Key Points
- EMIR imposes mandatory requirements for non-cleared OTC derivatives to be collateralised using Initial Margin and Variation Margin.
- The requirements will apply to financial counterparties and certain non-financial counterparties which have exceeded the clearing threshold (explained in the box below).
- EU-authorised insurers and reinsurers will be caught by the requirements, as well as EEA-authorised insurers and reinsurers once EMIR and the delegated act made under it are incorporated into the EEA Agreement.
- UCITS and AIFs managed by an EEA-authorised or registered AIFM will also be caught by the requirements.
- Certain exemptions and thresholds are available which will mitigate the impact of the rules.
- The rules, adopted by the European Commission on 4 October 2016, impose eligibility criteria, concentration limits and requirements for segregation of collateral. The adopted rules are subject to scrutiny by the European Parliament and the Council.
- Both initial and variation margin requirements will begin to apply to the largest derivative counterparties one month after the date the regulatory technical standards come into force. Best estimates are that this will be early in 2017.
- Initial Margin requirements are then phased in for other counterparties over a five year period, although variation margin will need to be exchanged for all counterparties from March 2017.
- Market participants will need to review and amend their collateral documentation to comply with the rules.
- ISDA has developed a Variation Margin Protocol and new standard credit support documentation to assist with implementation.
- If the UK remains in the EEA post-Brexit, EMIR will continue to apply within the UK. If not, the UK is nevertheless likely to adopt the margin requirements and seek an equivalence decision from the European Commission which will allow derivatives participants to trade with counterparties in the EU without having to comply with two sets of margin rules.
Current status and timing of the margin rules
This briefing summarises the current status and main provisions of the regulatory technical standards (the "RTS") on the requirements under the European Market Infrastructure Regulation (648/2012/EU) ("EMIR") for risk-mitigation techniques for non-cleared OTC derivative contracts, primarily being the requirements for exchange of collateral (the "Margin Rules").
The version of the RTS adopted by the European Commission on 4 October 2016 differs in some respects from that last submitted by the European Supervisory Authorities ("ESAs") on 8 September and as a result Parliament and the Counsel have a three month scrutiny period before the RTS come into force, during which they can veto the rules (see "Next Stages in the Legislative Process" below for further detail) although it looks likely they will not use this full period. The first margin exchange requirements will apply from one month after the RTS come into force. As things stand that date is likely to be at the end of 2016 with the rules applying from early 2017 although it could conceivably be earlier.
Once they are finalised and in force, the RTS will have a considerable impact on the commercial terms, operational processes and legal documentation for non-cleared derivative contracts.
Impact on insurers, reinsurers and asset managers
Whilst much of the discussion in the market has focused on the impact of the new Margin Rules on banks and investment firms, there has been less visible comment around what insurers, reinsurers and asset managers need to do to comply with those rules. The Margin Rules will affect insurers, reinsurers and asset managers who use OTC derivatives that are not cleared through an authorised or recognised central counterparty. In this briefing, we look at when and how such market participants must exchange margin with their counterparties.
In addition, particular issues relating to margin arise under the Solvency II Directive (2009/138/EC) ("Solvency II"), including the impact of the rules relating to the management of assets ascribed to the matching adjustment ("MA") portfolio. UK insurers may find that as a result of the Margin Rules and the PRA's view on netting in the context of the MA portfolio, they may need to repaper their trading relationships to cover separately the posting of Initial and Variation Margin both under the Margin Rules and according to whether the derivatives are within the MA portfolio or not.
This briefing discusses the adopted version of the RTS. In the event that the European Parliament or Council vetos the RTS, further changes are possible. However this is unlikely at this stage.
Key concepts – EMIR classification of counterparties to OTC derivativesEMIR categorises counterparties to OTC derivative contracts into "financial counterparties" ("FCs") and "non-financial counterparties" ("NFCs"). As well as banks and investment firms, FCs include:
An "NFC+" is an entity which is not a FC but is part of a group whose aggregate notional amount of outstanding derivatives, excluding hedging transactions, entered by NFCs within the group, exceeds the applicable "clearing threshold". The clearing thresholds are currently: (a) EUR 1 billion in gross notional value for OTC credit derivatives; (b) EUR 1 billion in gross notional value for OTC equity derivatives; (c) EUR 3 billion in gross notional value for OTC interest rate derivatives; (d) EUR 3 billion in gross notional value for OTC foreign exchange derivatives; and (e) EUR 3 billion in gross notional value for OTC commodity derivatives and other OTC derivatives not covered by points (a) to (d). An NFC- ("NFC-") is a counterparty to a derivatives contract which is neither an FC nor an NFC+. |
Use of derivatives by insurers and asset managers
Insurers use OTC derivatives for various purposes, including the following:
- to hedge the exposure of an insurer's on-balance-sheet assets to the market risk of movements in interest rates, currency values and inflation;
- to manage balance sheet exposure to corporate credit risk through the use of credit derivatives;
- to manage portfolio exposure to different asset classes and/or risks within those classes e.g. to create eligible assets for the MA portfolio;
- to offset the insurer's underwriting of the longevity risk of annuity contracts by entering a longevity swap with a bank (although this is often done instead by way of a reinsurance contract with a reinsurer); and
- to offset the mortality risk in life insurance contracts by entering a derivative with a bank (although this is often done instead by way of a reinsurance contract with a reinsurer).
Asset managers use derivatives for various purposes, including the following:
- to hedge the exposure of the fund to the market risk of movements in interest rates, currency values and inflation;
- to invest the fund in corporate credit risk through the use of credit derivatives; and
- to gain exposure to equities, bonds or other securities through use of swaps, options or other OTC derivatives, or to take positions in commodities through commodity index derivatives, each in accordance with the fund's investment strategy.
The Margin Rules
The requirements under EMIR
The RTS are made under Article 11(3) of EMIR, which provides that FCs and NFC+s must have risk-management procedures in place that require the exchange of collateral for OTC derivative contracts which are not centrally cleared. The RTS apply these risk-management requirements to any OTC derivative contract which is subject to the requirements at its inception, but not to contracts already existing before the requirements come into effect. A new transaction entered into under a pre-existing master agreement would be caught by the new requirements.
Key Concepts - when must OTC Derivative contracts be cleared?EMIR requires that OTC derivatives contracts must be cleared by a central counterparty ("CCP") if (i) they fall within a class of derivative (a "Clearing Class") which has been designated as subject to the clearing obligation by means of regulatory technical standards published by ESMA, and (ii) they are entered into between the following entities:
Authorised insurers and reinsurers established in the EU and any UCITS or AIFs managed by asset managers authorised under AIFMD (regardless of the jurisdiction of the AIF itself) will be categorised as FCs for the purpose of EMIR. OTC derivative contracts entered by insurers with other FCs (such as banks and investment firms) will require clearing. Insurers and Reinsurers outside the EU will also have to clear contracts entered with FCs and NFC+s within the EU. However, as yet, the categories of OTC derivatives which have been designated as Clearing Classes are limited to the following:
Other classes of derivative may be designated as Clearing Classes over time. However, where insurers, reinsurers and funds enter OTC derivative contracts which are not within the Clearing Classes, they will need to apply the Margin Rules unless an exemption or other opt-out is available. |
Margin requirements under the Margin Rules
In summary, the Margin Rules require counterparties to non-cleared OTC derivatives to establish, apply and document risk management procedures which include:
- a requirement to collect Initial Margin (without offsetting amounts due between the parties) and Variation Margin from counterparties to OTC derivative transactions that are not centrally cleared;
- a requirement to segregate Initial Margin and a restriction on its re-hypothecation/re-use;
- a requirement that Initial Margin in the form of cash must be held with a central bank or other third-party bank custodian;
- concentration limits for Initial Margin;
- eligibility criteria for Initial Margin and Variation Margin;
- details of calculation timing and methodology for Initial Margin and Variation Margin; and
- the use of certain exemptions and thresholds limiting the requirements to collect margin.
The Rules also require (although only in the Recitals to the RTS) that EU1 entities also post margin in respect of OTC derivative contracts with counterparties which are established outside the EU and would be subject to the rules if they were established in the EU.
These risk management procedures must be tested, renewed and updated at least annually and supporting documentation must be provided to competent authorities on request at any time.
There are various opt-outs and exemptions from the application of the Margin Rules. The possible availability of these opt-outs and exemptions to insurers, reinsurers, special purpose vehicles used by insurers and asset managers is discussed below.
What are Initial Margin and Variation Margin in a derivatives context?Initial margin ("Initial Margin") is collateral collected by a party to cover its current and potential future exposure under a derivative transaction in the interval between the last exchange of margin and (i) the liquidation of positions following the default of its counterparty or (ii) the hedging of that exposure (that period being the "Margin Period of Risk" or "MPOR"). In the existing ISDA credit support documentation, Initial Margin is represented by the "Independent Amount". Variation margin ("Variation Margin") is collateral collected by a party on a regular basis to reflect changes in market value of relevant outstanding contracts. |
Opt-out for counterparties which are NFC-s
The opt-out
In relation to both Initial Margin and Variation Margin, the risk-mitigation procedures of FCs and NFC+s may provide that no Initial Margin or Variation Margin is required for trades with NFC-s or with entities which would be NFC-s if they were established in the EU (see "Key Concepts" box above for a description of the clearing thresholds).
Accordingly, special purpose vehicles which are not UCITS or FC-AIFs, should be able to agree bilateral collateral requirements with any hedge providers without having to comply with the new rules, provided that the notional amount of OTC derivative transactions entered into by the vehicle or fund and the other NFC-s within its group remains at all times below the applicable clearing thresholds. This should be possible for many special purpose vehicles which are orphan entities, particularly as the clearing thresholds exclude certain hedging transactions entered by the vehicle and other members of its group from the calculation of the threshold notional amount.
The group test
However, if the special purpose vehicle is an on-balance-sheet entity, or is otherwise subject to the de facto control of entities within the wider insurance group, it is possible that the thresholds could be exceeded depending on the level of non-hedging derivatives activity conducted by other NFCs within the same group.
Under IFRS 10 and equivalent GAAPs, it is arguable that NFC investment funds (i.e. those other than UCITS and FC-AIFs) must be treated as part of the same "group" as other funds under common management or control. This issue has not been addressed in relation to calculation of the clearing thresholds, and it remains possible that funds which are NFCs but are under common management will be treated as part of the same group for this purpose and that their non-hedging derivatives activity must therefore be aggregated with such other funds in assessing whether the clearing threshold is exceeded.
Financial counterparties
FCs, such as insurers and reinsurers, will not be able to opt out from the Margin Rules if entering a derivative contract, including a hedge transaction, with another FC such as a bank. Therefore, either the transaction would need to be cleared or the parties will be required to collect and post margin in accordance with the Margin Rules.
IM notional amount threshold
The threshold for collection of Initial Margin
FCs and NFC+s may provide in their risk-management procedures that Initial Margin is not collected for new contracts in each calendar year where one of the counterparties has, or belongs to a group which has, an average month-end aggregate notional amount of non-cleared derivatives for the months March, April and May of the preceding year which is below EUR 8 billion (the "IM Notional Amount Threshold"). This threshold amount is subject to the phase-in requirements described below under "Phase-in of Initial Margin Requirements" so will only apply for calendar years from and including 2021.
Calculating the notional amount
When applying the IM Notional Amount Threshold, the notional amounts of all non-cleared OTC derivative contracts, including with counterparties which are permanently or temporarily exempted or partially exempted, should be included in the calculation of the aggregate notional amount. These will include currency swaps, contracts subject to the opt-outs and exempted intragroup contracts (the latter being taken into account only once). Hedging transactions must also be included, which is not the case when assessing whether the clearing threshold has been exceeded.
Treatment of investment funds
For the purpose of assessing the IM Notional Amount Threshold for an investment fund, the RTS address the concern above that management by a single manager could improperly capture individual funds in a single group under IFRS10. Consequently, the RTS provide that a fund which is a UCITS or an AIF managed by an AIFM authorised under AIFMD may be treated as a distinct entity and treated separately for the purposes of applying the IM Notional Amount Threshold where such fund (i) comprises "a distinct segregated pool of assets" for the purposes of treatment on insolvency or bankruptcy and (ii) those assets are not collateralised, guaranteed or otherwise supported by other investment funds or the investment managers – even if the fund is under common management with other funds. This means that provided the fund itself is below the IM Notional Amount Threshold it will not be required to post Initial Margin under the Margin Rules.
Phase-in of initial margin requirements
Phase-in over five years
The RTS provide that the Initial Margin requirements and Variation Margin requirements will each be phased in on a different, staggered, timetable. The Initial Margin requirements will be phased in over five years during which the IM Notional Amount Threshold reduces from EUR 3 trillion to EUR 8 billion. The Variation Margin requirements come into effect in two stages, with participants who exceed a "VM Notional Amount Threshold" of EUR 3 trillion (calculated in the same way as the IM Notional Amount Threshold) being required to implement in the first phase and all those below the VM Notional Amount Threshold being caught at the second phase.
The indicative timeline below shows our best estimate of the phase-in schedule in the light of the adopted RTS. The first set of margin requirements will apply one month after the RTS enter into force.
No phase-in of eligibility requirements
The RTS do not include a separate phase-in of the eligibility requirements for assets posted as collateral, thus derivatives documentation will need to provide for the new eligibility requirements on the date the margin requirements begin to apply to an individual insurer or fund according to the relevant phase-in schedule.
IM transfer threshold
The RTS state that the risk-management procedures of FCs and NFC+s may provide that where the counterparties are unconnected the amount of Initial Margin otherwise required to be collected by all parties in the collecting group from all parties in the posting group (or by individual parties, if neither party is part of a group) for all non-cleared OTC derivatives can be reduced by up to EUR 50 million (the "IM Transfer Threshold"). Where the counterparties are part of the same group, the IM Transfer Threshold reduces to EUR 10 million.
In calculating the IM Transfer Threshold for an investment fund, the same treatment applies as for the IM Notional Amount Threshold explained above.
Minimum transfer amount
FCs and NFC+s can also provide in their risk-management procedures that no collateral (whether Initial Margin or Variation Margin) need be collected from a counterparty where the amount due from that counterparty would be equal to or less than EUR 500,000 (or its equivalent in another currency) across all relevant transactions (the "Minimum Transfer Amount"). The Minimum Transfer Amount is assessed on a per-transfer basis. Parties can agree a lower amount than EUR 500,000, but that figure is the maximum permitted. If the amount due exceeds the Minimum Transfer Amount, the full amount must be transferred.
The RTS do not make any express provision governing how the Minimum Transfer Amount should be calculated where a fund trades with a counterparty through accounts with different investment managers. It is arguable that the strict wording of the rules therefore requires Minimum Transfer Amounts to be calculated on the basis of the legal entity, rather than at individual account level. This approach would present some operational difficulties for fund managers and their counterparties.
Other opt-outs and exclusions
The RTS also include the following opt-outs and exclusions which are relevant to insurers, reinsurers and funds:
Initial Margin: FX forwards
Counterparties' risk-management procedures may provide that no Initial Margin is required on physically settled FX forwards and swaps or on the exchange of principal and interest in currency swaps.
Variation Margin: FX forwards
There is also a delay in the application of the requirement to post Variation Margin in respect of physically settled FX forwards (Initial Margin is not required - see above) until the earlier of (i) the later of the adoption of rules defining such instruments under the Markets in Financial Instruments Directive ("MiFID II"), which is expected to be in January 2018 and the date the variation margin requirements otherwise apply, and (ii) 31 December 2018.
Equity options
The RTS also delay application of the rules to single-stock equity options or options on equity indices until three years after the rules enter into force. This is due to uncertainty as to whether these products will be subject to margin requirements in other jurisdictions and is intended to avoid regulatory arbitrage.
The rules do not prescribe how OTC derivative contracts subject to delayed implementation should be treated where they are part of the same netting set as other OTC derivatives which are within scope of the rules as soon as they come into force. Insurers, reinsurers and asset managers will need to discuss with their counterparties whether these types of derivatives should nevertheless be included in the margin model under the same credit support documentation as though they were subject to the requirements in the RTS, or whether they should be subject to a separate model under separate credit support arrangements. The ISDA Variation Margin Protocol allows counterparties to choose either of these options.
Eligible collateral
Eligible assets
Assets eligible for use as collateral include cash, gold, gilts, corporate bonds, 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 certain UCITS. Each category is subject to various credit quality thresholds and cannot include assets with significant positive correlation with the creditworthiness of the posting party. Collateral cannot therefore consist of securities issued by the posting party or any member of its group.
Haircuts
Collected collateral is also subject to haircuts, either on the basis of standard discounts set out in the RTS or the parties' own estimates based on prescribed requirements. The standard haircuts are based on rating, residual maturity and type of collateral and range 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 certain securitisation positions.
Concentration limits
Under the RTS, concentration limits apply to assets transferred as Initial Margin but not to those transferred as Variation Margin.
Single-issuer limits
For an individual counterparty, corporate bonds or equities of the same issuer (or group) collected as Initial Margin may make up a maximum of the greater of (i) 15 per cent of the collateral collected from that counterparty and (ii) EUR 10 million or its equivalent in another currency. This limit applies to debt securities issued by credit institutions or investment firms in addition to the limit described below.
Limits on securities issues by banks and investment firms
Furthermore, assets collected as Initial Margin consisting of (a) certain equities issued by institutions subject to the Capital Requirements Regulation (575/2013/EU) ("CRR") (i.e. banks and certain investment firms); and/or (b) convertibles issued by such institutions; and/or (c) securitisation positions, may constitute a maximum of the greater of (i) 40 per cent and (ii) EUR 10 million or its equivalent in another currency of the collateral posted as Initial Margin. This limit also applies where those assets are included in a UCITS.
Exception for public-sector debt
Separate concentration limits applies to collateral consisting of central-government debt, certain other public-sector debt and the debt securities of certain multi-national development banks and other international organisations. For these instruments a 50 per cent single-issuer (or issuers domiciled in the same country) concentration limit applies to individual counterparties collecting from an individual counterparty if the Initial Margin to be collected is in excess of EUR 1 billion, and the limit applies to the excess over EUR 1 billion. This will allow those insurers, reinsurers and asset managers who use derivatives to a lesser extent to continue using solely sovereign debt as collateral and requires only entities with larger OTC derivative portfolios to diversify such collateral. Occupational pension funds are exempt from these limits on public sector debt even if they are collecting Initial Margin in greater amounts than EUR 1 billion.
Exception where collateral is the same asset class as the reference asset
The RTS allow the collecting party to disapply the diversification requirements above where collateral is collected in the form of an asset class which is the same as the underlying asset class of the derivative contract. This allows margining using assets as collateral which effectively provide a hedge to cover a derivative exposure to movement in the market value of that asset.
Limits relating to cash
Where Initial Margin is collected in cash, the 50 per cent concentration limit for exposure to assets of a single public sector issuer, or issuers domiciled in the same country, must also include the exposure to a third-party custodian holding that cash. This appears to mean, for example, that if collateral is posted in the form of bonds issued by Country A and cash which is held by ABC Bank in Country A, that collateral in aggregate can only form 50% of the total initial margin over EUR 1 billion.
Segregation of initial margin
The RTS require collateral collected as Initial Margin to be segregated as follows:
- where the collateral is held by the collecting counterparty, it must be segregated from the other proprietary assets of the collecting party;
- where collateral is held by the posting party, it must be segregated from the other proprietary assets of the posting party; and
- where collateral is held on the books and records of a custodian or other third party, it must be segregated from the proprietary assets of the third-party holder or custodian (the "Account Bank").
The posting party must also be given the option to have Initial Margin individually segregated from that of other posting parties.
"Segregation" in each case must be effected either on the books and records of the Account Bank or via other legally binding arrangements "so that the Initial Margin is protected from the default or insolvency of the collecting counterparty". Where Initial Margin is held with the posting party, it must be held in "insolvency - remote custody accounts".
Return of collateral
The RTS also contain a requirement that Initial Margin is available to the posting party in a timely manner on the default of the collecting party. In practice, all collateral arrangements which do not involve title transfer will require the collecting party to be granted an effective security interest over the collateral. Security documents do not ordinarily provide for automatic release of security on default of the collecting party. The collecting party may be the party owed a net termination payment under the master derivative documentation, therefore the security over the collateral would usually remain in place until the final payment is made. It appears that the intention implied in the Margin Rules must therefore be to require release of collateral back to the posting party only once it has discharged its obligations under the secured transactions, and this is the approach being taken in the new draft English Law Initial Margin Credit Support Deed published by ISDA.
Cash collateral
As cash is difficult to segregate, the RTS require that cash collateral posted as Initial Margin must be held in accounts maintained at central banks or with an Account Bank which is an EU credit institution or a credit institution authorised in a third country whose supervisory and regulatory arrangements have been found by the Commission to be equivalent to those in the EU in accordance with CRR.
The RTS provide that the Account Bank should not belong to the same group as either of the parties. The collecting party is required to take into account the credit quality of the prospective Account Bank in deciding whether to appoint it, but without solely relying on external ratings. It appears that cash could be posted into an account of the collecting party with an Account Bank on a title transfer basis, so that such margin could be applied in any netting or set-off calculations under the relevant master agreement upon a default or insolvency of either party. However, the cash must be held in such a way as to be available to the posting party in a timely manner in case the collecting counterparty defaults. The approach taken by the new English law Initial Margin CSD published by ISDA is for cash to be credited to a custody account in the name of the posting party, which is subject to a security interest in favour of the collecting party. Cash collateral will remain open to the risk of default of the Account Bank although the 50 per cent limit explained above goes some way towards mitigating this risk for larger collateral exposures.
Cash collateral posted as Initial Margin may be re-invested where the Account Bank is a credit institution which is not able to segregate cash collateral.
Legal review of effectiveness of netting and segregation
The Margin Rules also require that segregation and netting arrangements governing the exchange of margin are appropriately documented prior to trading. An "independent legal review" is required in order to confirm that each of the netting and segregation arrangements are effective. These reviews may be carried out either by an external third party or by an independent internal unit. On request of the competent authority, counterparties must also provide documentation supporting the effectiveness of segregation in each relevant jurisdiction and set up policies ensuring continuous compliance with the segregation requirements.
Specific rules apply where the legal review concludes that the netting arrangements may not be enforceable in a particular jurisdiction, but it is unlikely that a European insurer, reinsurer or fund would have a derivatives counterparty in such jurisdictions, as it will usually transact with a major US, UK or European bank.
Ban on re-hypothecation
Collected Initial Margin may not be re-hypothecated, re-pledged or otherwise re-used. This ban prevents the collateral taker from re-using the collateral for other purposes such as repo or securities-lending transactions. However, there is a carve-out for the re-investment of cash collateral by a credit institution where required because of the difficulties with segregating cash outlined above.
Calculation of margin and modelling
Initial Margin is to be calculated upon the occurrence of certain events set out in the Margin Rules, such as the execution of a new transaction or a payment / delivery under an existing transaction. For large portfolios or counterparties that trade frequently, this may effectively mean that Initial Margin has to be calculated daily (which is the requirement for calculation of Variation Margin).
Certain occupational pension schemes are permitted to calculate Initial Margin less frequently than other counterparties. Provided that an occupational pension scheme has, in the preceding three months, not collected Initial Margin of EUR 800 million or more from any individual counterparty, the scheme may calculate its Initial Margin requirement only once every three months, rather than the business day following the triggers applicable to other counterparties for Initial Margin calculation (e.g. the execution of a new contract within the netting set). This provision does not appear to remove the obligation of the pension scheme's counterparty to calculate Initial Margin more frequently, therefore, as drafted, the pension scheme may still be required to post Initial Margin on a more frequent basis.
In order to calculate Initial Margin, counterparties may use either the standardised approach set out in the Margin Rules or a model developed by one of the counterparties or a third party. The characteristics of any Initial Margin model and the data to be used must be agreed with the other counterparty to the trade. The rules do allow each counterparty to use a different model, although this may prove to be impractical. The standardised approach is less flexible and is likely to require more collateral in general than a bespoke Initial Margin model. However, many smaller derivatives users, including some asset managers, may not have the capability to create their own internal margin models. To address this, ISDA launched a standard Initial Margin model (ISDA SIMM™) (see "Initial Margin models" below).
Collection of margin
Under the Margin Rules, both Initial Margin and Variation Margin are to be provided within the same business day as the calculation date (although additional time is permitted where required because of time zone differences between counterparties). We understand that the Commission distinguished "providing" margin from "collecting" margin, with the intention to follow the language used in the Financial Collateral Directive, under which "provision" of collateral equates to collateral "being delivered, transferred, held, registered or otherwise designated so as to be in the possession or under the control of the collateral taker or of a person acting on the collateral taker's behalf." It may be that an irrevocable instruction by the posting party to a third party custodian could be sufficient to meet this test, but this will depend on how the collateral is held and the account structure.
Variation margin may instead be provided within two business days of calculation where the initial margin already collected has been adjusted to account for the greater margin period of risk ("MPOR") of doing so. If the collecting party is not required to collect initial margin under the Margin Rules, T+2 settlement will only be available if the collecting party does in fact collect initial margin in the manner required by the rules, including the adjustment for the additional margin period of risk.
Collateral management requirements
Each collecting party must have in place certain risk-management procedures with respect to collected margin. These must ensure:
- that assets held as collateral are valued daily;
- that legal arrangements are put in place which allow access to collateral if held by a third-party custodian;
- that Initial Margin is held in appropriately segregated custody accounts;
- that cash accounts used to hold cash collateral are maintained with a central bank or third-party credit institution authorised under CRR for the holding of Initial Margin in cash;
- that unused collateral can be made available to the insolvency official of the defaulting party;
- that, in the event of default of the collecting counterparty, Initial Margin is freely transferable in a timely manner back to the posting party; and
- that non-cash collateral is transferable without any regulatory or legal constraints or third-party claims, including those of a liquidator or the collecting counterparty or custodian, other than liens for fees and expenses incurred in providing the custody account or otherwise routinely imposed by clearing systems in which the collateral is held.
The requirement for daily evaluation may mean a change in practice for longevity swaps (if structured as an OTC derivative rather than as reinsurance), where, as the underlying asset is not traded in a liquid market, current practice does not require daily margin valuation.
Trading documentation
The RTS also require the trading relationship between parties to be documented prior to or simultaneously with the entry into non-cleared OTC derivative transactions, regardless of whether the parties are required to exchange margin. As the trading relationship between insurers, reinsurers or asset managers and their counterparties will usually be documented prior to trading, this should not cause undue difficulty.
Intragroup transactions
Articles 11(6) to 11(10) of EMIR provide an exemption from the requirements to collect margin for intragroup transactions where there are no practical or legal impediments to the transfer of own funds and repayment of liabilities among entities within the group. The RTS include detailed criteria which must be met for a group to obtain this exemption.
Intragroup transactions will generally include OTC derivative contracts between an EU FC or NFC and an entity within the same consolidated accounting group or supervision group, where that other party is either also established in the EU or is subject to a third country's equivalent rules on exchange of margin. This may allow insurers entering into hedging transactions with banks in the same group to disapply the Margin Rules.
Where one of the two counterparties in the group is domiciled in a third country for which an equivalence determination under Article 13(2) of EMIR has not yet been provided, Variation Margin and Initial Margin must be exchanged for all intragroup transactions with counterparties in that third country. However, the RTS delay the implementation of this requirement in respect of Initial Margin for up to three years to allow enough time to complete the equivalence process, and enable counterparties to assess whether a contract with a group member will fall within the exemption. Otherwise, where no intragroup exemption is obtained, the requirements for exchange of both Initial Margin and Variation Margin for contracts with entities in the same group, will apply from six months after the date the RTS comes into force.
Applications for the exemption for intragroup contracts must be made according to the procedure set out in the RTS, and decisions on such applications are to be made within three months of receipt of all relevant information.
Effect of the Solvency II Matching Adjustment Portfolio on collateral managementArticle 77b of Solvency II allows insurers to use the Matching Adjustment ("MA"), with approval from their supervisors, if they assign and manage separately a portfolio of bonds or assets with similar cash-flow characteristics ("MA Portfolio") to a portfolio of insurance obligations ("MA Liabilities") and maintain that assignment over the life of the MA Liabilities. The MA allows an insurer calculating the technical provisions required to cover its insurance liabilities to adjust the discount rate at which those liabilities are valued. In order to qualify for the MA Portfolio, the assets must meet certain criteria to ensure that the matching of asset and liability cashflows is maintained. The portfolio must also be managed separately from other assets of the insurer. Although no legal ring-fencing is required – such as a security interest or SPV structure – assets in the MA Portfolio cannot be used to cover losses arising in the non-MA business of the insurer. In the UK, the PRA has taken the stance that this means there can be no netting of collateral across the MA and the non-MA portfolios, as this would conflict with the requirement to manage the MA Portfolio separately. As insurers routinely use OTC derivatives to match asset and liability cashflows, this position presents certain difficulties. Where derivatives in the MA Portfolio have a net positive market value and those in the non-MA portfolio have a net negative market value, the ability to net the amounts against each other to create a single margin amount due may be lost. Furthermore, the close-out netting provisions of the ISDA Master Agreement would be likely to fall foul of the PRA's rule if the net amount is calculated by reference to the replacement cost of derivatives in the non-MA portfolio as well as the MA Portfolio. Thus where the insurer would, prior to the introduction of the Solvency II requirements, have executed a single ISDA Master Agreement with its bank counterparty, it may now have to separate derivative transactions within the MA Portfolio from those in the non-MA portfolio, and collateralise each with a separate pool of assets. |
Grandfathering
The recitals to the RTS state that the Margin Rules will only apply to new contracts entered into after the relevant phase-in dates (see timeline above). Parties to OTC derivative contracts entered into before those dates will need to choose whether to amend their existing documentation to apply the new rules across all of their OTC derivative contracts with a counterparty or enter into new documentation to apply the new rules only to new trades.
Interaction of the rules with non-EU regimes
The RTS include certain rules that will be relevant if European insurers, reinsurers or asset managers transact with non-EU counterparties.
The RTS aim to remove some of the inconsistencies between international rules for the margining of non-cleared derivative transactions, by extending the scope of contracts caught by the rules to contracts which do not fall within the EMIR definition of OTC derivatives. Where a counterparty is domiciled in a third country using a definition of OTC derivative contracts that is different from that used in EMIR, counterparties must calculate margin for all contracts that fall within either the EMIR definition of OTC derivative contract or the definition used in the third country provided that the counterparty domiciled in the third country is subject to margin requirements. For the purposes of calculating the margin, where a netting agreement is in place between two counterparties, one of which is domiciled outside the EU, that agreement has to meet the same conditions that it would have to meet if both counterparties were domiciled in the EU.
Brexit and the margin rules – equivalence provisions
Until the post-Brexit model is established it is difficult to predict what is likely to be the effect of the UK's decision to leave the EU on the application of the Margin Rules. If the UK remains in the EEA, margining obligations which apply to UK-based derivatives counterparties under EMIR will continue to apply, assuming that EMIR is (as expected) incorporated into the EEA Agreement.
If the UK does not remain in the EEA and therefore becomes a "third country" for EMIR purposes, EMIR will no longer apply under UK law unless the UK adopts legislation preserving the status quo. Given that the UK is a G20 member and a member of the Basel Committee on Banking Supervision ("BCBS"), the UK is likely to transpose EMIR and its related secondary legislation into domestic legislation so that the obligations which apply to UK-based derivative counterparties under EMIR would continue to apply.
In these circumstances, EMIR will also stll apply to any EEA-based counterparty of a UK entity, so that trades with an EEA-based entity would still need to comply with the margin rules under EMIR. This could mean that counterparties have to comply with two sets of margining rules – the UK domestic rules and those under EMIR.
However, Article 13 of EMIR provides that the Commission may adopt implementing acts declaring that the legal, supervisory and enforcement arrangements of a third country are equivalent to the margin requirements laid down in EMIR and are being effectively applied and enforced so as to ensure effective supervision and enforcement in that third country. If the UK were to become a third country, an equivalence decision would be required in order to prevent counterparties to OTC derivative transactions from having to comply with two, possibly conflicting, sets of margining rules.
Where such an equivalence decision is made, counterparties to derivatives transactions will be deemed to have fulfilled the EMIR margin requirements where at least one of the counterparties is established in that equivalent third country. This means that compliance with only one set of rules is required (i.e. the EMIR margin rules or the equivalent third country’s margin rules). This would mean that, post-Brexit, a UK entity transacting with an EU counterparty would need to comply with the UK margin rules or the EU margin rules but not both, provided an equivalence decision is made by the Commission and provided that (if the parties choose to apply the EU rules) the UK continues to recognise the EU rules as equivalent to those applying within the UK.
What do insurers and asset managers need to do to prepare?
Credit support documentation
In the immediate future, various terms of existing credit support documentation will require modification, including eligible collateral, collateral haircuts, timing of calculation, and collection and dispute resolution provisions.
As the Initial Margin requirements are phased in, the market is moving away from title transfer arrangements, such as the ISDA English law Credit Support Annex ("CSA"), towards security arrangements, such as the ISDA English law Credit Support Deed ("CSD"), given the requirement to ensure that an entity posting Initial Margin is sufficiently protected in the event of the insolvency of the collecting counterparty. Title transfer arrangements are less problematic for Variation Margin, as the segregation and protection requirements do not apply. Counterparties are likely to want to separate the credit support documentation for Variation Margin from that used for Initial Margin as a result.
Working groups coordinated by ISDA have published documentation to comply with the new requirements and are taking this approach. The new documents include:
- a new form of English law CSD for Initial Margin;
- a new form of English law CSA for Variation Margin;
- a self-disclosure form that will be available through ISDA Amend and will facilitate counterparty classification in order to determine whether and when the Margin Rules apply; and
- a Protocol which will allow adhering parties to amend, replicate and amend, or enter into new ISDA CSAs to comply with the requirements in relation to Variation Margin.
ISDA is also aiming to allow for equivalent rules in the US and Japan to be incorporated consistently by market participants without the need for individual re-negotiation of ISDA Master Agreements and CSAs. Currently, the New York law governed Credit Support Annex (the "NY CSA") provides for the transfer of both Initial and Variation Margin and creates a security interest over each. The new form of NY CSA will be split into two, so that segregation requirements can be complied with for Initial Margin.
For any one trading relationship governed by English law, many market participants will aim to retain their existing English law CSA for legacy transactions and (i) in respect of Variation Margin, to implement a new English law CSA for compliance with the Margin Rules for new transactions and (ii) in respect of Initial Margin, to implement a new English law CSD for compliance with the Margin Rules. Parties may also wish to create a new English law CSA for bilaterally agreed Initial Margin for new transactions, which are outside the current scope of the Initial Margin requirement. ISDA has also published a version of the English Law CSA which provides for exchange of Variation Margin in compliance with the margin rules, whilst also providing for exchange of Initial Margin on a non-regulatory basis (i.e. where Initial Margin is not required to be exchanged in compliance with the margin rules).
Custody and collateral management arrangements
In order to segregate Initial Margin, counterparties will need to set up accounts with Account Banks and tripartite custody agreements or account control 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 rather than the standardised approach included in the RTS will need to implement a model which complies with the detailed requirements of the 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.
ISDA has recently launched an Initial Margin model (ISDA SIMM™) with the aim of creating an industry-standard Initial Margin model for use by all market participants and has published provisional documentation on its website. Service providers may acquire the right to use ISDA SIMM™ through a licence from ISDA. The hope is that this will create a single framework for licensed counterparties to calculate Initial Margin, thereby enabling them to use an Initial Margin model which may otherwise be beyond their internal operational capability and reducing the potential for disputes.
Risk-management procedures
Insurers, reinsurers and asset managers will need to ensure that provision is made in their risk-management procedures for the opt-outs discussed above to take effect.
Next stages in the legislative process
As the Commission has adopted a draft inconsistent with that submitted by the ESAs, Parliament and the Council will have a window of three months (extendable by a further three months at the initiative of either Parliament or the Council) to veto the final draft, after which the adopted RTS will be published in the Official Journal of the European Union and enter into force 20 days thereafter. Whilst the final timetable for implementation cannot yet be confirmed, we understand that the ECON Committee of the Parliament has released an early notice of no objection. If this is approved by the full Parliament and followed by the Council, it could mean that the RTS are published in the Official Journal earlier than the end of the three month scrutiny period. This would mean the first margin exchanges could take place in January 2017.
International standards
The RTS state that they are fully aligned with the BCBS/IOSCO Margin Framework. However, the ESAs continue to follow the work of the expert group that the BCBS and IOSCO set up to monitor the implementation of the margin framework in various jurisdictions. There may, therefore, be further changes to these requirements in the future.
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