Canada: Collateral Damage: New Margin Rules Set To Shake Up The Derivatives Industry

Last Updated: February 22 2017
Article by Simon Williams

Starting March 1, many derivatives counterparties will be subject to new margin rules. The impact of mandatory margining will be significant: higher transaction costs, new collateral documentation and more ground for disputes.  

What You Need To Know

  • Mandatory posting of both initial and variation margin will be required, to be phased in under separate timetables.
  • The regulatory landscape covering the new margin regime is complex, with similar but not equivalent rules potentially applying to the same trades within Canada. Trades with a cross-border element may be eligible for substituted compliance under the margin requirements of a qualifying foreign jurisdiction.
  • Legacy trades will be grandfathered, but covered transactions entered into after March 1, 2017 will need to be documented under regulatory-compliant collateral documentation.
  • The new rules are intended to make Canada a "protocol eligible regime" under the International Swaps and Derivatives Association’s (ISDA) documentation framework, and ISDA has published a self-disclosure letter to help counterparties determine which trades will be subject to the new margin regime, and when compliance will be required.

Background

The economic and political fallout from the financial crisis nearly a decade ago ignited a widespread push for global financial reform. Derivatives were high on the list for regulatory oversight given their perceived role in exacerbating market instability. In particular, over-the-counter (OTC) derivatives were singled out for their hand in fuelling excessive leverage on the balance sheets of the largest financial firms. The ever-increasing complexity and interconnectedness of global derivatives activities contributed to a concentration of risk among the major dealers on what was then a largely unregulated market.

In the wake of the global economic crisis, G-20 countries committed in 2009 to implement a series of reforms to bolster oversight of the OTC derivatives markets and reduce systemic risk. Hallmarks of the reforms included new rules requiring standardized OTC derivatives to be traded on exchanges and cleared through central counterparties, higher capital and margin requirements on uncleared trades, and mandating reporting of derivatives trades to designated entities.

The G-20 commitments laid the foundation for a policy framework developed jointly by the Basel Committee on Banking Supervision and International Organization of Securities Commissions (BCBS-IOSCO Framework) which evaluated margin requirements for non-centrally cleared derivatives. This bulletin focuses on Canada’s implementation of the principles outlined in the BCBS-IOSCO Framework in relation to new margin rules that apply to derivatives trades that are not centrally cleared.

In Canada, the new margin regime is implemented for certain financial institutions through Guideline E-22 – Margin Requirements for Non-Centrally Cleared Derivatives (the Guideline), which was published in its final form on September 2016 by The Office of the Superintendent of Financial Institutions (OSFI). A parallel regime has been outlined by the Canadian Securities Administrators in CSA Consultation Paper 95-401 – Margin and Collateral Requirements for Non-Centrally Cleared Derivatives (the CSA Proposal). This regime would apply to qualifying trades not otherwise covered by OSFI’s Guideline, but not yet in force.

Scope of the New Margin Rules

OSFI's Guideline

Under the Guideline, margin requirements apply to uncleared derivatives trades between federally regulated financial institutions (FRFIs) and their counterparties where both entities have a sufficiently large uncleared derivatives book to qualify as "Covered Entities."1

A Covered Entity is a financial entity belonging to a consolidated group having an aggregate month-end average notional amount (AANA) of non-centrally cleared derivatives (excluding inter-affiliate trades) for each of March, April and May of any calendar year exceeding C$12 billion.2 If the AANA threshold is met on those three months in a particular calendar year, margin must be exchanged under the Guideline beginning on September 1st of that year.  An FRFI that is a Covered Entity is referred to as a "Covered FRFI."

With the exception of FX forwards and FX swaps (and the FX component of cross-currency swaps), the margin requirements are triggered when a particular counterparty meets the "Covered Entity" criteria described above and apply to any trades between a Covered FRFI and a counterparty. If a counterparty’s status changes such that it can no longer be deemed to be a "Covered Entity," then the margin rules will cease to apply to all trades between the counterparty and the Covered FRFI, regardless of when those trades were entered into.

CSA Proposal

The CSA Proposal, which is also modelled on the BCBS-IOSCO Framework, is intended to regulate uncleared derivatives to which the Guideline does not apply. Accordingly, FRFIs that are subject to, and compliant with, the Guideline would be relieved from the requirements contemplated by the CSA Proposal. The CSA Proposal will likely apply to only a narrow band of trades given the further relief available under the proposal on the basis of substituted compliance with a foreign jurisdiction (discussed below). 

In circumstances where the CSA Proposal is not pre-empted by the Guideline or the rules of a foreign jurisdiction, it would require the exchange of margin in circumstances where both counterparties to a non-centrally cleared derivative are financial entities with an AANA exceeding C$12 billion of non-centrally cleared derivatives (excluding inter-affiliate trades) for each of March, April and May of any calendar year. Consistent with the Guideline, if the AANA threshold is met on those three months in a particular calendar year, margin must be exchanged beginning on September 1 of that year. 

While the portfolio size threshold is the same under both the Guideline and the CSA Proposal, the definition of "financial entity" in the CSA Proposal differs slightly.3 The margin requirements under the CSA Proposal would apply to all OTC derivatives, except that FX forwards and FX swaps which would be excluded from initial margin requirements (in contrast to the Guideline, which excludes FX forwards and FX swaps from both initial and variation margin requirements).

Exemptions for Substituted Compliance

Guideline

Trades between a Covered FRFI and a foreign (non-Canadian) Covered Entity will be exempt from the margin requirements under the Guideline if (1) the Covered FRFI is subject to, and has complied with, the margin requirements of the foreign Covered Entity that is not subject to OSFI’s oversight and (2) the Covered FRFI has documentary evidence that the margin rules of that foreign jurisdiction are comparable to the BCBS-IOSCO Framework.

CSA Proposal

The CSA Proposal also provides for substituted compliance where a foreign counterparty—which would otherwise be in-scope under the CSA Proposal—is subject to and compliant with the margin rules of that counterparty's home jurisdiction and which are assessed to be equivalent to the CSA Proposal’s requirements and meet the standards outlined by the BCBS-IOSCO Framework. If substituted compliance were available on that basis, the counterparties would elect whether the derivatives trades between them would be subject to the CSA Proposal (as it may be enacted) or the rules of the foreign jurisdiction.

When do the New Margin Rules Take Effect?

Guideline

The requirements for initial margin and variation margin, which are being phased in on separate timelines, are both based on the size of the counterparties’ uncleared derivatives book (including physically settled FX forwards and FX swaps, but excluding inter-affiliate trades). The margin requirements will apply to all new derivatives contracts entered into during the periods specified in the table below. Novations of grandfathered trades and—so long as they are undertaken for a genuine legal or commercial purpose (i.e., not for the purpose of avoiding the margin rules)—amendments to existing derivatives contracts do not qualify as new derivatives contracts.

Initial Margin

The requirement to exchange two-way initial margin will apply to trades between a Covered FRFI and a Covered Entity where both parties have an aggregate month-end AANA for March, April and May of the applicable calendar year exceeding the corresponding amounts below for the related phase-in period:

Phase-in Period

AANA Exceeding

September 1, 2016 to August 31, 2017

C$5 trillion

September 1, 2017 to August 31, 2018

C$3.75 trillion

September 1, 2018 to August 31, 2019

C$2.5 trillion

September 1, 2019 to August 31, 2020

C$1.25 trillion

September 1, 2020 and thereafter

C$12 billion

Variation Margin

The requirement to exchange variation margin will be phased-in in two stages. From September 1, 2016 to February 28, 2017, trades between a Covered FRFI and a Covered Entity where both parties have an AANA of non-centrally cleared derivatives exceeding C$5 trillion are required to post variation margin. Thereafter, all other Covered FRFI’s and Covered Entities will be subject to the variation margin requirements beginning on March 1, 2017.

CSA Proposal

Specific details regarding timing have not yet been published, but the CSA Proposal states that a similar phase-in approach would be adapted from the BCBS-IOSCO Framework. 

What are the New Margin Requirements?

Guideline

Variation Margin

The purpose of variation margin is to protect transacting parties from current exposure arising due to daily fluctuations in the mark-to-market value of their underlying trades. The animating principle is that posting variation margin to collateralize trade exposure would reduce adverse liquidity shocks and mitigate counterparty credit risk. If a trade moves out-of-the-money for one party, then that party will be required to fully cover that exposure by posting collateral to its in-the-money counterparty in the same amount (subject to a minimum transfer amount of C$750,000 for all margin transfers, both initial and variation).

Like initial margin, variation margin must be calculated and called within two business days of entering into a trade, and calculated and called on a daily basis thereafter. Following each call for variation margin, the requisite amount of margin must be posted within two business days.

The Guideline provides that variation margin should be calculated and exchanged pursuant to a single, legally enforceable netting agreement. If a legally enforceable netting agreement is not in place, variation margin must be exchanged on a gross basis.

Initial Margin

The purpose of initial margin is to provide a collateral buffer to protect transacting parties against future exposure from adverse changes in the mark-to-market value of the underlying trades between the time of default and the date on which the trade is subsequently closed-out or replaced.

Initial margin must be calculated and called within two business days of entering into a trade, and calculated and called on a daily basis thereafter. Upon receiving a call for initial margin, the receiving party must post the specified margin on or before the second business day following each such call. The exchange of initial margin between counterparties is subject to a maximum threshold of C$75,000,000; i.e., only initial margin in excess of the threshold is required to be exchanged. The threshold is determined on a consolidated group basis based on all outstanding non-centrally cleared derivatives between the two counterparties’ respective consolidated groups.

The required amount of initial margin may be calculated by using either (i) a counterparty’s internal "quantitative portfolio margin model" (Internal Model) or (ii) the standardized margin schedule set forth in the Guideline (Standardized Model). A counterparty’s election to use an Internal Model is subject to meeting a number of conditions informing the standards for building a suitable model, such as prescribing certain risk factors and stress-testing parameters which must be incorporated. Covered FRFIs are required to review their Internal Models no less frequently than annually in light of prevailing market conditions and modelling practices.

In recognition of the complexity involved in calculating initial and variation margin and the potential for valuation discrepancies between counterparties, the Guideline requires counterparties to have dispute resolution procedures in place prior to entering into derivatives transactions with each other.

CSA Proposal

The requirements for posting both initial and variation margin under the CSA Proposal are substantially similar to those of the Guideline. Under the CSA Proposal: (i) initial margin will be required to be calculated using either a quantitative margining model or a standardized schedule to be prescribed by the CSA (and the same model should be applied consistently across each class of derivatives); (ii) any quantitative models employed must be recalibrated and reviewed at least annually; (iii) margin must be calculated and called within two business days of entering into a trade, and daily thereafter; (iv) initial margin would only need to be exchanged over and above a threshold not to exceed C$75,000,000 (determined on a consolidated group basis consistent with the Guideline); (v) margin transfers are also subject to a minimum transfer amount not to exceed $750,000 (combined for both initial and variation margin); and (vi) counterparties which are both covered by the CSA Proposal must establish dispute resolution procedures to deal with potential disputes relating to initial and variation margin.

Eligible Collateral

The types of collateral eligible for posting as margin under the Guideline and CSA Proposal are similar, although some differences are apparent, as illustrated by this side-by-side comparison:

Guideline

CSA Proposal

Cash

Cash

Gold

Gold

Debt Securities

Debt securities rated at least:

  • ≥ BB- when issued by sovereigns
  • ≥ BBB- when issued by other entities
  • ≥ A-3/P-3 for short-term debt instruments

Debt securities that are:

  • Issued or guaranteed by the Government of Canada, Bank of Canada or a provincial government of Canada
  • Issued and fully guaranteed by the Bank for International Settlements, the International Monetary Fund or a multilateral development bank with a rating of at least BB-
  • Debt securities issued and guaranteed by foreign governments  with a rating of at least BB-
  • Debt securities issued by corporate entities with a rating of at least BBB-
Unrated Debt Securities

Unrated debt securities where all of the following apply:

  • Issued by a bank
  • Listed on a recognized exchange
  • Classified as senior debt
  • All rated issues of the same seniority issued by the issuing bank must be rated at least BBB- or A-3/P-3 by a recognized external credit assessment institution
  • The institution holding the securities as collateral has no information to suggest that the issue justifies a rating below BB- or A-3/P-3

N/A

Equities

Equities (including convertible bonds) included in a main index

Equities included in major Canadian stock indices;

Equities (including convertible bonds) not included in a main index but which are listed on a recognized exchange

N/A

Transferable Securities and Mutual Funds

Undertakings for collective investments in transferable securities (UCITS) and mutual funds where:

  • a price for the units is publicly quoted daily; and
  • the UCITS/mutual fund is limited to investing in the instruments listed above.

Mutual funds, where:

  • a price for the fund’s units is publicly quoted daily; and
  • (ii) the mutual fund is limited to investing in the assets above.

Implications

From a commercial perspective, mandatory margin requirements can generally be expected to increase the transaction costs of covered trades, and we anticipate a surge in demand for liquid collateral that satisfies the criteria described above. There will also be significant implications from a documentation perspective as existing Credit Support Annexes will need to be either amended or replaced for trades falling under the new rules. 

In that regard, ISDA has published new forms of Credit Support Annexes for both initial and variation margin designed to be compliant with the regulations. Given the grandfathering rules discussed above, it is possible that two counterparties might have three different Credit Support Annexes in effect between them (one for legacy trades not subject to the margin rules, one for initial margin and one for variation margin). 

Fortunately, ISDA has also developed an online "protocol" to facilitate amending existing Credit Support Annexes to be compliant with the new margin regime. Consequently, counterparties to derivatives trades can expect to receive a request from their FRFI counterparties to complete the ISDA Regulatory Margin Self Disclosure Letter, which is designed to help market participants determine if and when compliance with one or more of the new regulatory margin regimes will be required.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions