EMIR NON-CLEARED OTC DERIVATIVES REGULATION: A FUNDAMENTAL CHANGE IN HOW FINANCIAL INSTITUTIONS ARE DEALING WITH CREDIT RISKS
Authored by: Thomas Schiebe, Manager, Collateral Management GSASebastian Wrz, Associate, Collateral Management GSAFarid Rahba, Senior Consultant at MurexEtienne Ravex, Product Manager at Murex
EMIR NON-CLEARED OTC-DERIVATIVES REGULATION2
A fundamental change from survivor pay to defaulter pay 3
Key aspects of the regulation 5
Related implementation projects typically come with several challenges 6
Implementation efficiency and solutions 8
Authors and Editors 11
TABLE OF CONTENTS
Figure 1: Margining regulatory reforms from a European perspective
Over-the-counter (OTC) derivatives were identified as one of the main scapegoats of the 2007/2008 financial crisis. The G20 group, amongst others, suggested that all standardized OTC derivative contracts should be cleared, and that non-centrally cleared OTC derivatives should be held accountable for margin requirements. Subsequently, several policy frameworks and regulations have paved the way for a fully collateralized OTC derivative market, as illustrated in Figure 1 below.
In 2013, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) defined a policy framework for margin requirements for non-centrally cleared derivatives. The main objectives and benefits of this framework were a significant reduction of systemic risk in the market with the mandatory exchange of both initial margin (IM) and variation margin (VM). Margin is a defaulter-pay risk mitigation function, and has been preferred to capital, which is survivor pay. Margins are thus expected to give better incentives to market participants to better internalize the cost of their risk taking.
In Europe, the European Supervisory Authorities (ESAs)1 have drafted technical standards for the implementation of these rules under the EMIR regulation Article 5.
THIS NEW REGULATION IS INTRODUCING A FUNDAMENTAL CHANGE FROM SURVIVOR PAY TO DEFAULTER PAY
G20All standardized OTC derivative contracts should be [ ] cleared
Global Policy framework
EMIRRegulation 648/2012Article 5
Clearing Obligations Phase-In
Non-cleared Margins Phase-In
G20agreed that non-cleared OTC derivative contracts will have to be collateralized
BCBS/IOSCOMargin requirements for non-centrally cleared derivatives
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
EMIRRegulation 648/2012Article 11
ESAsRegulatory Technical standards
1European Securities and Markets Authority (ESMA), European Banking Authority (EBA) and European Insurance and Occupational Pensions Authority (EIOPA)
EMIR NON-CLEARED OTC-DERIVATIVES REGULATION4
below the clearing threshold from non-cleared margin requirements. Figure 2 highlights the implementation and phase-in timeline until 2020.
Requirements to exchange VM in the European Union will abide by proposed international timelines. Large financial firms are obliged to comply from September 1, 2016, while smaller ones will follow in March 2017.
Requirements to exchange two-way IM with a 50 million threshold on the group level will be in place from September 1, 2016, until August 31, 2020, depending on the month-end average notional amount of non-centrally cleared derivatives exceeding a particular transaction volume. From September 1, 2020, any entity which is part of a group with an average notional amount exceeding 8 billion will be obligated to comply with the margin requirements.
In terms of coverage, all types of non-centrally cleared OTC derivatives are affected by the new rule for IM exchange, apart from physically settled commodity derivatives. Counterparties may agree not to collect IM on physically settled foreign exchange forwards and swaps, or the principal in cross-currency swaps. Nevertheless, they are expected to post and collect the variation margin associated with these physically settled contracts, and these contracts do account for the IM threshold.
All financial firms and systemically important non-financial firms who are involved in trading OTC derivatives are subject to these margin requirements. In their second consultation paper (published in June 2015) the ESAs finally exempt non-EU non-financial entities that are
End of consultation period July 10, 2015
Exchange of Variation Margin starting from a group volume of more than EUR 3 trillion.
Exchange of Variation Margin between all counter-parties involved.
Approval of the technical standards by the EU commission and commencement 20 days after publication in the official journal of the EU. Market expectation after the end of the consultation period.
JULY 2015 SEP/OCT 2015 SEP 1, 2016 MAR 1, 2017 SEP 1. 2017 SEP 1, 2018 SEP 1, 2019 SEP 1, 2020
Exchange of Initial Margin starting from a group volume of more than EUR 3 trillion.
Exchange of Initial Margin starting from a group volume of more than EUR 2.25 trillion.
Exchange of Initial Margin starting from a group volume of more than EUR 1.5 trillion.
Exchange of Initial Margin starting from a group volume of more than EUR 8 billion.
Exchange of Initial Margin starting from a group volume of more than EUR 750 billion.
Figure 2: Implementation timeline
Basis of computation for the group volume is the aggregate month-end average notional amount of non-centrally cleared OTC derivatives for March, April and May.
In terms of eligible assets used as collateral, especially regarding the share of funds, the ESAs provide non-exhaustive and general guidelines. Those assets should be liquidated within a reasonable amount of time and keep their value over time after subtracting an appropriate haircut during periods of financial turmoil. They should not be subject to excessive credit, FX or market risk, and should not be affected by the correlation between the pledged asset and the counterparty. In particular, securities issued by the counterparty itself should not be accepted as collateral.
BCBS and IOSCO have developed a standardized haircut schedule, as shown in Figure 3, for a list of assets, including cash, high-quality government and corporate bonds, as well as central bank securities, equities and gold. The haircut figures are based on the standard supervisory schedule set by the Basel Accords. Internally developed models can be used if they
KEY ASPECTS OF THE REGULATION
evaluate the risk in a granular form. These haircuts should be transparent and easy to calculate. The industry may push for a shared solution since the haircut figures are considered high and thus costly.
In particular, the 8 percent haircut has been one of the most contentious elements of the original draft rules, as it would force counterparties to post more VM than their mark-to-market position would otherwise require compensating for currency mismatch. In its analysis published in August 2014, the International Swaps and Derivatives Association (ISDA) recognized that when collateral is denominated in a different currency to the underlying derivative, additional risk is created. This risk is manifested if FX markets move between the time of the default and the close-out, exposing a difference in value between the derivative and the collateral. ISDAs paper suggests that the 8 percent haircut will accentuate rather than mitigate the risk.
These concerns have been partly addressed since the ESAs exempt cash collateral from the 8 percent haircut rule per their second consultation paper.
Finally, in accordance with BCBS/IOSCO principles, the ESAs have set concentration limit requirements to ensure the diversification of collateral. The Regulatory Technical Standards (RTS) differentiate between two different types of concentration limits. The first is on the asset class level, permitting a 50 percent maximum of sovereign debt per issuer and country and a 10 percent maximum on non-sovereign debt, gold, corporate bonds and investment funds. The second limit is on the portfolio level, allowing a 40 percent maximum on securitization, convertible bonds, stocks and investment funds. All parties involved in the transaction are obliged to ensure compliance with the concentration limits at any time.
Asset classHaircut (% of
Cash in same currency 0
High-quality government and central bank securities: residual maturity less than one year
High-quality government and central bank securities: residual maturity between one and five years
High-quality government and central bank securities: residual maturity greater than five years
High-quality corporate\covered bonds: residual maturity less than one year
High-quality corporate\covered bonds: residual maturity greater than one year and less than five years
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
Figure 3: Standardized haircut schedule
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international environment. The policy change for market participants will be significant in any case.
Methodologies for calculating IM and VM have to be consistent across all