Australian regulators should consult before they determine how to implement the margin requirements framework to clarify its impact on Australia's securitisation market.
The final framework for margin requirements for non-centrally cleared derivatives has been released by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (BCBS / IOSCO).
The globally agreed standards under the framework require all financial firms and systemically important non-financial entities that engage in non-centrally cleared over-the-counter (OTC) derivatives to exchange initial and variation margin commensurate with the counterparty risks arising from such transactions.
While the final framework has addressed some concerns from the previous two rounds of consultation, it leaves unanswered a number of significant questions. This article considers one of those questions: what are the implications of the margin requirements for securitisation transactions which utilise OTC derivatives as a way to manage cash flows?
In this article we'll briefly cover the main elements of the finalised framework, before analysing the main issues for Australia's securitisation industry.
The underlying rationale and principles of the framework for margin requirements for non-centrally-cleared derivatives
The finalised margin requirements are an attempt to achieve two goals:
- reduce systemic risks related to OTC derivatives markets; and
- make central clearing more attractive while managing the overall impact on liquidity.
Eight elements underlie the framework:
Element 1: Scope of coverage – instruments subject to the requirements: Appropriate margining practices should be in place with respect to all derivatives transactions that are not cleared by CCPs.
Element 2: Scope of coverage – scope of applicability: All financial firms and systemically important non-financial entities ("covered entities") that engage in non-centrally cleared derivatives must exchange initial and variation margin as appropriate to the counterparty risks posed by such transactions.
Element 3: Baseline minimum amounts and methodologies for initial and variation margin: The methodologies for calculating initial and variation margin that serve as the baseline for margin collected from a counterparty should:
- be consistent across entities covered by the requirements and reflect the potential future exposure (initial margin) and current exposure (variation margin) associated with the portfolio of non-centrally cleared derivatives in question; and
- ensure that all counterparty risk exposures are fully covered with a high degree of confidence.
The framework provides a choice of two methodologies for calculating the amount of the initial margin:
- a quantitative portfolio margin model; or
- a standardised margin model.
Under the standardised margin model, the required initial margin will be computed by referencing standardised margin rates and adjusting the gross initial margin amount by an amount that relates to the net-to-gross ratio pertaining to all derivatives in a legally enforceable netting set.
Element 4: Eligible collateral for margin: To ensure that assets collected as collateral for initial and variation margin purposes can be liquidated in a reasonable amount of time to generate proceeds that could sufficiently protect collecting entities covered by the requirements from losses on non-centrally cleared derivatives in the event of a counterparty default, these assets should be highly liquid and should, after accounting for an appropriate haircut, be able to hold their value in a time of financial stress. The framework contemplates that the potential methods for determining appropriate haircuts could include either internal or third-party quantitative model-based haircuts or schedule-based haircuts. Under the schedule-based approach, haircut levels are derived from the standard supervisory haircuts adopted in the Basel Accord's comprehensive approach to collateralised transactions framework.
Element 5: Treatment of provided initial margin Initial margin should be exchanged by both parties, without netting of amounts collected by each party (ie. on a gross basis), and held in such a way as to ensure that:
- the margin collected is immediately available to the collecting party in the event of the counterparty's default; and
- the collected margin must be subject to arrangements that fully protect the posting party to the extent possible under applicable law in the event that the collecting party enters bankruptcy.
Element 6: Treatment of transactions with affiliates Transactions between a firm and its affiliates should be subject to appropriate regulation in a manner consistent with each jurisdiction's legal and regulatory framework.
Element 7: Interaction of national regimes in cross-border transactions Regulatory regimes should interact so as to result in sufficiently consistent and non-duplicative regulatory margin requirements for non-centrally cleared derivatives across jurisdictions.
Element 8: Phase-in of requirements Margin requirements should be phased in over an appropriate period of time to ensure that the transition costs associated with the new framework can be appropriately managed. Regulators should undertake a co-ordinated review of the margin standards once the requirements are in place and functioning to assess the overall efficacy of the standards and to ensure harmonisation across national jurisdictions as well as across related regulatory initiatives.
Three key changes from the last draft
BCBS / IOSCO identify three changes from the last round of consultation:
- physically settled foreign exchange (FX) forwards and swaps are now exempt from initial margin requirements. Variation margin on these derivatives should be exchanged in accordance with standards developed after considering the Basel Committee supervisory guidance for managing settlement risk in FX transactions;
- fixed, physically settled FX transactions that are associated with the exchange of principal of cross-currency swaps are also exempt from initial margin requirements, but not from the variation margin requirements which apply to all components of cross-currency swaps; and
- "one-time" re-hypothecation of initial margin collateral is permitted subject to a number of strict conditions. This is intended to help to mitigate the liquidity impact associated with the requirements, along with other features such as the introduction of a universal initial margin threshold of €50 million below which a firm would have the option of not collecting initial margin and allowance for a broad array of eligible collateral to satisfy initial margin requirements.
Will Australian securitisation vehicles be subject to the margin requirements?
There is some uncertainty as to whether securitisation vehicles will be caught by the framework in the first place. This is currently a grey area because the framework only requires margin to be exchanged with respect to uncleared OTC derivatives between two "covered entities". In other words, uncleared OTC derivatives entered into by a securitisation vehicle will not be governed by the framework if the securitisation vehicle (or its swap counterparty) is not a "covered entity".
Although the framework defines covered entities in terms of "financial firms" and "systemically important non-financial entities" it does not give any guidance on what these terms mean; instead, this is left to national regulators. As a result, the definitions could vary from country to country, and Australian securitisation vehicles could be inside the scope of the framework in one place, but not another. Although the position of the Australian regulators on this issue will need to be clarified, the position of other national regulators could also be relevant where hedges to Australian securitisation vehicles are provided by offshore swap counterparties.
Should Australian securitisation vehicles be subject to the margin requirements?
The main purposes of the margin requirement are to reduce systemic risk and promote central clearing.
It is arguable that Australian securitisation transactions should be exempted from the framework as they already mitigate the risk of default, and hence systemic risk, arising from their use of OTC derivatives in three ways:
- first, securitisation vehicles are bankruptcy remote entities;
- second, swap counterparties usually have the benefit of a charge over all the securitisation vehicle's assets and rank above (or at least equal to AAA) noteholders in an enforcement scenario; and
- third, the leading rating agencies require swap counterparties to post collateral to fully cover the securitisation vehicle's current exposure to them unless the swap counterparty is sufficiently rated.
Given that Australian securitisation transactions already build in robust protections against systemic risk, the benefits of introducing the framework for the Australian securitisation industry would appear limited, especially given the significant costs the framework could impose on the industry (see further below).
Would it matter if Australian securitisation vehicles were subject to the margin requirements?
If they are required to comply with the margin requirements, Australian securitisation vehicles would need to post high quality collateral. It is unlikely, however, that they would have access to this, at least under the current structures for securitisation transactions.
This could lead to a slowdown in the securitisation market as new transaction structures and practices are developed to allow for the posting of collateral as margin. This will also have obvious cost implications for the industry.
Doesn't the exemption for OTC derivative transactions with affiliates solve this?
Element 6 amounts to an exemption from the Basel margin framework for uncleared intra-group OTC derivatives. The margining requirements for these derivatives will therefore be left to national regulators.
The policy underlying the exemption recognises that affiliated parties to a non-centrally cleared derivative do not usually exchange initial or variation margin and, accordingly, extending the initial margin requirement would create additional liquidity demands. In addition, the legal and regulatory frameworks governing intra-group derivatives vary from jurisdiction to jurisdiction and so may not be suited to harmonisation across varying jurisdictions.
It is unclear whether this exemption will benefit Australian securitisation vehicles, most of which are special purpose trusts. To the extent sponsor banks own units in a special purpose securitisation trust, the sponsor bank and the trust are generally regarded as part of the same group for tax and accounting purposes.
If this satisfies the "affiliation" criteria for the intra-group exemption, and the sponsor bank is also the swap provider to the vehicle, it is possible that OTC derivatives between the vehicle and the sponsor bank will be exempt from the framework.
On the other hand, the separation requirements of APS 120 may argue against this position. In addition, this will not assist securitisation vehicles which hedge with third party swap providers.
Are asset-backed securities "collateral" for the purposes of the margin requirements?
The framework lists high quality government and central bank securities, high quality corporate bonds, high quality covered bonds, equities and gold as eligible collateral, but says this is not exhaustive.
It is therefore possible that other tradeable instruments such as asset-backed securities might qualify. The Global Financial Markets Association has suggested that given their high trading volume, high quality asset-backed securities are more liquid than the asset classes that are identified as eligible collateral, and BCBS / IOSCO should consider adding them.
The framework envisages a gradual phase-in period to provide market participants with sufficient time to adjust to the requirements.
The requirement to exchange variation margin between covered entities only applies to new contracts entered into after 1 December 2015.
The requirement to collect and post initial margin on non-centrally cleared trades will be phased in over a four-year period, beginning in December 2015 with the largest, most active and most systemically important derivatives market participants.
BCBS / IOSCO have recognised that the impact of the margin requirements is subject to various factors and uncertainties including among others, the ratio of cleared to non-centrally cleared derivatives and changes in market volatility over time. They will therefore set up a monitoring group to evaluate the margin requirements in 2014. Certain elements of the framework may need to be re-evaluated or modified if forthcoming data and further analyses reveal that the incentives and impacts of them are substantially different from the results reflected in previous impact studies, inconsistent with the framework goals or do not effectively balance the costs and benefits of the requirements.
In recognition that the BCBS / IOSCO framework is not legally binding in any jurisdiction but rather is intended to form the general basis for national rulemaking, BCBS / IOSCO have clarified that the monitoring process is not intended to deter national regulatory authorities from proceeding with implementing rules consistent with the framework while the monitoring group is conducting its work.
We expect that the Australian regulators will consult with the relevant stakeholders, including potentially offshore regulators, before they determine which aspects of the framework will be implemented in Australia. Any such consultation process will be critical for the industry to clarify the extent to which the framework will impact Australia's securitisation market. Given that BCBS / IOSCO have expressed a very clear desire for the framework to be implemented on an internationally consistent basis, Australia may well be required to align its implementation with the standards set by other jurisdictions.
Standardised initial margin schedule
|Asset class||Initial margin requirement (% of notional exposure)|
|Credit: 0–2 year duration||2|
|Credit: 2–5 year duration||5|
|Credit: 5+ year duration||10|
|Interest rate: 0–2 year duration||1|
|Interest rate: 2–5 year duration||2|
|Interest rate: 5+ year duration||4|
Standardised haircut schedule
|Asset class||Haircut (% of market value)|
|Cash in same currency||0|
|High-quality government and central bank securities: residual maturity less than one year||0.5|
|High-quality government and central bank securities: residual maturity between one and five years||2|
|High-quality government and central bank securities: residual maturity greater than five years||4|
|High-quality corporate\covered bonds: residual maturity less than one year||1|
|High-quality corporate\covered bonds: residual maturity greater than one year and less than five years||4|
|High-quality corporate\covered bonds: residual maturity greater than five years||8|
|Equities included in major stock indices||15|
|Additional (additive) haircut on asset in which the currency of the derivatives obligation differs from that of the collateral asset||8|
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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.