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September 2015

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 Würz, 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

Conclusion 10

Authors and Editors 11

TABLE OF CONTENTS

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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’

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G20“All standardized OTC derivative contracts should be [… ] cleared”

Global Policy framework

European Regulation

EMIRRegulation 648/2012Article 5

Clearing Obligations Phase-In

Non-cleared Margins Phase-In

G20“agreed 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)


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.

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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. ISDA’s 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

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

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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

Gold 15

Additional (additive) haircut on asset in which the currency of the derivatives obligation differs from that of the collateral asset

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Figure 3: Standardized haircut schedule


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 entities. Margin calculation should reflect future exposure (IM) and current exposure (VM).

VM depends on the mark-to-market (MtM) value of the derivative and is already commonly used. The value of IM reflects the size of the potential future exposure and depends on a number of factors, such as revaluation period of the contract, how often VM is exchanged between counterparties, the volatility of the underlying assets and duration of the contract.

In the latest RTS, the ESAs announced that a 50 percent concentration limit on sovereign debt will only apply if a 1 billion threshold in government bonds is exceeded.

The industry is currently facing several implementation challenges, such as the likely short time frame between the publication of the final rules and the implementation deadline (approximately six months). Due to the short time period and possible late changes in the final regulation, major hurdles and increased project complexity can easily build up. Once again, banks are faced with moving targets. Additionally, the effectiveness of the rules is highly dependent on consistent requirements and coordination of regulations in the

RELATED IMPLEMENTATION PROJECTS TYPICALLY COME WITH SEVERAL CHALLENGES

CHALLENGES

Competing Industry

Solutions

Short Time Frame

Contract Renegotiations

Intra Group

Exceptions

Margin Calculation

Models

Figure 4: Key implementation challenges

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Another intricate issue is the appropriate valuation of fund shares that are pledged as collateral. Fund shares are technically split into components that must be evaluated separately. Because the IM calculation in general will be based on the constituents of the specific fund, the decomposition of a certain fund might lead to further transparency issues. Another question that has to be addressed is whether or not the required information can be retrieved on a timely basis.

In addition, the concentration limits represent a big hurdle for IT systems and solutions in terms of the actual calculation and computational processes as well as real-time monitoring and end-of-day (EOD) reporting to risk departments. Those interfaces within a single entity will require a re-design of current processes and data flows. In the end, the collateral manager has to assure that both received and pledged collateral is compliant with the regulation.

Changes in regulations would require the renegotiation of existing contracts with counterparties. Current Credit Support Annexes (CSAs) are subject to important changes, affecting the IT landscape in terms of the unpredictable cost of system changes. A temporary arrangement for the transition period affects IT systems and data warehouses as well. A possible scenario could have multiple valid agreement versions in existence as new rules only apply to new transactions.

Finally, exempting intragroup transactions from the exchange of collateral will represent an important challenge, as these exceptions need to go through a stringent approval process from national authorities.

The IM calculation is either based on a quantitative portfolio margin model (more risk-sensitive but less transparent) or a standardized margin schedule (less risk sensitive but more transparent). The common method for some of the larger CCPs is to use the internal quantitative model. The RTS requires IM models to assume the variations in value at a confidence level of 99% with a risk horizon of at least 10 days. These models must be calibrated on a historical period of at least three years, including a period of financial stress. However, a quantitative model in use needs prior approval by the relevant/national supervisor authority.

The Standard Initial Margin Model (SIMM) developed by ISDA and used by the industry as an alternative to IM models is less restrictive than the standardized model. One of its objectives is the development of a valid, cross-border market standard.

It is also worth noting that an alternative option based on BIS SA-CCR is currently gaining traction in the industry and may be used in a future margin computation model.

These various competing and evolving margin models might coexist for quite some time, thus creating a challenge for each collateral management and risk management system tasked with computing IM.

The introduction of IM also imposes additional costs on trading. These costs have to be taken into account in trading decisions, representing another challenge of computing various trade-level margin metrics in real time.


The ability of IT systems to rapidly adapt to an ever-evolving regulatory environment is a key success factor for institutions to cope with these challenges. In particular, it’s important to have systems in place in the following areas:

› Support for various possible margin models along with real-time trading decision support

› Implementation of robust operational procedures to drive efficiency, reduce operational risk, and ensure documentation will be available in a timely manner

› Risk control procedures to comply with concentration limit requirements

Multiple margin models need to be supported

As mentioned earlier, from a computation perspective, the challenge is concentrated around IM rather than VM. ISDA is strongly pushing for a standard model, but there are still uncertainties around the final framework. In this context, systems need to be able to support possible competing models, including:

› A standardized, schedule-based model with a full representation of regulatory add-ons

› IM models based on VaR capabilities

› ISDA SIMM

› Or any new model similar to SA-CCR that may arise

These capabilities must be brought together at an aggregate level for the generation of IMs. Systems can add greater value by incorporating real-time incremental margins metrics into the trade decision-making process. Systems should not only cover possible models for uncleared margins, but more generally across all execution venues – bilateral, cleared and listed.

Robust operational procedures

These regulatory changes place collateral management at the forefront. Collateral management departments will need to leverage their core competencies in operations management to cope with multiple challenges:

› An exploding number of margin calls to be processed on a daily basis

› Compliance with new operational procedures

› Onboarding of new agreements while managing legacy contracts

Margin call volumes are expected to dramatically rise by 2020 when the regulation will be fully phased-in. An increasing number of agreements will be signed, with zero-threshold VM exchanged on a daily basis and IMs. Therefore, systems need to bring value and efficiencies by providing automation along the full lifecycle of margin calls. This represents an important shift from manually intensive work based on e-mail communication, to a higher level of automation leveraging electronic messaging standards.

The underlying workflows driving the settlement of calls are also undergoing dramatic changes and becoming more complex. ISDA is pushing to standardize these workflows, with the publication of a minimum standards document (published in November 2014) for the future-state margin workflow. While standards bring the important benefit of reducing the number of disputes on computed margins, there will still be a need to manage these processes.

The challenge for systems is not only to comply with these standards when they become effective, but also to be flexible enough to adapt and support operations towards this future state.

IMPLEMENTATION EFFICIENCY AND SOLUTIONS

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Legal departments play a key role: they are currently facing the strain of CSA renegotiations, the dramatic increase of agreements to be signed and cross-border jurisdictional issues. Systems can support a smooth transition towards this new legal environment by:

› Properly representing new types of CSA agreements

› Supporting the progressive amendments of legacy agreements

› Enabling trades to be covered by multiple agreements (for cross-border purposes in particular)

It is also imperative that these functionalities come with full auditing capabilities, as this transition will be given high attention from internal control and local supervisors.

One of the terms of legal agreements is given higher scrutiny with non-cleared margins regulations: threshold. For the IM, it may be agreed bilaterally to introduce a threshold of up to €50 million, which will ensure that only counterparties with significant exposures are subject to the IM requirements. This threshold will be monitored at the group level; in other words, a group having a CSA signed with multiple entities belonging to the same parent group will need to allocate these €50 million thresholds across these multiple entities. Systems can facilitate this threshold management, by enabling:

› The monitoring of the group-level threshold to make sure it does not exceed €50 million

› A regular (yearly) review of contract thresholds to possibly reallocate thresholds between entities, in case of excess or to ensure the €50 million threshold is fully used

Management of thresholds thus relies more on credit risk systems capabilities.

Concentration limits

Requirements around concentration limits will require an even closer integration with credit risk systems. This represents an important change. Until recently, most margin calls were allocated with cash and traditional collateral systems would not incorporate any credit risk monitoring capabilities. This will need to change since the increased use of securities and the loosening of eligibility criteria will require the enforcement of risk control measures.

Indeed, abiding by these requirements implies the need for systems to:

› Fully represent new sets of asset class definitions, and automatically categorize these assets based on underlying attributes

› Check these limits in real time, at the time collateral assets are being allocated to ensure there is no breach

› Allow for multiple risk control measures to be checked in parallel (such as monitoring both concentration risk and wrong-way risk) and at various levels (entity/group levels)

› Support processes to analyze any limit excesses


CreditRisk

Front-office

CollateralManagement

Cred

it Risk

Front-office Real-time Margining


Robust OperationsCreditRisk

Front-office


Cred

it Risk

Front-office Real-time Margining


Robust Operations

CONCLUSION

Margin requirements for non-cleared derivatives pose a series of challenges by further increasing the cost of doing business in OTC derivatives markets, while bringing more stability and shifting credit risks from survivor to defaulter. Systems can act as a key enabler to help institutions face these challenges by better monitoring trading costs and implementing regulatory requirements. This requires a unified infrastructure to overcome inefficiencies and fragmentation arising from legacy systems.

Figure 5: From fragmented and siloed legacy systems to a unified infrastructure

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AUTHORS AND EDITORS

THOMAS SCHIEBE IS A BUSINESS CONSULTANT AT SAPIENT GLOBAL MARKETS with a particular focus on trading, treasury, clearing and collateral management. Prior to joining Sapient Global Markets, Thomas worked in the treasury department of a medium-sized bank in Germany. An integral member of the clearing and collateral business develop team, Thomas has strong expertise in the regulatory environment covering DFA and EMIR requirements, as well as interest rate derivatives, FX products and static data management and regulatory reporting.

SEBASTIAN WÜRZ IS A BUSINESS CONSULTANT AT SAPIENT GLOBAL MARKETS and part of the Clearing and Collateral practice in Frankfurt. After joining Sapient Global Markets, he spent three months working with the Murex offshore team in the Bangalore office. Sebastian currently works on a collateral management and optimization project for a German tier I bank. Prior to joining Sapient as a consultant in the area of capital markets, he worked in asset and investment management for a fund management company and in SME Consulting.

FARID RAHBA IS A SENIOR CONSULTANT in the Collateral Management practice at Murex. He’s been with the company since 2007, first leading the credit and fixed income expertise for a portfolio of clients across Europe, then focusing on collateral management. Farid has been involved in key activities of the product management value chain, including strategic marketing, business development and evangelization. Farid also worked as a consultant for a major strategy consulting firm, where he led strategic studies for private equity, telecom and pharmaceutical companies.

ETIENNE RAVEX IS PRODUCT MANAGER AT MUREX for Collateral Management Solutions. After beginning his career in banking operations, he has since focused his efforts on developing vendor risk and collateral management solutions at Murex. Recently, Etienne oversaw the overhaul of Murex collateral management solution to address the new regulatory requirements and operational challenges the industry faces today.

Through his access to a diverse and global client base covering both buy-side and sell-side firms, Etienne has expanded his expertise to include knowledge of regulatory change, collateral transformation and optimization challenges.


About Sapient Global MarketsSapient Global Markets, a part of Publicis.Sapient, is a leading provider of services to today’s evolving financial and commodity markets. We provide a full range of capabilities to help our clients grow and enhance their businesses, create robust and transparent infrastructure, manage operating costs, and foster innovation throughout their organisations. We offer services across Advisory, Analytics, Technology, and Process, as well as unique methodologies in program management, technology development, and process outsourcing. Sapient Global Markets operates in key financial and commodity centers worldwide, including Boston, Calgary, Chicago, Düsseldorf, Frankfurt, Houston, London, Los Angeles, Milan, New York, Singapore, Washington D.C. and Zürich, as well as in large technology development and operations outsourcing centers in Bangalore, Delhi, and Noida, India.

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About Murex’s solutions for Collateral Management and Securities FinanceMX.3™ for Collateral Management and Securities Finance is an enterprise collateral management solution for bilateral or cleared OTC, repo or securities lending, and exchange-traded derivatives products.

Key features include:

› BCBS/IOSCO WGMR and CCP margining

› Real-time inventory with a flexible optimization engine

› Powerful STP workflow manager providing connectivity to TriResolve, MarginSphere and Swift.

About MurexSince its creation in 1986, Murex has played a key role in proposing effective technology as a catalyst for growth in capital markets, through the design and implementation of integrated trading, risk management and processing and post-trade platforms. Driven by innovation, Murex’s MX.3 Front-to-Back-to-Risk platform leverages the firm’s collective experience and expertise to offer an unrivalled asset class coverage and best-of-breed business solutions at every step of the financial trade lifecycle.

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