Second consultation on margin rules under EMIR: still some margin left for concerns
The European Supervisory Authorities (ESAs) launched on 10th June 2015 a second consultation on draft Regulatory Technical Standards (RTS) outlining the framework for the risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of the European Market Infrastructure Regulation (EMIR).
Second consultation on margin rules under EMIR: still some margin left for concerns
The European Supervisory Authorities (ESAs) launched on 10th June 2015 a second consultation on draft Regulatory Technical Standards (RTS) outlining the framework for the risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of the European Market Infrastructure Regulation (EMIR). The consultation runs until 10 July 2015.
Some issues which arose in the first consultation paper have been addressed in this amended version of the RTS. However, the newly introduced concepts and some proposed alternatives leave margin for uncertainty and practical difficulties in their implementation.
The major changes introduced in the second consultation include:
- The treatment of non-financial counterparties: Third-country non-financial counterparties below the clearing threshold (NFC-) receive the same treatment as their EU based equivalents (Art 2 GEN). The proposal of the first draft RTS in April 2014 that the margin has to be collected from all non-European entities without exemption given to the small EU based non-financial entities has raised a few eyebrows in the derivative industry. Inequality of treatment threatened to make the EU markets uncompetitive internationally. The playing field has been leveled in the second draft RTS by extending the same exemption from margin requirements to all NFC- wherever based. Nevertheless, the recital (3) suggests that the counterparties should have internal risk policies in place to determine whether the exchange of collateral is appropriate even in absence of mandatory requirement (in light of the size and nature of the trade). This slightly waters down the whole NFC- exemption, at least when it comes to the risk policies in practice.
- The exchange of margins with third countries entities:
- When trading with a third country FC and NFC+, an EU in-scope entity has obligation to “exchange” margin – meaning not only to “collect” but also to “post” margin. This is because the home regulations of that entity may not require the collection otherwise.
- Where assessment of legal enforceability of initial margin segregation arrangements in the relevant third country would be negative, there is obligation to put in place an alternative custody arrangement in the “clean” jurisdiction. This is likely to create a legal headache and in practice discourage trading with emerging markets with “dirty” netting status.
- The treatment of covered bonds swaps: Second draft RTS clarified that while the exempted covered bond issuers are not required to post initial margin or variation margin, they have to collect variation margin (but not initial margin) from their in-scope counterparties. Neither are they exempted from returning the collected excess collateral, of course (Art. 8 GEN). As a practical consequence, the interaction with the third country regime seems to reverse the burden when it comes to the third country covered bonds issuers – it is their EU in-scope counterparties that seems to be liable for posting variation margin (whether it is actually required or feasible to call on margin by the third country issuers).
- The timing of margin exchanges: More, but still not enough, flexibility has been introduced to account for the reality of settlement cycle for certain collateral assets. Where initial margin is required, the margin is allowed to be collected within 3 business days from the calculation date. However, where the parties are exempted from initial margin, the variation margin has to be collected within 1 business day. This is controversial as disadvantaging the smaller players posting only variation margin while they do not have the infrastructure and liquidity alike the bigger players subject to initial margin. Also, it discriminates the asset classes which may not be settled within 1 business day (such as Japanese government bonds or Yen cash). The concepts of “calculation date”, “business day” or “delivery” are furthermore unclear. Margins collected beyond the first business day are subject to the increased “margin period of risk” (MPOR) component (art. 1 VM). The proposal effectively reduces usage of non-cash collateral (mostly for the smaller entities solely exchanging variation margin) and raises concerns of liquidity and funding for such smaller players.
- Concentration limits for sovereign debt securities: The obligation to diversify the collateral strikes against certain the small players holding a single type of securities on their books. The application of concentration limits has therefore been limited to systemically important entities and other entities with large OTC derivatives portfolios (i.e. if the total initial margin collected exceeds EUR 1 billion), in each case only to collateral collected in excess of EUR 1 billion (Art. 7 LEC). The exemption is welcome but its practical implementation requires yet another monitoring procedure increasing an already high operational burden of the parties posting government bonds. Although the ESAs noted the intention to align with the international standards, the requirement to monitor the concentration limits and wrong way risk of the collected collateral remains at odds with the US margining regime.
- The requirements on trading documentation:
- The second draft RTS confirms expressly that having in place a master agreement or a long form confirmation is a precondition for trading (recital (32)). Art. 2 OPD further provides for certain requirements to be met by the derivatives trading documentation, such as importance of legally effective close-out netting provisions. An “independent legal review” of the enforceability of the netting arrangements shall be reviewed “at least on annual basis”. Parties should “always be able to provide documentation […]” forming base of this review. The second draft RTS effectively removed the requirement for a “legal opinion”, however it is unclear whether the independent legal review in each relevant jurisdiction does not in practice imply seeking an external advice. In any case, the annual review process may prove potentially very cumbersome for in-house legal departments.
- The requirement for “negative written agreements” not to exchange margin as precondition to benefit from various exemption was removed and replaced by requirement of having such “provision” in the internal risk management procedures (Art. 2 GEN).
- Minimum credit quality of collateral: The receiving party is required to have “access to the market” or “ability to liquidate” collateral in “timely manner” in case of default of the posting party (Art. 1 LEC). The segregation arrangements shall ensure that the initial margin is available to the posting party “in a timely manner” in case the counterparty defaults. The previous standard of “immediate” availability has been removed as striking against the legal impediments. The requirement for obtaining a “satisfactory legal opinions in all relevant jurisdictions” on the effectiveness of the bankruptcy remote segregation has been removed as “excessively cumbersome”. ESAs introduces a lower standard (but still) of “independent legal review“ to this effect and ability to “provide the documentation supporting the legal basis of compliance with segregation requirements in each jurisdiction”. This raises the same concerns as with respect to the annual legal review of netting arrangements discussed.
- Initial margin models: More flexibility has allowed in modeling and recalibration of parties´ respective initial margin models (Section 4)
- Haircuts for foreign exchange (FX) mismatch on cash collateral: One of the most controversial points of the first draft RTS setting out the eight percent haircut on mismatched collateral (i.e. where the currency of collateral is different from the currency of the underlying trade) was amended but not removed (art. 2 HC). An 8% haircut is imposed on initial margin if collateral is in a different currency than the "termination currency" identified in the agreement. An 8% haircut is imposed on variation margin if collateral is in a different currency than then "transfer currency" identified in the agreement. The second draft RTS does not define "termination currency" or "transfer currency", the latter not being a concept generally used in the ISDA documentation. Cash collateral in the same currency as the termination/transfer currency has a zero haircut.
- The treatment of cash collateral for initial margin: Cash initial margin can be re-invested to a limited extent (Art. 1 REU). This novelty is to be read in combination with another amendment (Article 1 SEG (1)) which requires that the posting party is also protected from the default or insolvency of the third party holder or custodian (in addition to the collecting party). It is not possible to achieve this in respect of cash as the return of the cash is inherently linked to the solvency of the third party bank. As a consequence, the second draft RTS implies that that cash will only be permissible as initial margin if it is re-invested. The consequential prohibition of initial margin in cash unless it is transformed into an alternative asset is controversial as cash was expressly envisaged by the BCBS IOSCO framework for margin requirements for non-centrally cleared derivatives as a major liquidity safety net where securities are not available (distressed markets).
- Reviewed criteria on intragroup exemptions: The second draft RTS introduced more granular elements defining the approval process and timelines (Chapter 2).
- Implementation timeline: The timeline was brought in line with BCBS IOSCO recommendations (Art. 1 FP). It is clarified that the phased-in compliance dates are determined by reference to the average of total gross notional amount recorded in “the last business day of the months of March, April and May” of the relevant year (art 1 FP(4)). Confusingly, the Art 7 GEN provides that initial margin may not be collected for “all new contracts from January of each calendar year” if at least one of the counterparties falls below the EUR 8bn threshold for months of “June, July and August” of the preceding year. An interpretation is that this threshold applies after the phase-in periods expire (i.e. 2020 onwards).
- Minimum Transfer Amount: The cap on MTA is clarified to be cumulative for both initial margin and variation margin. Parties may agree to split the MTA for each type of margin but their sum cannot exceed EUR 500,000 (Art. 4 GEN (2)).
- Treatment of OTC derivatives implying payment of premium upfront: A party collecting the premium should not collect initial margin or variation margin whereas its counterparty paying premium shall collect both, if applicable (recital 6).
- Scope for threshold calculations: The second draft RTS clarified that non-centrally cleared OTC derivatives that may be exempted from variation margin and initial margin shall still be counted towards the IM thresholds (i.e. EUR 8bn and 50 million) (recital (15)). However, it does not say expressly whether “non-centrally cleared derivatives” shall be defined by reference to the clearing mandate scope or clearing as a matter of fact (i.e. including on voluntary basis). It does not say whether the intra-group exempted derivatives shall be counted in or not.
- Treatment of cross-currency swaps: The second draft RTS clarified that the FX forward component is exempted from IM while the interest rate component is not (recital (17)).
This article is a private contribution from the author and does not represent or engage Swedbank in any respect