Interviewed by Alex Heshmaty and published on LexisNexis on August 25, 2016
Banking & Finance analysis: New margining requirements under the European Market Infrastructure Regulation (EMIR) were originally due to be phased in from September 2016 but this has now been pushed back to 2017. Daniel Franks, partner at Norton Rose Fulbright LLP, and Victoria Nevins, associate, explain the new requirements, the impact of the delay and the associated International Swaps and Derivatives Association (ISDA) standard initial margin model (SIMM).
What are the new EMIR margining requirements for non-cleared derivatives?
The European Market Infrastructure Regulation (EU) 648/2012 (EMIR) establishes a set of rules (the EMIR Margin Rules) that require the users of uncleared, over the counter (OTC) derivatives to put in place risk-management procedures to ensure the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts.
Through EMIR, the EU is implementing various G20 commitments to reform OTC derivatives markets in an effort to promote greater stability and transparency. The draft regulatory technical standards for risk-mitigation techniques (RTS) are also designed to be consistent with the recommendations of the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions in their September 2013 report on margin requirements for non-centrally cleared derivatives.
The EMIR Margin Rules, which are set out in the RTS, require market participants to protect themselves against counterparty credit risk by exchanging collateral in the form of initial margin (IM) and variation margin (VM) for uncleared OTC derivative transactions. IM is designed to protect counterparties at the outset against potential future losses, and VM is designed to protect counterparties on an ongoing basis against exposure to the current market value of their OTC derivative contracts.
The RTS provide detail to the complex requirements arising under the EMIR Margin Rules, including:
- required amounts of IM and VM to be exchanged
- timing of collateral exchange
- methods for calculating the amount of collateral to be exchanged
- methods for determining haircuts
- collateral eligibility criteria, and
- operational procedures and documentation necessary to satisfy EMIR Margin Rule requirements.
Who are subject to margining requirements from 1 September 2016?
While there are some exemptions available, the margin requirements apply broadly to the following entities:
- ‘financial counterparties’ (FCs)
- ‘non-financial counterparties’ above the relevant EMIR clearing thresholds (NFC+s), and
- non-EEA entities which would be FCs or NFC+s if they were established in the EU.
The G20 countries (including the EU) have committed to phasing in margin rules along the same timeframes, in order to ensure that no individual jurisdiction has a competitive advantage by delaying implementation into domestic law.
In the EU, the EMIR Margin Rules were originally scheduled to be phased in from 1 September 2016. This first phase was applicable to counterparties with an aggregate average notional amount (on a group basis) of non-centrally cleared OTC derivatives (AANA) of more than €3trn. However, this first phase-in date for the EMIR Margin Rules has been pushed back to 2017. Nonetheless, the US and Japanese margin rules are still scheduled to be phased in from 1 September 2016 and apply to the relevant qualifying counterparties who meet the thresholds set out below:
|AANA > $3trn
||JP Average Aggregate Notional Amount > 420 trillion yen
|AANA > $3trn
||JP Average Aggregate Notional Amount > 420 trillion yen
What are the documentation and operational challenges of European phase-one banks not subject to those rules until 2017?
As mentioned, the original intention was for the EU, US, Japanese and other countries to phase in their margin rules at the same time, which would prevent one jurisdiction from having a competitive advantage over the others. Additionally, market participants could benefit from ‘substituted compliance’ (ie compliance with one regime would be deemed to satisfy the other regimes) and avoid the added costs of having to comply with more than one regime. Because the amended RTS includes a revised implementation timeline for the EMIR Margin Rules and provides that the first phase-in will not apply until one month after entry into force of the RTS, the US and Japanese rules will come into effect first.
As a result, parties that are also subject to the US or Japanese rules will need to comply with them first, which means they will not benefit from substituted compliance and may be at a competitive disadvantage. When the EMIR Margin Rules come into effect, such parties will need to determine what adjustments to their margin arrangements are necessary to comply with them as well.
This change to the phase-in timeline in Europe will result in the margin rules being implemented by counterparties in a piecemeal fashion, which will pose documentation and operational challenges. It may result in counterparties putting in place two sets of documentation and processes to accommodate, firstly, those margin rules that come into effect as of 1 September 2016 and, secondly, those which come into effect as of a later date. This additional burden is likely to create further expense and complexity for the market.
An immediate example of the impact of the delayed implementation on market documentation is the ISDA’s 2016 Variation Margin Protocol. Like other protocols, this is designed to allow parties to amend their documentation on a multilateral basis in order to comply with the various margin frameworks. The Protocol has developed over a number of months, and was designed to facilitate compliance with the EMIR Margin Rules as well as US (CFTC and Prudentially Regulated), Japanese, Canadian and Swiss rules. Delayed implementation of the EMIR Margin Rules will also delay implementation of Swiss rules. As a result, the Protocol has been published in a form that addresses the US, Japanese and Canadian rules, but the EU and Swiss aspects have been omitted for adoption at a later date when the rules are finalised.
How does the ISDA SIMM work?
ISDA has developed the standard initial margin model (SIMM). The SIMM allows market participants to calculate (using a standardised methodology) their IM requirements relating to their uncleared OTC derivative contracts. The SIMM has been designed to comply with the margin rules in Europe, the US and Japan and thus can be used by market participants which are subject to any of these rules.
The common methodology set out in the SIMM is designed to allow market participants to plan in advance to manage their liquidity needs for margin calls. It will also provide a timely and transparent dispute resolution process, and allow for regulatory supervision of IM calculation requirements.
Market participants should note that the documents relating to the SIMM are still subject to change as they will only be finalised when the final regulations are published and they should therefore continue to monitor the progress of the SIMM carefully.
In parallel with the on-going progress of the SIMM, market participants will need to determine whether the SIMM is an appropriate method for calculating their IM requirements or whether an alternative model is more suitable, and should be taking steps to put infrastructure in place to accommodate the SIMM or any alternative models.