In the UK and EU, Phase 6 of IM requirements will also take effect on 1 September 2022. Firms active in trading OTC derivatives with UK or EU dealers will need to consider now whether they will be affected by local rules. In the UK and EU, the exchange of IM will be among counterparties that are either financial counterparties (“FCs”) or non-financial counterparties (“NFC+s”) above the EMIR clearing thresholds and that have an aggregated average notional amount of £8 billion or more. These counterparties will be required to exchange IM when transacting with any third country entities that would be FC or NFC+s if they were established in the UK or EU. This means that UK and EU dealers will need to assess the average aggregated notional amount (“AANA”) of their clients in the US and other third country locations. Firms active in trading uncleared OTC derivatives with UK and EU dealers can therefore expect to have to confirm to their dealers whether their AANA reaches the £8 billion threshold.
The process to be ready for initial margin is a complex one, and Phase 6 fund managers will need to be working with their custodians and counterparties now to be prepared for a 1 September start.
what is initial margin?
There are two types of collateral required to protect a party to a contract. A variation margin is paid regularly to reflect the current market value of a trade, whereas an initial margin is a type of derivative that is paid when the trade is executed and then adjusted as necessary throughout the life of a trade. This type of derivative is held to cover the losses that may arise in the event of a default. Counterparty risk is only the credit risk of counterparties not being able to pay what they promised, not just on this one swap, but on all their debts.
Uncleared derivatives are over-the-counter (“OTC”), where the trade has been completed on the risk of two counterparties; unlike cleared derivatives which take place on an exchange and which are generally considered low risker risk than uncleared derivatives.
why was it introduced?
The 2007 financial crisis exposed significant weaknesses in the resilience of banks and other market participants to financial and economic shocks. It also demonstrated that improved transparency in OTC derivatives markets and further regulation of OTC derivatives and market participants would be necessary to limit excessive risk-taking through OTC derivatives and to limit the risk posed by current practices. In response, the G20, The International Swaps and Derivatives Association (“ISDA”) and other organisations have been seeking to implement IM reforms.
The objectives of the IM requirements for non-centrally cleared derivatives is the reduction of systemic risk and the promotion of central clearing. Only standardised derivatives are suitable for central clearing. Totalling trillions of dollars, non-centrally cleared derivatives pose the same systemic and spill over risks that transpired in the financial crisis.
who does it impact?
ISDA has estimated that Phase 6 will affect 775 entities and more than 5,400 counterparty relationships, creating a tremendous compliance and documentation challenge for the industry. This is a massive shift given that the first four Phases captured between six and 20 firms at a time and the fifth implementation Phase affected approximately 300 firms.
CPS 226 applies directly to all authorised deposit-taking institutions, general insurance, life companies and registrable superannuation entities but indirectly picks up their investment managers as counterparties to these types of trades.
There are managers who will not hit the Phase 6 thresholds, but even those managers are likely to need to be able to accurately monitor their AANA positions to ensure compliance. There are several IT vendors out there who can assist, but implementation of systems is rarely able to be done effectively in very short periods of time. For most managers, the new requirements will be difficult to avoid.
when should i prepare?
APRA has stated that they will not provide specific guidance on when an entity should begin its preparation. Although, APRA has made it clear that entities are expected to monitor their exposures and ensure that custodial arrangements, operational processes and documentation are in place “sufficiently in advance” of exceeding the threshold. ISDA have indicated that to meet the IM requirements firms should have started “diligent preparation over a period of at least nine to 12 months to make sure relationships with custodians are in place, documentation is negotiated, and all the relevant systems and processes are fully tested. By this stage, firms should be advanced in their planning.”
how do i prepare for it?
Organisations will have to establish programs of work to manage the implementation. This should include a focussed approach to managing average aggregate notional amount levels, regulatory model approval, counterparty exposure and threshold management to optimise access to liquidity.
If your organisation has determined it will need to meet the new IM requirements for non-cleared derivatives, you will need to ensure your documentation meets your IM obligations.
According to ISDA the steps that need to be taken to meet IM regulatory requirements are as follows:
Step 1: identify in-scope entities early.
Step 2: make early disclosures to counterparties.
Step 3: exchange information on compliance.
Step 4: identify special cases.
Step 5: establish custodial relationships.
Step 6: prepare for compliance.
Step 7: negotiate/execute documentation.
Step 8: finalise preparations.
what documentation will i need?
Among the key factors to consider are:
- who are the custodians?
- what segregation model do you need?
- where are those custodians located?
- what is the governing law of the ISDA Master Agreements between you and your counterparties?
ISDA has published a series of bilateral documents that allow counterparties to enter into agreements to exchange initial margins as well as a summary table of the available forms of IM documents. This summary includes an overview and the purpose of each document. Some IM documentation is standardised and published by ISDA, while other documents are specific to the situation.
Please note that there will be multiple documents required for each trading relationship.
conclusion
To meet the IM requirements for uncleared derivatives transactions, the preparation required is demanding. In order for organisations to sufficiently meet their obligations, fund managers should begin preparation as soon as possible. Many firms will need assistance in these programs and there is a risk that managers will not be ready in time and that counterparties will close their books to amendments quite early, leaving some managers out of the OTC market altogether.
This September, the final phase of initial margin (“IM”) requirements, Phase 6, for uncleared derivatives transactions will come into effect. Uncleared margin rules have been co-ordinated by regulators globally, including APRA in Australia and FCA /ESMA in the UK and EU. After a year’s delay to the final implementation for IM requirements, APRA is continuing with its proposal to amend the Prudential Standard CPS 226 margining and risk mitigation for non-centrally cleared derivatives (“CPS 226”)…
