Trading Non-Centrally Cleared Derivatives Under IOSCO

 

The Regulator: International Organization of Securities Commissions (IOSCO)

 

The International Organization of Securities Commissions (IOSCO) is an international body that is recognized as the global standards setter for the securities industry. IOSCO works with the G20, the Financial Stability Board (FSB), and other securities regulators and publishes directives that serve as the global framework for financial regulatory requirements. IOSCO’s stated objectives for securities regulation are to protect investors, to maintain fair, efficient and transparent markets, and to seek to address systemic risks.[1]

IOSCO publishes directives that serve as the natural starting point for international regulators. For example, in 2015 IOSCO published the final framework for “margin requirements for non-centrally cleared derivatives,” which established minimum standards for margin requirements as agreed by the Basel Committee on Banking Supervision (BCBS) and IOSCO.[2] This framework has been implemented in the United States through “CFTC Final Margin Rules” and “Prudential Regulator Final Margin ” and in Europe as the “European Market Infrastructure Regulation” (EMIR). IOSCO’s margining standards have also been implemented in APAC throughout the various jurisdictions.[3]

 

Global Margin Requirements for Non-Centrally Cleared Derivatives

 

Since the global financial crisis, a key role of IOSCO has been producing standards, guidelines, and sound practices for the regulation of derivatives. Specifically, IOSCO has worked with the Basel Committee on Banking Supervision (BCBS) to develop a policy for margin requirements for non-centrally cleared derivatives. The policy addresses several principles:

  • Initial Margin (IM) and Variation Margin (VM) must be exchanged by all financial firms and systemically important non-financial entities[4]
  • IM should be exchanged by both parties on a gross basis:
    • There is an optional IM threshold of €50 million, so that IM need not be posted if less than €50 million and if threshold is exceeded then a €50 million reduction in IM would be applicable.
    • These requirements were phased in from September 2016 to September 2020 according to volume of trades, starting with institutions trading over €3 trillion.
    • Margin must be immediately available and fully protected.
    • Firms can use a quantitative portfolio margin model (supervisor approved) or a standardized schedule to calculate IM.
  • VM: The VM must be calculated and collected frequently (i.e. daily) for all non-cleared derivatives (phased in from September 2016 – March 2017).
  • Eligible collateral: Eligible collateral includes cash; high quality government and central bank securities; high quality corporate and covered bonds; equities included in major stock indices; and gold.
  • Exemptions:
    • Products: Physically settled FX swaps and forwards are exempted from IM.
    • Counterparties: Counterparties include non-financial entities that are not systemically important, sovereigns and central banks.
  • Re-hypothecation of initial margin collateral: IM collateral can only be re-hypothecated under strict conditions. Re-hypothecation of collateral is only permitted for hedging the IM collector’s derivatives position arising out of customer transactions.
  • Main conditions:
    • The customer must express consent for re-hypothecation in writing.
    • Collateral must be segregated from the IM collector’s assets, and re-hypothecated collateral must be segregated from the third party’s assets.
    • Re-hypothecation is only permitted once. The third party is not allowed to re-hypothecate the collateral again.
    • The customer and the third party may not be within the same group.
    • The IM collector and the third party must keep appropriate records.

 

EU Adaptation: European Market Infrastructure Regulation (EMIR)

 

Overall, the European Supervisory Authority’s (ESA) regulatory technical standards (RTS) are broadly in line with the BCBS-IOSCO standard.[5] However, a few significant differences exist between the BCBS-IOSCO standard and the RTS. The RTS includes:[6]

  • A broader list of eligible collateral. The list includes debt securities issued by credit institutions and investment firms, convertible bonds, and the most senior tranche of securitizations that is not re-securitization.
  • An explicit diversification requirement. Initial margin and variation margin is subject to concentration limits to avoid counterparties becoming overly exposed to specific assets or issuers.
  • An outright ban on re-hypothecation and other re-use of collateral as initial margin.

 

The Pros and Cons of the Requirements

 

As a result of the new margin requirements, large financial institutions benefit from reduction in both counterparty and systemic risk but face significant capital and operational costs.

Margin requirements for non-centrally cleared derivatives are expected to reduce contagion and spillover effects by ensuring that collateral is available to offset losses caused by the default of a derivatives counterparty. The added burden of tying up assets as margin collateral also forces parties to have more “skin in the game.” It reduces the number of swap agreements a firm can execute, and therefore reduces the “build-up of risk that may ultimately pose systemic risk” to the financial system as a whole.[7]

The reduction of risk comes at a cost. In addition to the costs arising from the requirement for additional collateral, the new bilateral margin standard may lead to costs in terms of liquidity management and collateral optimization due to restrictions on the rehypothecation of collateral.[8] Furthermore, firms would need to maintain highly liquid, risk-free assets beyond their initial margin requirements in order to ensure that they could meet their variation margin obligations in the event of mark-to-market losses in a fast-moving market.[9]

European margin rules go a step further and define strict limits for concentration to specific asset types posted as collateral to meet uncleared derivative margin calls. If non-European firms trading with European covered entities do not also implement the EU-style concentration limit checks as part of their margin processing workflow, they risk operational challenges with rejection by their counterparty due to breaches of limits.

In addition to the capital costs, operational costs include:[10]

  • Educating counterparties and sales teams on regulatory changes,
  • Managing the balance sheet for liquidity and capital impacts,
  • Initial and variation margin computations,
  • Creating and maintaining internal ratings for counterparties for internal haircut model,
  • Management and settlement of collateral through segregated custody accounts for IM,
  • Updating client onboarding process, and
  • Negotiating new CSAs, and re-papering of existing CSAs, with counterparties in scope of regulations.

 

More Confusion: What is Considered a Derivative in Each Jurisdiction?

 

Generally, the scope of IOSCO’s margin requirements affect non-centrally cleared over the counter (OTC) derivatives.[11] However, derivatives may be defined differently across various jurisdictions.

US: For example, to-be-announced (TBA) trades relate to a distinct market in the US and are classified as spot trades (cash market trades), instead of derivatives, since they settle within the standard settlement cycle of the securities being purchased. As such, they are considered Covered Agency Transactions under FINRA Rule 4210.

EU: The definition of derivative in EMIR simply states “options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities … which may be settled physically or in cash”.[12] Since the EU has not issued a clarification of derivatives in relation to securities, it is possible that Covered Agency Transactions entered into between a U.S. registered broker-dealer and an entity subject to the requirements in EMIR will be subject to both the margin requirements under FINRA Rule 4210 and the margin requirements for non-cleared OTC derivatives under EMIR.[13]

Although TBA’s are still a mystery, the European Commission (EC) recently announced an equivalence decision which finds that the CFTC’s uncleared swap margin rules are comparable in outcome to the EU’s corresponding margin requirements for uncleared OTC derivatives.[14] This provides a little comfort for parties trading uncleared OTC derivatives from different jurisdictions who were unsure whether they would have to comply with both countries’ margin rules.

 

[1] https://www.iosco.org/about/?subsection=about_iosco

[2] https://www.bis.org/bcbs/publ/d317.pdf

[3] Australia implemented Prudential Standard CPS 226, Hong Kong implemented the Supervisory Policy Manual CR-G-14, Japan implemented the Final Margin Rules for Non-Centrally Cleared OTC Derivative, and Singapore implemented the Securities and Futures Act. http://securities.bnpparibas.com/files/live/sites/web/files/medias/documents/research-paper/broch_apac_2017-06-29.pdf

[4]https://www2.deloitte.com/content/dam/Deloitte/ie/Documents/FinancialServices/investmentmanagement/ie_2015_Linkn_Learn_Regulatory_EMIR_SFTR_Deloitte_Ireland.pdf

[5]https://www.eba.europa.eu/documents/10180/1398349/RTS+on+Risk+Mitigation+Techniques+for+OTC+contracts+(JC-2016-+18).pdf

[6] For a detailed comparison of US vs EU margin rules see http://www.fieldfisher.com/media/5054275/margin-rules-12-16-v4.pdf. See also https://www.lw.com/thoughtLeadership/US-EU-margin-rules-reference-guide.

[7] http://www.cftc.gov/idc/groups/public/@aboutcftc/documents/file/oig_rcbcmrus060517.pdf

[8] https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/financial-services/deloitte-uk-fs-otc-derivatives-april-14.pdf

[9]http://www.nera.com/content/dam/nera/publications/2014/NERA_Margin_Requirements_Uncleared_Swaps.pdf

[10] https://assets.kpmg.com/content/dam/kpmg/pdf/2016/03/SG-Bracing-for-change.pdf

[11] See Appendix 1 for a list of financial products subject to margin requirements across various jurisdictions.

[12] https://www.sifma.org/wp-content/uploads/2017/05/sifma-amg-submits-comments-to-fca-to-exclude-mortgage-tbas-from-the-definition-of-derivative-contracts-under-emir.pdf

[13] https://www.ropesgray.com/newsroom/alerts/2016/July/Amended-FINRA-Rule-Will-Require-Margin-for-TBA-Transactions.aspx

[14] http://www.cftc.gov/PressRoom/PressReleases/pr7629-17#PrRoWMBL