Final European OTC Derivatives Margin Rule
Frequently Asked Questions
On 4 October, 2016, the European Commission published its Final Draft Regulatory Technical Standards on margin for derivatives that are not centrally cleared (“OTC Margin Rule”). The OTC Margin Rule, which is arguably the most significant of the derivative risk mitigation rules introduced under EMIR, requires financial counterparties (“FCs”) and non-financial counterparties that exceed specific thresholds (“NFC+s” and together with FCs, “Impacted Entities”) to exchange collateral in respect of their uncleared over-the-counter derivative transactions. The OTC Margin Rule does not require banks to impose margin requirements on nonfinancial counterparties whose volume of non-hedging derivative transactions are below the clearing threshold (“NFC-s”). The requirements will be phased in beginning in early 2017 and ending 1 September, 2020, giving market participants some time to prepare for the changes.
Frequently Asked Questions
To whom does the OTC Margin Rule apply and what are the key requirements for Impacted Entities and NFC-s?
The impact of the OTC Margin Rule varies depending on a market participant’s entity classification. The rule establishes three entity classifications: (1) Impacted Entities exceeding the notional outstanding amount of €8 billion (2) Impacted Entities not exceeding the notional outstanding amount, and (3) other counterparties (e.g., NFC-s, sovereigns, etc.).
An entity’s classification determines whether and to what extent it is subject to the OTC Margin Rule. Broadly speaking, variation margin applies to the first two classifications above and initial margin to the first classification above.
Who is considered an Impacted Entity?
The Impacted Entity definition includes both FCs and NFC+s. FCs include credit institutions, investment firms authorized under MiFID, insurance, assurance, and reinsurance undertakings, pension funds, UCITS and alternative investment funds (“AIFs”) managed by alternative investment fund managers (“AIFMs”) registered or authorized under the Alternative Investment Fund Managers Directive (“AIFMD”). An NFC+ is an entity that is not an FC, the total gross notional amount of whose positions in non-hedging derivative transactions exceed at least one of the applicable clearing thresholds on a 30 working day rolling average. All non-hedging positions of all non-financial entities within the entity’s consolidated corporate group are counted towards the threshold and exceeding the threshold in one asset class triggers NFC+ status across all asset classes. The table below lists the clearing threshold by asset class.
NFC-s are not subject to margin. Thus, because hedging transactions are excluded from the calculation, most corporate end-users are classified as NFC-s and not subject to the margin requirement. Additionally, funds hedging at the SPV, asset or acquisition level are unlikely to be subject to the margin requirement, provided these entities are not NFC+s.
What does it mean to “exceed the notional amount threshold”?
For Impacted Entities, the “exceed the notional amount threshold” definition applies to those with an aggregate month-end average gross notional amount of non-centrally cleared derivatives exceeding €8 billion for the months of March, April and May of the year that the calculation is made. Transactions of both the hedging entity and its group1 are to be included in determining whether an entity exceeds this notional threshold. Additionally, this threshold includes FX forwards, cross-currency swaps, covered bonds and derivatives with exempted counterparties that are otherwise exempted from VM and IM (as discussed further below).
What is variation margin (“VM”) and how does it apply?
VM is collected to collateralize the mark-to-market value of a derivative. VM requirements are bilateral – that is, VM must be both posted and collected, as dictated by the value of the derivative. NFC-s are not required to post VM unless otherwise required to do so by their dealer counterparties.
Impacted Entities – both those exceeding and not exceeding the notional threshold – are required to fully collateralize the mark-to-market value of their swaps on a daily basis on or around March 1, 2017.2 VM is required to be calculated daily and provided, with certain exceptions, within the business day of the calculation.3
Impacted Entities are not permitted unsecured thresholds, but rather are required to exchange collateral on the first Euro of exposure to its counterparties (i.e., a zero threshold CSA). They are, however, permitted minimum transfer amounts up to €500,000.4 Impacted Entities are permitted to collect and post VM in the form of cash or other non-cash forms of collateral, and there are no third party segregation requirements for VM.
What is initial margin (“IM”) and how does it apply?
IM is an amount collected above and beyond that necessary to collateralize the mark-to-market value of the derivative. It is an additional buffer of collateral used to cover potential losses in a closeout scenario.5 IM only applies to Impacted Entities exceeding the notional threshold.6 The application of IM requirements occurs according to a phase-in schedule, wherein the largest market participants (which mainly consist of large banking entities) will begin exchanging IM one month after the date of entry into force of the delegated regulation and others begin exchanging as late as 1 September, 2020. The current expectation is that the delegated regulation will go into effect towards the end of January 2017 or the beginning of February 2017. The table below illustrates the phased-in timeline of the initial margin and variation margin timelines.
IM amounts are to be calculated at a minimum every ten business days or upon the occurrence of certain specified events, the most common of which are expected to include: (i) where a new OTC derivative contract is executed or (ii) where an existing OTC derivative contract expires. IM is required to be collected within the business day of the calculation, but is subject to thresholds below which no IM is required to be exchanged. Specifically, an Impacted Entity exceeding the notional amount threshold is only required to post IM if the IM calculation amount exceeds €50 million – an amount that must be allocated across all relationships between a counterparty and its group. As discussed further below, FX forwards and swaps are not subject to initial margin. The initial margin calculation amount is based on the degree to which a swaps portfolio could change in value over a 10-day period.7 Eligible IM collateral includes cash and a range of liquid securities, which are subject to concentration limits and to haircuts depending on the type of collateral. IM must be segregated from proprietary assets and held by an independent third party custodian or via other legally binding arrangements that protect the IM from default or insolvency of the collecting counterparty. Collateral collected as IM may not be re-used or re-hypothecated.
What transactions are subject to the OTC Margin Rule?
The OTC Margin Rule only applies to transactions which are not cleared by a central counterparty entered into by an Impacted Entity after the relevant phase-in dates. The OTC Margin Rule will not apply to transactions entered into before the relevant phase-in date even if collateral arrangements are put in place in respect of such transaction after the phase-in date. Collateral arrangements relating to transactions not cleared by a central counterparty entered into before these dates will remain subject to the existing agreements. However, certain life-cycle events, such as the novation or modification of a derivative, may bring a pre-existing transaction within the scope of the OTC Margin Rule.
How does the OTC Margin Rule apply to cross-border transactions?
The OTC Margin Rule applies to certain foreign transactions. When one entity in a transaction is an Impacted Entity established in the European Union and is trading with an entity established outside of the European Union but would be an Impacted Entity if the second entity were established in the European Union, the OTC Margin Rule will apply. The effect of this is that non-EU entities will be required to comply with the OTC Margin Rule in certain circumstances, even though those entities are not directly subject to EMIR. If a non-EU entity is trading with an EU Impacted Entity and the non-EU entity would be an NFC- if it were established in the EU, the OTC Margin Rule does not apply.
Additionally, when one entity to a transaction is subject to EU law, substituted compliance may be available. Substituted compliance would apply when the European Supervisory Authorities (the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority and, together, the “ESAs”) recognize a foreign regulatory regime’s margin requirements as comparable to those established by the OTC Margin Rule. A substituted compliance determination by the ESAs would permit an entity to satisfy EU margin requirements by adhering to the margin requirements of an approved non-EU regulatory regime.8
How is the OTC Margin Rule likely to impact hedging decisions?
Aside from the direct impacts applied to particular parties (as described above), the margin requirements are also likely to have indirect impacts that could influence hedging decisions. In particular, because an end user’s hedging transactions with a swap dealer may cause the swap dealer to post initial margin to a third party, we expect that swap dealers will increase transaction pricing on swaps that are not centrally cleared. Regulators expect that these indirect costs will cause some market participants to consider margining or clearing their derivatives transactions, even if they are not required to do so. In practice, these pricing effects will not apply immediately, but rather are likely to apply as initial margin requirements phase-in over the next four years. How a market participant responds to these pricing changes will depend on a range of factors, including an entity’s cost of capital, access to liquidity, and transaction volumes.
What do market participants need to do to prepare for these requirements?
Impacted Entities will need to enter into documentation with their counterparties to comply with the OTC Margin Rule. It is likely that this documentation will be standardized and effected either via a protocol or by way of a bilateral amendment to the trading documentation currently in place between the parties. However, it will take some time before industry standard documentation is available to be completed. Impacted Entities may have increased motivation to invest in systems that allow them to track collateral exchanges in accordance with the rules. Further, market participants will need to assess the potential liquidity impact of these requirements, and begin to prepare for this impact. Finally, these requirements will likely affect hedging strategies for many market participants, who are now in a better position to begin considering whether and how to alter their hedging strategies.
Are there any trades exempted from the OTC Margin Rule?
Physically-settled FX forwards and swaps as well as the exchange of principal for cross-currency swaps are exempted from IM. VM still applies to these products.9 However, VM is not required for physically-settled FX forwards until the earlier of 31 December, 2018 or when a Commission Delegated Act called for under MiFID II which specifies certain technical elements related to the physically-settled FX forward definition enters into application. This Commission Delegated Act is currently anticipated to enter into application on 3 January, 2018. The OTC Margin Rule defines FX forwards and swaps narrowly. An FX forward is an over-the-counter derivative contract that solely involves the exchange of two different currencies on a specific future date at a fixed rate agreed at the inception of the contract covering the exchange. An FX swap is an over-the-counter derivative contract that solely involves an exchange of two different currencies on a specific date at a fixed rate that is agreed at the inception of the contract covering the exchange; and a reverse exchange of the two currencies at a later date and at a fixed rate that is agreed at the inception of the contract covering the exchange.
When is my fund considered as a separate entity?
Generally speaking, the determination of whether an Impacted Entity exceeds the notional threshold and, thus, is subject to IM is determined by the Impacted Entity’s gross notional OTC derivative exposure and is calculated at the group level. However, if an Impacted Entity is an investment fund, in certain circumstances, the investment fund should be treated as a separate legal entity. This means that the calculation of whether an investment fund exceeds the notional amount threshold will be calculated at the fund level instead of the group level, and reduces the likelihood that an investment fund will be subject to IM. Specifically, investment funds managed by a single investment advisor may be treated as distinct entities, where funds are (i) distinct legal entities and (ii) not collateralized, guaranteed or supported by each other or the investment advisor. Effectively, this means that funds that are non-recourse legal entities are analyzed separately under the OTC Margin Rule.