Initial Margin Implementation under EMIR and the ISDA 2018 Credit Support Deed (for IM)

Introduction

The International Securities and Derivatives Association ("ISDA") recently published the 2018 Credit Support Deed for Initial Margin (IM) (the "2018 IM CSD"), which is designed to facilitate the exchange of initial margin between relevant counterparties under applicable margin rules as they are phased in over the next two years.

The 2018 IM CSD is closely based on the ISDA 2016 Phase One IM Credit Support Deed (the "2016 IM CSD"), which had been developed to assist parties subject to the first phase of initial margin requirement implementation on 1 September 2016 and was also used by parties on the second and third phases of implementation (see "Implementation Timeline" below).

In this briefing, we give an overview of the key initial margin requirements under the European Market Infrastructure Regulation (EU) 648/2012 ("EMIR") and the regulatory technical standards contained in Commission Delegated Regulation (EU) 2016/2251 (the "EMIR Margin Rules") as well as some of the main features of the 2018 IM CSD. We also highlight some key points for parties to consider as they plan for the next phases of initial margin implementation.

Background

What is initial margin?

Initial margin is, in essence, a volatility buffer – it is defined under the Margin Rules to be the collateral collected by one party to cover its current and potential future exposure in the interval between the last collection of margin and (i) the liquidation of positions or hedging of market risk following a default of the other party or (ii) the hedging of that exposure.

General requirement to collect initial margin

EMIR introduced the requirement that parties to a non-cleared OTC derivative contracts ensure the timely, accurate and appropriately segregated exchange of collateral between the parties to non-cleared OTC derivative contracts. Further specifications specific to initial margin are set out in the EMIR Margin Rules including, requirements for collateral agreements, collateral eligibility criteria, collateral concentration limits, calculation methodologies, segregation requirements and phase-in thresholds.

The phase-in thresholds, which must be exceeded by both parties in order for the initial margin requirements under the EMIR Margin Rules to apply, are calculated by reference to the outstanding aggregate average notional amount of all non-centrally cleared OTC derivatives of that party's group of companies measured at the last business day of March, April and May in the relevant year ("IM Notional Amount Threshold").

Implementation timeline

 

Requirements applicable to exchange of initial margin

The principal requirements under the EMIR Margin Rules applicable to the exchange of initial margin are:

• the collateral agreement must cover certain prescribed matters, including segregation arrangements (which are subject to an independent legal review);
• initial margin is to be valued daily using prescribed calculation and valuation methods;
• the collection of initial margin is to be done on a same-day basis without offsetting of initial margin amount between the counterparties;
• collateral constituting initial margin must meet the eligibility criteria in respect of permitted asset type and comply with specified concentration limits;
• collateral collected as initial margin must be segregated from the collecting party's other proprietary assets or those of the custodian, as applicable;
• collateral collected as initial margin must be available to the posting party in a timely manner following the default of the collecting party;
• cash collateral collected as initial margin must be held at a third party account bank that is an EU credit institution or the equivalent thereof in a third country whose supervisory and regulatory regime is recognised as equivalent and may be reinvested by the account bank where the account bank cannot hold such cash collateral on a segregated basis;
• where a third party holds the collateral collected as initial margin, the collateral holding structure must allow access to the collateral; and
• the collateral taker cannot rehypothecate, re-pledge or other reuse the collateral except where reinvested.

Exemptions to the obligation to collect initial margin

Parties to certain OTC derivative contracts are exempt from, or are out of scope of, the requirement to collect initial margin.  The main exemptions other than the IM Notional Amount Threshold referred to above are as follows:

• foreign exchange forwards, foreign exchange swaps and currency swaps are excluded from the obligation to collect initial margin;
• interest rate or currency hedges in respect of covered bonds where certain structural features are complied with;
• where the amount due from that counterparty would be equal to or less than EUR500,000 (or its equivalent in another currency);
• where the counterparties are unconnected and the amount of initial margin required to be collected from all parties in the posting group is equal to or less than €50,000,000 (or its equivalent in another currency) and where parties are part of the same group, the threshold is €10,000,000 (or its equivalent in another currency);
• intra-group transactions where there is (a) no practical or legal impediment to the transfer of capital or payment of liabilities between the counterparties and (b) the risk management procedures of the counterparties are adequate and consistent with the complexity of the transaction, and the competent authority has determined that to be the case or it has been notified and does not disagree;
• certain non-cleared OTC derivatives transactions entered into by central counterparties; and
• where the netting set exclusively consists of options under which the premiums are paid up front.

ISDA 2018 Credit Support Deed For Initial Margin (IM)

The 2018 IM CSD takes on board some of the experiences that parties have had in negotiating the 2016 IM CSD in phases 1 to 3 of the implementation of initial margin requirements and provides more flexibility through a larger number of elective provisions to account for the broader range of counterparties that will be subject to phases 4 and 5.

We discuss some of the key features of the 2018 IM CSD and their interaction with the initial margin requirements under the EMIR Margin Rules in this section 3.

Required contents of Collateral Agreement under EMIR Margin Rules

As mentioned above, the EMIR Margin Rules require the documentation regulating the collection of collateral to contain as a minimum the following:

• the levels and type of collateral required;
• the segregation arrangements;
• the netting set to which the exchange of collateral refers;
• the procedures for notification, confirmation and adjustment of margin calls;
• the procedures for settlement of margin calls for each type of eligible collateral;
• the procedures, methods, timeframes and allocation of responsibilities for the calculation of margin and the valuation of collateral;
• the events that are considered to be default or termination events; and
• the law applicable to the non-centrally cleared OTC derivative.

The 2018 IM CSD has been developed through an ISDA working group with a view to enabling parties to comply with these requirements.  The 2018 IM CSD, like the 2016 IM CSD, also contains provisions designed to comply with the principal margin requirements of, among other regimes, the EMIR Margin Rules, including daily valuation, same-day delivery and timing of posting of undisputed amounts. We do not discuss those provisions in significant detail below.

As mentioned above, parties are obligated to perform an independent legal review of the collateral exchange arrangements and the segregation arrangements contained therein to ensure their enforceability and compliance with the EMIR Margin Rules.  ISDA has published collateral opinions covering the enforceability of the rights of the collateral provider and the collateral taker respectively under English law, among others, and the 2016 IM CSD.  We expect that ISDA will revise those opinions to cover the 2018 IM CSD.

Covered Transactions

The scope of transactions that are included in the determination of the Margin Amount (IM) under the 2018 IM CSD is limited to each Covered Transaction, which is defined as an outstanding transaction which is subject to initial margin collection or delivery requirements under the Regime(s) elected by each party (or the relevant party if the 2018 IM CSD is specified as being one-way).  Under the 2016 IM CSD, Covered Transactions also included "Additional Types" of transaction under Regimes not yet in effect but this has been removed from the 2018 IM CSD as the Regimes in most significant jurisdictions for derivatives trading are now in effect.

Parties may also elect to exclude any Covered Transaction from the scope of transactions under any other credit support annex, credit support deed or collateral transfer arrangement.  This exclusion was automatic under the 2016 IM CSD but the change to make it elective recognises that parties may have existing initial margin arrangements in place that they wish to preserve, for example, because they are more stringent that the Margin Amount (IM) that would be calculated under the 2018 IM CSD.

Margin Amount (IM)

Delivery Amounts and Return Amounts under the 2018 IM CSD are determined by reference to the Credit Support Amount (IM), and how that amount is determined depends on the Margin Approach the parties elect.  There are three Margin Approaches:

1. the Distinct Margin Flow (IM) Approach, which represents a standard formulation, where the Credit Support Amount (IM) is Margin Amount (IM) minus Chargor's Threshold;
2. the Allocated Margin Flow (IM/IA) Approach, which also uses the standard formulation to determine the Credit Support Amount (IM) but provides for the Chargor's posting obligation with respect to the sum of all Independent Amounts determined under other collateral agreements (the "Margin Amount (IA)") to be reduced by the Credit Support Amount (IM); and
3. the Greater of Margin Flow (IM/IA) Approach, where the Credit Support Amount (IM) is the greater of (i) Margin Amount (IM) minus Chargor's Threshold and (ii) the Margin Amount (IA).

The Margin Approach that parties will want to apply will therefore depend in large part on what existing collateral arrangements they have in place under which they collect Independent Amounts and to what extent those arrangements already contemplate the parties collecting regulatory required initial margin under a separate agreement, such as the 2018 IM CSD.

The Margin Amount (IM) is defined with respect to a Chargor's posting obligation as the amount of initial margin required under a Regime in respect of the Covered Transactions (IM) determined using the Method, being ISDA SIMM^TM or, if SIMM Exception is specified with respect to such Chargor, such other calculation methodology specified by such party.  If more than one Regime applies, the Margin Amount (IM) is the greatest amount determined under each applicable Regime.

Security Interest

Each party as Chargor creates security by way of first fixed charge over the collateral and the collateral account and by way of assignment of all rights in the collateral.  The 2018 IM CSD also contains:
(a) a negative pledge which restricts the Chargor from creating or allowing to subsist any other security interest over or dispose of any right in the collateral, the collateral account or the assigned rights; and
(b) a prohibition on the Chargor selling, pledging, rehypothecating, assigning or investing the collateral or registering the collateral in the name of the Secured Party or the custodian in line with the EMIR Margin Rule requirement.

The 2018 IM CSD provides for the collateral to be released from the security interest and transferred by the custodian to the Chargor only following instructions from the Secured Party, following delivery of a Chargor Access Notice under the Control Agreement or otherwise as agreed by the parties.  A Chargor Access Notice can only be delivered upon the occurrence of a Chargor Rights Event, which is the designation of an Early Termination Date as a result of an Event of Default or a specified Termination Event with respect to the Secured Party.

If Chargor Full Discharge Condition is specified as applicable, a Chargor Rights Event will not occur until the Chargor has delivered a calculation statement under Section 6(d) of the ISDA Master Agreement and no Early Termination Amount is or remains payable by the Chargor or such amount is payable by the Chargor but will be satisfied in full by delivery of Posted Collateral (IM) to the Secured Party.  The Chargor Full Discharge Condition applies as standard under the 2016 IM CSD and the ability to elect not to apply it is new to the 2018 IM CSD.  This allows parties to take a view as to whether the EMIR Margin Rules requirement to return collateral in a timely manner should be construed as requiring a return where the Chargor still owes secured obligations, notwithstanding that that could make the analysis more complex as to whether or not the Secured Party has sufficient "control" over the collateral to establish a fixed charge.  Parties can also elect to apply the Cooling-off Period Condition, which applies an additional two business day period before the Chargor Rights Event occurs.

Transfers of Collateral

The provisions of the 2018 IM CSD relating to the calculation, transfer and substitution of collateral are largely unchanged from the 2016 IM CSD and consist principally of provisions:

1. providing conditions precedent to the delivery and return of collateral, being no Events of Default, Potential Events of Default or specified Termination Events having occurred and continuing;
2. specifying the means of transfer of collateral (i.e., book-entry, wire transfer or other means);
3. legislating for the same-day transfer of collateral in line with the EMIR Margin Rules, subject to notification being made by agreed cut-off times, and requiring the Secured Party to instruct the custodian prior to the custodian's cut-off times for same-day transfers;
4. on the timing of calculations made by the Calculation Agent and the information the Calculation Agent may use in performing those calculations;
5. permitting substitutions of collateral to be effected, subject to consent of the Secured Party (if consent is elected as applicable) and subject to the Secured Party having received the substitute collateral prior to being obligated to instruct the Custodian to return the collateral being substituted; and
6. addressing ineligible collateral, which upon notice is valued at zero from the specified Ineligibility Date and the Chargor has five Local Business Days to replace it prior to the Secured Party being able to designate an Event of Default or treat the circumstance as a Potential Event of Default.

Relationship with Custodian

There are a number of provisions in the 2018 IM CSD, like the 2016 IM CSD, which reflect the introduction of a third party custodian into initial margin collateral arrangements.  These provisions cover matters such as instructions to the custodian to deliver or return collateral, dealings with the collateral accounts, notification mechanics and cut-off times to effect transfers of collateral.

In particular, Paragraph 6 of the 2018 IM CSD requires each party as Chargor and as Secured Party together with the custodian to enter into a control agreement that regulates the mechanics of giving instructions to the custodian, interest and dividend payments and voting rights.  Paragraph 6 also allocates liability for the acts and omissions of the custodian to the Chargor and provides that such acts or omissions are treated as acts or omissions of the Chargor for the purposes of defaults under Paragraph 7 of the 2018 IM CSD.  The parties can, however, specify certain acts or omissions of the custodian as constituting a Custodian Event, which entitles the Chargor to identify a replacement custodian within a prescribed time frame or, failing that, to terminate the related ISDA Master Agreement pursuant to an Additional Termination Event.

The parties can also elect whether or not:

1.  the control agreement is a Credit Support Document (which is particularly relevant to the Event of Default under Section 5(a)(iii) (Credit Support Default) of the ISDA Master Agreement);
2. the provisions of the 2018 IM CSD prevail over the control agreement; and
3. they agree to certain actions and determinations that are performed in accordance with the control agreement being recognised as satisfying equivalent obligations under the 2018 IM CSD, including with respect to substitutions, custodian valuations, service of demands, instructions to the custodian and return or delivery in lieu obligations of the Secured Party.

Defaults and enforcement

While a Custodian Event, if applicable, will not constitute an event of default under the ISDA Master Agreement, Paragraph 7 of the 2018 IM CSD amends Section 5(a)(iii) (Credit Support Default) of the ISDA Master Agreement to include:

1. failure of collateral delivery by the Chargor (with a grace period of 2 days);
2. failure of the Secured Party to instruct the custodian to return collateral to the Chargor (with a grace period of 2 days); and
3. a failure to perform any obligation under the 2018 IM CSD other than those in (a) and (b) (with a grace period of 30 days).

The 2018 IM CSD gives the Secured Party a range of rights and remedies following a Chargor default that are typical for English law security agreements, including a right of appropriation (to the extent the 2018 IM CSD constitutes a "security financial collateral agreement" under the Financial Collateral Arrangements (No.2) Regulations 2003), a security power of attorney and a right to appoint a receiver.  

Key Points To Consider

Parties that will be subject to phases 4 and 5 of implementation of the initial margin requirements and phase 1 to 3 parties that need to negotiate margin-rule compliant documentation with phase 4 and 5 counterparties will need to consider:

1. the impact of Brexit on their trading relationships and identifying the group entities that will be involved in implementing the contractual negotiations;
2. whether they wish, or will be required by their counterparties, to adhere to one of the electronic platforms through which initial margin negotiations can be undertaken (several of which provide free access for buy-side parties);
3. which custodian they will use for initial margin purposes and the steps required to get their custodial arrangements in place;
4. where the 2018 IM CSD is used, their preferred elective positions thereunder; and
5. whether their custodian relationship and documentation may necessitate a "transfer-only" version of the 2018 IM CSD – for example where parties wish to apply the governing law of the ISDA to the mechanical and operative aspects of their collateral relationship and a different governing law to the grant of security over the custody account and collateral therein.