The long-awaited EMIR rules for margining non-cleared OTC derivatives have been published in the Official Journal of the EU1 which sets the timetable for implementation.
On 4th October 2016 the European Commission (the Commission) approved and published proposed technical standards 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). Following no objections from either the European Parliament or Council of the EU, the final rules which were published in the Official Journal and entered into force on 4th January 2017 (i.e. the twentieth day following that of its publication).
Variation margin requirements will apply in two stages: from 4th February 2017 for those counterparties with more than EUR 3 trillion aggregate average notional of non-centrally cleared OTC derivatives and from 1st March 2017 for all other in-scope counterparties. Initial margin requirements are also being phased-in: applying to the first category of in-scope entities from 4th February 2017 and being fully applied by 1st September 2020. Product specific phase-in relief from the variation margin requirements is available for physically settled FX forwards, and from variation and initial margin requirements for single stock equity index and index options. Phase-in relief has also been provided for intragroup transactions.
Will the Margin Rules apply to you?
The Margin Rules set out the requirement for certain European financial counterparties (including banks, credit institutions, investment firms, insurers and pension providers, authorised collective investment funds / managers or authorised alternative investment funds with regulated managers) and non-financial counterparties whose 30-day rolling average OTC derivative positions entered into for non-hedging purposes are above specified clearing thresholds (so called EU FC and EU NFC+ respectively) to collect variation margin and initial margin from their OTC derivatives counterparties with respect to transactions not subject to the EMIR clearing obligation. These requirements will also impact certain third country entities that would be subject to the Margin Rules if they were established in the European Union.
For certain trading relationships involving a party subject to similar margin regimes under the laws of another jurisdiction, it may be possible to comply with the third country margin requirements and be deemed to have satisfied the EMIR Margin Rules (sometimes known as substituted compliance). However, this will only be available when the EU adopts positive decisions on the equivalence of third country regimes in accordance with Article 13 of EMIR. To date, no such decision has been adopted.
If an entity determines that it is impacted by the Margin Rules, then prior to the phase-in date applicable to it (see Phase-In Timetable below), it will need to:
- consider the documentation in place today with each affected counterparty
- determine what needs to be amended to bring the documentation into compliance with the Margin Rules and how they wish to treat legacy trades
- agree with each relevant counterparty how they wish to amend the documentation to comply with variation margin requirements. This can be done either by bilateral negotiation or, by adhering to the ISDA Variation Margin Protocol and exchanging a series of questionnaires with each of its counterparties
- if the trading relationship has not previously been collateralised, internal processes and collateral agreements will need to be put in place and in any event will need to be revised to ensure compliance with the new requirements. For example, changes to collateral types, haircuts, settlement timelines, and so on.
The consequence of not being compliant by the relevant phase-in date is that a party may be prohibited from trading new OTC derivatives in the EU. The Margin Rules permit parties to continue to use their existing risk-management procedures for legacy transactions (i.e. those entered into before the relevant application date of the margin requirements) which may provide for no exchange of collateral.
A party must collect variation margin equal to the positive mark-to-market value of its OTC derivatives. The variation margin must be calculated on a daily basis based on the values of all the outstanding derivatives contracts under the relevant master agreement on the previous business day. Parties are able to agree a minimum transfer amount (up to EUR 500,000 in aggregate over variation margin and initial margin, the MTA) to avoid small transfers. However once the MTA is exceeded, there is no threshold under the variation margin requirements, so the full amount must then be provided.
Parties are required to meet strict delivery timing requirements for collateral, in most cases requiring collateral to be provided within the same business day as the date of the calculation5. Subject to certain conditions6, variation margin may be provided within two business days of calculation under limited circumstances.
A party must calculate initial margin requirements not only on each trade date but also at a minimum, every ten business days. In addition an initial margin calculation must be performed following certain events, such as a payment or delivery date, an expiry date and every time the underlying risk measurement has changed. If the initial margin requirement is over the MTA (applied on an aggregate basis across both variation margin and initial margin amounts) then the initial margin must be provided within the same business day as the calculation date. The collection of initial margin must be performed without offsetting the initial margin amounts to be exchanged between the two counterparties. A counterparty can calculate the initial margin requirement using either a standardised approach set out in the Annex to the Margin Rules or an initial margin model, provided it satisfies certain requirements set out in the Margin Rules.
The same collateral that is eligible to satisfy the variation margin requirement is also eligible for the initial margin requirement. Collateral posted as initial margin must be segregated from the collecting party's assets to protect it from the insolvency or default of the collecting counterparty. The collecting party is not able to re-hypothecate the initial margin collateral but the third-party holder/custodian or central bank may reinvest any cash collateral in other Eligible Collateral.
Collateral and collateral haircuts
The Margin Rules set out a wide range of collateral that is eligible to satisfy both the variation margin and initial margin obligations (see Eligible Collateral summary below).
The value of any eligible collateral collected or posted to satisfy the Margin Rules is subject to the application of haircuts. Haircuts may be determined using either the standard methodology provided for under the Margin Rules7 or the party's own estimates using internal models (based on volatility estimates) compliant with the Margin Rules. Under the standard methodology:
- no haircut is applied to cash collateral posted as variation margin
- an 8% haircut is applied to variation margin which is non-cash eligible collateral denominated in a currency other than those agreed in the parties derivatives documentation
- an 8% haircut is applied to cash and non-cash collateral posted as initial margin if it is denominated in a currency other than the agreed termination currency with respect to such counterparty
General Exemptions from Initial Margin or Variation Margin
Some of the impact of the new margin requirements may be reduced by certain exemptions and thresholds provided for under the Margin Rules. The exemptions that apply to both variation margin and initial margin requirements are set out below:
- Legacy trades - The requirements to exchange initial margin and variation margin will only apply to trades entered into after the relevant application date of the Margin Rules. 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 apply to a counterparty can continue to be subject to those historic procedures.
- Minimum Transfer Amount - The risk management procedures may provide that no collateral is collected where the aggregate amount due is less than or equal to EUR500,000. Counterparties are allowed to agree on separate minimum transfer amounts for variation margin and initial margin, however, the sum of the separate minimum transfer amounts should not exceed EUR500,000. Once this MTA is reached, the entire collateral amount must be collected.
- NFC- exemption - An EU FC or EU 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-).
- Intragroup Exemption - EMIR provides an intragroup exemption from exchange of collateral if adequate risk management procedures are in place and there is no current or foreseen practical or legal impediment to the prompt transfer of own funds or repayment of liabilities between group counterparties8. The Margin Rules set out a list of defined restrictions that it deems to be impediments of a legal or practical nature. These include currency or exchange controls; regulatory, administrative legal or contractual frameworks that prevent mutual financial support or significantly affect the transfer of funds within the group as well as insufficient availability of unencumbered or liquid assets to the relevant company when due and impediments of an operational nature which effectively delay or prevent such transfers or repayments when due. Note also that the Margin Rules provide a phase-in period for initial and variation margin requirements related to intragroup transactions until 4th July 2017 at the earliest.
- Covered Bonds exemption - Counterparties to covered bond hedging swaps, subject to certain conditions9, may provide in their risk procedures that there are no requirements to post or collect initial margin or variation margin. Nonetheless in such cases the covered bond issuer or cover pool may still collect variation margin in cash (and return it when due) on a one-way basis.
- Non-netting jurisdictions - The Margin Rules, make specific provision for derivatives with counterparties in third countries where the legal enforceability of netting or collateral protection cannot be ensured (so-called "non-netting jurisdictions"). The Margin Rules10 provide that an EU FC or EU NFC+ is not required to post variation or initial margin to counterparties established in third-countries when the legal review required under Article 2(3) confirms either:
- “that the netting agreement and, where used, the exchange of collateral agreement cannot be legally enforced with certainty at all times.”
- or, with respect to initial margin, confirms that segregation compliant with the EU Margin Rules is not possible.
Notably however, the rules do not appear to prohibit the posting of margin to a TCE in a non-netting jurisdiction. The rules also state that unless the volume exemption mentioned below (or another provision of the Margin Rules) excuses collection of margin, EU counterparties must collect margin from TCEs in non-netting jurisdictions “on a gross basis.”11 This appears to result in a number of options being available to EU counterparties trading with entities in non-netting jurisdictions: (1) to have a one-way collateral arrangement under which they receive gross and post nothing or (2) to agree a two-way collateral arrangement under which the EU counterparty collects gross and posts net. Conceivably a third option of collecting gross and posting gross might also be adopted.
Volume exemption - Article 31(2)12 provides an exemption for an EU FC or an EU NFC+ from both posting and collecting variation or initial margin with a TCE in a non-netting jurisdiction if, in addition to the above conditions (i) and (ii) being met, the legal review indicates that the collection of collateral is not possible, even on a gross basis. In this case the Margin Rules allow an amount of trading to be conducted on a non-collateralised basis provided that the amount is below a trading volume ratio of 2.5%. The trading volume ratio compares the amount of an EU entity's13 new14 non-collateralised OTC derivatives with entities in non-netting jurisdictions against the EU entity's total OTC derivatives portfolio15.
- CCPs exemption - Counterparties entering into non-centrally cleared OTC derivatives contracts with CCPs authorised as credit institutions under CRD IV are not required to provide for the exchange of collateral with respect to such contracts.
Exemptions from Initial Margin
The Margin Rules envisage the right for counterparties to agree not to exchange initial margin in a number of additional circumstances:
- EUR 50 million initial margin Threshold - Initial margin 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.
- EUR 8 billion Notional Amount Threshold - No initial margin is required 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 initial margin is 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).
Phase-in timetable for Margin Rules
- Variation Margin phase-in - Variation margin requirements will apply in two stages: from 4th February 2017, for those counterparties with more than EUR 3 trillion aggregate average notional of non-centrally cleared OTC derivatives and, from 1st March 2017, for all other in-scope counterparties
- Initial Margin phase-in - Initial margin requirements will apply as follows:
a) from 4th February 2017, where both counterparties have, or belong to groups each of which has, an aggregate average notional amount of non-centrally cleared derivatives that is above EUR 3,000 billion;
b) from 1 September 2017, where both counterparties have, or belong to groups each of which has, an aggregate average notional amount of non-centrally cleared derivatives that is above EUR 2,250 billion;
c) from 1 September 2018, where both counterparties have, or belong to groups each of which has, an aggregate average notional amount of non-centrally cleared derivatives that is above EUR 1,500 billion;
d) from 1 September 2019, where both counterparties have, or belong to groups each of which has, an aggregate average notional amount of non-centrally cleared derivatives that is above EUR 750 billion;
e) from 1 September 2020, where both counterparties have, or belong to groups each of which has, an aggregate average notional amount of non-centrally cleared derivatives that is above EUR 8 billion.
- Product specific phase-in - Physically settled foreign exchange forwards and single-stock equity options and index options are subject to additional phase-in periods such that, with respect to:
- Physically settled foreign exchange forwards - No variation margin is required to be exchanged until the earlier of 31st December 2018 and the date MiFID technical standards come into force harmonising the definition of FX forwards across the European Union.
- Single-stock equity options and index options - No variation margin or initial margin is required to be exchanged until 3 years from the entry into force of the margin rules.
- Intragroup phase-in - Where an entity established in the EU enters into an OTC derivatives contract with another entity which belongs to the same group, then no initial margin or variation margin requirements will apply until 4th July 2017 at the earliest.
The Margin Rules provide for a broad range of eligible collateral for both the initial margin and variation margin requirements including:
- Cash in the form of money credited to an account in any currency, or similar claims for the repayment of money (e.g., money market deposits accounts)
- Gold in the form of allocated pure gold bullion of recognised good delivery
- Certain debt securities issued by EU central governments, EU central banks, certain regional and local authorities of EU Member States and certain public sector entities of EU Member States, multilateral development banks or international organisations
- Certain debt securities issued by third countries' governments, central banks and certain regional and local authorities
- Certain debt securities issued by credit institutions or investment firms
- Corporate bonds
- Most senior tranche of a securitisation that is not a re-securitisation
- Certain convertible bonds provided that they can be converted only into equities which are included in a main index
- Certain equities included in a main index
- Shares or units in UCITS, where specified conditions are satisfied
Additional considerations are required for credit quality risk, wrong-way risk and concentration risk.
1 Regulatory technical standards ("Margin Rules") pursuant to Article 11 European Market Infrastructure Regulation (EU) No 648/2012 of the European Parliament and of the Council ("EMIR").
2 "TCE FC" means a financial entity, established in a third country jurisdiction which has not been deemed to be equivalent by the European Commission and, that would be subject to the margin rules if it were established in the European Union.
3 "TCE NFC+" means a non-financial entity, established in a third country jurisdiction which has not been deemed to be equivalent by the European Commission and, that would be subject to the margin rules if it were established in the European Union.
4 "TCE NFC-" means a non-financial entity, established in a third country jurisdiction which has not been deemed to be equivalent by the European Commission that would not be subject to the margin rules if it were established in the European Union by virtue of being below all clearing thresholds.
5 Earlier drafts of the Margin Rules required variation margin to be collected within the same business day as the date of calculation. The European Commission changed the emphasis in the final version of the rules such that the requirement is now for the posting party to provide variation margin within the same business day as the day of calculation.
6 For example by providing an advance amount of eligible collateral calculated based on a longer margin period of risk.
7 See Annex II of the EMIR Rules.
8 Depending upon where the parties are established, an authorisation or notification process may apply.
9 See Margin RTS Article 30(2).
10 Article 31(1) Margin Rules.
11 The Margin Rules do not define "gross margin" but it is to be assumed that margin should be calculated as provided in Article 10 or 11, but taking account only of transactions in the netting set for which the mark to market or mark to model are in favour of the collecting party and related collateral.
12 Article 31(2) Margin Rules.
13 Calculated on a group-wide basis.
14 I.e. entered into after the Margin Rules came into force on 4th January 2017.
15 Calculated on a group wide basis but excluding intragroup transactions.
16 See Article 11 Regulatory Technical Standards 149/2013