On 15 February 2013, The Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) published a second consultative paper, representing “near-final” margin requirements for non-centrally cleared derivatives. The BIS/IOSCO proposals focus on 8 key principles, as detailed below. Comments on limited aspects of the consultation paper are sought by 15 March 2013.
1. Appropriate margining practices should be in place for all non-cleared derivatives
The BCBS/IOSCO margin rules apply to all non-cleared derivatives, regardless of whether or not those transactions are capable of being cleared. However, comments are sought on the application to physically-settled FX forwards and swaps, specifically whether:
- these transactions should be exempted from initial margin (“IM”) requirements;
- variation margin (“VM”) rules should be determined at a national level; and
- different transaction maturities should be treated differently.
2. All financial firms and systemically-important non-financial entities must exchange margin
BCBS/IOSCO believes that the margin requirements should apply to transactions between financial firms and systemically important non-financial entities (“Covered Entities”). As such, transactions between two Covered Entities would require the mandatory two-way exchange of both IM and VM. However, a transaction between a Covered Entity and a non-Covered Entity (i.e. a non-systemic, non-financial firm) wouldnot be covered by the rules. In addition, sovereigns, central banks, multilateral development banks and the Bank for International Settlements would be specifically excluded.
It is envisaged that VM would be subject to zero thresholds and be exchanged on a ‘sufficiently frequent’ (taken to mean ‘daily’) basis. The threshold applicable to transfers of IM would be calculated on a consolidated group basis and could not exceed EUR 50 million in aggregate. Transfers of both IM and VM would be subject to a minimum transfer amount that could not exceed EUR 100,000.
3. Methodologies for calculating IM and VM should be consistently applied and be adequate to address risks
IM calculations should be based on “a one-tailed 99% confidence interval over a 10-day horizon, based on historical data that incorporates a period of significant financial stress”. The use of approved internal models is possible, but BCBS/IOSCO has also provided at Appendix A, a standardised schedule which can be used to compute IM requirements where no approved internal model exists or where there is no agreement between counterparties on the use of such a model. The IM requirements within the schedule are defined by reference to asset class and range from between 1% (in the case of short dated IRS) to 15% (in the case of commodities and equities transactions). Market participants may use model-based IM calculations for one class of derivatives and schedule-based IM calculations for other classes (e.g. those in which it trades less frequently). However, it will not be possible to switch between model- and schedule- based margin calculations simply in an effort to “cherry pick” the most favourable IM terms. Large, discrete calls for additional IM due to “cliff-edge” triggers are discouraged due to pro-cyclical effects. Finally, market participants should agree “rigorous and robust” dispute resolution procedures before executing a transaction which, inter alia, specify the methods and parameters for calculating IM.
4. IM and VM collateral should be “highly liquid” and subject to appropriate haircuts
BCBS/IOSCO recommends that a broad set of eligible collateral should be acceptable as it:
- reduces the potential liquidity impact of the margin requirements; and
- is more consistent with existing practices among CCPs.
National supervisors are encouraged to develop their own sets of eligible collateral but the following are regarded as generally acceptable:
- high-quality government and central bank securities;
- high-quality corporate bonds;
- high-quality covered bonds;
- equities included in major stock indices; and
Model-based or standardised haircuts should be applied to address credit, market and FX risk associated with collateral, although schedule-based haircuts should be “sufficiently stringent” so as to incentivise firms to develop/adopt internal models. Collateral should not be overly concentrated by type and a transferee should not accept securities issued by the counterparty or its related entities due to the inherent wrong way risk. For those not using internal models, BCBS/IOSCO has provided in Appendix B, a standardised schedule of haircuts for each of the above asset classes. Note that, whilst eligible collateral can be denominated in any currency, an additive haircut of 8% is applied in the event that the currency of the relevant obligation differs from the currency of the associated collateral. Again, there are provisions aimed at preventing firms from ‘cherry-picking’ between the model- and standardised- approaches to haircuts.
5. IM should be exchanged on a gross basis and be protected against recipient bankruptcy
IM should be exchanged on a gross basis and held in such a way that it is:
- immediately available to the collecting party in the event of counterparty default; and
- protected from the bankruptcy of the collecting party.
BCBS/IOSCO recommends that cash and non-cash collateral collected as IM should not be re-hypothecated, re-pledged or re-used, but seeks responses as to whether re-hypothecation should be allowed to finance/hedge customer positions, provided that re-hypothecated customer assets are adequately protected.
6. Margin arrangements for intra-group transactions should be regulated at national level
BCBS/IOSCO notes that the exchange of IM or VM by affiliated parties is not customary in the market and may not be “necessarily suited to harmonisation”. As such, it believes that regulators should establish appropriate IM and VM requirements at a national level in order to address this issue.
7. Co-ordination is necessary so as to create consistent and non-duplicative regulatory margin requirements across jurisdictions8. Margin requirements should be phased-in over an appropriate period of time
The proposal envisages a gradual phase-in of IM requirements over a four year period, beginning with the most systemically important firms, on 1 January 2015. The trigger point requiring the exchange of two-way IM (the “Trigger Point”) is defined by reference to the average aggregate month-end notional amount of non-cleared derivatives (the “Notional”) which the group of which the relevant Covered Entity is a part has executed in the three-month period preceding the relevant date, in accordance with the table below:
1 January 2015
1 January 2016
1 January 2017
1 January 2018
1 January 2019
Notional > EUR 3 trillion
Notional > EUR 2.25 trillion
Notional > EUR 1.5 trillion
Notional > EUR 0.75 trillion
Notional >= EUR 8 billion
The impact of the BCBS/IOSCO margin rules is sufficiently imminent and significant to merit attention now. It is imminent in that the FSA has confirmed that it expects the technical standards in relation to Article 11(3) of EMIR (regarding the segregated exchange of collateral for non-cleared transactions) to follow the BCBS/IOSCO guidelines. It is significant in that BCBS/IOSCO estimates that the market requirement for IM resulting from the implementation of the rules, assuming the use of internal models, will be approximately EUR 0.7 trillion, but could be as much as 11 times higher if the standardised schedule is applied.
The ultimate impact of the rules will, to a large degree, be a function of the answers to a number of questions which currently remain outstanding. The precise definition of “Covered Entity” remains unknown, the consultation paper noting that the terms “financial firms”, “non-financial firms” and “systemically important non-financial firms” will be determined by national regulation. Hopefully, these concepts will be aligned to existing definitions of “Swap Dealer” and “Major Swap Participant” under Dodd-Frank and “Financial Counterparty” and “Non-Financial Counterparty” (whether ‘plus’ or ‘minus’) under EMIR. If not, implementation and documentation of this initiative will rapidly descend into a farce. Proposals regarding the margining of intra-group transactions also remain to be fleshed out at a national level.
On a more practical note, the ability of firms on both sides of a transaction to effectively monitor both the allocation and use of IM threshold capacity on a consolidated group-wide basis poses huge problems in data management and process change. At the very least, it will be necessary to:
- understand whether additional documentation is required in order to facilitate the transfer of margin – by way of example, historically, many FX-only trading relationships have been undocumented;
- understand which group of entities form part of a counterparty’s consolidated group for the purposes of the margin rules;
- understand (and amend) margin thresholds that have been granted to the group of which a counterparty is part;
- internally monitor the use of counterparty group margin threshold capacity on an on-going basis across multiple systems within the firm’s own group (most of which are unlikely to use consistent client identification numbers); and
- implement a process for both the allocation and use of threshold capacity within the group – even if that policy is simply to operate in a zero-threshold environment.
ortunately, portfolios of CSA documentation may not currently be all that dusty. Many firms are already looking at the standardisation of Credit Support Annex terms, either by adoption of the ISDA Standard CSA, or by way of amendment to existing agreements. Typically, the areas being addressed include:
- eligible collateral;
- reduced thresholds and minimum transfer amounts;
- daily calls; and
- interest rate amendments.
- notification requirements for counterparties which become “Covered Entities”;
- notification requirements regarding the identity of entities which form part of a counterparty’s consolidated group for the purposes of threshold calculation; and
- possible amendment of ratings dependent thresholds in light of the move away from clauses which have pro-cyclical effects.
This should enable firms to efficiently address documentation needs arising from the BCBS/IOSCO proposals and focus resource on the process changes and system upgrades which will undoubtedly form the most challenging aspect of compliance with the new regulations.