Among other regulatory changes introduced by the European Market Infrastructure Regulation (EU) No 648/2012
(EMIR), there is now an obligation on OTC derivatives participants to collateralise their non-cleared OTC
derivatives’ positions. This is aimed at increasing the safety and transparency of the OTC derivatives markets in
the EU. Specifically, EMIR requires counterparties to exchange both initial margin (IM) and variation margin
(VM) with respect to their non-cleared OTC derivatives transactions. In simple terms, IM is designed to cover
potential future credit exposure of a party to its counterparty whereas VM protects against trade exposure arising
from market fluctuations.
In-scope entities “shall have risk-management procedures
that require the timely, accurate and appropriately
segregated exchange of collateral with respect to OTC
derivative contracts”.
(Article 11(3) EMIR)
RTS and International Policy
Framework
While the overarching principles for margining trades were
established under EMIR, the implementation detail was
separately developed under the draft Regulatory Technical
Standards on risk-mitigation techniques (RTS). The RTS
were developed on the basis of, and as contemplated under,
Article 11(15) of EMIR.
As part of a joint consultation, draft RTS were initially
published in April 2014. Following subsequent engagement
with authorities and stakeholders, a second consultation
paper and revised draft RTS were published in June 2015.
Final draft RTS were published on 8 March 2016 providing
clarity on the new margin requirements. As at the time of
writing, the final draft RTS were yet to be endorsed by the
European Commission (and reviewed by the Parliament and
Council) and are therefore still subject to change.
The EU margin rules need to be considered in conjunction
with the international regulatory framework for non-cleared
OTC derivatives: namely, in March 2015, a final policy
framework for margin requirements for non-centrally cleared
derivatives was set up by the International Organization of
Securities Commissions (IOSCO) and the Basel Committee
on Banking Supervisions (BCBS) (International Policy
Framework). This international structure served as
a framework for the European Supervisory Authorities
(ESA s) when drafting the RTS.
On 9 June 2016, the European Commission announced
that the original timeline proposed for finalising the RTS
will not apply (i.e. the original proposed adoption date of
September 2016), and the Commission instead proposes to
finalise the RTS by the end of 2016. As at the time of writing
(14 July 2016), the degree to which the timings for phase-in
of exchange of IM and VM will change is not clear.
The European Commission has come under strong criticism
from a number of stakeholders, most notably from the
Joint Committee of the ESAs, for its delayed adoption of
the RTS, particularly as it is now expected that the delay
will mean that implementation of the RTS will not meet the
implementation timeline set out in the International Policy
Framework.
The ESA has asked the European Commission to ensure that
the delay in adopting the RTS will be as short as possible.
Entities in-scope
The following entities (Covered Entities) fall within
the scope of the RTS and in principle would be subject to
the rules requiring the exchange of IM and VM:
- 'financial counterparties' (FCs)
- 'non-financial counterparties' above the applicable EMIR
clearing thresholds (NFC+s), and
- non-EEA entities which would be FCs or NFC+s if they
were established in the EU.
Timings and Scope
The requirements to exchange both IM and VM originally were
to be phased in from September 2016. See separate table.
The RTS are not retrospective in effect (ie the margining
requirements will only apply to future transactions). However,
where an existing Credit Support Annex is being amended
to ensure compliance with the new margining rules (i.e. such
that the legacy transactions and any new transactions will
form a single netting set), then the legacy transactions will be
brought within the scope of the rules for both IM and VM
purposes (subject to the thresholds below).
The RTS prescribe, inter alia, the amount of IM and VM that
counterparties should post and collect, the methodologies to
be used for calculating the requisite amounts, the timing for
posting and the collateral eligibility criteria. Collateral that can
be used for this purpose and that complies with the collateral
eligibility criteria is required to be agreed between the
counterparties up front. Key elements of the RTS are further
described below.
IM Rules: An Overview
- Two-way exchange: both parties must exchange an
amount of IM on a gross basis (ie without any netting
being applied).
- Segregation: IM must be segregated (operationally and
legally) to ensure that collateral is available in the event
of a counterparty defaulting. This is supplemented with
restrictions on the ability of counterparties to re-use
collateral. This means that IM will have to be subject to
security arrangements rather than title transfer collateral
arrangements.
- Methodologies: under the proposed rules,
counterparties can use a standard method provided
by the regulator or an IM model, agreed between the
counterparties within the scope defined by the regulator.
The collecting party is responsible for ensuring its model
complies with the minimum requirements set out in the
RTS (including, inter alia, recalibration of the model every
12 months and ongoing monitoring and independent
validation). These models and the assumptions used have
the potential to differ significantly, raising the possibility
that counterparties will arrive at different IM figures
for similar trades. To counteract this, ISDA has set up a
Working Group on Margin Requirements (WGMR)
to develop a Standard Initial Margin Model (SI MM)
with the aim of developing a common IM methodology to
be adopted by market participants globally and aiming to
provide open and transparent methodology to all.
- Structure: on a practical level, in order to ensure
successful repapering of their contracts, affected
parties will have to choose the most appropriate form
of structure and service provider/custodian for the
segregation of collateral.
- Exceptions: covered Entities are not subject to the IM
rules in all circumstances. Exceptions include:
- FX and currency transactions: physically-settled
foreign exchange swaps and forwards and crosscurrency
swaps (subject to certain conditions).
- Intra-group: intra-group transactions subject to
certain conditions (which may include regulatory
approval).
- Covered Bonds: covered bond issuers or covered
pools (again subject to certain conditions).
- Thresholds: counterparties have flexibility to agree
Minimum Transfer Amounts and IM Thresholds on
a bilateral basis, subject to caps of €500,000 for the
former (when aggregated with the MTA for VM) and
€50 million (at group level, on an aggregated basis) for
the latter.
Original IM implementation timeline1:
| €3 trillion |
1 September 2016 |
| €2.25 trillion |
1 September 2017 |
| €1.5 trillion |
1 September 2018 |
| €0.75 trillion |
1 September 2019 |
*AANA – aggregate average notional amount. This is calculated across its group and recorded on the last business day of the
months March, April, and May of the relevant year (including all uncleared OTC derivatives of the group and all intra-group
non-centrally cleared OTC derivative contracts of the group, taken into account only once).** Notional Amount Threshold – IM not collected for all new contracts from January of each year where one of the
two counterparties has or belongs to a group which has AANA of the preceding year of below €8 billion.
- Phased-in Implementation: there is a phase-in period
linked to the counterparties’ uncleared OTC derivatives’
volume (see 'IM Implementation Timeline') and there are
extended phase-in timings for certain transactions (eg intra-group).
- Documentation – IM Credit Support Annex: on
3 June 2016, ISDA published for discussion purposes a
working draft of its Credit Support Deed for Initial Margin
and is expected to produce a final version shortly.2 This
document has been prepared based on the existing English
law CSD template, with changes to allow parties to agree
collateral terms for initial margin that comply with the RTS
requirements.
VM Rules: An Overview
- Exchange: the exchange of VM must be in an amount
equal to the net mark-to-market exposure of all of
the counterparties’ non-centrally cleared derivatives
transactions.
- Timings: VM is generally required to be posted daily,
which could prove to be operationally challenging for
smaller entities and trades across different time zones.
For this reason, greater flexibility has been granted to
smaller firms but only under strict conditions (including the
pre-funding of margin).
- Exceptions: covered Entities are not subject to the VM
rules in all circumstances. Exceptions include:
- Intra-group: intra-group transactions subject to
certain conditions (which may include regulatory
approval).
- Covered Bonds: covered bond issuers or covered
pools (again subject to certain conditions).
- Minimum Transfer Amounts: as agreed by
counterparties on a bilateral basis (albeit not exceeding
€500,000 when aggregated with the MTA for IM).
Original VM Implementation Timeline:3
| €3 trillion |
1 September 2016 |
(all Covered Entities subject to VM requirements)
- Phased-in Implementation: there is a phase-in period
linked to the counterparties’ uncleared OTC derivatives’
volume: see 'VM Implementation Timeline'.
- Documentation:
- VM Credit Support Annex: ISDA published the
Credit Support Annex for Variation Margin (Title
Transfer – English Law) on 29 April 2016. Parties will be
able to choose between (i) the template ISDA VM CSA
(ii) a bespoke new document based on their existing
collateral documentation or (iii) an amendment to their
existing collateral documentation (see below).
- ISDA Protocol: it is anticipated that ISDA will in due
course produce a protocol regulating the posting of VM,
particularly its scope and methodology for calculating
the amount of VM required. It is suggested that, when
published, the market will generally adhere to the
protocol in order to ensure efficient implementation of
the VM margin rules (i.e. adopting limb (iii) above).
Eligible Collateral
Parties may agree to collect, with respect to both IM and
VM, the following collateral (provided the counterparty has
access to the market and is able to liquidate the collateral in a
timely manner):
- cash (in the form of money credited to an account in any
currency or money market deposits accounts)
- gold (in the form of allocated pure gold bullion of
recognised good delivery)
- sovereign Securities
- debt securities issued by credit institutions and
investment firms
- corporate bonds
- the most senior tranche of certain securitisations
- equities included in a main index, and
- shares or units in UCITS.
It is important to note that, with respect to IM only, the
RTS prescribe that any cash must be held in accounts with a
central bank or an EU credit institution and the third party
credit institution cannot belong to the same group as either
of the counterparties. Interestingly, where IM is collected in
cash in a currency different to the transaction currency, an
additional currency mismatch haircut will apply (to counteract
the foreign exchange risk); however, VM is not subject to
the additional currency mismatch haircut in line with the
International Policy Framework.
Summary
The introduction of the EU Margin Rules for non-centrally
cleared derivatives presents significant commercial,
operational and legal challenges for market counterparties,
and it is important that, in-scope entities are considering the
impact of these changes now so that the necessary contract
repapering and related technological build-outs are put in
place within the implementation timescales.
1 Based on the European Commission’s announcement of 9 June 2016, discussed above, this timeline is now likely to change
2 This is correct at the time of writing on 14 July 2016
3 Based on the European Commission’s announcement of 9 June 2016, discussed above, this timeline is now likely to change