On July 6, 2012, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) released a consultative paper (Consultative Paper) that sets out a proposed framework regarding margin requirements for non-centrallycleared (NCC) derivatives. The proposals on margin requirements for NCC derivatives are part of the G20's reform program to reduce the systemic risk from over-the-counter derivatives. The policy proposals, when adopted, will establish minimum standards for margin requirements for NCC derivatives. The BCBS and IOSCO are seeking comments from the public on the proposals and the comment period will end on September 28, 2012.
The Canadian Securities Administrators (CSA) are expected to release a consultative paper on capital and collateral later this year. We anticipate that many of the proposals in the Consultative Paper will inform the CSA's discussion in their paper. While there may still be some time before we will see any concrete rules in Canada regarding margin requirements, the Consultative Paper provides a helpful discussion on the various methods and parameters that firms can consider for their collateral arrangements with counterparties to their NCC derivatives transactions in order to manage counterparty risk.
There are seven elements in the framework proposed by the BCBS and IOSCO:
- Instruments subject to the requirements;
- Scope of applicability;
- Baseline minimum amounts and methodologies
- for initial and variation margin;
- Eligible collateral for margin;
- Treatment of provided margin;
- Treatment of transactions with affiliates; and
- Interaction of national regimes in cross-border transactions.
For each element, the Consultative Paper sets out a key principle and the proposed requirements.
1. Instruments Subject to the Requirements
Key Principle #1: Appropriate margining practices should be in place with respect to all derivative transactions that are not cleared by central counterparties.
The BCBS and IOSCO propose that all derivatives that are not centrally-cleared should be subject to margin requirements. This includes derivatives that cover all five major asset classes (interest rate, credit, equity, foreign exchange and commodity), whether they are standardized or bespoke.
While the BCBS and IOSCO have considered criteria that could be used to determine whether a NCC derivative should be exempt from margin requirements, they have not settled on any particular criteria and are seeking comment in this regard.
2. Scope of Applicability
Key Principle #2: All financial firms and systemicallyimportant non-financial entities that engage in NCC derivatives must exchange initial and variation margin as appropriate to the risks posed by such transactions.
The BCBS and IOSCO propose that there is no need to impose margin requirements on non-financial entities that are not systemically-important. They suggest this approach because NCC derivative transactions by such firms would pose little or no systemic risk and because such transactions are exempt from central clearing requirements under most national regimes. In other words, the proposal is to require only firms that are financial entities and firms that are considered to be systemically important to be subject to margin requirements for their NCC derivative transactions.
In addition, the BCBS and IOSCO propose that for firms that are subject to margin requirements, there should be, as a general rule, the exchange of both initial and variation margin. However, the BCBS and IOSCO are also mindful of the liquidity costs associated with this requirement. In that connection, the Consultative Paper sets out a number of options that have been considered by the BCBS and IOSCO that would help mitigate the related costs associated with the full bilateral exchange of margin while, at the same time, protecting the financial system from the risks posed by NCC derivatives. These include varying the margin requirement based on the nature of the firm or providing for a threshold below which a firm would have the option (and not the requirement) to post margin. The Consultative Paper does not indicate any specific option that is more favoured by the BCBS and IOSCO and comments are specifically sought in this regard.
3. Baseline Minimum Amounts and Methodologies for Initial and Variation Margin
Key Principle #3: The methodologies for calculating initial and variation margin that must serve as the baseline for margin that is collected from a counterparty should (i) be consistent across entities covered by the proposed requirements and reflect the potential future exposure (initial margin) and current exposure (variation margin) associated with the portfolio of NCC derivatives at issue and (ii) ensure that all exposures are covered fully with a high degree of confidence.
The BCBS and IOSCO articulate that the amount of initial margin should reflect the potential future exposure associated with the portfolio of NCC derivatives, while the amount of variation margin should reflect the current exposure. The "potential future exposure" should reflect "an extreme but plausible estimate of an increase in the value of the instrument that is consistent with a one-tailed 99 percent confidence interval over a 10-day horizon, based on historical data that incorporates a period of significant financial stress" and the initial margin should be an amount that is sufficient to cover such exposure. To determine an initial margin amount for any given NCC derivative, the BCBS and IOSCO propose that firms can either use a quantitative model or a standardized margin schedule. The quantitative model may be developed by the firm or by a third party; however, such quantitative model must be approved by the applicable regulatory authority and must be subject to an internal governance process that continuously assesses the rigor, applicability and appropriateness of the model. Alternatively, a firm may determine initial margin amounts by using a margin schedule prescribed by the applicable regulatory authority that sets out the initial margin requirements (expressed as a percentage of notional exposure) for different types of derivatives. The Consultative Paper includes a margin schedule proposed by the BCBS and IOSCO.
Firms should not be allowed to switch between using a quantitative model and the margin schedule so as to arrive at initial margin amounts that are more favourable. Instead, the choice of one over the other should be made on a consistent basis over time, for all transactions within the same well-defined asset class.
With respect to determining the amount of variation margin, the Consultative Paper proposes that the full net current exposure of the NCC derivative must be used. Variation margin should be calculated and collected for NCC derivatives subject to a single, legally enforceable netting agreement on a frequent basis (the Consultative Paper suggests daily). Minimum transfer amounts should be set sufficiently low so as to ensure that current exposure does not build up before variation margin is exchanged between the parties.
4. Eligible Collateral for Margin
Key Principle #4: 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 proposed requirements from losses on NCC 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 Consultative Paper indicates that examples of the types of eligible collateral that satisfy the key principle are cash, high quality government and central bank securities, high quality corporate bonds, high quality covered bonds, equities included in major stock indices and gold.
The BCBS and IOSCO state that haircut levels should be risk-based and should be calibrated appropriately to reflect the underlying risks that affect the value of the eligible collateral, such as market price volatility, liquidity, credit risk and foreign exchange volatility, during both normal and stressed market conditions. As in the case of determining the amount of initial margin required, a firm is permitted to use quantitative models or a prescribed schedule from the applicable regulatory authority to determine the haircuts based on the asset type of the collateral. Quantitative models used by a firm must be approved by the applicable regulatory authority and must be subject to appropriate internal governance standards. The Consultative Paper includes a schedule of haircuts proposed by the BCBS and IOSCO; however, regulators are encouraged to develop their own schedule with a list of eligible collateral assets and the haircuts for such assets, taking into account the conditions in their own markets. The BCBS and IOSCO add that haircut schedules should be sufficiently stringent so that firms have an incentive to develop internal models.
5. Treatment of Provided Margin
Key Principle #5: 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 (i) the margin collected is immediately available to the collecting party in the event of the counterparty's default; and (ii) the collected margin must be subject to arrangements that fully protect the posting party in the event that the collecting party enters bankruptcy to the extent possible under applicable law.
The BCBS and IOSCO propose that cash and non-cash collateral collected as initial margin should not be rehypothecated or re-used. If a counterparty is permitted to re-hypothecate or re-use collateral posted to it, then third parties would have legal or beneficial title over the collateral, or the collateral may be co-mingled with assets belonging to others. If such counterparty defaults, then the surviving firm's claim to the collateral becomes entangled in legal complications, thereby delaying or denying the return of re-hypothecated or re-used assets to the surviving firm. In this situation, the amount of initial margin that the surviving firm receives from the counterparty may not be sufficient to cover the loss caused by the re-hypothecation of collateral by the counterparty.
6. Treatment of Transactions with Affiliates
Key Principle #6: Transactions between a firm and its affiliates should be subject to appropriate variation margin arrangements to prevent the accumulation of significant current exposure to any affiliated entity arising out of NCC derivatives.
The BCBS and IOSCO considered the approach of requiring transactions between affiliates to comply with the same margin requirements applicable to transactions with non-affiliates versus the approach of exempting such transactions from the margin requirements. The first approach would fully extend the systemic risk reduction benefits of the margin requirements to intra-group arrangements; however, the BCBS and IOSCO recognize that doing so would require a corresponding increase in liquidity demands on the relevant firm. The second approach, in comparison, would not create any additional liquidity demands on the applicable entities, but would also provide no protection against the systemic risk posed by such transactions.
The BCBS and IOSCO propose a compromised approach: NCC derivatives between affiliated entities would be subject to variation margin requirements, but initial margin requirements would be left to the discretion of the applicable regulatory authority. Local authorities should review their own market conditions and impose the appropriate initial margin requirements.
7. Interaction of National Regimes in Cross-Border Transactions
Key Principle #7: Regulatory regimes should interact so as to result in sufficiently consistent and nonduplicative regulatory margin requirements for NCC derivatives across jurisdictions.
The BCBS and IOSCO propose that the margin requirements in a jurisdiction should be applied to legal entities established in that local jurisdiction, which would include locally established subsidiaries of foreign entities. The regulator in an entity's home jurisdiction should permit a covered entity to comply with the margin requirements of a host-country margin regime with respect to its derivative activities, so long as the regulator in the home jurisdiction considers the host-country margin regime to be consistent with the proposed margin requirements described in the Consultative Paper. A branch should be treated as part of the same legal entity as the headquarter, thus subject to the margin requirements of the jurisdiction where the headquarter is established.
Impact of Margin Requirements for NCC Derivatives
In our view, the proposed margin requirements, if implemented, will have a tremendous impact on firms that will be subject to the margin requirements, particularly the requirements relating to determining the minimum initial margin amount (i.e., either having a quantitative model approved by the regulator or posting initial margin according to a prescribed schedule), the requirement to exchange variation margin on a "frequent basis" (i.e., daily) with "low" minimum transfer amounts and the restriction on the re-hypothecation or re-use of posted collateral. Such requirements will increase the cost of entering into NCC derivative transactions and will potentially result in an increased demand for assets that are considered to be "eligible collateral". The extent and implications of these consequences are not known, but can be expected to be significant.
The BCBS and IOSCO acknowledge that some of the proposed requirements, such as requiring universal two-way margin with a low threshold and prohibiting the re-hypothecation of initial margin, will have a significant liquidity impact and an overall impact on market function. The BCBS and IOSCO are conducting a quantitative impact study (QIS) in order to gauge the impact of the margin proposals. According to the Consultative Paper, the QIS is expected to involve a large number of internationally active institutions that engage in significant amounts of derivative transactions across a number of national jurisdictions.
The QIS will be conducted during the consultation period and the results will be considered in conjunction with the comments received in respect of the Consultative Paper in forming a final proposal on margin requirements for NCC derivatives. A full copy of the Consultative Paper is [available here].
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