Collateral Managers Weep, Lawyers Rejoice: EU Consults on non-cleared OTC derivatives

The ESA recently published a consultation paper on the draft RTS on risk-mitigation techniques for non-cleared OTC derivatives.  Michael Beaton of DRS explains the main elements of this new consultation paper including the proposed requirements for counterparty risk management procedures, margin methods, collateral eligibility and related operational procedures.

Introduction

 On 14 April 2014, the Joint Committee of the European Supervisory Authorities (ESAs) [1] published a consultation paper on draft regulatory technical standards (RTS) on risk-mitigation techniques for OTC derivative contracts not cleared by a CCP under Article 11(15) of EMIR.  The consultation paper represents the beginning of the EU’s legislative process to implement the Basel Committee’s “Margin requirements for non-centrally cleared derivatives” published on 2 September 2013 (see this blog post for more detail).  The consultation remains open until 14 July 2014 and the plan is to finalise the RTS by the end of 2014.

Article 11 of EMIR requires the use of “risk mitigation techniques” in relation to non-cleared OTC derivatives transactions and mandates the ESAs to develop RTS in this area.  The draft RTS within the consultation paper is divided into five main chapters:

• Counterparty risk management procedures; 
• Margin methods; 
• Eligibility and treatment of collateral; 
• Operational procedures; and
• Procedures concerning intragroup derivative contracts. 

Counterparty Risk Management Procedures 

Article 11(3) of EMIR requires financial counterparties (FCs) and non-financial counterparties which exceed the clearing threshold (NFCs+) to implement risk management procedures “that require the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts”.  Accordingly, the draft RTS propose new requirements with respect to both initial margin and variation margin [2].

General

In general, there is no requirement for non-financial counterparties below the EMIR clearing threshold (NFCs-) [3] or any entity which is exempt under Article 1 of EMIR [4] to exchange either initial or variation margin.  In addition, subject to certain conditions, the posting of initial or variation margin is not required in relation to covered bond issuances [5].  Beyond this, counterparties may agree that, where the total [6] amount of margin to be posted does not exceed EUR 500,000, no collateral needs be exchanged (i.e. a “Minimum Transfer Amount” of EUR 500,000 can apply) [7].  Transitional provisions also apply to the RTS as detailed in “Phase-in of the requirements” below.  However, to the extent that they do apply, the RTS impose an obligation on EU entities to collect margin, regardless of whether their counterparty is an EU or non-EU entity and regardless of whether they would be an FC, NFC+ or NFC- if established in the EU.

Initial Margin

FCs and NFCs- will be required to exchange initial margin on a gross basis, commencing no later than the business day following execution of a new derivative contract [8].  However, initial margin Thresholds of up to EUR 50 million  [9] remain permissible provided that counterparties hold capital against their exposures [10].

In addition, counterparty initial margin requirements must be recalculated if:

• a new contract is executed;
• an existing contract:
   –  expires;
   –  triggers a payment [11] or delivery; or
   –  is reclassified in terms of asset category[12] ;
• the initial margin model is recalibrated; or
• no initial margin recalculation has been performed in the last 10 business days [13]. 

Counterparties may agree not to exchange initial margin [14] with respect to physically-settled foreign exchange forwards and swaps [15], or the principal in currency swaps [16], although it appears as if this agreement may have to be renewed on an annual basis[17].

Variation Margin

Daily [18] exchange of variation margin will be required, starting from the business day following the execution of the relevant contract [19].

Margin Methods

The RTS detail two methods by which counterparties can calculate initial margin requirements – the standardised method (based on the notional value of derivative contracts) and initial margin models (an internal exposure-based modelling approach).

The standardised method

The Standardised Method employs a two-step approach [20].  In the first step, the portfolio of trades between two counterparties is divided into “netting sets” [21], each of which is considered separately.  Next, the notional amount of each trade within a particular netting set is multiplied by a (rather confusingly titled) “Add-on factor”.  The Add-on factors range between 1% and 15% depending on the asset class of the underlying trade and its remaining tenor[22].  The results obtained by multiplying all of the Add-on factors are then added to arrive at a “Gross initial margin” figure.  In the second step, the Gross initial margin figure is reduced to take into account potential offsetting benefits in the netting set in order to arrive at a “Net initial margin”.

Internal margin models

Initial margin models can either be developed by the counterparties or provided by a third-party. They must:

•  assume the maximum variations in the value of the netting set at a confidence level of 99%      with a risk horizon of at least 10 days;
• be calibrated on a historical period of at least three years;
• include at least 25% of observations from a period of “financial stress; 
• assign each derivative contract to one of the following asset classes based on its primary       risk factor (in order to limit the recognition of   diversification benefits to contracts belonging to     the same netting set and the same asset class):
    –      interest rates, currency (including inflation) and gold;
    –      equity;
    –      credit; and
    –      commodity and other;
•  be subject to initial and periodic validation (at least annual), periodical back-tests and regular     audits;
• be properly documented; and
• be recalibrated at least every 6 months.

In addition, counterparties must establish transparent and predictable procedures for adjusting margin requirements in response to changing market conditions. These procedures must permit the posting of initial margin resulting from the recalibration of the model over a period longer than one day [23] so as to avoid regulatory cliff effects.

Eligibility and treatment of collateral

Chapter 3 considers the minimum eligibility criteria for collateral and its treatment, particularly in relation to haircuts.

Eligible Asset Classes

Broadly, the following are regarded as eligible collateral in relation to both initial and variation margin for the purposes of Article 11 of EMIR [24]:

• Cash;
• Debt securities;
• Equities or convertible bonds that are included in a main index or traded on a recognised      exchange;
• Gold;
• The most senior tranche of a securitisation (but not re-securitisations); and
• Units or shares of UCITS, subject to certain conditions.

Eligibility Criteria

However, even if of an eligible type, all collateral must meet additional eligible criteria.  Specifically, assets must be:

• sufficiently liquid;
• not be exposed to excessive credit, market and FX risk;
• hold their value in a time of financial stress;
• not be subject to significant ‘wrong way risk’ (i.e. not exhibit a significant positive correlation     with the creditworthiness of the counterparty);and
• sufficiently diversified (in the case of bonds and equities).

Own-issued securities (including affiliates) are not regarded as eligible collateral, except on sovereign debt securities [25].

Operational and technical capabilities

The RTS impose a number of operational and technical requirements on collateral receivers [26], including:

• the ability to perform daily re-evaluation of collateral; [27] 
• the ability to assess the credit quality of bonds (other than supranational or domestic      currency EU Member State government bonds) and securitisations in accordance with      specified methodologies; [28]
• the establishment of procedures in case the credit quality of collateral no longer meets      requirements which:
   –   prohibit the counterparties from accepting additional collateral assets which now fall                below the requisite level;
   –   define a schedule by which already accepted collateral is replaced over a period of time           not exceeding 2 months; and
   –   increase haircuts during the collateral replacement phase. 

Concentration Limits

Cash collateral is not subject to concentration limits.  However, with respect to both initial and variation margin, non-cash collateral is subject to the concentration limits detailed in the table below. 

 * whether calculated by reference to a single issuer or a group or entities which have close links

Σ the sum of all eligible collateral marked Σ cannot exceed 40% of the collateral collected from an individual counterparty

Haircuts

The RTS require haircuts to be applied to the market value of collateral in order to reflect potential market and FX volatility.  Counterparties can apply either a standard methodology [33] or use internal estimates [34].  Haircuts must be calculated using updated data sets at least once every three months.  In addition, data sets must be reassessed whenever market prices are subject to material changes. 

The standard methodology specifies haircuts by reference to the following parameters:

• Collateral type
• Collateral credit quality
• Residual maturity

Haircuts vary from 0.5% (in the case of higher quality, shorter tenor government bonds) to 24% (in the case of lower quality, longer tenor securitisations).  Cash is subject to a zero haircut, whereas equities in main indices, bonds convertible to equities in main indices and gold have a haircut of 15%. An additional haircut of 8% is to be applied where the collateral currency is different from the settlement currency.

Operational Procedures

General

The ESAs recognise that operational aspects documented in the RTS relating to the exchange of margin will require substantial effort to implement.  Operational requirements include:

• senior management reporting;
• escalation procedures;
• requirements to ensure and verify sufficient liquidity of the collateral;
• fully documented agreements (executed before entry into the relevant transactions)      regarding:
   –   the levels and type of collateral required;
   –   segregation arrangements;
   –   the transactions to be included in the calculation of margin;
   –   the procedures for notification, confirmation and adjustment of margin calls;
   –   the procedures for settlement of margin calls in respect of all relevant types of collateral;           and
   –   the methods, timings and responsibilities for calculating margin and valuing collateral;
• procedures for the storing of agreements and for the prompt recording and application of the     terms and arrangements agreed above[35] ; and
• annual procedure testing. 

Segregation

Collateral received in relation to initial margin must be segregated from proprietary assets in a way that is bankruptcy remote and renders the collateral available in the event of a counterparty default.  Collateral receivers must also offer collateral posters the option to segregate collateral from the assets of other posting counterparties.  Finally, at inception of a transaction and at least annually thereafter, counterparties must obtain “satisfactory” legal opinion(s) in all relevant jurisdictions on whether the segregation arrangement continue to meet the requirements of the RTS. 

Rehypothecation

In contrast to the BCBS rules, the ESAs have decided to prohibit the rehypothecation of initial margin “because the restrictions appear to be of limited use within the European market, and ruling out this possibility will simplify the overall framework”.

Procedures concerning intragroup derivative contracts

Pursuant to Article 11 of EMIR, intragroup transactions can be exempted from the requirement to exchange collateral if certain requirements are met and there are no practical or legal impediments on the transferability of own funds and the repayment of liabilities.  The RTS provide further detail in this respect in order to promote consistency of application across EU Member States.

Phase-in of the requirements

Under the proposed RTS, provisions regarding intragroup derivatives contracts would apply from the date upon which the RTS enter force.  The remainder of the RTS takes effect from 1 December 2015.  However, initial margining requirements will be phased-in over a four year period and will only apply to new non-cleared contracts  [36] entered into by counterparties which, on the relevant date, both have an aggregate month-end average notional amount (AMEANA) of non-centrally cleared derivatives  [37] exceeding the level detailed in the table below.

However, it should be noted that the explanatory text to the RTS states that “within reasonable limits, market participants should strive to extend the requirements to the widest set of non-centrally cleared OTC derivatives possible” [38] (i.e. to pre-existing as well as new contracts).

Conclusion

The quantitative analysis accompanying the RTS estimates that initial margin requirements for the EU will range between EUR 200 billion and EUR 420 billion [39] in a market that is estimated to be EUR 74.9 trillion in size (in gross notional terms).  Although it is thought that only 12 firms will be impacted by initial margin rules on day one (rising to 59 by the time of full implementation in 2019), this belies the true impact of the RTS.  Segregation is already proving difficult for the market to implement.  Add to this the myriad of other requirements with respect to initial margin, such as the requirement to monitor consolidated thresholds and minimum transfer amount usage and the need to establish annual processes for verifying that netting agreements considered for initial margin calculations [40] are legally enforceable and the conclusion is that the operational impact of the new regulations will be at least as hard-felt as the financial impact.

Of course, the RTS go beyond simply initial margining practices.  According to the 2014 ISDA Margin Survey, 90% of non-cleared OTC derivatives trades are already subject to collateral agreements [41].  Nonetheless, firms will still be required to revisit documentation with all FCs and NFCs+ in order to confirm that the operational and technical requirements of the rules are documented correctly with respect to variation margining practices.  Unfortunately, the resourcing requirement will not only be significant but ongoing as EMIR counterparty classifications can (and do) change and initial margin thresholds can be exceeded.  Compliance in this area then becomes a moving target, emphasising the importance to firms of implementing robust procedures for monitoring EMIR counterparty classification and implementing period reviews based on then current information.

The new haircutting regime is also likely to constitute an area of concern.  Indeed, the impact of the new rules is already being felt, with the additional 8% haircut applicable where the currency of the collateral does not match the underlying having already triggered a re-write of ISDAs new Standard CSA.  Even implementation of the ‘Standard’ approach to haircuts will provide challenging, with haircuts to be dependent on (a) collateral type, (b) collateral credit quality, and (c) residual maturity.  Although questionable how often it is used in practice, the requirement that haircuts for collateral in the form of units in UCITS must be the weighted average of the haircuts that would apply to the assets in which the fund has invested seems likely to effectively rule that asset class out on operational grounds alone.  

It is difficult to avoid the conclusion that compliance with the RTS represents a fixed cost of doing business which, by definition, plays into the hands of the largest market participants.  Whether this is entirely consistent with the regulatory desire to introduce transparency and broaden choice within markets is moot.  However, what is clear is that any FC or NFC+ needs to factor the impact of these rules into its future resourcing requirements.  A well-defined and executable plan to assess the current state of collateral agreement portfolios and collateralisation processes and to remediate to the target state where necessary is a must.  The proposed rules within the RTS are consistent with the benchmark set by the BCBS.  To that extent, even at this early stage, it would be surprising if there were any major u-turns in policy.  As such, firms should feel confident enough to begin the planning exercise sooner rather than later.  Indeed, given the entry into force of most of the provisions of the RTS on 1 December 2015 and the scale of the task faced by some, a number of firms have already started this process, setting an example which others would do well to follow.

• [1] Comprising the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA)
• [2] “Background and Rationale”, page 7
• [3] Article 2(4)(b) GEN
• [4] Article 2(4)(c) GEN
• [5] Article 3(1) GEN
• [6] Calculated as the sum (i) total initial margin requirement, (ii) total variation margin requirement, and (iii) any excess collateral requirements
• [7] Article 2(4) GEN
• [8] Article 1 EIM
• [9] Calculated by reference to group wide initial margin requirements (or on a per fund basis) with respect to all non-centrally cleared OTC derivatives
• [10] Article 2(3) GEN
• [11] Other than a posting or collection of variation margin
• [12] This will occur as the OTC derivative approaches maturity by virtue of Table 1 SMI in Annex IV
• [13] Article 1(4) EIM
• [14] This does not apply to variation margin, which must still be collected
• [15] Article 2(1) GEN
• [16] See “Background”, page 7
• [17] Article 1(4) FP
• [18] Strictly speaking, the draft RTS state that VM should be exchanged “at least on a daily basis”
• [19] Article 1(1) VM
• [20] See Annex IV
• [21] Groups of transactions between the entity and its counterparty which are subject to a legally enforceable bilateral netting agreement
• [22] See Annex IV for more detail
• [23] Article 3(8) MRM
• [24] See articles 197 and 198 of Regulation (EU) No 575/2013 and Article 1 LEC
• [25] Article 6 LEC
• [26] See Article 2 LEC to Article 4 LEC
• [27] Article 2 LEC
• [28] Article 3 LEC
• [29] Measured as a percentage of collateral collected from the individual counterparty
• [30] Regulation (EU) No. 575/2013
• [31] It is difficult to see how this can be correct.  It may be that this is an inadvertent omission which will be corrected at a later date
• [32] See Article 5 LEC
• [33] See Annex II
• [34] See Article 2 HC
• [35] Article 1 OPE
• [36] Exchanges of variation margin and initial margin on non-cleared contracts entered into before the dates referred to in the table are subject to existing bilateral agreements
• [37] Calculated on a consolidated basis by reference to all of the groups non-centrally cleared derivatives (including FX forwards, swaps and currency swaps) executed in the immediately preceding months of June, July and August
• [38] Page 25
• [39] This may underestimate the collateral requirement as it relies on data within the BCBS quantitative impact survey which, in turn, were based on the assumption that the threshold could apply at a counterparty level rather than a group level
• [40] Article 6(2) MRM
• [41] Although the survey results are based on the responses of only 61 firms, all of which are ISDA members and therefore may not be wholly representative of the market