In the ongoing journey to transform OTC Derivatives, the next major step in reducing systemic risk is the finalization and adoption of the “Initial Margin” and “Variation Margin” rules for Uncleared Derivatives. This is based on the final (among the four) key elements of the reform agreed by G20 in 2009.
After central clearing of the eligible trades in standardized products, the remaining uncleared Derivatives (instrument and party scope to be finalized in each jurisdiction) would be subject to the capital and margin requirements to mitigate the risk with the Complex/Bespoke products. With the rules around Capital Requirements published/adopted in multiple jurisdictions, the focus is now on the margin requirements.
Although not all countries/regions are in the same state in achieving the goals related to the earlier elements in the reform, i.e, execution on standard venues, trade reporting and central clearing, there has been a significant amount of analysis and consultaiton in this area.
Based on ISDA study in April 2014, at the end of 2013, 65% of Interest Rate Derivatives outstanding has been centrally cleared and remaining (between $123 trillion and $141 trillion in IRD notional) remains uncleared. The percentage of centrally cleared derivatives would keep increasing as “Mandatory Clearing” rules get adopted in the different jurisdictions.
A point to note is that even in case of standardized products, the mandatory clearing does not apply for certain parties trades which are not in scope of the rules based on exemptions or interim reliefs.
In March 2015, the final margin framework to establish minimum standards has been released by the Basel Committee on Banking Supervision (BCBS) and International Organization of Securities Commissions (IOSCO). See References section for the full document.
In the document released, there is a very good explanation of the difference between the Capital Requirements and Margin Requirements where the earlier is targeted towards reducing risk of the survivor with their own capital, the later is targeted towards reducing the risk with the “defaulter pay”.
While each jurisdiction has to come up with Instrument Scope and Party Scope/Covered Entities, the key differentiators would be the rules around the use of Schedule-Based and Quantitative Portfolio/Risk-Based Margin models. The trading parties would need to prepare themselves in choosing the best model for their needs and if the choice is risk based models, the model requires an approval from the regulator. Also, as internal risk models may vary from party to party, the calculated margin can differ and lead to disputes. To avoid this risk of disputes, trading parties can also choose to use the ISDA Standard Initial Margin Model. Details on ISDA SIMM can be found on the ISDA website (see References section).
In terms of the collateral, the framework covers the requirements around the types of collateral that can be used for the purposes of margin. Though the framework mentions that trades since a particular date would need to meet the new requirements (earlier December 1 2015 and now 1 September 2016), parties would need to plan for the collateral already posted which might be ineligible after the rules are adopted. This would also potentially lead to the trading parties maintaining 2 different CSAs between them, one to cover for the pre-compliance trades and other for post-compliance trades.
Based in ISDA Margin Survey in 2014, approximately 75% of Collateral is Cash and remaining 25% constitute Government and Other Equities/Bonds. The percentage of collateral which would be ineligible after the rules are adopted may be low but it’s still an area to consider.
The framework sets standards for rehypothetication of the received collateral from the counterparty. Listed below are some of the processes that would be considered during the final rule making.
- Taking express consent to re-hypotheticate
- Segregate the received collateral from the collector’s proprietary assets
- Preventing re-hypotheticated collateral from being further re-hypotheticated
- Re-hypotheticated collateral to be again segregated from other assets by the receipent of the re-hypotheticated collateral
- Record keeping
These rules will have an impact if the current business model of parties includes re-hypothetication. There would be an operational effort in these cases during the transition period where the consents need to be exchanged, collateral segregated, etc
Another important point in the framework is that the collateral would need to be exchanged on a gross basis and not a net basis.
And for Haircuts, the framework suggests potential methods for calculating haircuts. It allows for having internal or third- party quantitative model-based haircuts or schedule-based haircuts. Again, quantitative model would need to be approved by relevant supervisors and can be subject to internal conduct rules.
In firms with other businesses like Repos or Stock Borrow/Lending, there would be existing standard models for haircuts as per standards/best practices in the respective markets, example – ICMA European Repo Council has provided a Best Practice Guide in the European Repo Market.
These rules around Collateral and Haircuts will also have an impact to collateral optimisation systems right from identifying and proposing collateral that can be used, re-allocations, substitutions, etc.
Finally, the cross-border trades are an interesting set where they have multi-jurisdiction impact based on the location of the Parties, their Parent entities, their Guarantees, Execution/Prime Broker, Traders, etc. As with other rules, the final rules across jurisdictions can vary and how these would be treated need to be carefully considered.
As with any industry wide initiative, there are additional resources required for analysis, implementation and support during transition phase. Financial players can immensely benefit by leveraging the niche service providers with cross-functional expertise.
- BCBS and IOSCO Margin Framework
- ISDA WGMR Implementation Program
- ISDA Study April 2014
- ISDA Margin Survery
- FSB Ninth Progress Report on Implementation of OTC Derivatives Market Reforms
- European Supervisory Authorities (ESAs) Second Consultation Paper on Draft Regulatory Technical Standards (RTS) on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012
About the Author
The author of the blog is a cross-functional leader and part of the Core team at Tectoro Consulting, India. He currently works on multi-market multi-asset enhancements to Gloss for our client in Hyderabad. His prior expertise is in analysis, design and development for OTC Derivatives Regulations – Dodd Frank, EMIR, MiFID, JFSA, etc across product/entity/counterparty scope, entity registration, mandatory clearing and transaction reporting.