Asset managers face not just clearing and bilateral margin regulations, but also new reporting requirements for securities financing, and a requirement to contractually waive their termination rights, giving regulators time to split a defaulting bank’s good and bad assets in order to mitigate future crises. Allan Yip, partner at Simmons and Simmons explores.
In the context of EU derivatives regulation, the biggest challenges for derivatives market participants in 2016 will be the onset of clearing for OTC derivatives, and margin rules for uncleared derivatives. Both are due to come into effect at some stage during 2016.
Clearing Obligation Lags Mandate
The clearing obligation will probably not come in until November or December 2016, which seems a long way away. However, the mandate will be phased in from about May—starting with the largest asset managers with the biggest derivatives businesses—and firms will be expected to clear retroactively from that front-loading date, once the clearing obligation comes into effect at the end of the year.
The largest funds that do a lot of derivatives trading will have to be thinking about the fact that the bilateral trades they enter into from about May or June will have to be cleared at some point in the future. This affects their documentation responsibilities, because they need to think about the consequences if a trade does not clear. It may also affect the price of the trade.
“The largest funds that do a lot of derivatives trading will have to be thinking about the fact that the bilateral trades they enter into from about May or June will have to be cleared at some point in the future.”
The front-loading and timing of the phase-in depends on how the funds or counterparties are going to be categorized, which can be very complicated. Will they be classed as a financial counterparty or a non-financial counterparty? If they are a financial counterparty, are they above or below certain thresholds? If they are a non-financial counterparty above the clearing threshold, you have to decide if they are category 2 or 3, depending on a different threshold.
As well as the actual clearing obligations in 2016, people are going to have to grapple with all the different categorisations. They need to think about how to categorise themselves. Asset managers with external clients as well as their own sponsored funds will also have to think about how they classify their clients. They need to communicate with those clients to make sure they provide all the right information so they can be categorized properly. There is quite a long lead-time, but a lot of work to do before the clearing obligations arise later in the year.
UPDATE: Since the interview, the final rules were published and the start dates for both the clearing obligation and the front-loading periods are therefore now fixed as follows:
- Start of clearing obligation for:
- Category 1 entities: 21 June 2016
- Category 2 entities: 21 December 2016
- Category 3 entities: 21 June 2017
- Category 4 entities: 21 December 2018
- Effective start of frontloading (FCs only) for:
- Category 1 entities: 21 February 2016
- Category 2 entities: 21 May 2016
Bilateral Margin Rules Due September
In terms of the margin rules, these should be coming in from September 2016. For the larger derivatives users, there will be obligations in relation to variation margin. In relation to initial margin, there will be phase-ins for the very largest players in the field starting in 2016. However some smaller players may not be phased in until as far away as 2020. Entities that trade fewer than 8 billion euros’ worth of derivatives will not be subject to the initial margin rules at all.
This also seems a long way off, but firms need to look at their derivatives positions and figure out their categorization by around March, April or May to determine which rules apply. The rules—which have not yet been completely finalized—will go into a lot of detail regarding procedural and timing requirements, as well as eligibility of collateral.
New Reporting Requirements for Sec Financing
As if those two developments were not enough, there are others that have flown somewhat under the radar that will also affect derivatives market participants. For example, the Securities Financing Transaction Regulation (SFTR) will likely come into force in the EU zone in January next year. That imposes additional reporting obligations for securities financing transactions—repos, securities lending transactions will all need to be reported to trade repositories, similar but supplementary to rules under EMIR and Dodd-Frank.
Under this regulation there will be new rules in relation to collateral re-use. Any kind of collateral arrangement—whether under a repo, securities lending, or under an ISDA, or a prime brokerage agreement—will be subject to these new requirements. They will include certain disclosures, risk warnings that have to be exchanged, given by the party receiving the collateral to the other party—and not just from a bank counterparty to an asset manager, but also from an asset manager to a bank counterparty.
There will also be new rules subjecting alternative investment fund managers (AIFMs) to new disclosure requirements in their prospectuses and annual reports. This will include quite a lot of detail around things like the repos and the sec lending that they do, as well as total return swaps.
Asset Managers Must Waive Termination Rights
The ISDA Resolution Stay Protocol is expected midway through the year. This covers the additional powers that regulators have to step in when a financial institution is in trouble, to be able to step in and try and resolve the issues, rather than let it become bankrupt. To split good assets from bad assets, or create a good bank and a bad bank, for example. Under those powers, regulators will effectively be able to suspend counterparties’ termination rights.
Say you are a counterparty to a defaulting bank. They default and go into bankruptcy. You would ordinarily terminate your agreement and take all the remedial action you’re entitled to take, but in this situation, the resolution authority would be able to put the shutters down, and say, for a period of 24 or 48 hours, everybody take a breather. You can’t do anything while the resolution authority takes its steps to separate the assets out. It’s effectively a moratorium on termination rights.
Those powers are actually already in effect—in the UK, they have been in effect from the beginning of January 2015—but there was always a concern from the regulators that those powers couldn’t be enforced on a cross-border basis. If you were a Cayman hedge fund facing a UK broker-dealer entity under an ISDA transaction, and the ISDA was governed by New York law, for example, there was a concern that, even if the UK bank went into one of these resolutions, and the UK regulator tried to impose this moratorium, that wouldn’t be enforceable, because the agreement is governed by New York law and the counterparty is a Cayman hedge fund.
“Regulators have imposed new prudential rules on banks, which say, after a certain date, they cannot enter into any new trades with any counterparty, unless they have agreed to contractually waive their rights.”
The answer to this was to have ISDA produce this contractual remedy, which basically means getting people to contractually agree to effectively waive their termination rights in that kind of situation. The regulators all put pressure on the largest banks, and they signed up to that last year. Now the regulators want to expand it to cover all counterparties, including smaller banks, and funds. Regulators have imposed new prudential rules on banks, which say, after a certain date, they cannot enter into any new trades with any counterparty, unless they have agreed to contractually waive their rights.
In the UK, this will be phased in for smaller banks from January, and for asset management firms around July. ISDA has been working on the relevant documentation—in the first half of next year, they will probably start asking people to sign up to this kind of waiver by way of contractual amendments. Many people are not aware of this change. Some people have not heard of it at all. Some have, but thought it was for banks and weren’t aware it was going to affect them as well. People need to know they will start to get these requests from their counterparties in the first half of next year.
UPDATE: Since the interview, the phase-in dates for the UK were amended, so that the apply from 1 June 2015 for counterparties that are banks and investment firms, and from 1 January 2017 for other counterparties.
*Comments from a recent DerivSource Influencers Video you can watch here.
Allan Yip is a derivatives lawyer, advising asset managers, banks, and corporates on derivatives matters such as documentation, trading agreements, confirmations, prime brokerage agreements and derivatives regulations.
