writing on the approach to be used, and in the case of an IM model, on the characteristics of the model and on the data to be used for calibration

• IM is to be recalculated and collected whenever:

• a new contract is executed

• an existing contract expires

• an existing contract triggers a (non-margin) payment/delivery obligation

• an existing contract is reclassified by way of reduced time to maturity

• the IM model is recalibrated

• no IM recalculation has been performed in the past 10 business days.

Chapter 2 – margin methods

The methods that counterparties may use to calculate IM are either a standardised method (details of which are set out in the RTS) or an IM model.  An IM model may be developed by one of the or both counterparties or provided by a third party agent.  There are detailed criteria for IM models, which are outside the scope of this alerter.

Chapter 3 – eligibility and treatment of collateral

Eligible collateral under the RTS includes the following asset classes:

• cash and money market deposits

• gold

• debt securities issued by: EU and non-EU governments; central banks; local authorities; public sector entities; multilateral development banks; credit institutions; and investment firms

• corporate bonds

• senior tranches of securitisations

• certain convertible bonds, equities and shares or units in UCITS (subject to eligibility criteria).

The counterparty receiving collateral is required to have the following operational and technical capabilities:

• daily re-evaluation of collateral

• a collateral-holding structure to access the collateral if held with a third party custodian

• where the collateral is held with the collateral provider, alternative custody accounts for the management of assets following any default of the collateral provider

• access to an active outright sale/repo market

• cash accounts in all currencies (with a party other than the collateral provider) for depositing cash collateral and for crediting the proceeds of repurchase agreements on the collateral

• the ability to return unused collateral proceeds to the insolvency estate of a defaulted counterparty

• arrangements to ensure that collateral is freely transferable, without legal or regulatory constraints on default by the collateral taker.

In addition, collateral takers should have the ability to undertake credit quality assessments on designated asset classes using an approved internal model (its own or that of its counterparty) or a recognised credit agency, with procedures for phased substitution and increases in haircuts in the interim period following a diminution in credit quality.

In respect of certain asset classes, collateral takers should also ensure that collateral securities are not issued by the posting counterparty (or by entities in the same group) and are not otherwise subject to significant "wrong way risk".

Finally, concentration limits may apply and haircuts should be calculated using either the standard methodology set out in the RTS or a party's own estimates subject to specified criteria.

Chapter 4 – operational procedures

The RTS requires robust risk management procedures to be in place, including detailed written policy and processes relating to the exchange of collateral.  Over and above general administrative and operational considerations, the RTS allows for consensual substitution of eligible collateral and imposes a segregation requirement in relation to IM.  The criteria for segregation are as follows:

• IM shall be segregated from proprietary assets and held by a third party or custodian, or via other legally effective arrangements made by the collecting counterparty

• the collecting counterparty shall give the posting counterparty the option to have the collateral segregated from the assets of other posting counterparties (so called “individual segregation”)

• IM in the form of cash shall be segregated individually, unless the collecting counterparty can satisfy the posting counterparty and the relevant competent authority that legally effective arrangements are in place to segregate it from proprietary assets

• IM must be immediately available to the collecting counterparty when the posting counterparty defaults

• the posting counterparty must be sufficiently protected when the collecting counterparty enters into bankruptcy or other insolvency proceedings

• relevant legal opinions must be obtained at inception and at least annually thereafter attesting to the efficacy of the segregation arrangements and the protection of the respective counterparties.

Finally, the RTS provide that the collecting counterparty shall not re-hypothecate, re-pledge or otherwise re-use posted IM.

Chapter 5 – Procedures concerning intragroup derivative contracts

There is a notification procedure for counterparties seeking to benefit from the exemptions set out in Article 11 of EMIR in relation to intragroup transactions.  A proviso to the exemption under Article 11 is that there must be no legal or practical impediment to the prompt transfer of own funds or repayment of liabilities between the exemption-seeking entities.

Further, risk management procedures must be in place to monitor intragroup exposures and the timely settlement of obligations resulting from intragroup transactions.

Implementation time-line

The time-line for implementation of the RTS is identical to that set out on the BCBS-IOSCO guidelines, namely:

• for VM, starting 1 December 2015

• for IM, a 5-year phase-in, starting 1 December 2015 where both counterparties have an aggregate month-end group-wide average notional of non-cleared derivatives for June, July and August of the relevant year in excess of EUR 3 trillion, with that threshold reducing annually over the 5-year period to EUR 8 billion.  For the purposes of calculating the group aggregate, FX forwards and swaps are included.

Key differences between the RTS and the BCBS-IOSCO guidelines

In very broad terms there is little to choose between the RTS and the BCBS-IOSCO guidelines.  The categories of eligible collateral are wider under the RTS and there are differences between the standardised haircut schedules (whereas the standardised IM schedules are identical).  The RTS are prescriptive in relation to the timing of provision of IM (various triggers exist) and, perhaps most significantly, the RTS do not allow a one-time re-use of IM as proposed under the guidelines - although this is an issue on which the CP seeks consultation.  It remains to be seen whether these differences will continue to exist post-consultation.