Earlier this week, the European Supervisory Authorities (ESAs) published the much anticipated consultation paper and draft regulatory technical standards (RTS) setting out of risk-mitigation techniques for OTC derivative contracts not cleared by a CCP under Article 11 of the European Market Infrastructure Regulation (EMIR).
Article 11 requires financial counterparties, and non-financial counterparties that enter into an OTC derivative contract not cleared by a CCP, to ensure that appropriate procedures and arrangements are in place to measure, monitor and mitigate operational risk and counterparty credit risk, including the exchange of collateral as initial and variation margin.
The draft RTS sets out the specific aspects of the risk mitigation framework, including margin models, the eligibility of collateral to be used for margins, operational processes and risk-management procedures. The ESAs have stated their intention to achieve regulatory consistency by transposing international standards as far as possible. In September 2013, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) published key principles for margin requirements for non-centrally cleared derivatives.
Overall, the ESA's draft RTS is broadly in line with the BCBS-IOSCO standard, e.g. with respect to operational requirements such as senior management reporting, escalation procedures, and requirements to ensure sufficient liquidity of collateral, and also in terms of application of the standard. Financial and non-financial counterparties will be required to exchange two-way initial margin; existing transactions will not be subject to the framework; intragroup transactions are exempted if certain requirements are met; physically settled FX OTC derivatives are exempted from the requirement to exchange initial margin, but not from variation margin.
The draft RTS also provides further details on the methods that counterparties may use to calculate initial margin requirements. In summary, the draft RTS confirms the EMIR two-step approach to mark-to-market methods and the model-based approach broadly in line with requirements in the BCBS-IOSCO standard (99% confidence interval, 10 day risk horizon, netting only within, not across, asset classes, model validation, back-testing and regular audit process).
There are however a few significant differences between the BCBS-IOSCO standard and the draft RTS, and instances where the draft RTS goes beyond the provisions of the BCBS-IOSCO standard. Firstly, the list of eligible collateral in the draft RTS includes more asset classes than the list provided in the international standard. Under the draft RTS, collateral "with a lower, albeit still sufficiently high credit quality", such as debt securities issued by credit institutions and investment firms, convertible bonds or the most senior tranche of securitisations that is not re-securitisation, is also eligible. Secondly, the consultation paper proposes an explicit diversification requirement. Initial margin and variation margin would be subject to concentration limits to avoid counterparties becoming overly exposed to specific assets or issuers. This requirement is stricter than the respective provision in the BCBS-IOSCO standard.
The most material deviation from the international standard is the proposed outright ban on rehypothecation and other re-use of collateral as initial margin. The BCBS-IOSCO framework provides for some flexibility and allows rehypothecation for related hedges. The ESAs justify the ban by reference to legal and operational difficulties, conditions in the European markets, and simplification of the framework. While the BCBS-IOSCO provision would pose some operational challenges to market participants, prohibiting the practice of collateral re-use altogether is likely to affect some business models severely.
As a result of the new standards, non-cleared OTC derivatives will become more expensive. Particularly for those transactions that have so far not been subject to collateral agreements, the move to exchange margin is likely to lead to a significant step change in the costs of trading. A recently published paper from the Deloitte EMEA Centre for Regulatory Strategy has estimated – based on the BCBS-IOSCO proposals – that additional costs arising from the new initial margin requirements for non-cleared transactions amount to €50 per €1 million notional.
The framework will enter into force on 1 December 2015. Initially, the requirements will only apply to the largest market participants that have an aggregate month-end average notional amount of non-centrally cleared derivatives exceeding €3tn. Gradually, the requirements will be expanded to more market participants and from 1 December 2019, any counterparty belonging to a group that exceeds a threshold of €8bn will be covered. These proposals are very much in line with the international standards, even if some of the thresholds differ slightly.
Market participants will be studying these proposals carefully, judging them on their own merit and in light of the differences from the BCBS-IOSCO standard. The deadline for comments on the draft RTS is 14 July 2014.
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