Karsten Meyer, partner at d-fine, answers some of the questions asked by audience members in a recent webinar looking at how firms can prepare for the BCBS/IOSCO margin requirements for non-cleared derivatives.
Q. FX is not in scope, does this mean that cross currency swaps are not in scope or just a portion of them?
A. FX transactions receive a special treatment under the new margin requirements. In their key principles BCBS and IOSCO do not require margining for physically settled FX forwards and swaps. BCBS/IOSCO recommend that margin standards are implemented under supervisory guidance or national regulation.
Under EMIR physically settled FX forwards and swaps are subject to variation margin (VM), but are not subject to initial margin (IM) requirement. However, counterparties are required to maintain written documentation confirming that IM is not collected for these transactions.
Under Dodd Frank the Prudential Regulators and the CFTC do not require the exchange of either VM or IM for physically settled FX forwards and swaps.
Cross currency swaps are in scope of margin requirements, but EMIR as well as Dodd Frank exclude the contribution of the principal exchange to IM.
Q. How will netting of IM work? My understanding is that IM can be netted among transactions in the same asset class. Assuming both parties are required to post IM, does that mean that both requirements are effectively netted and no obligation would ever arise?
A. When using a margin model approach then netting of IM is allowed within a netting set and underlying class (Dodd Frank: “broad risk category”). Underlying classes (EMIR) are defined as (a) interest rates, currency and gold; (b) equity; (c) credit; and (d) commodity and other. The broad risk category under Dodd Frank further distinguishes agricultural, energy, metal and other for commodities.
The standardised method only allows for netting in a very limited way using the Basel exposure at default approach: IM_net= 40* IM_gross + 60%* NGR * IM_gross. The net-to-gross ratio (NGR) is calculated as the quotient of the net replacement cost and the gross replacement cost of the netting set.
Between the counterparties there is no possibility of netting the initial margin amounts with each other. Posted IM must be segregated from proprietary assets and must be immediately available on default (EMIR). Under Dodd Frank the posted IM must be held by a 3rd party custodian.
Q. To clarify… exp ccy has to match collateral ccy? so to avoid the 8% add on haircut, we should separate margin calls by underlying exposure ccy? So given a portfolio has 3 different ccy trades (JPY, EUR, and USD) ideally to avoid the 8% we should have 3 margin calls?
A. Under Dodd Frank no haircuts apply to VM requirements, but an 8% haircut for cross-currency collateral applies to IM. The EMIR draft applies a cross-currency haircut for both IM and VM.
Under EMIR the haircut on VM could be avoided if derivatives are collateralized in cash in the settlement currency (this treatment applies to centrally cleared trades).
A problem arises under both regimes when the standardised approach for IM is used and a netting set contains transactions in different currencies. This issue is still under discussion.
