ESAs publish revised draft margin requirements for non-cleared derivatives

On 10 June 2015, the European Banking Authority, the European Securities Markets Authority and the European Insurance and Occupational Pensions Authority (the ESAs) published a second draft of the proposed regulatory technical standards on the requirements for exchange of margin for non-cleared derivatives under Article 11(3) of EMIR (the Revised Draft RTS). This follows the consultation on the first draft regulatory technical standards published by the ESAs on 14 April 2014 (the First Draft RTS), which closed in July 2014. The Revised Draft RTS include some further questions for a second consultation, which closes on 10 July 2015.

In short, the rules set out the requirement for financial counterparties (FCs) (as defined in EMIR) and non-financial counterparties (as defined in EMIR) who are over the clearing threshold specified in Article 10 of EMIR (NFC+s) to collect initial margin and variation margin from the parties facing them in OTC derivatives transactions that are not subject to mandatory clearing. The rules also impose various operational requirements aimed at reducing risk in the OTC derivatives market including, in the case of initial margin, a requirement to segregate and a restriction on re-hypothecation of the collateral.

The First Draft RTS were the subject of much discussion in the derivatives market and a large number of market participants and advisers, including Ashurst, submitted feedback on them to the ESAs. The Revised Draft RTS include some changes arising from that feedback. In this briefing we analyse the main provisions of the Revised Draft RTS, their effect on certain transaction types, and whether concerns voiced by market participants have been addressed. We also suggest the steps market participants may need to take to prepare for implementation, set out the next stages in the legislative process and consider certain related legislative developments.

 

Industry concerns

Market participants voiced concerns in relation to certain provisions of the First Draft RTS. Below we set out the outcomes in relation to those issues under the Revised Draft RTS and the consequences for various transaction types.

Non-EU non-financial counterparties

Concern:

The First Draft RTS provided that "counterparties" (being FCs and NFC+s) would be required to collect both initial and variation margin for non-cleared derivatives transactions unless an opt-out were available. The effect of this would be that, if unable to rely on one of the opt-outs, a counterparty would have to collect margin from each entity that it faces in a non-cleared OTC derivatives transaction, whether such entity is in the EU or not, and whether the entity is above the clearing threshold or not.

In relation to both initial margin and variation margin, FCs and NFC+s could opt out by agreeing with non-financial counterparties (as defined in EMIR) that are under the clearing threshold (NFC-s) not to exchange either initial margin or variation margin. Since the definition of "non-financial counterparty" in EMIR refers to entities established within the EU, the wording of this opt-out provision appeared not to apply to contracts with non-EU entities. The ESAs made clear in the consultation process on the First Draft RTS that this result was intentional.

In relation to initial margin, counterparties could agree to opt out of exchange of initial margin if the aggregate notional amount of all non-cleared derivatives entered by either party to the contract (or by its group) fell below certain thresholds (the Initial Margin Threshold) (see Grandfathering and Phase-in below). The wording of this opt-out provision was ambiguous and did not clearly allow counterparties to agree not to exchange initial margin where one of the parties was a non-EU entity.

Outcome:

The Revised Draft RTS make clear that counterparties' risk management procedures may provide that no collateral (either initial or variation margin) need be exchanged in relation to transactions with entities established in a third country outside the EU, where such entities would be considered non-financial counterparties under the clearing thresholds if they were established in the EU (non-EU NFC-s).

This change of approach from the ESAs means that, for instance, repackaging, CLO and other securitisation vehicles outside the EU will be able to agree collateral requirements with their swap providers that meet rating agency criteria, such as one-way posting of collateral by the swap provider to the vehicle, rather than the new rules. Note however that to take advantage of this change, the notional amount of OTC derivative transactions entered by the vehicle and other NFCs within its group will have to remain at all times below the clearing thresholds. This should be possible, as, unlike other thresholds used in the Revised Draft RTS, the clearing thresholds exclude eligible hedge transactions from the calculation of the threshold notional amount.

Under the Revised Draft RTS, the requirement to exchange initial margin bites only if both parties (or their groups) are over the relevant Initial Margin Threshold, whereas in the First Draft RTS the parties would have to agree to opt out of exchange of initial margin where one counterparty (or its group) has a notional amount of derivatives contracts below the threshold. This change reduces the impact on documentation as it is no longer necessary to amend documentation in order to benefit from this threshold.

Initial margin floor and minimum transfer amount

Concern:

The First Draft RTS allowed FCs to hold capital against an exposure as an alternative to collecting initial margin, if the initial margin otherwise to be exchanged between the parties at a group level for all non-cleared OTC derivatives would be equal to or less than €50m (for the purpose of this briefing, the Initial Margin Floor). The amount of initial margin to be exchanged could also be reduced by this amount.

Also, under the First Draft RTS, FCs and NFC+s could agree that, if the total collateral amount would be equal to or less than €500,000 across all their relevant transactions (the Minimum Transfer Amount) then they would not exchange collateral.

However, the wording of the First Draft RTS also appeared to restrict the operation of these provisions to transactions between EU entities, meaning that transactions with non-EU entities would not be eligible to benefit from them.

Outcome:

As it is now possible for counterparties' risk management procedures to provide that no collateral be collected from non-EU NFC-s, these provisions are less of a concern. However, in the event that the opt-out mentioned above is not available, e.g. if an EU or non-EU entity is over the clearing threshold, the Initial Margin Floor and Minimum Transfer Amount remain significant.

The Revised Draft RTS provide that for contracts between counterparties and entities which would be subject to the rules if they were established in the EU, the risk management procedures must provide for exchange of initial and variation margin in accordance with the RTS. Our view is that this means all provisions relating to exchange of margin, including the Initial Margin Floor and Minimum Transfer Amount, will extend to contracts with such non-EU entities.
Furthermore, it is now clear that the Minimum Transfer Amount is assessed on a per-transfer basis, to be calculated by reference to the last collection of collateral. Parties can agree a lower amount than €500,000, but that figure is the maximum permitted.
In the case of the Initial Margin Floor and Minimum Transfer Amount, there will be a need to amend documentation if the terms already in place are inconsistent with the parameters in the Revised Draft RTS.

Concentration limits and eligible collateral

Concern:

Market participants commented that the concentration limits in the First Draft RTS were overly prescriptive. As a general matter, market participants are incentivised to ensure that the collateral they take provides effective protection, which includes ensuring that the collateral is appropriately diversified. Furthermore, in certain specific scenarios diversification could worsen rather than improve the protection provided by collateral. For example, it is common for an equity derivative transaction to be collateralised by taking security over the shares underlying the transaction, such that the collateral perfectly hedges the exposure. Imposing a concentration limit here actually makes the hedge less effective.

Outcome:

The requirements for eligible collateral and concentration limits for both initial and variation margin are set out in the Revised Draft RTS. Eligible assets include cash, gold, gilts, debt securities issued by certain public entities, bank bonds including covered bonds, senior securitisation bonds, equities included on a main index (and related convertibles), and units in UCITS. Each category is subject to various credit quality thresholds¹. Eligible collateral must not include significant wrong-way risk (i.e. positive correlation with the creditworthiness of the counterparty).

The Final Draft RTS include only a limited relaxation of the application of the original concentration limits. The limit on collateral constituted by corporate bonds or equities of the same issuer (or group) remains at ten per cent and there is a 40 per cent limit on equities in credit institutions or investment firms).

The new carve-out from the scope of the concentration limits only applies to collateral consisting of central government debt or certain other public sector debt meeting similar credit standards to central government debt. For those instruments a 50 per cent concentration limit applies only to contracts entered into by global and other systemically important institutions, and only applies to other counterparties if the initial margin to be collected is in excess of €1bn, in each case the limit only being applied to collateral collected in excess of €1bn. The aim of this relaxation of the limits is to allow smaller market participants to continue using solely sovereign debt as collateral and only to require systemically important institutions and entities with large OTC derivative portfolios and more sophisticated trading strategies to diversify such collateral.

Thus the difficulties for equity derivatives, or derivatives referenced to corporate bonds or securitisations of a single issuer, remain. The ESAs do however ask for feedback as to whether the new draft rules on concentration limits address the concerns expressed in responses to the First Draft RTS.

FX haircut

Concern:

The First Draft RTS required counterparties who use standardised haircuts (rather than own estimates of market volatility for the assets) to apply a haircut of eight per cent to the market value of the collateral if there is a currency mismatch, i.e. where the collateral is denominated in a currency different from the settlement currency of the relevant transaction(s). Market participants argued that this FX haircut would cause various inefficiencies and that these inefficiencies would outweigh the intended reduction in risk.

Firstly, where a counterparty provides variation margin in a currency different from the exposure, the FX haircut would require it to provide more collateral than is required by the mark-to-market valuation, therefore the collateral provider would be exposed to the collateral taker for the return of the amount of over-collateralisation in respect of variation margin.

Secondly, since the FX risk relating to a particular trading position would be taken into account in the initial margin calculation, the FX haircut effectively results in a double-counting of FX risk. Similarly, the FX haircut would ignore the possibility that the currency exposures under transactions in different asset classes could offset each other and would impose the requirement to post additional collateral notwithstanding such offset.

Outcome:

The eight per cent standardised haircut for currency mismatch remains in the Final Draft RTS. However there are new provisions which govern which reference currency should be used to identify whether there is a mismatch. For variation margin the Revised Draft RTS draft states that the reference currency will be the "transfer currency", where one is included in the agreement. It is not entirely clear what is intended by the "transfer currency", particularly as there may be several eligible currencies specified in the agreement. For initial margin the Revised Draft RTS states that the reference currency will be the termination currency, where one is specified in the agreement. In each case, the haircut will apply to "the market value of all assets posted as collateral" if denominated in a different currency, however if no transfer or termination currency is specified all collateral will be subject to the eight per cent haircut.

In the case of currency mismatches with respect to collateral in the form of cash, the provisions appear somewhat ambiguous. There is a clear provision of the draft which states that "Cash shall be subject to a haircut of 0 per cent", yet the provision is silent as to whether this provision applies only where there is no currency mismatch, and whether the eight per cent FX haircut applies to cash collateral otherwise. Further, the explanatory text seems to indicate that variation margin (but not initial margin) in the form of cash may be exempt from the FX haircut, but as yet there is no operative provision to that effect. This needs to be clarified in the final draft.

The ESAs do specifically invite comment on the requirements for the treatment of FX mismatch, so further changes to the application of the FX haircut are possible.

Segregation

Concern:

The First Draft RTS required initial margin to be segregated from proprietary assets of the collecting party on the books of a third-party holder or custodian, who would also have to give the posting party the option for its initial margin to be individually segregated from that of other posting parties. Exactly what was meant by "segregated" was not clear.

In particular, it was not clear whether segregation of the assets by way of identification in the books of the collecting counterparty would be sufficient if such assets would be subject to a regulatory regime giving client assets preferential treatment upon the insolvency of the collecting counterparty or whether collateral arrangements with a third-party custodian would be required in order to satisfy this requirement.

In relation to the requirement on the collecting counterparty to segregate initial margin, this would appear to require that collateral is held in a custody account with the collecting counterparty as custodian in an account in the name of the posting party or is held with a third-party custodian in an account either in the name of the posting party or in the name of the collecting counterparty but separate from any account containing its proprietary assets. These requirements seem somewhat inconsistent with a full title transfer as the collateral must be held separately from the collecting party's own assets, implying that the posting party is intended to retain an interest in the collateral.

It was also difficult to reconcile this segregation requirement with the requirement in the First Draft RTS that initial margin be immediately available to the collecting entity where the posting party defaults. The latter requirement would imply that there may have to be (if not a title transfer) a security financial collateral arrangement giving the collateral-taker control of the collateral. Such a financial collateral arrangement, if structured in compliance with local law implementation of the 2002 EU Financial Collateral Directive, should give the collateral taker immediate access to the collateral without the need for the consent of any administrator of the defaulting entity, and without having to obtain a court order (at least in relation to EU jurisdictions). Absent such a security interest, the requirement that the collecting party has immediate access to the collateral may not be met.

The First Draft RTS required the counterparties to obtain annual legal opinions in respect of the segregation requirements. It would be difficult, however, to provide a "clean" legal opinion as the segregation requirements required confirmation that the collateral would be "immediately available" to the collecting entity on a default whilst also confirming that the posting entity is "sufficiently protected" on an insolvency, and neither of these terms was clearly defined.

A further concern was that the requirement for the collecting party to provide individual segregation of cash collateral effectively meant that cash could not be posted as initial margin as this requirement would be operationally difficult. Cash could be individually segregated from other assets of the collecting party by holding the cash with a third-party custodian, but this does not effectively segregate the cash from the risk of the custodian's default (assuming the custodian is a bank). In the case of cash on account with a bank, the account-holder's recourse is an unsecured claim against the bank.

Outcome:

There have been some changes to the segregation requirements for initial margin, although they still do not provide for a clear method of segregation and fail to address the apparent conflict with the use of title transfer collateral arrangements such as the ISDA Credit Support Annex. However, the ESAs seem to have elected to place the emphasis on protecting the posting party rather than allowing title transfer arrangements.

The requirement to segregate cash posted as initial margin on an individual basis remains in the Revised Draft RTS, as does the requirement for the collecting party to offer the posting party individual segregation of other types of collateral. In any event, all initial margin is required to be segregated from proprietary assets of the collecting party and the custodian to protect the initial margin from the default or insolvency of the collecting party or custodian. No additional detail is given as to how this should be achieved. The implication is that either the collateral must be held in accounts in the name of the posting party, or accounts in the name of the collecting party which are effectively ring-fenced from its own assets. Methods for achieving this could include subjecting such accounts to a trust or security interest in favour of the posting party.

In the case of collateral in the form of cash, no solution is offered to the problem of how to segregate cash collateral from the risk of default of the custodian. The explanatory text suggests that the solution is to reinvest the cash – and to that end, cash is exempted from the prohibition on re-use of collateral (see Ban on re-hypothecation below). Effectively the result appears to be that cash collateral cannot comply with the requirements on segregation, and will have to be re-invested in other eligible collateral.

The consultation acknowledges that the requirement for an annual legal opinion on effective segregation is cumbersome, but states that there is a need for internal due diligence of the enforceability of segregation arrangements. There is now a requirement for "independent legal review" and "documentation supporting" the legal basis for the segregation arrangements in relevant jurisdictions, although it is not clear how this differs from an independent legal opinion. However, the provision requiring that initial margin be "immediately available" to the collecting party on default of the posting party has been removed and the segregation arrangements now have to ensure that initial margin is available to the posting party in a timely manner on the default of the collateral-taker.

Although the specific provision requiring that initial margin be immediately available to the collecting party on the posting party's default has gone, in practice, all collateral arrangements which do not involve title transfer will require the collecting party to be granted a robust security interest over the collateral. Such arrangements remain difficult to reconcile with the requirement that initial margin is available to the posting party in a timely manner on default of the collecting party. Default of the collecting party does not automatically release security – the collecting party may actually be the party owed a termination payment under the master documentation, and the security would usually remain in place until sums owed are paid.

The ESAs have, however, asked for specific feedback on the legal basis of the segregation requirements as part of this consultation.

The Recitals to the Final Draft RTS provide that where the legal review highlights possible non-compliance with the requirements for enforceable segregation arrangements, EU counterparties should identify alternative processes for the posting of collateral, such as posting to a third-party custodian in a jurisdiction in which enforceability can be assured.

Ban on re-hypothecation

Concern:

The First Draft RTS provided that the collected initial margin could not be re hypothecated. Market participants gave feedback to the ESAs that this would impose a significant constraint on the liquidity of assets that could be used as collateral.

Outcome:

A full ban on re-hypothecation of collateral posted as initial margin remains, except that there is a carve-out for the re-investment of cash collateral, provided that cash is reinvested in eligible collateral which is then appropriately segregated in compliance with the Revised Draft RTS. Any reinvestment must be for the purpose of protecting the collateral for the posting party and not for the benefit of the collecting party, and such reinvestment can only be made if agreed between the parties. Such a ban may be expected to have a restrictive effect on liquidity as it would prevent the collateral-taker from re-using the collateral for other purposes such as repo or securities-lending transactions.

Netting enforceability

Concern:

The First Draft RTS contained a requirement that counterparties annually verify the legal enforceability of netting agreements constituting the netting sets referenced in the initial margin calculation. This requirement is less flexible than the current standard applicable to credit institutions and investment firms under the Capital Requirements Regulation and is a change to general market practice, which generally allows a certain level of flexibility to parties to determine whether or not there have been material changes in the legal regimes in the relevant jurisdictions that merit obtaining updated opinion coverage.

Outcome:

This requirement is now that counterparties conduct an "independent legal review" at least annually in order to verify the legal enforceability of the relevant bilateral netting arrangements and always be able to provide documentation supporting the legal basis for compliance of the arrangements in each jurisdiction. As is the case with the requirement in respect of segregation arrangements, it is not clear how this differs from a legal opinion.

The requirement that a legal review or opinion is "independent" has been addressed in the context of recognition of credit risk mitigation under Article 194 of the Capital Requirements Regulation, where the European Banking Authority has clarified, in its single rulebook Q&A, that "independent" legal opinions need not be given by external counsel, but can be provided by internal legal departments provided they are in fact independent. By analogy it may be that this is also what is intended here. In any event, as these requirements will normally be addressed by industry standard netting opinions on trading agreements such as the ISDA Master Agreement, this requirement should not be problematic.

Grandfathering and phase-in

Concern:

Under the First Draft RTS the treatment of existing derivatives contracts was unclear as express grandfathering provisions were not included. The accompanying commentary from the ESAs stated that only "new contracts at the time of entry into force" of the RTS would be caught, however it also stated that market participants should endeavour to apply the principles to the widest set of non-cleared derivatives possible. The statement from the ESAs provided some comfort but was not entirely clear.

Furthermore, many Credit Support Annexes would have to be renegotiated within a short time unless the eligibility requirements for collateral were also phased in. This is a concern even if existing transactions are grandfathered as parties to existing master agreements will have privately negotiated the eligibility of different types of collateral under master documentation which will govern new transactions entered after the phase-in dates.

Outcome:

The recitals to the Revised Draft RTS now state that they will only apply to new contracts entered into after the relevant phase-in dates. Thus parties to OTC derivative contracts entered into before those dates will not need to modify existing documentation to ensure future margin exchanges comply with the new rules.
It is not immediately clear from the Revised Draft RTS how the grandfathering provisions are expected to apply to a netting set within which a portion of the individual OTC derivative contracts are entered prior to the relevant phase-in date, and the remainder are entered after that date. Potentially, unless separate rules can be applied within the netting set, the effect could still be to bring existing contracts within the same netting set into compliance with the Revised Draft RTS.

The phase-in dates have been amended from the first draft, so that initial margin requirements and variation margin requirements are each phased in on a different, staggered, timetable. Initial margin requirements are phased in over five years. If both parties have an average notional amount of non-cleared OTC derivatives over €3trn each on 1 September 2016 they will be required to exchange initial margin. The Initial Margin Threshold falls over five years, until reaching €8bn on 1 September 2020. Variation margin requirements take effect on 1 September 2016 for the largest counterparties by OTC derivatives trading volume (those over €3trn in average notional amount), and from 1 March 2017 for all other counterparties.

Applications for intra-group exemptions under Article 11 of EMIR can be made from the date the final RTS come into force, and decisions on such applications are to be made within three months.

The ESAs have not included separate phase-in of the eligibility requirements in the Revised Draft RTS. However, the start date for mandatory exchange of margin has been pushed out to 1 September 2016 for the largest counterparties. Thus there is a slightly longer window for re-negotiating ISDA documentation than appeared in the First Draft RTS.

Other points to note

Other opt-outs and exclusions

Indirectly cleared transactions are subject to CCP margin requirements and are therefore treated as out of the scope of the requirements of the Revised Draft RTS.

As well as the opt-out available for transactions with NFC-s, the Initial Margin Floor and the Minimum Transfer Amount, the Revised Draft RTS retain the following opt-outs and exclusions:

• Counterparties may agree not to collect initial margin on physically-settled FX forwards and swaps, or on the exchange of principal and interest in currency swaps. There is no such flexibility for interest rate swaps or other types of derivative.
• Covered bond issuers can agree with their hedge counterparties not to post either inital or variation margin provided that certain structural protections for the hedge counterparties are built in to the transaction. No such relief is provided for securitisation vehicles, such as CLOs, or for repackaging vehicles. Such issuers will usually fall below the Initial Margin Threshold but will have to rely on the their swap counterparties agreeing not to collect variation margin on the basis of the issuer being an NFC-.
• Parties can agree that no initial or variation margin is collected in relation to derivatives contracts used by a CCP to hedge the portfolio of an insolvent clearing member.

It should be noted that the opt-out provisions are not automatic exemptions, but are expressed as permissions for the collecting party to have risk management procedures which allow it not to collect collateral in these circumstances. Although the Final Draft RTS have removed the requirement for such agreement to be in writing or permanent electronic form, in practice FCs and NFC+s will still need to agree with their counterparty to use the opt-outs where available.

In the First Draft RTS, FCs and NFC+s could agree not to exchange margin with certain public entities, central banks and multilateral development banks. This opt-out seems to have been removed from the revised draft RTS, perhaps in the belief that those public entities are out of the scope of EMIR under Article 1(4). However, it is not clear that Article 1(4) of EMIR operates to allow parties who are within the scope of EMIR and subject to the collateral exchange requirements not to collect margin from such public entities. In our view an explicit opt-out should be reinstated for these contracts.

Operational requirements

The collecting party must have certain operational capabilities with respect to collected margin. These include daily re-evaluation, legal arrangements for holding and access to collateral if held by a third party custodian.

The requirement for daily re-evaluation may mean a change in practice in some markets, such as the insurance longevity swaps market, where current practice does not require daily margin valuation as the underlying asset is not traded in a liquid market.

Overall, the Revised Draft RTS make these operational provisions more "posting party-friendly" in that they require more robust protection of posted collateral, such as the use of "insolvency remote custody accounts" if collateral is held by the collecting party, and arrangements for the free and timely transfer of the collateral to the posting party on default of the collecting party.

Trading documentation

There is also a general new requirement for documentation of the trading relationship between the parties which will apply to all OTC derivative contracts and must be executed prior to or simultaneously with the transaction, regardless of whether the counterparties are required to exchange margin. The documentation must include terms covering payment obligations, payment netting, close-out netting, events of default, calculation methods, and governing law.

The ESAs have requested feedback on this requirement for mandatory documentation of trading relationships as part of this consultation.

Calculation of thresholds

There was some uncertainty in the First Draft RTS surrounding the calculation of the Initial Margin Threshold, and whether either exempt contracts (such as intra-group contracts) or contracts to which the opt-outs apply under the rules should be included. The Revised Draft RTS provides some clarification to the effect that all non-cleared OTC derivative contracts, including those "subject to a special treatment according to this regulation", should be included in the total. These will include physically settled FX options and swaps, currency swaps, swaps with covered bond vehicles, contracts below the Initial Margin Threshold, contracts subject to the opt-outs and exempted intra-group contracts. The Revised RTS also require that non-cleared OTC derivatives contracts with "exempted counterparties" are included in the thresholds, although it is not clear which counterparties this is intended to catch.

Calculation of margin and modelling

Collection of initial margin is to be made without netting the initial margin amounts due from each counterparty to the other. The First Draft RTS provided that initial margin must be collected within a business day of the trade (T+1) and variation margin must be collected daily starting on the day following the trade. The Revised Draft makes some changes to these requirements. Initial Margin must still be collected on a T+1 basis following the execution of a new contract, additions to or removals from the netting set, triggering of non-margin payments, change of categorisation of a contract or where no calculation has been performed within the last ten business days.

Variation margin meanwhile must be calculated daily but can be collected within three business days of the calculation. However, as the rules on use of models assume a margin period of risk (MPOR) based on collection one business day after calculation, if the parties agree a longer settlement, they must adjust the MPOR accordingly.

In order to calculate initial margin, counterparties may use either the standardised margin model set out in the Final Draft RTS or an initial margin model, the characteristics of which, and the data to be used, must be agreed with the counterparty facing them in the trade. The rules do allow counterparties to use different models from each other, although this may prove to be impractical. The standardised model is likely to be less flexible and require more collateral in general than a bespoke initial margin model.

ISDA has been working on an initial margin model with the aim of creating an industry-standard model for use by all market participants and following discussions with regulators recently announced the launch of a licensing program for ISDA SIMM™. The hope is that this will create a single framework for licensed counterparties to calculate initial margin, thereby reducing the potential for disputes and facilitating swift resolution where disputes do arise.

Outside of ISDA's initiative, the development of bespoke models may be difficult for smaller counterparties, as the ESAs have acknowledged, and therefore the RTS allow the use of models provided by the facing counterparty, although this may not be practicable since these models may be proprietary.

Note that a new proposal for consultation (but as yet no substantive text) has been included which allows parties to exclude from the margin calculation OTC derivative contracts in respect of which that counterparty has assumed no credit risk, due to the payment of an upfront premium where the premium effectively guarantees the obligations of the party paying it. The party not exposed to any credit risk can therefore exclude those contracts from its margin calculation.

Haircuts

Collected collateral is also subject to haircuts, either on the basis of standard discounts set out in the Final Draft RTS or by own estimates based on prescribed requirements. The standard haircuts are based on rating, residual maturity and type of collateral and vary from 0 per cent for cash and 0.5 per cent for highly-rated government debt with less than a year to maturity, to 24 per cent for securitisation positions with five year residual maturity and a rating between A+ and BBB-.

What do firms need to do to prepare?

Although the Final Draft RTS still need to make their way through the remaining legislative process (as explained below), market participants should be planning now for the steps that they will take in order to prepare for implementation of the new rules.

Credit support documentation

In the immediate future various terms of existing credit support documentation are likely to need to be modified, including eligible collateral, collateral haircuts; timing of calculation and collection and dispute resolution provisions.

As the initial margin requirements are phased in there is likely to be a move away from title transfer arrangements and towards security arrangements, given the requirement to ensure that an entity posting initial margin is sufficiently protected in the event of the insolvency of the collecting counterparty.

Working groups coordinated by ISDA have been developing documentation to comply with the new requirements.

Custody arrangements

In order to segregate initial margin, counterparties will need to set up new accounts with third party custodians and tripartite custody agreements, together with the associated systems and processes to provide for the exchange and settlement of collateral.

Initial margin models

Counterparties intending to use bilaterally agreed initial margin models will need to implement a model which complies with the detailed requirements of the Revised RTS. These requirements cover the confidence interval and risk horizon, the calibration of the model, diversification and hedging, integrity of the approach to risk capture, and measures covering internal governance and audit of the model.

Next stages in the legislative process

This second consultation closes on 10 July 2015. Once finalised by the ESAs, the final draft RTS will be submitted to the European Commission pursuant to EMIR Article 11(15). The Commission will have three months from receipt to decide whether or not to endorse the Final RTS. If it decides not to endorse the RTS, or to endorse the draft with changes, the ESAs

will then have a further six weeks to resubmit the RTS to the Commission for endorsement, in the form of a formal opinion to the Commission, and to the Council and Parliament. The Commission can then either adopt the amended RTS, or reject them and adopt a version consistent with the amendments it requested.
Once the RTS are adopted, Parliament and the Council generally have a window of one month during which they can veto the final draft, although this period is longer if the Commission adopts a version which differs from the ESAs' draft. Once that window closes, the adopted RTS are published in the Official Journal of the European Union and enter into force 20 days later. This means that if there are no changes made by the Commission, there will be roughly a four month period between publication of the ESAs' final draft and publication in the Official Journal.

Whilst the requirements were originally intended to come into force from 1 December 2015, following the announcement by BCBS/IOSCO in March 2015 of a nine-month delay to targeted implementation this has now been revised to 1 September 2016, subject to the phase-ins described above.

International standards

In the Recitals to the Revised Draft RTS the ESAs acknowledge that the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) are expected to conduct a review of international standards on margin exchange once these are settled and there is some data available on their functioning. The ESAs note that at that stage, it may be necessary to amend the European provisions in accordance with the outcome of the BCBS/IOSCO review.

Related legislative developments

On 17 June 2015 the European Parliament and the Council reached political agreement on the European Commission's legislative proposal for a Regulation (the SFT Regulation) on the reporting and transparency of securities financing transactions (SFTs), published in January 2014. SFTs include repurchase or "repo" transactions, reverse-repo transactions, securities lending transactions and any transactions having similar effect, such as a buy-sell back transaction or a collateral swap.

The SFT Regulation aso imposes certain conditions on re-hypothecation of collateral, in that the receiving counterparty will only be permitted to re-hypothecate assets where the posting party has been informed of the associated risks and has provided express consent and the collateral is transferred to an account opened in the name of the collecting counterparty. This does not amount to a restriction on re-hypothecation in the SFT market, but rather is aimed at increasing transparency and monitoring of risk.

As yet no revised text has been published, as the technical specifications will need to be finalised. A formal vote by Parliament on whether to adopt the proposal is expected later this year.

^{1 The credit quality provisions for eligible collateral do not appear to be correctly drafted in the Revised Draft RTS and appear to conflict with their description in the "Background and Rationale" section - we expect they will be revisited by the ESAs in the final draft and we have not attempted to summarise them here.}