Segregation of initial margin (IM) for non cleared derivatives, legal considerations
As a result of the turbulences caused by the global financial crisis, regulators worldwide increasingly focus on derivatives markets. Given the enormous risks posed by the unregulated off-exchange (“over the counter”/ OTC) market, there is a growing recognition that greater transparency in exchange trading significantly contributes to the future stability of the international financial markets.
As a result of the turbulences caused by the global financial crisis, regulators worldwide increasingly focus on derivatives markets. Given the enormous risks posed by the unregulated off-exchange (“over the counter” OTC) market, there is a growing recognition that greater transparency in exchange trading significantly contributes to the future stability of the international financial markets.
At their 2009 summit in Pittsburgh, the G20 member heads of state and government came to the agreement that, by the end of 2012, all standardised derivatives contracts will have to be traded through exchanges or electronic trading platforms. In addition, large parts of OTC trading will have to be settled on a collateralised basis and reported to central trade repositories.
Within the European Union, this objective has already been implemented through the European Market Infrastructure Regulation (EMIR). The 2nd draft Regulatory Technical Standards (RTS), which fall under one of the 3 pillars of EMIR, were published in June 2015. The regulations are due for go live 1st September 2016 for eligible covered entities.
Under the Global Standards
“Collected collateral must be segregated from the initial margin collector’s proprietary assets. In addition, the initial margin collector must give the customer the option to segregate the collateral that it posts from the assets of all the initial margin collector’s other customers and counterparties (i.e. individual segregation).”
“Market participants must ensure that their choice of segregation meets the qualification requirement of the regulatory bodies and where choosing Third/Tri-party custodial arrangements, ensure that arrangements provide sufficient automation to support bilateral risk monitoring and daily balance reconciliations”
“Market participants must be clear on which segregation structures can be used between counterparties in particular jurisdictions. Updates of opinions must meet local regulatory requirements of different jurisdictions”
There is rightly a growing concern in the industry around how new regulatory requirements will be documented. The exercise of documenting these new regulatory obligations will be complex and consume a large amount of resource, further the timeframe in which this must be done, and the number of relationships in scope adds an additional pressure.
Whichever approach an institution opts for a number of factors must be taken into consideration and will influence the final model.
- Existing documentation set
- Counterparty domicile
- Choice of Triparty agent
- Location of custody of assets used to cover the IM requirement
The new documentation framework
The requirement to provide annual legal opinions introduces an additional cost consideration.
Clearstreams documentation structure
By contrast, our documentation structure is multilateral and open to multiple products so our customers will only need to have one single triparty contract (CMSA) with Clearstream that covers all their listed bilaterally-contracted counterparties.
The CMSA covers our Triparty Collateral Management Service (TCMS) and enables the collateralisation of various exposures resulting from different underlying transactions. It allows for margin to be pledged or transferred with title to a segregated account with respect to any underlying credit exposure agreed between two parties.
The services provided by CBL under the CMSA are independent of the provisions and obligations of the respective parties under the principal agreement. The services provided by CBL under the CMSA consist mainly in the creation of collateral account, execution of collateral receiver and/or collateral giver instructions and in the valuation of exposure and substitution. CBL will not inquire into the legality or validity of any collateral or of any transfers of collateral or eligible assets or of the underlying transactions. This is the sole responsibility of the parties to the principal agreement. Nothing in the CMSA is intended to affect, amend or otherwise change any provision of the principal agreements.
Clearstream’s role as triparty collateral agent in the new regulatory framework does not require any amendment to our existing documentation set, which is flexible enough to already accommodate any regulatory requirements suggested or currently in effect.
A standardised multilateral pledge conditions option?
Clearstream are interested in the idea of 'standardising' reg IM documentation. In the current market model participants will be required to have their ISDA master, CSA + CSD/CTA + local law pledge + triparty docs or third party custody docs, this 'doc set' will be multiplied by the number of relationships each dealer pairing has. CBL will and can support this model. However removing the need for multiple bespoke IM and pledge docs would offer significant efficiencies to the market.
The requirement is to reduce the overall documentation burden, and have a document or set of documents that works seamlessly with Clearstream's current documentation set, operational process and Luxembourg law. In fact a credit support deed/collateral transfer agreement duplicates much of what is already provided for in current triparty documentation. These documents were not really designed for in Triparty structures.
CBL already offer a standardised and multi lateral document to the Repo market the Clearstream Repurchase Conditions. The Clearstream concept is to offer to clients an optional appendix to our CMSA. Clients could subscribe to this appendix for any relationship in which both counterparts were clients of Clearstream (participants of CBL triparty). The document would be a set of pledge conditions under Luxembourg law reflecting the EMIR requirements in relation to the provision of IM. Specifically here the focus is uncleared OTC derivative contracts as set out in the relevant RTS. However a set of standard pledge conditions could also be used for the pledge back of haircuts in Repo transactions, or any other collateral arrangement.
The parties to a relevant uncleared derivative transaction (customers of CBL) would confirm to each other (bilaterally) that IM is provided pursuant to such pledge conditions. Each of the parties to the derivative transaction would then notify CBL under the respective CMSA that it has entered into the pledge conditions with the relevant counterparty and that CBL shall provide TCMS services in relation to such transaction.
This structure would mean that clients of CBL would not be required to bilaterally negotiate multiple new bespoke IM docs for each relationship, it would be scalable as more entities are impacted by upcoming regulatory requirements and it would bring standardisation to the market.