The European Commission has published longawaited EMIR rules for margining non-cleared OTC derivatives. Furthermore the European Parliament has indicated no objection to the rules raising the likelihood of an expedited timetable with possible January 2017 start.
On 4th October 2016 the European Commission (the Commission) approved and published technical standards1 which set out detailed rules on margin (collateral) that must be exchanged with respect to OTC derivatives not cleared by a central counterparty (the Margin Rules). The Commission's approval of the Margin Rules kick-started a 90 day period2 within which the European Parliament or Council of the EU could object. On 26th October the European Parliament declared that it would raise no objections to the Margin Rules. To date, the Council has not declared its own position, but if, as anticipated, it confirms its non-objection to the Margin Rules this month then they could conceivably be published in the Official Journal of the EU in December and come into force 20 days thereafter. This leads to the possibility of the initial margin mandate taking effect as early as January 2017 for the largest European dealers. This has raised criticism from market participants who fear implementation close to year end could lead to significant market difficulties.
Whilst pension scheme arrangements3 entering into OTC derivatives for hedging purposes have been given a deferral from the obligations under EMIR to clear OTC derivatives transactions (currently until 16 August 2017 but with a Commission proposal to extended this until 16 August 20184), any such OTC derivative transactions may still be subject to the Margin Rules once they come in force. For most pension schemes this will mean that they need to ensure they are compliant with the variation margin requirements by 1 March 20175.
Overview of margin requirements for pensions schemes
The Margin Rules set out the requirement for financial counterparties and non-financial counterparties (as both terms are defined in EMIR6) who are over the clearing threshold7 (so called NFC+) to exchange initial margin (IM) and variation margin (VM) with their OTC derivatives counterparties with respect to transactions not subject to the clearing obligation. This will mean that pension scheme arrangements which are categorised as an FC or an NFC+ will be required to comply with the many procedures and operational requirements imposed by the Margin Rules such as the requirement to have documentation risk procedures in place covering, amongst other things, collateral eligibility, VM & IM calculations and collection, collateral liquidity verification, regular monitoring and reporting. Such "in-scope" entities8 must, subject to the exemptions and phase-in mentioned below,
- Calculate and exchange variation margin (VM) on a daily basis
- Calculate and exchange initial margin (IM) on each trade date, payment date, expiry date and at a minimum every ten business days with no offset being allowed between IM posted and collected
- Meet strict delivery timing requirements for the collateral, in most cases requiring collateral to be provided within the same business day as the date of the calculation although, subject to certain conditions, VM can be provided within two business days of calculation9
- Comply with concentration limits and diversification requirements which set quantitative limits on the amount of assets that can be collected from a counterparty based on asset class, issuer and/or the domicile of the issuer. The latest version of the Margin Rules continue to give pensions schemes that are the most active in the OTC derivatives market (i.e. those where IM exchange with its counterparty would be over EUR1 billion) a carve-out from certain IM concentration limits on sovereign debt and instead, in such cases (against the opinion of the ESAs10) has allowed pensions schemes merely to have procedures and manage concentration risk of certain assets with a requirement for diversification. Moreover pensions schemes are now permitted to monitor concentration limit compliance on a quarterly basis as opposed to daily basis as previously provided
- Enter into netting and exchange of collateral documentation with their counterparties which meet certain minimum requirements and conduct legal enforceability assessments
- Undertake credit quality assessments of collateral collected from its OTC counterparties
Some of the impact on pension schemes of these onerous requirements will be reduced by the exemptions and thresholds provided by the Margin Rules. The most relevant to pension schemes are set out below.
General Exemptions and Transitional provisions
- Legacy trades - The requirements to exchange IM and VM will only apply to trades entered into after the date that the Margin Rules comes into force. Whilst EMIR Article 11 requires counterparties to have risk-management procedures that require the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts entered into on or after 16 August 2012, the Margin Rules make it clear that trades entered into after EMIR itself came into force but before the Margin Rules are in force can continue to be subject to those existing procedures.
- Minimum Transfer Amount - The risk management procedures may provide that no collateral is collected where the amount due is less than or equal to EUR 500,000. Counterparties are allowed to agree on separate minimum transfer amounts for VM and IM however, the sum of the separate minimum transfer amounts should not exceed EUR 500,000. Note, that once this amount is reached the entire collateral amount must be collected.
- NFC- exemption - An EU pension scheme which is an FC or NFC+ is allowed to have risk management procedures which provide for no collateral exchange if transacting with either EU or non-EU NFCs below the clearing thresholds (so-called NFC-). So if a pension scheme is an NFC- it can negotiate with its counterparties not to post collateral.
Exemptions from Initial Margin
The Margin Rules envisage the right for counterparties to agree not to exchange IM in a number of circumstances:
- IM Threshold - IM collected may be reduced by EUR50 million (or EUR10 million if both parties are in the same corporate group) subject to an on-going requirement to monitor whether the threshold is exceeded.
- Notional Amount Threshold - No IM for new OTC transactions if, measured over a given 3 month period in a calendar year, one of the two counterparties has, or belongs to a group that has, aggregate month-end average notional amount of non-centrally cleared OTC derivatives of less than EUR8 billion.
- Foreign exchange contracts - No IM required with respect to physically settled FX forwards, FX swaps and the FX "legs" of cross-currency swaps. (NB these transactions are nonetheless to be included when calculating the aggregate notional amount threshold referred to above).
- No credit risk - Recital 5 of the Margin RTS clarifies that a counterparty under a non-centrally cleared OTC derivative transaction should be able to choose not to collect IM or VM as long as it is not exposed to any credit risk. The recital gives the example of an option seller that need not collect IM or VM from the option buyer if the premium has been fully paid in advance.
Phase-in timetable for Margin Rules
- VM phase-in - VM requirements will apply in two stages. For those counterparties with more than EUR3 trillion aggregate average notional of non-centrally cleared OTC derivatives, the start date will be one month after the Margin Rules are in force (possibly mid January 2017). For all other in-scope counterparties, VM requirements will commence from the later of 1 March 2017 or one month following the Margin Rules coming into force.
- IM phase-in - IM requirements are being phased-in over the period commencing one month after the Margin Rules are in force (possibly mid January 2017) and will be fully applied from 1 September 2020. Initially, the IM requirement will apply where both parties have, or belong to groups each of which has, an aggregate average notional of non-centrally cleared derivatives over EUR3 trillion. This figure gradually reduces until by 1 September 2020, the threshold for being in-scope of the IM requirements is set at EUR8 billion.
- VM Product specific phase-in - Foreign exchange forwards and single stock equity options and index options are subject to additional phase-in periods. No VM is required to be exchanged with respect to
- FX forwards Until the earlier of 31 December 2018 and the date MiFID technical standards are in force which will harmonise the definition of FX forwards across the Union.
- Single stock equity options and index options Until 3 years from the entry into force of the Margin Rules.
1 Regulatory technical standards pursuant to Article 11 European Market Infrastructure Regulation (EU) No 648/2012 of the European Parliament and of the Council.
2 Extendable by one further 3 month period although this seems unlikely in this case.
3 See Glossary below for definition of "pension scheme arrangement"
4 The Commission has determined that this should be extended further and a draft regulation is in progress to extend the transitional period to 16 August 2018 see Client Alert Moreover on 29th November in its Report on the EMIR Review the European Commission has concluded that an assessment should be made as to whether the current exemption could be prolonged or made permanent without compromising on EMIR's objective of reducing systemic risk as pension scheme arrangements would still be subject to bilateral margin requirements for OTC transactions that are not centrally cleared that mitigate systemic risks.
5 Assuming OTC derivatives portfolios of less than EUR3 billion, Article 37 (Transitional Provisions) will bring variation margin requirements into effect on the date that is the later of 1 March 2017 or one month following the date of entry into force of the Margin Rules, making 1st March 2017 the most likely date for application of the Variation Margin requirement to the majority of pension schemes. See Phase-in for VM below
6 See Glossary for definitions of FC and NFC
7 See Glossary for definitions of clearing threshold
8 In calculating the positions for the clearing thresholds, an NFC must include all the OTC derivative contracts entered into by the NFC or by other nonfinancial entities within its group, which are not objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the non-financial counterparty or of that group.
9 The emphasis in the Article dealing with the provision of Variation Margin (Article 12) has changed from a requirement to "collect" within the same business day to a requirement for the posting party to "provide" within the same business day. It may be that this subtle change of interpretation signals a move by the Commission to give a more favourable settlement cycle by requiring simply that instructions to move collateral are provided on the same day rather than requiring the collateral to be with the collateral taker on the same business day. However more clarity on this area is required possibly in the form of Q&A responses once the Margin Rules are published.
10 ESAs is the collective term for three European Supervisory Authorities, the European Securities & Markets Authority (ESMA), the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA)