Only days away from the 1 September regulatory deadline for the new collateral regime, it seems clear that, absent a last-minute no-action letter from the three regulators poised to meet the original timetable (namely, the US, Canada and Japan), the $493 trillion OTC derivatives market, the stage is set for a temporary market fracture.
In 2011, the G20 agreed to add to their wide-ranging financial reform programme margining requirements for derivatives not subject to central clearing and tasked the Basel Committee on Banking Supervision (“BCBS”) and theInternational Organization of Securities Commissions (“IOSCO”) with the development of global standards. The regulators of the main economies agreed to implement in their respective jurisdictions a collateralisation regime that largely mirrored BCBS/IOSCO’s proposal, with a 1 September 2016 global start date.
Last June the European Commission announced it would fail to meet the 1 September global deadline, pledging to make an effort to “align with internationally agreed timelines as closely as possible”. Adoption of the rules is expected to happen early next year. Singapore, Hong Kong and Australia have also announced delays to allow for industry preparedness. The exact deadline the EU, Singapore, Hong Kong and Australia will adopt is yet unknown.
Liquidity drain and models
For the banks concerned, getting ready to comply with the new collateral regime implies a major effort in terms of systems, processes, agreements (both with counterparties and third party custodians) and, indeed, liquidity. This is compounded by the fact that in some cases the final regulations were not issued until as little as six months before the intended deadline, leaving entities very little time to plan and prepare.
US regulators have estimated that the entities subject to the regulation would eventually need to post around $315 billion in initial margining, whereas the European regulators believe that sum to be around the EUR200 billion mark for entities subject to the EU rules. That is a sizeable chunk of a global market worth an estimated $493 trillion at the end of 2015, and doesn’t account for the liquidity drain that will result from collateral requirements in other markets.
Those estimates are based on the firms’ ability to use proprietary models, which are significantly less onerous than the regulators’ standard tables. Under the latter, the industry had estimated a $3.6 trillion drain.
It is therefore of capital importance for regulators to approve ISDA’s standard initial margin model (known as “SIMM”), that offers greater flexibility that the standard table and a more efficient use of the firms’ liquidity.
The market post 1 September 2016
So, what is the likely landscape going to be on 1 September? Absent a joint last-ditch reprieve, such as a no-action letter from the US prudential regulators, the Commodity Futures Trading Commission (“CFTC”), and the Canadian and Japanese regulators, there will be a fractured market that will require the biggest firms in those jurisdictions to exchange initial margin, to be held with a third party custodian.
Meanwhile, no such obligation will exist for firms in the EU, Singapore, Hong Kong and Australia, which will create opportunities for regulatory arbitrage until these jurisdictions too implement their respective initial margining regulations.
No firm statement has been made to the effect though, based on past experience, it is likely that the implementation of the initial margin regulations in the EU (and probably also in Hong Kong, Singapore and Australia) will coincide with the implementation date for the variation margin regime, on 1 March 2017.
Background info in a nutshell: the new collateral regime
The collateral regime devised by the BCBS/IOSCO as a measure to tackle systemic risk comprises two types of margin: initial margin and variation margin.
Initial margin is security posted and collected on a gross basis (i.e., cannot be netted out) at the transaction’s inception, calculated as an estimate of future exposure. If there is a netting set of transactions, initial margin will be calculated taking into account all such transactions. It must be segregated with an independent third party custodian and cannot be re-hypothecated, re-pledged or re-used, save for very limited circumstances.
Apart from the liquidity drain it implies, it removes the counterparty’s credit risk from the equation, introducing instead the third party custodian’s. For that reason, all firms must ensure that their collateral will be protected in every jurisdiction in case of custodian insolvency.
Covered entities and phase-in
All financial entities with material swaps exposure are subject to both the initial and variation margining requirements. End users that would qualify for an exemption from clearing are not subject to the margining requirements, so any uncleared derivatives entered into a covered entity and such an end user would be exempted.
Some other entities, such as cooperatives, certain affiliates, sovereigns, central banks, multilateral development banks and the Bank for International Settlements are also exempted from the margining requirements.
The initial margin requirements are subject to a phase-in period, whereby any covered entity belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives for March, April, and May of the year (the “relevant exposure”) is greater than $3 trillion shall be subject to the initial margin requirements as from 1 September 2016. For entities with a $2.25 trillion relevant exposure must comply by 1 September 2017. Those with a relevant exposure of $1.5 trillion must comply by 1 September 2018. For those with a relevant exposure of $0.75 trillion the compliance date is 1 September 2019, whereas the remaining entities must start complying by 1 September 2020, provided their relevant exposure is $8 billion or greater.
Threshold and minimum transfer amount
Initial margin may be made subject to a maximum $50 million threshold, calculated on a consolidated group basis for both parties. Between affiliated covered entities, a maximum $20 million threshold may apply, applicable for each affiliate.
No initial margin below the threshold needs to be posted or collected.
Variation margin is security posted or collected during the course of a transaction or a netting set of transactions, as the result of fluctuations in actual exposure. It does not need to be segregated with an independent custodian and may be re-hypothecated, re-pledged or re-used.
Phase-in and threshold
Any covered entity belonging to a group whose relevant exposure is greater than $3 trillion shall be subject to the initial margin requirements as from 1 September 2016. All other covered entities must comply with the variation margin regulations as from 1 March 2017.
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