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In September 2013, the Working Group on Margin Requirements (WGMR), an initiative jointly run by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO), issued the final margin policy framework for non-cleared, bilateral derivatives. In line with this framework, regulators across a number of jurisdictions have since developed their own margin rules, all with an implementation deadline starting on 1 September 2016. At the time of submission of this article the European Commission has just announced a delay for the implementation of the European margin rules for the Phase-1 dealers. The reason for this delay is that the European Commission is still in the process of reviewing the draft EU margin rules and considering some of the ISDA-driven advocacy efforts and will not be able to complete this process in time for the EU margin rules to enter into force on the originally scheduled 1 September 2016 deadline. In the meantime ISDA has approached the US regulators, as well as BCBS-IOSCO with a request for global harmonization of the implementation timeline of the margin rules.<\/p>\n
The International Swaps and Derivatives Association (ISDA) initiated a WGMR Implementation Program to facilitate the implementation of the margin rules across jurisdictions through a number of different workstreams. Each of those workstreams (Margin & Collateral Processing\/Portfolio Integrity; Risk Classification and Methodology; Data Sources; Dispute Resolution; and Legal & Documentation, with the ISDA WGMR Oversight Committee performing a coordinating role) was established with a view to addressing all areas necessary for broad market compliance with the new rules for both Initial Margin (IM) and Variation Margin (VM).<\/p>\n
With the first implementation date of 1 September 2016 looming on the horizon, the Phase-1 dealers who will need to be regulatory compliant by then for IM and VM are busy getting their infrastructure in place. A repapering exercise of the collateralisation documents under the ISDA swap documentation infrastructure will be part of this preparation. The adjustments to the documentation will be significant and will require modifications to key terms, including collateral eligibility, collateral haircuts, calculation and collection timing, dispute resolution, and in the procedure for exchanging IM. Linked to that, changes to existing custodial agreements or the setting up of new ones will be required to comply with IM segregation requirements. New or updated netting opinions will also be needed for some jurisdictions.<\/p>\n
In this article I will discuss the documentation suite and market solution which ISDA and the market have been working on for the last two years, to be used as industry standard templates. Some of those documents have recently been finalised and published in the Bookstore section on the ISDA website, others are still being drafted and discussed within the Legal & Documentation workstream at the time of writing this article and are expected to be finalised and published very shortly, leaving the Phase-1 dealers very little time to get their regulatory compliant documentation in place in time for the 1 September 2016 deadline (subject to the above-referenced delay for the European rules and the advocated delay of the US rules).<\/p>\n
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The Documentation Suite<\/h4>\n
The new legal documentation which is being developed by ISDA is designed to comply with all major regulatory regimes which have been or are in the process of being put in place in response to the BCBS-IOSCO margining framework, including the US (covering both CFTC and Prudential Regulators), the EU and Japan. The documentation includes:<\/p>\n
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- the VM-compliant collateral documents (under New York, English and Japanese law) (the “VM CSAs”);<\/li>\n
- the IM-compliant collateral documents (again under New York, English and Japanese law) (the “IM CSAs”);<\/li>\n
- the IM custody arrangements;<\/li>\n
- the ISDA 2016 Margin Protocol (the “VM Protocol”);<\/li>\n
- the ISDA 2016 Margin Protocol Questionnaire (the “VM Protocol Questionnaire”); and<\/li>\n
- the ISDA Regulatory Margin Self-Disclosure Letter (the “Self-Disclosure Letter”).<\/li>\n<\/ol>\n
On 14 April 2016 ISDA published the New York law 2016 Credit Support Annex for Variation Margin (VM). Subsequently, on 29 April 2016 it published the English law 2016 VM Credit Support Annex for Variation Margin (VM). All the other documents listed above are still in draft form but it is to be expected that they will all have been finalised at the time of publication of this article. I will discuss these documents below in no particular order and at a fairly high level, starting with the VM Protocol and the VM Protocol Questionnaire. The delay in the EU implementation deadline may have an effect on some of the above documents but again there is little that can be said about that with any level of certainty at this stage. In view of the delay in the EU margin rules (and consequently the Swiss margin rules which follow the EU timeline), the protocol documents are currently being amended to implement a new supplemental adherence mechanism to allow for later implementation of the EMIR and Swiss law provisions, once they are finalised.<\/p>\n
The VM Protocol and the VM Protocol Questionnaire<\/strong><\/p>\n
ISDA has designed a Protocol to facilitate the WGMR compliance. Unlike the usual protocol where parties seek to be bound by the substance of the protocol by merely executing an adherence letter (e.g. the ISDA 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol), this is a protocol which, in addition to parties executing an adherence letter, requires them to exchange questionnaires with elections on which they need to match with each other. The VM Protocol is designed to assist market participants with:<\/p>\n
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- the creation of new regulatory compliant VM CSAs; or<\/li>\n
- the upgrade of existing CSAs to make them VM-compliant.<\/li>\n<\/ol>\n
It will provide for three different methods for creating or upgrading existing CSAs and market participants will have to select one or more of those methods in their VM Protocol Questionnaire, which they will have to exchange with each of their counterparties with a view to matching on at least one method. A ‘match’ with a counterparty on one of these methods will determine how that pair of counterparties will proceed with updating their existing CSAs towards VM-compliance. These three methods are:<\/p>\n
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- Amend Method;<\/li>\n
- Replicate-and-Amend Method; and<\/li>\n
- New CSA Method.<\/li>\n<\/ol>\n
An election for the Amend Method means that counterparties have agreed to amend their existing CSA into a VM-compliant CSA, to cover both existing trades which were entered into before the compliance date (the so-called ‘legacy trades’), as well as future trades entered into after the regulatory compliance date. All transactions between counterparties who have opted for this method will then fall under one single regulatory-compliant CSA, which, from a collateral management and systems point of view, may be preferred over the other two methods which will result in multiple VM CSAs, but it will mean that existing trades entered into prior to the compliance date will also be captured by the new requirements. Under the Replicate-and-Amend Method, existing CSAs between counterparties are replicated and subsequently amended such that they become regulatory compliant. This method, if selected by a counterparty pairing, will result in<\/p>\n
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- a VM-compliant CSA for future trades, capturing most of the elections from the existing CSA but upgraded for VM-compliance; and<\/li>\n
- an existing CSA which will continue to cover the legacy trades.<\/li>\n<\/ol>\n
By definition this method, as well as the New CSA Method discussed below, will result in two VM CSAs between a counterparty pairing under one single ISDA Master Agreement. Finally, an election for the New CSA Method will have the effect of a counterparty pairing creating a new VM-compliant CSA for new transactions only, with the existing CSA continuing to govern pre-implementation, legacy, trades.<\/p>\n
Attached to the VM Protocol are a number of exhibits, representing template documents, governed by New York law, English law or Japanese law, as applicable, designed by ISDA with a view to documenting:<\/p>\n
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- the amendments to the existing CSA if counterparties have agreed on the Amend Method or Replicate-and-Amend Method or<\/li>\n
- the new VM-compliant CSA if counterparties have agreed on the New CSA Method. These exhibits allow for a degree of flexibility between parties to agree otherwise provided always that the documents will remain regulatory compliant.<\/li>\n<\/ol>\n
The VM Protocol is not expected to be ready for use by the Phase-1 Dealers which, by necessity, will have to engage in bilateral negotiations on the above and other points, but will likely be used by the rest of the market, in scope for the margin rules, by March 2017. The intention is that there will be an electronic build for the VM Protocol and the VM Protocol Questionnaire through the ISDA Amend tool which will enable the market to exchange these documents in a quick and easy way.<\/p>\n
Other topics covered by the VM Protocol Questionnaire<\/strong><\/p>\n
In addition to making a selection for one of the methods discussed above, the VM Protocol Questionnaire also requires market participants who want to adhere to the VM Protocol to, inter alia:<\/p>\n
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- indicate what margin regime they are covered by (Prudential Regulators Rules, CFTC Rules, EMIR Rules, Japan Rules, Canada Rules);<\/li>\n
- identify the applicable “Notification Time” under the relevant CSA;<\/li>\n
- select an early implementation date for the Amend Method;<\/li>\n
- select a broad product set of coverage for the Replicate-and-Amend and the New CSA Method;<\/li>\n
- select a Valuation Agent;<\/li>\n
- elect for negative interest provisions to apply;<\/li>\n
- switch off any ‘independent amount’ provisions in existing CSAs (if counterparties agree on the Amend Method or the Replicate-and-Amend Method).<\/li>\n<\/ul>\n
Parties will need to make an election and match on some of these items or redeliver amended Questionnaires until they match. In other cases, a fall-back scenario may apply if they fail to elect or match.<\/p>\n
The Self-Disclosure Letter<\/strong><\/p>\n
ISDA is also in the process of finalizing a Self-Disclosure Letter which is intended to provide market participants with a standard form for providing counterparties with information necessary to determine if and when compliance with one or more of the new regulatory margin regimes (US, Europe, Japan, Switzerland and Canada for now) will be required. The information provided through this Self-Disclosure Letter will be provided solely for making such determinations.<\/p>\n
The Letter will request the market participant to provide general information about itself (the so called “general biographical information”) and will have to be completed by all users. The remaining sections of this Letter request jurisdiction or regulator-specific information and cover all the different jurisdictions where regulatory margin regimes are in force. Important sections for completion here are the ones where a market participant provides information on its status (FC, NFC+ or NFC-) and therefore whether it is in scope for the margin rules, but also on its average aggregate notional amount (“AANA”) of un-cleared derivatives at group level, which will be an indication of when it is required to be regulatory compliant for VM and IM.<\/p>\n
As with the VM Protocol Questionnaire, it is expected that the Self-Disclosure Letter will be used and completed on ISDA Amend (http:\/\/www.markit.com\/product\/isda-amend), once it will have been built on that system. ISDA Amend will be designed to cause information about an entity that has been previously submitted to “pre-populate” the responses to this form on the site. By way of example: if a person has previously completed any protocol on ISDA Amend and has provided address and LEI information therein, such information will pre-populate any fields in this Self-Disclosure Letter.<\/p>\n
The VM CSA<\/strong><\/p>\n
As mentioned above, ISDA published the New York law CSA on 14 April 2016 and the English law CSA on 29 April 2016 and both are now available from the ISDA Bookstore (http:\/\/www.isda.org\/publications\/pubguide.aspx). These documents are to be used by counterparties to document their collateralisation arrangements under the ISDA infrastructure following the implementation of the margin requirements and are updated versions of the 1994 ISDA Credit Support Annex (Security Interest – New York Law) and the 1995 ISDA Credit Support Annex (Title Transfer – English Law), respectively.<\/p>\n
The VM CSAs apply only to “Covered Transactions”, entered into on or after an agreed date, which could be any of “Swaps”, “Security-Based Swaps”, “OTC Derivatives”, “Physically Settled FX Forwards” or “Physically Settled FX Swaps” (all defined terms in the VM CSAs), the in- or exclusion of which will have to be agreed between the parties. With the introduction of the VM CSA for Covered Transactions under an ISDA Master Agreement comes the concept of the “Other CSA” in relation to transactions which are not Covered Transactions under the VM CSA and which will affect the “Exposure” under both the new CSA and the existing CSA.<\/p>\n
A number of concepts which were part of the 1994 New York law CSA and the 1995 English law CSA have disappeared from the VM CSAs, such as:<\/p>\n
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- “Independent Amount”<\/strong> – this is equivalent to the new Initial Margin and will therefore be captured by the IM CSA\/IM CSD and is no longer part of the VM CSAs;<\/li>\n
- “Credit Support Amount”<\/strong> – this definition consisted of elements such as “Independent Amount” and “Threshold”, none of which are still relevant in the VM CSAs, and has now been replaced by “Exposure”;<\/li>\n
- “Delivery Amount”<\/strong> and “Return Amount”<\/strong> – these concepts have been replaced by “Delivery Amount (VM)” and “Return Amount (VM)” and are fairly similar to, and operate in the same way as, their equivalents under the ‘old’ CSAs, although the absence of “Credit Support Amount” in the new regulatory compliant VM CSAs means that there is a difference in the way these amounts are calculated;<\/li>\n
- “Threshold”<\/strong> – where the new margin rules do not allow for uncollateralized exposures between parties and the threshold should therefore effectively always be zero, the regulatory compliant VM CSAs do no longer use this concept;
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<\/li>\n- “Minimum Transfer Amount”<\/strong> – although this concept has been retained in the regulatory compliant VM CSAs, the final draft of the EU margin regulations has set a maximum threshold of EUR 500,000 (in USD under the US margin rules), such amount to be allocated by counterparties across VM and IM.<\/li>\n<\/ul>\n
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Other points to note with respect to the VM CSA are:<\/strong><\/p>\n
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- where parties could previously agree and specify the “Valuation Date”, it is now hardwired into the document as being daily unless otherwise specified;<\/li>\n
- demands for transfers of eligible collateral support of variation margin or equivalent credit support of variation margin need to be effected on a “Regular Settlement Day” which is now the same (as opposed to previously the next) Local Business Day on which such demand was made, provided the demand for such transfer was received by the “Notification Time”. This has reduced the time available to effect a transfer of collateral compared to under the ‘old’ CSA;<\/li>\n
- the introduction of new ways of payment of interest amounts on the “Collateral Support Balance (VM)”, being:<\/li>\n<\/ul>\n
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- “Interest Transfer”, which allows the party which needs to pay interest to set off such amount against any “Delivery Amount (VM)” or “Return Amount (VM)” that may be due to it by the other party; or<\/li>\n
- “Interest Adjustment”, which allows for the making of adjustments to posted variation margin collateral by adding an amount to the balance of variation margin collateral or by reducing an amount (in case of a negative interest amount);<\/li>\n<\/ol>\n
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- parties can elect for set-off to apply to any obligations to transfer Eligible Credit Support (VM) or Equivalent Credit Support (VM) under the VM CSA with any obligations to transfer credit support under any “Other CSA” to the extent such credit support is fully fungible and does not require segregation. Effectively, this is cross-CSA payment netting;<\/li>\n
- the process to be followed when Eligible Credit Support (VM) loses its status of and ceases to be Eligible Credit Support (VM) or is subsequently reinstated as being eligible.<\/li>\n<\/ul>\n
The IM Documents<\/strong><\/p>\n
IM will require a set of new documentation for transactions which will be subject to regulatory IM. ISDA is also in the process of finalizing the collateralisation document for IM, being the 2016 Credit Support Annex for Initial Margin (IM) under New York Law and the 2016 IM Credit Support Deed under English law. The requirement under the different margin regimes for segregation of posted IM from the proprietary assets of the collecting counterparty and from the proprietary assets of the posting counterparty means that the current English law ISDA CSA which, unlike the New York law ISDA CSA, provides for full title transfer of collateral, will not be suitable.<\/p>\n
The segregation requirement with respect to IM is there to ensure that collateral posted as IM is available to the posting counterparty in a timely manner in case the collecting counterparty defaults. The proposed documentation structure for IM will in addition to the above include new tri-party agreements with a non-affiliated custodian to hold the segregated IM. Together with custodians such as Euroclear and Clearstream, ISDA is currently working on a documentation suite to offer the market fully regulatory compliant and comprehensive tri-party services for the segregation and management of IM where collateral assets will be held in individually segregated accounts under a pledge structure.<\/p>\n
The tri-party IM segregation arrangements offered by Euroclear and Clearstream have been diligently reviewed for regulatory compliance with the US and EU margin regimes and changes to their documentation have been agreed with the market under ISDA guidance to the extent such compliance was lacking.<\/p>\n
Without going into any level of detail on the IM documents here, there are some specific features worth mentioning here:<\/p>\n
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- Custodian (IM) Risk: the collateral provider (‘Chargor’), rather than the collateral receiver (‘Secured Party’) will in principle be liable for acts or omissions of the custodian, used for the purposes of IM segregation to the same extent the Chargor would be liable for its own acts or omissions;<\/li>\n
- the Secured Party will have no right to sell, pledge, rehypothecate, assign, invest, use, commingle or otherwise dispose of posted IM or register any such posted IM in its name or its custodian’s name, other than as set out in the IM documents in the context of enforcement;<\/li>\n
- no set-off is allowed of any IM amount delivered or returned under the IM documents with any margin to be delivered or returned under any other CSA;<\/li>\n
- like the VM CSA, the IM documents provide for the scenario that eligible credit support under the applicable margin regimes loses its eligibility status, temporarily or permanently;<\/li>\n
- the IM documents introduce the possibility for counterparties to toggle on a “Model Revocation Termination Event”, which then introduces an additional termination event under the CSA to apply where a party under applicable law is required to have approval from a governmental or regulatory authority to use a particular IM model and the use of such IM model is no longer permitted or has been prohibited without timely remediation. Given that the US regulators have expressed objections against this feature, it remains to be seen whether this will remain in the final documents;<\/li>\n
- equally, the IM documents enable counterparties to toggle on a “Custodian (IM) Non-Transfer Event” which would apply where a failure of the custodian to comply with appropriate instructions from the Chargor in accordance with the account control agreement could result in a potential event of default or even an event of default following a cure period;<\/li>\n<\/ul>\n
IM Segregation – Legal Reviews<\/strong><\/p>\n
The EUR margin rules require full segregation arrangements for posted IM such that collateral posted as initial margin will be available to the posting party in a timely manner in case the collecting counterparty defaults. Counterparties need to perform ‘independent legal reviews’ to ensure that segregation arrangements meet the requirements set out in the EU margin rules. ISDA has now commissioned market standard legal opinions for 15 prioritised jurisdictions (for the benefit of the Phase-1 dealers) to cover collateral provider insolvency issues and collateral taker insolvency issues on the basis of IM held with traditional custodians. The collateral provider insolvency reviews will be a supplement to ISDA’s existing collateral opinions in the relevant jurisdictions to cover issues associated with IM held with a third-party custodian and the new WGMR documents. The collateral taker insolvency reviews will be standalone and will cover issues associated with IM held with a third-party custodian in the case of a collateral taker (i.e., secured party\/transferee) insolvency.<\/p>\n
ISDA is specifically not commissioning any custodian insolvency reviews or reviews regarding the enforceability of custodian documents and it is expected that those opinions will be obtained based on each custodian’s specific legal and operational arrangements. However, the opinions that ISDA is obtaining are expected to address whether local law in the jurisdiction of a collateral provider or a collateral taker would generally recognise the enforceability of custodial arrangements under their governing law.<\/p>\n
\nThis article was first published in edition 7 of Rocket, our magazine. Download available Rocket editions here<\/a>, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop<\/a>.
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<\/p>\nTo save your address into your profile:<\/p>\n
- “Credit Support Amount”<\/strong> – this definition consisted of elements such as “Independent Amount” and “Threshold”, none of which are still relevant in the VM CSAs, and has now been replaced by “Exposure”;<\/li>\n
- “Independent Amount”<\/strong> – this is equivalent to the new Initial Margin and will therefore be captured by the IM CSA\/IM CSD and is no longer part of the VM CSAs;<\/li>\n