Erscheinung:04.01.2017 | Topic OTC derivatives OTC derivatives: Margin requirements for non-centrally cleared contracts
Content
The Delegated Regulation on risk-mitigation techniques for non-standardised OTC derivatives was published in the Official Journal of the European Union on 15 December 2016. It will therefore come into force on 4 January 2017. The underlying regulatory technical standards were developed jointly by the three European Supervisory Authorities (ESAs ), since the requirements for OTC derivatives are to be applied across the different sectors.
The financial crisis of 2007/2008 proved that the OTC derivatives market as it was then – characterised by a lack of transparency and large volumes of mostly uncollateralised OTC derivatives, among other things – could jeopardise financial stability.
The G20 states identified this as a systemic risk and decided to take measures to contain the potential risk posed by OTC derivatives. They agreed that standardised OTC derivatives must be cleared and traded through central counterparties, all OTC derivatives must be recorded in trade repositories and there must be margin requirements for OTC derivatives which are not cleared through a CCP.
Definitions:Important terms
OTC derivative (over-the-counter derivative):
a derivative contract not executed on a regulated market.
Counterparties:
parties to an OTC contract.
Central counterparty (CCP):
a legal person that interposes itself between the counterparties to the contracts traded on one or more financial markets, becoming the buyer to every seller and the seller to every buyer.
Financial counterparty:
undertakings from the financial sector such as investment firms, credit institutions, insurance undertakings, undertakings for collective investment in transferable securities (UCITS) and alternative investment funds (AIFs).
Non-financial counterparty:
an undertaking which is not a CCP or a financial counterparty.
Variation margin (VM):
collateral to compensate for market price variations of the contracts.
Initial margin (IM):
collateral exchanged by the two counterparties to mitigate current and potential future risks which are to be expected in the event of the default of a counterparty.
Global principles as starting point
In September 2013, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) published a global framework, which has since been revised, specifying the margin requirements for non-centrally cleared OTC derivatives on the basis of eight main elements. The two international standard-setters deliberately formulated the margin standards as high-level principles to allow countries a certain degree of flexibility in their implementation. Nevertheless, one of the principles asserts that national regulatory regimes should interact so as to result in sufficiently consistent and non-duplicative regulatory requirements.
The other principles deal with different matters including the scope of the new margin requirements at the product and counterparty level, the methodologies for calculating margin and the quality and nature of the eligible collateral including the application of possible haircuts.
European provisions
Back in 2012, before the publication of the BCBS/IOSCO principles, the EU specified minimum requirements for risk management and transparency of transactions in OTC derivatives, among other things, in the European Markets and Infrastructure Regulation (EMIR). Article 11(3) of EMIR, for example, requires OTC derivatives not cleared by a CCP to have "risk-management procedures that require the timely, accurate and appropriately segregated exchange of collateral".
The Delegated Regulation which has now been published provides more detail for this provision and is also based on the principles of the BCBS and IOSCO in order to ensure maximum international harmonisation and consistency.
It contains, firstly, requirements of risk management procedures which enable the timely and accurate exchange of collateral. It defines, for example, the amount and type of eligible collateral and regulates how collected and posted initial margin is to be held. Secondly, it contains requirements for procedures which must be observed by the counterparties and the relevant competent authorities when exempting intragroup transactions from the margin requirements, and specifies the criteria which must be fulfilled in such a case.
Types of collateral
Variation margin and initial margin are envisaged as collateralisation instruments. VM is used for the daily compensation of fluctuations in the value of derivative contracts. IM, on the other hand, is intended to cover current and potential future fluctuations in value which can occur between the last exchange of margins and the re-coverage of risk or the liquidation of positions if a counterparty defaults. The IM may be calculated using either a standardised approach or an internal model. The Delegated Regulation contains requirements for these models and for the timing of the posting of collateral.
The Delegated Regulation defines which assets are eligible as collateral and contains provisions on their valuation and on the haircuts to be applied in the process. In addition, it includes requirements for the segregation of IM and requires the collecting counterparty not to rehypothecate, repledge or otherwise reuse the collateral collected as initial margin. Moreover, concentration limits for initial margin collected are intended to ensure that there is sufficient diversification with regard to individual issuers, types of issuers and investment classes.
Scope
The requirements apply to financial counterparties, which include banks and insurance undertakings, and to non-financial counterparties which exceed the clearing threshold referred to in Article 10 of EMIR.
In the interests of proportionality, the Delegated Regulation defines thresholds at group level, below which certain requirements do not apply. It also includes product exemptions.
At a glance:Thresholds and product exemptions
Permanent exemptions:
- The regulations on IM must only be applied to newly concluded transactions if the two counterparties have an aggregated group gross notional volume of more than EUR 8 billion in non-centrally cleared OTC derivatives.
- A counterparty only has to collect collateral from another counterparty where the amount due from the last collection of collateral exceeds EUR 500,000 (minimum transfer amount).
- IM is only to be collected if it exceeds EUR 50 million.
- Transactions with counterparties in third countries where legal enforceability of netting agreements or collateral protection cannot be ensured are exempted from the margin requirements completely. However, European counterparties are only allowed to conclude a maximum of 2.5 percent of their derivatives volume with such counterparties.
- No IM has to be exchanged for physically settled foreign exchange forwards, foreign exchange swaps or the principal amount of cross-currency swaps.
Temporary exemptions:
- No VM has to be exchanged for physically settled foreign exchange forwards until a standard definition for these derivatives exists at the European level or 31 December 2018 at the latest.
- For single-stock equity options or index options, the requirements will apply from three years after the date of entry into force of the regulation.
Intragroup exemptions
In addition, the relevant competent authority may exempt OTC derivatives concluded between counterparties belonging to the same group from the margin requirements.
This exemption may only be granted if there are no practical or legal impediments to the prompt transfer of own funds and repayment of liabilities between the counterparties. The Delegated Regulation defines these impediments.
Start of the margin requirements
For market participants with a notional amount of non-centrally cleared OTC derivatives that is above EUR 3,000 billion, the requirement to exchange IM and VM starts on 4 February 2017.
Counterparties with lower volumes have more time to prepare for the application of the rules, since they are being introduced in several stages. The VM requirement will apply to them from 1 March 2017. The requirement to exchange IM is divided into four stages.
Start of margin requirements | Variation margin | Initial margin |
---|---|---|
4 February 2017 | for > €3,000 billion* | for > €3,000 billion* |
1 March 2017 | all market participants | - |
1 September 2017 | - | for > €2,250 billion* |
1 September 2018 | - | for > €1,500 billion* |
1 September 2019 | - | for > €750 billion* |
1 September 2020 | - | for > €8 billion* |
* Exceeding the notional OTC derivative volume by both of the counterparties involved in the transaction
Industry involvement
The introduction of IM as a collateralisation instrument for non-centrally cleared OTC derivatives also poses operational challenges for the industry. Companies have to develop and install new processes, adapt their IT systems to the new processes and calculations, redraft contracts and have resources available for the monitoring of the new systems, among other things.
The complexity of the new requirements led the ESAs to hold two consultations on the regulatory technical standards which form the basis of the Delegated Regulation. In addition, a series of meetings was held with various groups of market participants.
Outlook
A BCBS-IOSCO monitoring group is currently looking at which problems may arise in the national implementation of the global margin standards. If it finds substantial inconsistencies in the implementation, it can propose changes to the framework in the medium term.
Consistent application must also be ensured at the European level. The three ESAs are planning to develop and publish Questions and Answers (Q&As) on the Delegated Regulation.
Authors
Martin Liebl
Stephan Strauß
BaFin Division for Banking Supervision in the Department for International Policy, Financial Stability and Regulation
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