BCBS/IOSCO Second Consultation Paper and its implications for EMIR1
Much of EMIR is now coming more clearly into focus. But a major unknown has for a long time been the question of margin requirements for uncleared OTC derivatives.
Will there be universal initial margining, how will it be calculated, will thresholds be permitted, what will count as eligible collateral, will letters of credit be included and, if so, on what basis? These and many other questions remain unsettled.
These questions are internationally significant, as policy-makers across the world seek to agree a general set of standards for derivatives market reforms. The International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision (BCBS) are tasked with reaching an internationally agreed set of principles on these questions and the EU position will follow once the BCBS/IOSCO "policy framework" is settled.
BCBS/IOSCO issued a first consultation in July 2012, following which, amid concerns about the liquidity impact of the margining proposals, they conducted a quantitative impact study (QIS) and revised their proposals.
Eight principles on which these revised proposals will be based are now set out in a second BCBS/IOSCO consultative paper (the Paper) published on 15 February for comment by 15 March.
The Paper describes itself as a "near-final proposal", seeking views in only four areas:
the treatment of FX forwards and swaps;
whether initial margin may be reused, repledged or rehypothecated;
the proposed phase-in timetable and thresholds; and
the adequacy of the QIS, which is summarised in the Paper.
Despite this, the expected regulatory technical standards on margin requirements for uncleared OTC derivative (the RTS) are likely to be further delayed well beyond Q1 2013, as they will follow the delivery of BCBS/IOSCO’s final report.
The other areas covered by the Paper are stated to be broadly agreed. However, they do leave some significant areas of uncertainty and there is ample potential for divergent regulatory approaches internationally.
KEY POINTS IN SUMMARY
Only between systemically-important entities: BCBS/IOSCO intend margin requirements to apply to all financial firms and systemically-important non-financial entities (covered entities), when they deal with each other, but not when they deal with other parties.
Implementing this principle will be a matter for local regulators. In Europe, this raises the issue of the interpretation of article 11(3) of EMIR. When will "financial counterparties" (FC) and "non-financial counterparties over the clearing threshold" (NFC+) be required to exchange margin? This will need to be clarified in the expected RTS.
Under the BCBS/IOSCO principle, FC/NFC+ would not need to take margin when dealing in uncleared OTC derivatives with "non-financial counterparties under the clearing threshold" (NFC). The position vis-à-vis third country firms (TC) when those firms are systemically important is doubtful and may require clarification.
Intra-group transactions: The Paper falls seriously short on the question of intra-group transactions. Effectively it leaves it as a matter for local regulatory policy whether uncleared intra-group transactions should be subject to margining requirements.
This leaves scope for local regulators to take different approaches, increasing uncertainty and the potential for regulatory arbitrage, with some requiring margin and others providing for straightforward exemptions.
This approach exposes large groups, in particular, to the risk of conflicting treatments in multiple jurisdictions. Large groups routinely transfer risk on a cross-border basis, centralising it in global or regional risk aggregators. These arrangements will need to be reviewed in the light of each relevant jurisdiction’s approach to intra-group trades and many groups may need to restructure their internal arrangements.
Conflicting regimes: The Paper briefly outlines a substitutive compliance approach to situations where the rules of competing jurisdictions may apply. The way the approach is framed is problematic and it is significant, perhaps, that it is not one of the four items on which views are sought. In summary:
General approach: Where the rules of two jurisdictions may apply and they recognise each other as being "consistent", the parties "could choose to comply with only one set of rules". International regulators are asked to allow the parties to select a jurisdiction for substitutive compliance.
Branches: A branch should be subject to the rules of the jurisdiction where its head office is located. This would mean e.g. that a UK branch of a US bank would be subject to US requirements. This is consistent with the view expressed publicly by the UK Financial Services Authority that NFCs under EMIR must be incorporated in the EEA, so that an EU branch of a US firm would be regarded as a third country entity (TC) and not as an NFC.
Subsidiaries: It appears that BCBS/IOSCO would generally regard subsidiaries as being subject to the rules of their home jurisdiction, rather than that of their parent. However, where the subsidiary is in a jurisdiction whose regime the parent’s jurisdiction does not regard as consistent, BCBS/IOSCO would apply the regime of the parent’s jurisdiction. This may be driven by an anti-avoidance concern but could have unwelcome implications for tax-efficient group structures in particular.
It is not immediately clear how the RTS will tackle these points, as the position is to some extent constrained by the Level 1 text of EMIR.
Timing and Phase-in: Neither initial nor variation margin should apply retrospectively. They should apply only to new transactions from the date they come into force.
Variation margin will apply from 1st January 2015 between covered entities (with no threshold). If a minimum transfer amount is specified, it shall not exceed €100,000.
Initial margin requirements will be phased-in and would apply to the largest entities first, with the threshold lowering gradually over a period of 4 years from 1st January 2015 up to 2019. (But for some commodity derivatives market participants, the phase-in may be overtaken by a change in status from NFC to FC, if they become subject to regulation under MiFIR/MiFID2 during 2015/2016.)
Margin thresholds may apply to initial margin up to a maximum of €50 million, calculated on a group basis.
FX products: The Paper reopens the debate whether physically-settled FX forwards and swaps should be regarded as within scope of the margin requirements and seeks views on this.
Structured derivatives: There is no indication that BCBS/IOSCO are considering the exclusion of any other category of OTC derivatives. In particular, there is no suggestion of a carve-out for structured or bespoke derivatives.
Eligible collateral: The Paper requires "eligible collateral" to be highly liquid and able to hold its value in a time of financial stress. BCBS/IOSCO conclude that setting the categories of eligible collateral is a matter for local regulators and not international agreement: although cash, high-quality securities (including high-quality government, corporate and covered bonds), equities in major stock indices and gold would "generally" be included. There is no mention of letters of credit in this context.
Margin modelling: The Paper provides for standardised and quantitative models for calculation of both initial margin and haircuts on "eligible collateral". Any models used must be approved by regulators and entities cannot "cherry pick" between standardized and quantitative models: they must be consistent in their approach. If variation margin is not exchanged daily, then the amount of initial margin required is increased.
Ring-fencing of initial margin: The Paper requires initial margin to be exchanged gross and held so that it is immediately available on a counterparty default. It must be held in a way which protects the collateral-giver, if the collateral-taker becomes insolvent: i.e. as assets which are separate and distinguishable from the assets of the collateral-taker. This increases the likelihood that the RTS will require initial margin to be held under security collateral arrangements rather than under title-transfer collateral arrangements.
Re-use of initial margin: The Paper states that cash and non-cash collateral collected as initial margin should not be re-hypothecated, re-pledged or re-used, but seeks views on limited rights of re-hypothecation.
The Paper and associated press releases are available at the links below:
IOSCO press release: http://www.iosco.org/news/pdf/IOSCONEWS267.pdf
Bank of International Settlements press release: http://www.bis.org/publ/bcbs242.htm
Consultation Paper: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD403.pdf
1 European Market Infrastructure Regulation (648/2012/EC)