|Collateral requirements under EMIR|
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General policy framework
In September 2009, G20 Leaders agreed in Pittsburgh that all standardised OTC derivative contracts "should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements."
The Financial Stability Board and its relevant members were also asked by the G20 Leaders in Pittsburgh to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse (see the Financial Stability Board Ninth Progress Report on Implementation OTC Derivatives Market Reforms, 24 July 2015).
In November 2011, G20 Leaders in Cannes called on the Basel Committee on Banking Supervision (BCBS), the International Organization for Securities Commission (IOSCO) together with other relevant organisations to develop for consultation standards on margining for non-centrally cleared OTC derivatives by June 2012.
The policy-making legislative process in this regard is marked, in particular, by the following documents:
- document of the Joint Committee of European Supervisory Authorities (ESAs): the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA) Consultation Paper of 14 April 2014 "Draft regulatory technical standards on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012" (JC/CP/2014/03) (which presented the preliminary thinking of the European financial authorities on OTC derivatives' mandatory collateralisation),
- ESAs' Second Consultation on margin RTS for non-cleared derivatives of 10 June 2015 (JC/CP/2015/002),
- ESAs' Final Draft Regulatory Technical Standards of 8 March 2016 on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012 (ESAs 2016 23),
- Margin requirements for non-centrally cleared derivatives, September 2013, Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO),
- Margin requirements for non-centrally cleared derivatives (agreed and adopted in March 2015 by the BCBS and the IOSCO sets out the international final policy framework regarding minimum standards for margin requirements for non-centrally cleared derivatives and serves as a global benchmark for regulatory requirements in that regard).
The result of the aforementioned developments is the Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards for risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty.
ESA's RTS under EMIR vs. BCBS/IOSCO international framework
The question may, firstly, arise on interdependencies between the draft Commission Delegated Regulation adopted under EMIR and BCBS and IOSCO global framework.
This point has been referred to at the beginning of the aforementioned ESA's document of 10 June 2015 - European financial regulators say that in the standards' development process, the ESAs "have also kept in mind the need for international consistency and have consequently used the internationally agreed standards as the natural starting point. In addition, a number of specific issues have been clarified so that the proposed rules will implement the international standards while taking into account the specific aspects of the European financial market."
The document of 10 June 2015 adds, moreover, that the international standards "outline the final margin requirements, which the ESAs have endeavoured to transpose into the RTS", and, that in the ESA's opinion the Regulatory Technical Standards as proposed by the ESA's to be issued under EMIR are "in line with the principles of the international framework" (p. 6).
The above assurances have been upheld in the ESA's Final draft RTS of 8 March 2016.
When it comes to the impacts of new rules, the requirements at issue will represent a significant change in market practice and, equally, an operational and logistical challenge that will have to be properly managed (Recital 14 of the RTS).
"These new rules go far beyond current market practice on margining and will be relevant to anyone entering into OTC derivative contracts where there is an EU connection," says ReedSmith in EMIR Collateral Damage.
The background and rationale for the new collateral requirements for the OTC market have been explained in the said ESA's document of 10 June 2015.
The document reads as follows:
"The EMIR establishes provisions aimed at increasing the safety and transparency of the over-the-counter (OTC) derivative markets. Among other requirements, it introduces a legal obligation to clear certain types of OTC derivatives through central counterparties ('CCP'). However, not all OTC derivative contracts will be subject to the clearing obligation or would meet the conditions to be centrally cleared. In the absence of clearing by a CCP, it is essential that counterparties apply robust risk mitigation techniques to their bilateral relationships to reduce counterparty credit risk. This will also mitigate the potential systemic risk that can arise in this regard."
Scope of application
Article 11(3) EMIR requires financial counterparties (FCs) to have risk management procedures in place that require the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts.
Non-financial counterparties (NFCs) must have similar procedures in place, if they are above the clearing threshold (being the EMIR designation for sistemically important non-financial entities - so-called "NFCs+").
Hence, it may be concluded that the scope of the margin requirements under EMIR reflects the one of the clearing obligation and applies to all financial counterparties and NFCs+.
An important amendment has been proposed on 26 January 2018 by the Committee on Economic and Monetary Affairs of the European Parliament in the Draft Report on the proposal for a regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk- mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories (COM(2017)0208 – C8-0147/2017 – 2017/0090(COD)) that NFCs+ should not be subject to segregation and exchange of collateral requirements for other asset classes than the one where the threshold has been breached.
Intra-group exemption from margin requirements is, moreover, available (subject to certain conditions).
New rules impose an obligation on EU entities to collect margin in accordance with the prescribed procedures, regardless of whether they are facing EU or non-EU entities.
Recital 7 to Regulation 2016/2251 stipulates that in order to guarantee a level playing field across jurisdictions, where a counterparty established in the European Union enters into a non-centrally cleared OTC derivative contract with a counterparty that is established in a third country initial and variation margin should be exchanged in both directions.
Moreover, counterparties established in the Union transacting with counterparties established in third countries remain subject to the obligation of assessing the legal enforceability of the bilateral agreements and the effectiveness of the segregation agreements.
When such assessments highlight the potential for the non-compliance of the agreements with new rules, European counterparties should identify alternative processes to post collateral, such as relying on third-party banks or custodians domiciled in jurisdictions where those requirements can be guaranteed.
There may be seen an evolution of the regulatory approach to margin requirements in transactions with third-country counterparties, if somebody would compare the first ESMA's drafts and the final Regulation - see boxes.
Important rule for the entities established outside the EU is stipulated in Article 24 of the said Regulation 2016/2251, which envisions that counterparties may provide in their risk management procedures that no collateral is exchanged in relation to non-centrally cleared OTC derivative contracts entered into with:
- non-financial counterparties below clearing threshold or
Furthermore, counterparties established in the European Union may provide in their risk management procedures that variation and initial margins are not required to be posted for non-centrally cleared OTC derivative contracts concluded with counterparties established in a third country for which any of the conditions laid down under Article 31 of the Regulation 2016/2251 apply (see box below).
The process for granting equivalence status to the US legal framework on margins has been finalised by the Commission Implementing Decision (EU) 2017/1857 of 13 October 2017 on the recognition of the legal, supervisory and enforcement arrangements of the United States of America for derivatives transactions supervised by the Commodity Futures Trading Commission as equivalent to certain requirements of Article 11 of Regulation (EU) No 648/2012 of the European Parliament and Council on OTC derivatives, central counterparties and trade repositories.
The US counterpart CFTC issued the parallel media report: CFTC Comparability Determination on EU Margin Requirements and a Common Approach on Trading Venues, Release: pr7629-17, October 13, 2017).
Recitals to the said Commission Implementing Decision (EU) 2017/1857 of 13 October 2017 underline that as regards the margins for OTC derivative contracts not cleared by a CCP, the legally binding requirements of the CFTC consist of the Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants published in January 2016 (‘final margin rule’) and the Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants — Cross Border Application of the Margin Requirements (‘cross-border margin rule’) published in August 2016.
While the CFTC Regulations on operational risk mitigation techniques for OTC derivative contracts not cleared by a CCP apply to all swap dealers and major swap participants, the CFTC Regulations on margins for those OTC derivative contracts only apply to swap dealers and major swap participants that are not subject to a prudential regulator.
The US Commodity Exchange Act (CEA) definition of ‘prudential regulator’ includes the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Finance Agency.
CFTC Regulations applicable to margins for OTC derivative contracts not cleared by a CCP only require the exchange of initial margin with a ‘covered counterparty’ as defined in section 23.151 of the CFTC Regulations.
A covered counterparty is a counterparty that is a financial end user with material swaps exposure or a swap entity that enters into a swap with a covered swap entity.
According to section 23.150 of the CFTC Regulations, the material swaps exposure is an average daily notional value of non-cleared OTC derivatives that exceeds USD 8 billion (8 000 million), whereas the analogous threshold set out in Article 28 of Commission Delegated Regulation (EU) 2016/2251 (3) is EUR 8 billion (8 000 million).
In the European Union, the requirement to exchange variation margin does not have a materiality threshold, and applies to all counterparties subject to Article 11(3) of the EMIR Regulation.
The CFTC Regulations for combined minimum transfer amount of initial and variation margin in the final margin rule is USD 500 000, whereas the related requirement set out in Article 25 of Delegated Regulation (EU) 2016/2251 is EUR 500 000.
Taking into account the limited impact due to the difference in currencies, these amounts should be considered equivalent.
The requirements of the final margin rule apply to swaps, which encompass almost all contracts defined as OTC derivatives in Regulation (EU) No 648/2012 with the exception of foreign exchange forwards and foreign exchange swaps, for which the final margin rule sets no requirements.
In addition, CFTC Regulations do not contain any specific treatment for structured products including covered bonds and securitisations.
In the European Union, foreign exchange swaps and foreign exchange forwards are exempted from the initial margins requirements, and derivatives associated with covered bonds for hedging purposes may also be exempted from initial margin requirements.
The said Commission Implementing Decision (EU) 2017/1857 of 13 October 2017 therefore only applies to OTC derivatives that are subject to margins under both the European Union law and the CFTC Regulations.
Like Annex IV to Delegated Regulation (EU) 2016/2251, the CFTC Regulations allow the use of a standardised model.
Alternatively, internal or third party models may be used for that calculation where those models contain certain specific parameters, including minimum confidence intervals and margin periods of risk, and certain historical data, including stressed periods.
Those models must be approved by the CFTC or a registered futures association.
The CFTC Regulations contain an equivalent list of eligible collateral, and the preamble to the final margin rule states that swap dealers and major swap participants that are not subject to a prudential regulator should take collateral concentration into account.
The said Commission Implementing Decision (EU) 2017/1857 of 13 October 2017 concludes that:
- the requirements in the CFTC Regulations for the calculation of initial margin are equivalent to the requirements set out in EMIR Regulation,
The effect of the above determinations is that market participants are allowed to comply with only one set of rules and to avoid duplicative or conflicting rules, i.e. where at least one of the counterparties is established in the US, it is deemed to have fulfilled EMIR collateral requirements by complying with the requirements set out in the US legal regime.
However, it is noteworthy, the CFTC’s equivalence determination applies only where both the entity and the transaction are otherwise subject to both the CFTC and EU margin regulations, and not when a swap dealer voluntarily complies with the respective regime.
Initial and variation margin requirements
To prevent the build-up of uncollateralised exposures within the system, new rules require the daily exchange of variation margin (VM) between counterparties.
Moreover, subject to the provisions of the RTS, both financial and non-financial counterparties above the clearing threshold, are required to exchange two-way initial margin (IM) to cover the potential future exposure resulting from a counterparty default.
‘Initial margin’ is defined in the Regulation 2016/2251 as 'the collateral collected by a counterparty to cover its current and potential future exposure in the interval between the last collection of margin and the liquidation of positions or hedging of market risk following a default of the other counterparty' (Article 1(1)), while ‘variation margin’, according to Article 1(2), means 'the collateral collected by a counterparty to reflect the results of the daily marking-to-market or marking-to-model of outstanding contracts referred to in Article 11(2) of Regulation (EU) No 648/2012'.
Initial margin is envisioned to be exchanged by both parties, without netting of amounts collected by each party (i.e. on a gross basis).
To act as an effective risk mitigant, initial margin recalculations are to reflect changes in both the risk positions and market conditions.
Consequently, counterparties are required to recalculate initial margin, at least when the portfolio between the two entities has changed, or the underlying risk measurement approach has changed.
In addition, to ensure current market conditions are fully captured, initial margin is subject to a minimum recalculation period of 10 days.
It is noteworthy, Recital 2 of the ESMA's draft final RTS contained the rule that indirectly cleared OTC derivative contracts are considered as centrally cleared and are therefore not subject to the risk management procedures prescribed, however the Commission Delegated Regulation 2016/2251 of 4 October 2016 does not stipulate thereto.
New rules require counterparties collecting collateral, to introduce the risk management procedures, which ensure that all of the following are in place:
(a) a daily re-evaluation of collateral;
(b) legal arrangements and a collateral holding structure to access the received collateral where it is held in third party custody;
(c) where initial margin is maintained with the collateral provider, the securities should be maintained in bankruptcy or insolvency remote custody accounts;
(d) cash accounts in all the acceptable currencies are maintained with a party other than the collateral provider for depositing cash collateral collected as initial margin and for crediting the proceeds of repurchase agreements on the collateral;
(e) the ability to make available the unused collateral to the liquidator or other insolvency official of the defaulted counterparty;
(f) arrangements to ensure that, in the event of the default of the collecting counterparty, the initial margin is freely and transferable back in a timely manner to the posting counterparty;
(g) the collateral shall be transferable without any regulatory or legal constraints or third party claims, including those of the liquidator of the collecting counterparty or third party custodian;
(h) the collateral is returned in whole other than for costs and expenses incurred for that process or other than liens routinely imposed on all securities in a clearing system in which such collateral may be held.
Operational procedures and documentation
The ESA's Final Report of 8 March 2016 recognises that the operational aspects relating to the exchange of margin requirements will require substantial effort to implement in a stringent manner.
As the said Report observes (p. 11):
- it is necessary for counterparties to implement robust operational procedures that ensure that documentation is in place between counterparties and internally at the counterparty,
- the operational requirements must include, among other things, clear senior management reporting, escalation procedures (internally and between counterparties) and requirements to ensure sufficient liquidity of the collateral,
- counterparties are required to conduct tests on the procedures, at least on an annual basis,
- segregation requirements must be in place to ensure that collateral is available in the event of a counterparty defaulting.
In general, operational and legal arrangements must be in place to ensure that the collateral is bankruptcy remote.
Recital 32 of the Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 underlines that operational processes used by the counterparties for the bilateral exchange of collateral must be sufficiently detailed, transparent and robust.
A failure by counterparties to agree upon and establish an operational framework for efficient calculation, notification and finalisation of margin calls can lead to disputes and failed exchanges of collateral that result in uncollateralised exposures under OTC derivative contracts.
As a result, it is essential that counterparties set clear internal policies and standards in respect of collateral transfers.
Any deviation from those policies should be rigorously reviewed by all relevant internal stakeholders that are required to authorise those deviations. Furthermore, all applicable terms in respect of operational exchange of collateral should be accurately recorded in detail in a robust, prompt and systematic way.
According to Article 2 of the said Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016, firms are required to establish, apply and document risk management procedures for the exchange of collateral for non-centrally cleared OTC derivative contracts, providing for or specifying the following:
(a) the eligibility of collateral for non-centrally cleared OTC derivative contracts;
(b) the calculation and collection of margins for non-centrally cleared OTC derivative contracts;
(c) the management and segregation of collateral for non-centrally cleared OTC derivative contracts;
(d) the calculation of the adjusted value of collateral;
(e) the exchange of information between counterparties and the authorisation and recording of any exceptions to the risk management procedures;
(f) the reporting of the exceptions to senior management;
(g) the terms of all necessary agreements to be entered into by counterparties, at the latest, at the moment in which a non-centrally cleared OTC derivative contract is concluded, including the terms of the netting agreement and the terms of the exchange of collateral agreement;
(h) the periodic verification of the liquidity of the collateral to be exchanged;
(i) the timely re-appropriation of the collateral in the event of default by the posting counterparty from the collecting counterparty; and
(j) the regular monitoring of the exposures arising from OTC derivative contracts that are intragroup transactions and the timely settlement of the obligations resulting from those contracts.
The terms of agreements referred to above in point (g) must comprise all aspects concerning the obligations arising from any non-centrally cleared OTC derivative contract to be concluded, and at least the following:
(a) any payment obligations arising between counterparties;
(b) the conditions for netting payment obligations;
(c) events of default or other termination events of the non-centrally cleared OTC derivative contracts;
(d) all calculation methods used in relation to payment obligations;
(e) the conditions for netting payment obligations upon termination;
(f) the transfer of rights and obligations upon termination;
(g) the governing law of the transactions of the non-centrally cleared OTC derivative contracts.
Where counterparties enter into a netting or an exchange of collateral agreement, they must perform an independent legal review of the enforceability of those agreements.
That review may be conducted by an internal independent unit or by an independent third party (the requirement to perform the review is, however, considered to be satisfied in relation to the netting agreement where that agreement is recognised in accordance with Article 296 of Regulation No 575/2013 (CRR)).
In addition, counterparties are required to establish policies to assess on a continuous basis the enforceability of the netting and the exchange of collateral agreements that they enter into.
The above risk management procedures must be tested, reviewed and updated as necessary and at least annually.
The said Regulation, imposes, moreover, the obligation on counterparties using initial margin models to provide, upon request, the competent authorities with any documentation relating to the risk management procedures at any time.
Exchange of collateral agreement
The said Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 in Article 3 also stipulates for the necessary content of the exchange of collateral agreement, which must include at least the following terms:
Recital 33 of the Regulation at issue adds that an exchange of collateral agreement should be concluded between counterparties entering into non-centrally cleared OTC derivative contracts in order to provide legal certainty.
As a result, the exchange of collateral agreement should include all material rights and obligations of the counterparties applicable to non-centrally cleared OTC derivative contracts.
De minimis thresholds
The exchange of collateral for only minor movements in valuation may, in the opinion of European financial supervisory authorities, lead to an overly onerous exchange of collateral.
Therefore, Regulation 2016/2251 introduces the thresholds to limit the operational burden and a threshold for managing the liquidity impact associated with initial margin requirements. Thresholds are consistent with international standards.
Threshold based on initial margin amount
The first threshold ensures that the exchange of initial margin does not need to take place if a counterparty has no significant exposures to another counterparty.
Specifically, it may be agreed bilaterally to introduce a minimum threshold of up to EUR 50 million, which will ensure that only counterparties with significant exposures will be subject to the initial margin requirements (if both counterparties belong to the same group the threshold's value is EUR 10 million).
Where counterparties apply the threshold based on initial margin amount the following rules apply:
(a) counterparties may reduce the amount of initial margin collected by the value of the threshold;
(b) the risk management procedures must include determining how to allocate the received initial margin amongst the relevant entities within the group;
(c) the risk management procedures must include monitoring, at the group level, of whether the threshold is exceeded and the maintenance of appropriate records of its exposures to each single counterparty in the same group.
Minimum transfer amount
The second threshold ensures that, when market valuations fluctuate, new contracts are drawn up or other aspects of the covered transactions change; an exchange of collateral is only necessary if the change in the margin requirements exceeds EUR 500 000 (minimum transfer amount).
Similarly to the first threshold, counterparties may agree on the introduction of a threshold in their bilateral agreement as long as the minimum exchange threshold does not exceed EUR 500 000.
Therefore, the exchange of collateral only needs to take place when significant changes to the margin requirements occur. This is intended to limit the operational burden relating to these requirements.
Where counterparties agree on a minimum transfer amount, the amount due, pursuant to the RTS, is to be calculated as the sum of:
(a) the variation margin due from its last collection;
(b) the initial margin due from its last collection;
(c) any excess collateral that may have been provided to or returned by both counterparties.
In case the amount due to the counterparty collecting collateral exceeds the minimum transfer amount agreed by the counterparties in accordance with the above rules, the risk management procedures must provide that the counterparty collecting collateral collects the full amount without deduction of the minimum transfer amount.
Threshold based on notional amount
In order to align with international standards, the requirements of the RTS will apply only to key OTC derivative market participants.
According to Article 28 of the respective Regulation counterparties may provide in their risk management procedures that initial margins are not collected for all new OTC derivative contracts entered into within a calendar year where one of the two counterparties has an aggregate month-end average notional amount of non-centrally cleared OTC derivatives for the months March, April and May of the preceding year of below EUR 8 billion.
The aggregate month-end average notional amount referred to above is to be calculated at the counterparty level or at the group level where the counterparty belongs to a group.
Specific rules apply to UCITS (see below in the box Article 28(3) of the said Regulation).
Threshold based on notional amount has been considered necessary, since uniform application of margin requirements would violate the proportionality principle and would entail the significant change in market practice and potential costs associated with these requirements.
This is also acknowledged in the BCBS-IOSCO framework.
In the absence of this threshold, the Impact Assessment Document attached to the RTS argues these costs have the potential to fall disproportionately on smaller market participants, and, in extremis, discourage the use of derivatives markets, in particular for risk-reducing activities such as hedging.
Calculation at a group level
It needs to be underlined, the above de minimis thresholds are to be calculated at group level with the exception reserved to investment funds.
Recital 13 of the respective Regulation refers to this issue as follows:
"While the thresholds should always be calculated at group level, investment funds should be treated as a special case as they can be managed by a single investment manager and captured as a single group. However, where the funds are distinct pools of assets and they are not collateralised, guaranteed or supported by other investment funds or the investment manager itself, they are relatively risk remote in relation to the rest of the group. Such investment funds should therefore be treated as separate entities when calculating the thresholds, in line with the BCBS-IOSCO framework."
All requirements prescribed in terms of the 'group' or 'group level' refer to the definition of a group included in Regulation (EU) No 648/2012 (EMIR).
Counterparties may provide in their risk management procedures that no collateral is exchanged in relation to non-centrally cleared OTC derivative contracts entered into with:
- CCPs authorised as credit institutions in accordance with Directive 2013/36/EU,
Physically-settled foreign exchange contracts
Physically-settled foreign exchange swaps and forwards are the derivative instruments of which the underlying financial products (i.e. foreign currency) are physically delivered in exchange for a specific payment.
To maintain international consistency, entities subject to the EMIR regulatory technical standards on margin may agree in their risk management procedures not to collect initial margin on physically-settled foreign exchange forwards and foreign exchange swaps, or the principal in currency swaps.
The reasons for the exemption from initial margin have been explained by the ESA's Second Consultation Paper of 10 June 2015 (p. 65) as follows:
Nevertheless, the counterparties are still expected to post and collect the variation margin associated with these contracts, which is assessed to sufficiently cover the risk and ensure a proportionate approach.
It should be noted, however, that the European Supervisory Authorities (ESAs) in the Statement of 24 November 2017 on the variation margin exchange for physically-settled FX forwards under EMIR, observed:
“the Boards of the ESAs are currently undertaking a review of the Regulatory Technical Standards on risk mitigation techniques for OTC derivatives not cleared by a central counterparty (RTS) and develop draft amendments to these RTS that align the treatment of variation margin for physically-settled FX forwards with the supervisory guidance applicable in other key jurisdictions.
Specifically, the amendment of the RTS and their subsequent implementation would reiterate our commitment to apply the international standards, and require the exchange of variation margin for physically-settled FX forwards in a risk based and proportionate manner.
In particular, this would most likely imply that the scope should cover transactions between institutions (credit institutions and investment firms).
In addition for some institution-to-non-institution transactions the competent authorities should consider the actual risk that the exchange of variation margins would mitigate and whether non-institutions might face additional risks related to the daily exchange of variation margin.”
Further, on 18 December 2017 the ESAs published the Draft regulatory technical standards on amending Delegated Regulation (EU) 2016/2251 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on risk-mitigation techniques for OTC derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012 with regard to physically settled foreign exchange forwards (JC/2017/79) where the requirement to exchange variation margin for physically settled FX forwards target only transactions between ‘institutions’, within the meaning of the Capital Requirements Regulation (CRR), i.e. credit institutions and investment firms, or with an equivalent entity located in a third country that would meet the definition of ‘institution’ if located in the EU.
Moreover, in the aforementioned document the ESAs expressed the view that, for institution-to-non-institution transactions, the competent authorities should apply the EU framework in a risk-based and proportionate manner until the amended RTS enter into force.
Technically, the amendment is rather straightforward and laconic - a single new Article (31a) is proposed to be inserted after Article 31 of Delegated Regulation (EU) 2016/2251 in the following wording:
See also: FX spot contract
RTS propose the introduction of concentration limits on the collateral collected from a counterparty.
From several options available the approach has been chosen that applies concentration limits for margins irrespective of the position size.
Alternative regulatory possibilities like:
The policy objective is to ensure that the collateral taker is able to realise sufficient value from the collateral to replace the OTC contracts associated with a defaulted counterparty.
As opposite to all other types of collateral, collateral posted in the form of cash is treated by the regulatory technical standard preferentially.
Recital 36 of the Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 stipulates:
Imposing concentration limits on all other types of collateral is intended to help promote a diversified collateral pool, which will be less likely to face liquidation issues in the event of a counterparty default.
Regulators acknowledge, however, in the RTS Impact Assessment Document, the concentration limits make more difficult for counterparties to find suitable collateral and put an additional operational burden as the limits have to be monitored and collateral might occasionally have to be replaced in order not to breach the thresholds.
The option choosen might force the collection of diversified collateral even though the initial margin in total is small compared to the overall credit exposure that the collecting counterparty has.
A disadvantage of this option is also that smaller counterparties may face difficulties or impediments in posting collateral different from local sovereign debt securities.
Proportionality thresholds (below which the concentration limits would not apply) have not been included in RTS.
It is noteworthy that, according to Article 7(5) of the Regulation 2016/2251, counterparties are not allowed to use assets classes referred to above as eligible collateral "where they have no access to the market for those assets or where they are unable to liquidate those assets in a timely manner in case of default of the posting counterparty".
Ban on re-use of collateral collected as initial margin
Firms implementing re-use, re-pledge or re-hypothecation of initial margin as an essential component of their business models will have to reconsider strategies. Collateral transformation services may also be affected.
The aforementioned Consultation Paper of 14 April 2014 proposed the re-hypothecation, re-pledge or otherwise re-use of the collateral collected as initial margin to be forbidden. It was explained the purpose of the the said restriction was to mitigate the risk in the case the counterparty, to which initial margin has been posted, defaults.
The BCBS-IOSCO report has also been cited, which presented the following argumentation:
“The risk would be exacerbated if the counterparty re-hypothecates, re-pledges or re-uses the provided margin, which could result in third parties having legal or beneficial title over the margin, or a merging or pooling of the margin with assets belonging to the others as a result of which the firm’s claim to the margin becomes entangled in legal complications, thus delaying or even denying the return of re-hypothecated / re-used assets in the event that the counterparty defaults."
As the above Consultation Paper of 14 April 2014 further elaborated, the BCBS-IOSCO, in order to achieve a delicate balance between allowing some flexibility and still preserve the efficiency of the initial margin framework permitted each jurisdiction to allow if they deem it necessary a limited re-use of initial margin under strict conditions.
However, as was further argued, the implementation of those conditions leads to multiple legal and technical difficulties, such as the requested degree of insolvency protection of the initial posting counterparty taking into account the diversity of insolvency laws, the return of the collateral from the third counterparty to the initial posting counterparty in case the collecting party defaults, or the one-time re-use of cash collateral. The European Supervisory Financial Authorities therefore considered in the Consulatation Paper of 14 April 2014 appropriate to propose a full ban on the re-use of initial margin.
In turn, the final policy framework as set out in the aforementioned Margin requirements for non-centrally cleared derivatives adopted in March 2015 by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) has sustained the stance for the allowable re-use of initial margin under strict conditions.
The authorities underlined in the above final policy set-up of March 2015 the need to ensure such collateral use would only allow a one-time re-hypothecation, re-pledge or re-use in the global financial system; that is, once initial margin collateral has been re-hypothecated, re-pledged or re-used to a third party no further re-hypothecation, re-pledging or re-use of such initial margin collateral by the third party is permitted. Moreover, collected collateral must be segregated from the initial margin collector's proprietary assets.
Pursuant to the said BCBS and IOSCO final policy framework adopted in March 2015 cash and non-cash collateral collected as initial margin from a customer may be re-hypothecated, re-pledged or re-used (henceforth re-hypothecated) to a third party only for purposes of hedging the initial margin collector's derivatives position arising out of transactions with customers for which initial margin was collected and it must be subject to conditions that protect the customer's rights in the collateral, to the extent permitted by applicable national law.
The BCBS and IOSCO final policy framework adopted in March 2015 enumerates, moreover, the following preconditions for the re-hypothecation of the customer's collateral:
1. The customer, as part of its contractual agreement with the initial margin collector and after disclosure by the initial margin collector of (i) its right not to permit re-hypothecation and (ii) the risks associated with the nature of the customer's claim to the re-hypothecated collateral in the event of the insolvency of the initial margin collector or the third party, gives express consent in writing to the re-hypothecation of its collateral. In addition, the initial margin collector must give the customer the option to individually segregate the collateral that it posts.
2. The initial margin collector is subject to regulation of liquidity risk.
3. Collateral collected as initial margin from the customer is treated as a customer asset, and is segregated from the initial margin collector's proprietary assets until re-hypothecated. Once re-hypothecated, the third party must treat the collateral as a customer asset, and must segregate it from the third party's proprietary assets. Assets returned to the initial margin collector after re-hypothecation must also be treated as customer assets and must be segregated from the initial margin collector's proprietary assets.
4. The collateral of customers that have consented to the re-hypothecation of their collateral must be segregated from that of customers that have not so consented.
5. Where initial margin has been individually segregated, the collateral must only be re-hypothecated for the purpose of hedging the initial margin collector's derivatives position arising out of transactions with the customer in relation to which the collateral was provided.
6. Where initial margin has been individually segregated and subsequently re-hypothecated, the initial margin collector must require the third party similarly to segregate the collateral from the assets of the third party's other customers, counterparties and its proprietary assets.
7. Protection is given to the customer from the risk of loss of initial margin in circumstances where either the initial margin collector or the third party becomes insolvent and where both the initial margin collector and the third party become insolvent.
8. Where the initial margin collector re-hypothecates initial margin, the agreement with the recipient of the collateral (i.e. the third party) must prohibit the third party from further re-hypothecating the collateral.
9. Where collateral is re-hypothecated, the initial margin collector must notify the customer of that fact. Upon request by the customer and where the customer has opted for individual segregation, the initial margin collector must notify the customer of the amount of cash collateral and the value of non-cash collateral that has been re-hypothecated.
10. Collateral must only be re-hypothecated to, and held by, an entity that is regulated in a jurisdiction that meets all of the specific conditions mentioned and in which the specific conditions can be enforced by the initial margin collector.
11. The customer and the third party may not be within the same group.
12. The initial margin collector and the third party must keep appropriate records to show that all the above conditions have been met.
With respect to the EU market the said ESAs' Second Consultation on margin RTS for non-cleared derivatives of 10 June 2015 adopted the following stance:
"The international standards do not generally allow re-use or re-hypothecation of initial margins and restrict the re-use to very specific cases. After considering the characteristics of the European Market, where the re-use and the re-hypothecation subject to the restrictions of the international standards would be of limited use the ESAs propose that the RTS do not include such possibility. As a special case, re-investment of initial margin posted in cash to secure the collateral posted seems to be common market practice and it should allowed as long as the investments are used for no other purpose than protecting the collateral poster."
This statement has been upheld in the ESA's Final Report of 8 March 2016.
The draft RTS attached to the above ESA's Final Report of 8 March 2016 consequently included the provision with the following wording:
Treatment of collected initial margins
1. The collecting counterparty shall not re-hypothecate, re-pledge nor otherwise re-use the collateral collected as initial margin.
2. The requirement laid down in paragraph 1 shall be deemed to be met where a third party holder or custodian reinvests the initial margin received in cash."
The European financial market regulators referred, moreover, to the respondents' views that the difficulties in segregating cash could have resulted in a de-facto ban of cash as eligible collateral for initial margin.
The European financial market regulators consider, in order to avoid unwanted effects of the segregation requirements, the obligation concerning the re-use of collateral should exclude cash to the extent that the collected margin is reinvested to protect the liability that the counterparty collecting the collateral has towards the posting party.
Securities obtained from the (re)investment of cash collateral should be segregated and not re-used in line with the treatment of initial margin.
In the European regulators' opinion, this would appear to solve the issue that may inadvertently have resulted in a de facto ban of cash as initial margin, which was not the regulators' intention.
Article 20 and Recital 35 of the Commission Delegated Regulation 2016/2251 of 4 October 2016 reflect the analogous stance (see box).
The policy option adopted with respect to the implementation of margin rules under EMIR assumed the alignment with international standards and a phase-in period of four years.
The intention was to give smaller participants more time in the transition period, i.e. more time to put into place all the necessary processes and systems. Additionally, by adopting the international standards, the policy accounts for the proportionality principle and sets a level playing field.
These requirements would privilege smaller players in terms of costs, but it also leaves smaller entities exposed to counterparty risk for this period.
The initial assumption was that the requirements should be phased-in over a period of four years starting from 1 December 2015 (being the scheduled date of entry into force of the RTS), however, these deadlines were delayed.
Earlier proposals set a phased implementation schedule for initial margin starting from December 1, 2015 for the largest derivatives users and extending through to December 2019. Variation margin requirements were scheduled to come into force for all covered entities on December 1, 2015.
Specifically, from 1 December 2015, market participants that have an aggregate month-end average notional amount of non-centrally cleared derivatives exceeding EUR 3.0 trillion were intended to be subject to the requirements from the outset while from 1 December 2019, any counterparty belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives exceeds EUR 8 billion was set to be subject to the requirements.
Market participants had been preparing extensively for those rules, but it was argued it would be nearly impossible to complete the relevant modifications by the original December 2015 effective date.
In the light of the circumstances the aforementioned framework of the Basel Committee on Banking Supervision of March 2015 had extended the start date for non-cleared derivatives margin rules (see also Press release of 18 March 2015 Basel Committee and IOSCO issue revisions to implementation schedule of margin requirements for non-centrally cleared derivatives).
RTS (as proposed by the aforementioned ESAs' Second Consultation on margin RTS for non-cleared derivatives of 10 June 2015 (JC/CP/2015/002)) fully aligned the requirements envisioned for the use in the EU under the EMIR framework with the BCBS and IOSCO standards (as amended in March 2015). Draft RTS envisioned that the requirements will enter into force on 1 September 2016 with the initial margin phased-in period of four years.
However, these schedules in June 2016 had been once more called into question - due to legislative delays on the part of the EU institutions - see EU Collateral Rules Lag U.S. in $493 Trillion Swap Market.
Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards for risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty has been published in the EU Official Journal on 15 December 2016 and provides for the following key implementation dates (see details in Articles 35 - 40 of the said Regulation):
- 4 January 2017 - date of entry into force of the rules,
- 4 February 2017 - implementation date for the exchange of variation margin for firms with a group aggregate average notional amount of non-centrally cleared derivatives above EUR 3 trillion,
- 1 March 2017 - implementation dates for the exchange of variation margin for all other firms in scope,
- 4 February 2017 through to 1 September 2020 - phase-in period for implementation of the exchange of initial margin.
It is noteworthy, the initial wording of the Commission Delegated Regulation (EU) 2016/2251 contained an error in Article 37, which should contain a phase-in provision on variation margin requirements to intra-group transactions in a way analogous to initial margin requirements.
Commission Delegated Regulation (EU) of 20.1.2017 correcting Delegated Regulation (EU) 2016/2251 of 4 October 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards for risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty (C(2017) 149 final) has, therefore, been proposed.
The need for the correction was due to a technical error in the process leading to the adoption of Delegated Regulation (EU) 2016/2251 where the inclusion of the two paragraphs on the phase-in of the variation margin requirements to intra-group transactions was omitted.
The Explanatory Memorandum to the correcting draft Regulation gives the following overview of the content of the proposal:
"This Delegated Regulation corrects the Delegated Regulation (EU) 2016/2251 by adding two new paragraphs to Article 37, which is the Article specifying the phase-in schedule for variation margin requirements. These paragraphs are analogous to the existing Articles 36(2) and 36(3), with the result that where an intragroup transaction takes place between a Union entity and a third country entity, the exchange of variation margin will not be required until three years after entry into force of the Regulation where there is no equivalence decision for that third country. Where there is an equivalence decision, the requirements will apply either four months after the entry into force of the equivalence decision, or according to the general timeline, whichever is later."
CCP collateral under EMIR - requirement for fully-backed guarantees
Another aspect involved with collateral requirements under EMIR is CCP-eligible collateral, where the expired EMIR exemption made it - as from 15 March 2016 - much more costly for non-financial counterparties.
EMIR in Article 46(1) requires that bank guarantees, used as collateral for CCP clearing of power and gas derivatives, are fully backed by collateral that meets the following conditions:
- it is not subject to wrong way risk based on a correlation with the credit standing of the guarantor or the non-financial clearing member, unless that wrong way risk has been adequately mitigated by haircutting of the collateral;
- the CCP has prompt access to it and it is bankruptcy remote in case of the simultaneous default of the clearing member and the guarantor.
All CCPs were given a three year exemption in regards to EMIR Article 46(1) allowing non-financial participants to continue to use non-fully backed bank guarantee as collateral in respect to positions that were:
The three year exemption period lapsed on 15 March 2016 (Article 62 of the Regulation 153/2013).
ESMA did not decide to further extend the grace period of three years for the non-financial firms' use of non-collateralised bank guarantees to cover transactions in energy derivatives cleared by CCPs (ESMA statement of 19 November 2015 (ESMA/2015/1750)).
The firms were, moreover, reminded that from 15 March 2016 CCPs authorised under EMIR need to fully collateralise commercial bank guarantees used to cover transactions in derivatives relating to electricity or natural gas produced.
Given that the exemption was not extended, the relevant requirements of Article 39 of the Commission Delegated Regulation (EU) No 153/2013 of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on requirements for central counterparties and Annex I thereto are binding.
Article 39 of the Regulation 153/2013 stipulates that for the purposes of Article 46(1) of EMIR "financial instruments, bank guarantees and gold that meet the conditions set out in Annex I shall be considered as, highly liquid collateral".
Pursuant to point (h) in Section 2 of the Annex I to the Regulation 153/2013 a commercial bank guarantee, to be accepted as collateral under Article 46(1) EMIR must be fully backed by collateral that meets, among others, the following conditions:
(i) it is not subject to wrong way risk based on a correlation with the credit standing of the guarantor or the non- financial clearing member, unless that wrong way risk has been adequately mitigated by haircutting of the collateral;
(ii) the CCP has prompt access to it and it is bankruptcy remote in case of the simultaneous default of the clearing member and the guarantor.
Another nuance is that after the MiFID II entry into force the EU Member States' discretion with respect to determining collateral available for CCPs will become further restricted.
Pursuant to Article 29(1) of MiFIR the operator of a regulated market "shall ensure that all transactions in derivatives that are concluded on that regulated market are cleared by a CCP."
It means, collateral applied for regulated markets trading will have to fulfil identical requirements to the ones already used for OTC markets' settlements under EMIR.
Hence, after the MiFID II entry into force derivatives trading settlements carried out on regulated markets will be governed by the aforementioned Article 46 of EMIR.
Given strict requirements CCPs are subject to under EMIR, this is likely to entail higher collateral costs as from 2018.
When it comes to potential modifications of the EMIR legal framework for the margins it is to be noted that the European Commission Proposal of May 2017 for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories (COM(2017)208) envisions new requirement that risk-management procedures for exchange of collateral of counterparties, or any significant change to those procedures, must be approved by supervisors before they are applied.
Recital 16 of the said draft Regulation reads:
"To avoid inconsistencies across the Union in the application of the risk mitigation techniques, supervisors should approve risk-management procedures requiring the timely, accurate and appropriately segregated exchange of collateral of counterparties, or any significant change to those procedures, before they are applied."
It is, moreover, envisioned that the supervisory procedures for the said approval will be stipulated in the regulatory technical standards in the form of the European Commission's delegated act developed by EBA, EIOPA and ESMA.
Referring, in turn, to the broader impacts of the respective regime, it is useful to observe that the higher collateral requirements on bilateral transactions introduced by the EMIR has attracted many entities towards central clearing, even though they do not fall within the scope of the EMIR mandatory clearing.
Commission Staff Working Document of 13 June 2017 provides an example of the Germany's KfW, a development bank exempt from EMIR, which in early April 2017 indicated that it would begin centrally clearing its euro-denominated interest-rate derivatives through Deutsche Boerse's Eurex Clearing platform.
KfW highlighted that the use of central clearing was justified both by the need to expand the number of its derivatives partners and by the benefits of central clearing from a risk management perspective.
This followed a similar move by Germany's sovereign debt agency, Finanzagentur, which began centrally clearing OTC interest-rate derivatives through Eurex in late 2016.
According to the European Commission Staff, this shift towards voluntary central clearing is likely to lead to further increases in the volume of transactions being managed by CCPs.
However, it is expected that even after all reform areas are implemented, some portion of the OTC derivatives market (specifically, non-standardised derivatives) will remain non-centrally cleared (OTC Derivatives Market Reforms Twelfth Progress Report on Implementation, Financial Stability Board, 29 June 2017, p. 12).
When it comes to the geographical reach of the respective requirements, the said FSB Tweflth Progress Report observes as follows (p. 15):
"The BCBS–IOSCO standards for margin requirements for NCCDs set out internationally agreed phase-in schedules for variation and initial margin requirements that began on 1 September 2016.
With respect to variation margin, implementation of the second and final phase began on 1 March 2017, with several jurisdictions granting forms of time-limited transitional relief or supervisory guidance until 1 September 2017.
With respect to initial margin, the 5-year phase-in period that began on 1 September 2016 will finish on 1 September 2020.
Additional jurisdictions have implemented these requirements since then, with 14 jurisdictions that have comprehensive requirements in place as of end-June 2017.
Brazil, South Africa, and Korea expect to have such requirements in place by end-2017, and Mexico by end-2018."
The said Report mentions, moreover, six jurisdictions (Argentina, China, India, Indonesia, Russia, and Turkey) which do not report planning to have comprehensive margin requirements in place by end-2018.
|Last Updated on Tuesday, 29 May 2018 20:51|