Margin Requirements for OTC Derivatives – Regulators Listen but do they Hear?
On 2 September 2013, the Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) published their long-awaited final policy document dealing with “Margin requirements for non-centrally cleared derivatives”.
Subject to certain exemptions discussed below, the final rules apply to financial firms and systemically important non-financial entities (“Covered Entities”) that enter into non-centrally cleared derivatives with each other. Non-systemically important non-financial entities are exempt, and whilst the precise definitions will be determined at a national level, it seems likely that this will include those classified as NFCs- under EMIR. As is normal, exemptions also exist for:
- central banks;
- multilateral development banks; and
- the Bank for International Settlements.
The collateralisation of intra-group transactions will “be subject to appropriate regulation in a manner consistent with each jurisdiction’s legal and regulatory framework”.
Initial Margin (“IM”)
The requirement to post IM applies to all types of non-centrally cleared derivatives transactions, with the exception of physically settled foreign exchange forwards and swaps. IM must be exchanged by both parties on a gross basis and then segregated. A maximum group-wide IM threshold of EUR 50 million (calculated by reference to all non-centrally cleared derivatives entered into by the consolidated group of which the relevant counterparty is a member) is permissible. Minimum transfer amounts of up to EUR 500,000 are also allowed.
Firms may use a standard schedule or approved models to calculate IM requirements, but specific methodologies for calculating IM must be agreed and recorded on execution of each transaction. The standard schedule is provided in Appendix A to the final rules and details IM requirements (expressed as a percentage of notional amount), ranging from 1% (in the case of short-dated IRS) to 15% (in the case of equities and commodities). The amount of IM which must be posted is to be calculated by reference to potential future exposure based on a one-tailed 99% confidence interval over a 10-day horizon, based on historical data that incorporates a period of significant financial stress (and does not exceed five years in circumstances where IM is calculated by reference to an approved model). Switching between model based calculation methods and standard schedules is possible, provided that firms are not “cherry picking” the most favourable IM terms in the process.
Variation margin is to be exchanged on the following basis:
- zero thresholds;
- daily calls; and
- minimum transfer amounts not to exceed EUR 500,000.
BCBS/IOSCO has opted to allow a “broader set of eligible collateral” to be posted with respect to both IM and VM. Collateral must be “highly liquid”, diversified, capable of holding its value in a time of financial stress and subject to “appropriate” haircuts. Appendix B to the final rules sets out the standard haircut schedule with haircuts, expressed as a percentage of market value, ranging from 0% (in the case of cash) to 15% (in the case of equities and gold). Importantly, an additional haircut of 8% is levied in circumstances where the currency of the derivatives obligation differs from that of the collateral asset. Securities issued by the counterparty or its related entities are not acceptable collateral. A non-exhaustive list of qualifying assets includes:
- high-quality government and central bank securities;
- high-quality corporate bonds;
- high-quality covered bonds;
- equities included in major stock indices; and
VM collateral may be re-hypothecated. IM collateral posted by a client may only be rehypothecated by a firm if:
- it is only for purposes of hedging the firm’s derivatives position arising out of transactions with the client;
- the client’s rights in the collateral are protected;
- the client has been informed of its right not to permit re-hypothecation and the risks associated with rehypothecation in the event of the insolvency;
- the client has been given the option to individually segregate its collateral;
- the client gives “express consent in writing” to the re-hypothecation, is told of the fact of any rehypthecation and, where it has chosen individual segregation, can be informed of the value of the collateral that has been rehypothecated;
- IM collateral is treated as a segregated customer asset until re-hypothecated to a third party (and once returned to the firm by the third party to which it was rehypothecated);
- rehypothecation can only take place by a firm which is subject to regulation of liquidity risk;
- rehypothecation can only take place to a regulated and unaffiliated third party firm pursuant to a directly enforceable agreement;
- once re-hypothecated to a third party, the third party treats the collateral as a segregated customer asset and agrees not to further rehypothecate the collateral; and
- both the firm and the third party must keep appropriate records to show that all relevant conditions have been met.
The final rules are phased-in as follows:
|1 December 2015||Covered Entities to exchange VM with respect to new non-centrally cleared derivative transactions|
|1 December 2015 to 30 November 2016||Covered Entities to exchange IM if average aggregate notionals* exceed EUR 3 trillion|
|1 December 2016 to 30 November 2017||Covered Entities to exchange IM if average aggregate notionals* exceed EUR 2.25 trillion|
|1 December 2017 to 30 November 2018||Covered Entities to exchange IM if average aggregate notionals* exceed EUR 1.5 trillion|
|1 December 2018 to 30 November 2019||Covered Entities to exchange IM if average aggregate notionals* exceed EUR 0.75 trillion|
|From 1 December 2019||Covered Entities to exchange IM if average aggregate notionals* exceed EUR 8 billion|
*aggregate group-wide month-end average notional amount of non-centrally cleared derivatives (including physically settled FX forwards and swaps) newly executed during the immediately preceding June, July and August.
Since their publication in ‘near final’ form and the subsequent consultation process, BCBS/IOSCO has made a number of welcome modifications to the final rules in order to address industry concerns regarding foreign exchange and the right to rehypothecate. Nonetheless, the final rules will have a huge impact on the collateralisation and documentation of non-cleared derivatives transactions. CSA Thresholds and Minimum Transfer Amounts will have to be analysed and amended if necessary. Rehypothecation rights, IM calculation methodologies and dispute resolution procedures will have to be documented. The operational requirement to actively manage the allocation and use of IM Threshold capacity on a group-wide basis will represent a much greater challenge. Even more fundamental are the costs heaped onto the industry, in the form of IM requirements and the additional 8% haircut applied to collateral denominated in a currency which differs from that of the underlying transaction. All of this is levied in pursuance of the stated aim of promoting central clearing. Undoubtedly a laudable objective, but the medicine – served up on the basis of a questionable quantitative impact study – threatens to kill, rather than cure, the patient by raising the cost of non-cleared derivatives to the point of non-viability. This, despite the acceptance that clearing was only ever designed for standardised derivatives and that OTC markets continue to play an important role in the ability of the real economy to hedge its risks. Nonetheless, the die has been cast, the results are hardly surprising, and firms now have a little over two years in order to define and implement an effective response to this latest in a long line of threats to OTC derivative markets.