Months to Go: Margin on Bilateral OTC Trades
The focus for the European Market Infrastructure Regulation (EMIR) and Dodd Frank has been to reduce risk in the over the counter derivatives world by changing their trading, clearing and reporting protocols. The more bespoke, low volume OTC products were largely left untouched but their time is fast approaching as from December 1 2015, new rules requiring variation and initial margin on un-cleared OTC business will take effect.
Months to Go: Margin on Bilateral OTC Trades
The focus for the European Market Infrastructure Regulation (EMIR) and Dodd Frank has been to reduce risk in the over the counter derivatives world by changing their trading, clearing and reporting protocols. The more bespoke, low volume OTC products were largely left untouched but their time is fast approaching as from September 2016, new rules requiring variation and initial margin on un-cleared OTC business will take effect.
Please note: The start date for these rules was moved the September 2016 after this article was written and some of the charts formatted below, please assume the new dates apply.
The final details are still being written in Japan and on both sides of the Atlantic. In the US both the the Federal Deposit Insurance Corporation (FDIC) and the Commodity Futures Trading Commission (CFTC) are drafting their versions while in the European Union, the European Banking Authority (EBA) is producing its proposals.
While all three sets of rules closely follow the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) paper – Margin requirements for non-centrally cleared derivatives – there are variances,. Below is a summary of the proposals and the most significant differences.
Affected entities and portfolios
All three regulatory bodies target the major banks with large OTC exposures which the original BCBS paper defined as “systemically important.” The CFTC and FDIC employ the already established definitions of major swap participants and swap dealers whereas in the European Union (EU) entities are split into financial and non-financial entities as previously defined by EMIR.
All the proposals use a numerical definition to determine who is included in the initial margin (IM) exchange. Below is the summary of the calculations:
- A firm must have an average gross notional above [X] to be included on September 1st 2016
- In the US, the ‘X’ figure is $4trn (€3.2trn) while in the EU, it is €3trn ($3.6trn)
- In addition firms can apply a minimum threshold for IM of $65m (€52m) in the US or €50m ($61m) in the EU. This means that even if they have a large portfolio, they can avoid delivering IM if the risk on their portfolio is beneath this additional threshold
Material swaps exposure
The buy side is more impacted in the US than in Europe because the rules include any financial end-user with an average notional of all OTC business with all counterparties in the previous year for June, July and August of $3bn. This means any buy side user of the OTC market, whether a hedge fund, cor- porate of investment fund will have already made the qualifying measurement for that three month period in order to determine their inclusion for the September deadline. If they haven’t, then firms will need to retrieve their live portfolio data in order to make an informed decision on how to prepare for the implementation of the rules.
All three proposals exclude physically settled FX transactions such as spot and forwards, and the components of a cross currency swap.
Although there is widespread consensus that these rules should apply to new trades from September 2016, the US version advocates that the netting agreement which spans pre- and post- September 2016 must be honored. The implication is that firms would need to modify their existing credit support annexes (CSAs) or master agreements to exclude post-Sep 2016 trades. They would have to execute new CSAs for all the affected trades, to avoid having to post IM on their entire historic OTC portfolio, which would be expensive.
In the original BCBS proposal, affiliates or entities within a corporate group, were excluded from the proposal, but included for the measurement of the gross notional amounts. The BCBS left it to national regulators to determine how to treat inter-group trading. In this respect the US and the EU are far apart. The US requires OTC trades between affiliates to be subject to the IM rules, while the EU allows them to be excluded under existing EMIR rules whereby affiliates are exempt provided they meet specific rules.
One approach within corporate groups is to aggregate exposures and centralise the risk management of all OTC trades via one entity. Affiliates should have a matched book of trades with their external corporate customer on one side and the central risk taking entity on the other. But, the new US rules would judge a large intra-group portfolio as needing to be covered by IM, even if the net market risk at the affiliate is zero. The EU, on the other hand, provides a set of criteria that once met allows an affiliate to be excluded from the IM rules.
It is arguable that affiliates face credit risk from external counterparties that cannot be eliminated, and hence the US requirement for IM would achieve that aim by transforming credit risk into the IM assets. This would mitigate liquidity risk in the market, in the event of a default).
All three proposals require a number of co mon approaches such as splitting IM across assets classes with limited cross-market netting and allowing for an Historic VaR or a schedule-based approach to IM. The US and EU begin to deviate on the Historic Simulation Value-at-Risk (HSVaR) when their prerequisites for the modelling scenarios are defined. The EU requires a minimum three year history and at least 25% of the scenarios to be stress scenarios while the US history is between one and five years and requires at least one year of scenarios to be those of a ‘stressed period’.
Both proposals do not allow the scenarios to be weighted, which is common amongst central counterparties (CCPs), and is used to allow events like Lehman Brothers to slowly fade in significance over time. The implication being that once a period of high volatility enters the IM model, it will drive IM levels until such time as it expires due to the sliding time window.
CCPs have reacted to the low volatility environment by extending their historic period or setting a volatility floor, to avoid IM levels drifting lower due to market stability.
As with all regulations for a global market, there are issues over offshore counterparties. The EU proposal covers non-EU counterparties provided they don’t have an EMIR exemption and meet the threshold on portfolio size for EU entities. The US regulations do not yet make clear whether their version of these rules will extend beyond US regulated entities.
If you are a US or EU bank and user of OTC products, it is clear you need to apply the threshold criteria and establish which of your entities are affected. If you are a US end-user, the material swaps exposure criteria may also apply – and this means at the individual fund level, of which $3bn isn’t a big portfolio. Once you have established that an entity is impacted, you need to begin planning on how to meet the regulations using your existing legal, technical and operational infrastructure.
Another issue for consideration is the continuing work at the International Swaps and Derivatives Association (ISDA) on their standard initial margin model, which calculates the margin needed to back trades that would not be processed by clearing houses.
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