CPD Day 2016 - files.simmons-simmons.com

CPD Day 2016

Margin for Uncleared OTC Derivatives – What? Why? Who? When? How?

Speakers: Jason Valoti and Simon McKnight

19 October 2016

© Simmons & Simmons LLP 2016. Simmons & Simmons is an international legal practice carried on by Simmons & Simmons LLP and its affiliated partnerships and other entities.

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Overview

Comparative analysis of margin rules in the US, the EU, HK and Singapore– Affected counterparties– Timings– Key differences and similarities

Approaches to documenting new Initial Margin and Variation Margin arrangements for existing relationships– Bilateral amendments– Protocols– New forms of credit support annexes/deeds

Likely challenges that may be faced in implementing new margin arrangements– Focus on non-G-SIB counterparties


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What? Why?


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Relevant Lessons from Financial Crisis

Lehman Brothers’ derivatives:– Exchange traded derivatives mostly settled/ported within two weeks of

bankruptcy filings– Many OTC derivatives took up to six years to settle with no porting– Collateral rehypothecation by Lehman created substantial additional

unsecured exposure for collateral-giver– Collateral liquidity dramatically reduced– Rules on client money and custody inadequate (difficult to determine which

assets held by Lehman for which clients)

Change in OTC derivatives valuations due to deterioration in counterparty credit risk was a greater source of losses than outright defaults

Litigation on specific provisions of ISDA Master Agreement– e.g.s.2(a)(iii) on Non-defaulting Party delay (England: Lomas v JFB Firth

Rixson indefinite; US: Metavante limited period but not specified)


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Developments in OTC Derivatives

Central clearing(+ client clearing)

Risk mitigation for uncleared

OTC derivatives

Regulatory capital

Reporting

Timely confirmation

Processes to manage/identify

risks

Margin(marking-to-

market or model)

Portfolio compression


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Initial Margin (IM) and Variation Margin (VM)

CounterpartyA

CounterpartyB

IM AIM BVM

±IM A±IM B

Segregated Account for

IM B

Segregated Account for

IM A

IM:- Not netted- Levels of

segregation (prop. or omnibus accounts)

- Rehypothecation generally not allowed

Not all counterparties

caught

Acceptable forms of margin

prescribed

IM: Protects against price movements between last collection and liquidationVM: Reflects current value of derivativesNetting set important


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Regulatory Capital v Margin

Regulatory capital

“Survivor-pay” and “shared”

Applies to banks and other credit institutions

Capital ratios (e.g. Tier 1 ratio)

Credit quality steps (c.f. ratings) and risk weightings

Counterparty credit risk– Credit valuation adjustment (CVA)– Debit valuation adjustment (DVA)– Wrong-way risk (esp. for margin)

Margin

“Defaulter-pay” and “targeted”

Margin requirements for uncleared OTC derivatives applies to all entities above threshold

Reduces regulatory capital required

See BCBS-IOSCO papers:1. “Margin requirements for non-centrally

cleared derivatives” published March 2015 (orig. September 2013)

2. “Risk Mitigation Standards for Non-centrally Cleared OTC Derivatives” published January 2015


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EMIR RefresherDo the EU margin rules apply to your funds?

Dealer

FC Hypothetical FC

FC/NFC+ In-scope In-scope

Hypothetical FC/NFC+ In-scope Out-of-scope*

NFC– Out-of-scope Out-of-scope

Hypothetical NFC– Out-of-scope Out-of-scope

Fund

* Unless “direct, substantial and foreseeable effect” in the EU or necessary as anti-avoidance


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US Refresher (from a non-US lawyer)Do the US margin rules apply to your funds? Broadly yes, where dealer is SD, MSP, SBSD or MSBSP

And where your fund is:– SD, MSP, SBSD or MSBSP (unlikely)– Financial End User with Material Swap Exposure (maybe)– Financial End User without Material Swap Exposure (likely)

Unless:– PR rules: none of: (i) the dealer; (ii) your fund; and (iii) any guarantor (on

either side) is organised under US law, a US branch, a branch of a US entity, a subsidiary of a US entity; or

– CFTC rules: (i) dealer is not a US person, not guaranteed by a US person, not a US branch, not a consolidated subsidiary of a US person; and (ii) your fund is not a US person and is not guaranteed by a US person


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Who? When?


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International Convergence

Goal is to ensure margin requirements broadly consistent worldwide– Avoid regulatory arbitrage– Create level playing field

… but there are still differences among how local law implementations

Many jurisdictions do not recognise netting so these margin requirements are not being implemented in those jurisdictions (e.g. China)– No posting of initial margin to entities in those jurisdictions?


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State of Legislation/Rules

EU US HK SG

Primary Legislation

EMIR Art. 11 Dodd-Frank Draft SupervisoryPolicy Manual

TBC

Secondary Legislation

RTS 149/2013 + adopted RTS (waiting for OJ publication)

- - TBC

Rules - PR and CFTCRules published, SEC Rules awaited

- -

Consultation Paper

- - HKMA CP15.02 Dec 2015

MAS P017-2015 Oct 2015

Waiting for EU legislation to be finalised


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VM Timings

Uncleared AANA* for March, April, May 2016

EU US HK SG

EUR/USD 3 trillionHKD 24 trillionSGD 4.8 trillion

One month after RTS enters into force (~Jan 2017?)

1 Sep 2016

TBC (~1 Mar 2017?)

TBC (~1 Mar 2017?)

Otherwise

Later of 1 Mar 2017 and one month after RTS enters into force

1 Mar 2017

~1 Mar 2017 ~1 Mar 2017

* EU, HK and SG take month-end average, US daily average


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IM Timings

Uncleared AANA for March, April, May ofrelevant year*

EU US HK SG

EUR/USD 3 trillionHKD 24 trillion**SGD 4.8 trillion

One month after RTS enters into force (Jan 2017?)

1 Sep 2016

TBC (~1 Mar 2017?)

TBC (~1 Mar 2017?)

EUR/USD 2.25 trillionHKD 18 trillionSGD 3.6 trillion

1 Sep 2017 ~1 Sep 2017 ~1 Sep 2017


1 Sep 2018 ~1 Sep 2018 ~1 Sep 2018


1 Sep 2019 ~1 Sep 2019 ~1 Sep 2019

EUR/USD 8 billion*HKD 60 billionSGD 13 billion

1 Sep 2020 ~1 Sep 2020 ~1 Sep 2020

* USD threshold only available for Financial End User. USD amount determined over June, July and August of preceding year.** HKD thresholds reviewed if material EUR/HKD exchange rate change


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Covered Entities – Generally

EU US HK SG

Financial Counterparties(includes AIFs)

Swap Dealers

Security-Based Swap Dealers

FinancialCounterparties

MAS CoveredEntities

Non-Financial Counterparties above threshold (NFC+)

Major Swap Participants

Major Security-Based Swap Participants

Significant Non-Financial Counterparties

Potential MAS Covered Entities

HKMA Designated Entities


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Covered Entities – Some Margin Exemptions

EU US HK SG

Exemptaltogether

Intragroup transactions*

Intragroup transactions

AI intragroup transactions

Intra-group transactions*

Covered bonds Physically settled FX forwards and FX swaps

Physically settled FX forwards and FX swaps

Non-Financial End User hedging

Exempt from IM



Cross-currency swaps

Cross-currencyswaps

Limited exemptions

Minimum transferamounts (max EUR 500,000)

Minimum transferamounts (max USD 500,000)

Minimum transferamounts (max HKD 3,750,000)

Minimum transferamounts (max SGD 800,000)

* Regulatory approval needed


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Hong Kong Rules – Entities subject to the Rules Entity Type Subject to Rules Details

Hong Kong AI Yes – Rules cover all branches

Trade must be with a Covered Entity

Subsidiary of Hong Kong incorporated AI

No – subject to HKMAdetermination

HKMA may apply the Rules to the subsidiary in respect of a trade if it is with a Covered Entity and: (i) It transacts in non-centrally cleared derivatives of a significant amount relative to the AI as a whole; and(ii) is not subject to effective margin standards in the jurisdiction where it is incorporated

Foreign incorporated AI Yes – in respect of trades booked by its Hong Kong Branch

Trade must be with a Covered Entity

Guaranteeing AI Yes – subject to certain conditions being met

Conditions include:(i) Both parties must be Covered Entities(ii) Guaranteeing AI not subject to comparable rules in home jurisdiction(iii) If a non-Hong Kong incorporated Guaranteeing AI, the guarantee is booked in its Hong Kong branch; and(iv) Guarantee is legally and explicitly documented and covers liabilities of guaranteed Covered Entity for non-cleared derivatives of at least HKD60billion

Intragroup Transactions No – subject to certain conditions (and subject to HKMA’s right to require compliance to avoid circumvention of the Rules)

Conditions include:(i) Group is subject to group-wide supervision by HKMA or authorities in other jurisdictions; and(ii) Group wide integrated risk management function is established


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Hong Kong Rules – Covered EntitiesEntity Type Details

Financial Counterparties

Includes:- AIs- SFC licensed entities (holding Type 1, 2, 3, 4, 5, 6, 8, 9, 11 and 12 licences)- Mandatory provident fund schemes - Occupational retirement schemes- Companies authorised by the Insurance Authority to carry on any class of insurance business- Licensed Money service operators- Licensed lenders- Entities that carry on a business outside Hong Kong akin to the items above- Special purpose entities as defined in section 227 of the Banking (Capital) Rules- Collective investment schemes as defined in the Securities and Futures Ordinance- Private equity funds

Significant Non-Financial Counterparty

An entity other than a financial counterparty that for a one-year period from 1 September each year to 31 August the following year has an aggregate notional amount of non-centrally cleared derivatives exceeding HKD 60 billion

HKMA Designated Entity

An entity designated at the discretion of the HKMA and not covered by the above entity types


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Hong Kong Rules – Partial/Substituted Compliance

Entity Covered Entity Applicable Rules

Hong Kong incorporated AIs (covering all its Branches)

Locally incorporated AI HK Rules

Covered entities incorporated in Hong Kong HK Rules

Covered entities incorporated outside Hong Kong

Partial

AI incorporated outside of Hong Kong, booking through its Hong Kong Branch

Locally Incorporated AI (including all branches globally)

Partial

Non-AI covered entity incorporated in Hong Kong

Substituted

Covered entity incorporated outside Hong Kong Substituted


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Hong Kong Rules – Collateral Requirements Eligible Collateral IM – Requirements VM -

Requirements- Cash

- debt securities issued or fully guaranteed by a sovereign associated with a credit quality grade 3 or above

- debt securities issued or fully guaranteed by a multilateral development bank

- debt securities issued or fully guaranteed by a public sector entity associated with a credit quality grade 3 or above

- Other debt securities associated with a credit quality grade 3 or above

- Gold

- Publicly traded equities included in the Hang Seng Index or any other main index

Excluded: Securities issued by financial institutions, securities that would create wrong way risk and securities that would result in over concentration in terms of issue, issue type or asset type

Haircut:

Standardised schedule with 8% FX mismatch haircut

Timing for Calculation:

Every 10 business day or at the earliest possible time, and in no case later than T+1, after one of the following events:- execution of a non-centrally cleared OTC derivative transaction; - the non-centrally cleared OTC derivative transactions forming part of the netting set changes; or- the calculation methodology changes

Timing for Delivery:

Two business days following IM call

Segregation:

IM should be segregated from collector’s proprietary assetsIf a third party custodian is used for IM, the AI must ensure that the custodian meets certain criteria regarding its financial qualityIM collector must provide posting party with the option of individually segregated IM

Rehypothecation:

Prohibited, save that IM collected in the form of cash may be reinvested by the collecting party or its custodian if: - Securities are properly segregated; - Funds are only invested in eligible collateral; and- Re-investment is based on an agreement between the parties

Threshold:

Where cumulative IM exposure from a counterparty is equal or lower than HKD 375 million, parties may agree in writing not to exchange IM


Daily (by T+1)


Two business days following the margin call (by T+2)

Segregation:

N/A

Rehypothecation:

N/A


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Singapore Rules – Entities subject to the Rules

Entity Type Subject to Rules Details

MAS Covered Entity Yes – provided conditions are met

Trade must be:

(i) with another MAS Covered Entity or an overseas regulated financial firm; and

(ii) booked in Singapore

Non-MAS Covered Entity No

Intragroup Transactions Exemption possible MAS proposes that MAS Covered Entities may apply for exemption of intra-group transactions from the scope of margin requirements, subject to the condition that the MAS Covered Entity comes under group-wide supervision by MAS or regulators in other jurisdictions.

MAS proposes that the exemption be limited to transactions between entities belonging to the same group where the financial statements of these entities are consolidated upon preparation of the group consolidated financial statements. Such transactions do not transfer risks in or out of a corporate group and are best left to such groups to manage their group-wide risks in a manner most appropriate for their corporate structure


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Singapore Rules – MAS Covered Entities

Entity Type Details

MAS Covered Entities

Includes all entities regulated under the Securities and Futures Act:

- Banks licensed under the Banking Act

- Merchant banks approved as financial institutions under Section 28 of the Monetary Authority of Singapore Act

- Other licensed financial institutions

Potential MASCovered Entities

In addition to the above confirmed list of MAS Covered Entities, MAS is also considering whether to require Investment Funds domiciled in Singapore to comply with the proposed margin requirements subject to a threshold


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Singapore Rules – Deemed Compliance

Entity Covered Entity Applicable Rules

MAS Covered Entity MAS Covered Entity or overseas regulated financial firm

Deemed compliance with SG Rules:

- an MAS Covered Entity, established under the laws of, or that has a place of business in, a foreign jurisdiction with comparable margin requirements, is required to comply and has complied with the margin requirements of that relevant foreign jurisdiction; or

- an MAS Covered Entity, trading with a foreign counterparty, is required to comply with and has complied with comparable home- or host- margin requirements imposed on the foreign counterparty.

Note: MAS proposes to adopt a comparability assessment with a focus on whether the margin requirements in the foreign jurisdiction achieve the same regulatory objectives as MAS’ margin requirements. However, MAS is considering the requirement for MAS Covered Entities to collect the types of eligible collateral and hold them in a manner consistent with MAS’ rules


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Singapore Rules – Collateral Requirements Eligible Collateral IM – Requirements VM -

Requirements- cash

- gold

- debt securities issued by central governments and central banks (rating requirement AAA and BB-)

- debt of other issuers (rating requirement AAA to BBB-)

- equity securities in a main index of a securities exchange in Singapore or recognised exchange in Australia, Austria, Belgium, Canada, France, Germany, Hong Kong, Italy, Japan, Malaysia (except Labuan), Netherlands, New Zealand, South Korea, Spain, Sweden, Switzerland, Taiwan, Thailand, United Kingdom, United States

Haircut:

Standardised schedule with 8% FX mismatch haircut


At the outset of a transaction and thereafter on a sufficiently regular basis to reflect changes in risk positions and market conditions


At the outset of a transaction and thereafter within two Business Days following recalculation of the IM obligations

Segregation:

IM must be held with an independent third party on trustIM should not be mixed and must be held under distinguishable separate arrangements to that of the collecting party’s proprietary money and assets

Rehypothecation:

Non-cash IM may only be rehypothecated for the purposes of hedging the IM collector’s derivative positions arising out of transactions with the customer for which such IM was collected

Threshold:

IM only needs to be posed where the cumulative IM exposure from to counterparty exceeds SGD$80 million


At least daily


Two business days following execution of a new uncleared derivative contract

Segregation:

N/A

Rehypothecation:

N/A


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General Points to Note

Need for diversification

Periodic reassessment of liquidity

Wrong-way risk– Margin cannot comprise securities issued by the counterparty

Risk management procedures required to include prescribed details– To be reviewed and updated as necessary and at least annually– To be tested at least once a year

Written trading and exchange of collateral documentation required, which must include prescribed terms– ISDA master agreements will satisfy– “independent legal review” of legal enforceability of netting


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How?


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What do you need to do?Big picture

Banks: VM + IM requirements imminent

Funds/managed accounts: VM imminent, IM to come later

Analyse what VM + IM rules apply to you and your counterparties

Prepare for re-documentation exercise for CSAs (next slide)

Consider what operational changes needed

Review current risk procedures for compliance

Conduct independent legal reviews of trading agreements

Consider potential loss of liquidity as cash and liquid securities tied up as margin


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What do you need to do?Re-documentation exercise

Margin rules apply only on going forward basis– One VM CSA v two VM CSAs– IM CSD v NY CSA

Bilateral amendment:– Most flexible and avoids concerns of automatic application of Protocol

provisions, but can involve more work– ISDA Asia-Pacific producing templates

ISDA 2016 Variation Margin Protocol:– Adherence + Questionnaire exchange (+ Supplemental Questionnaire)– Amend, Replicate-and-Amend, New CSA, New ISDA– Much more complicated than bilateral, but potentially easier from document

management perspective

ISDA has produced several CSA/CSD templates for

IM/VM


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English law CSA with VM and IM – Example Diagram

ISDA Master

Trans.Trans. Trans.

CSA (1995)

CSA for VM (2016)

Trans. Trans. Trans.

Pre-EMIR OTC margin implementation

Post-EMIR OTC margin implementation

CSD for IM (2016)


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Calculation of MarginInitial Margin

Calculated using BCBS standardised approach or a model

Standard Initial Margin Model (SIMM)TM

– Reflects systemic risks– Not pro-cyclical– No be approved by regulators

Can use internal model instead– Numerous things to factor in– Regulators can ask to see them– Too complex for most market

participants

Variation Margin

Usually marked-to-market

Marking-to-model permitted only where market conditions prevent marking-to-market– Model can be developed

internally or externally– Needs to use as much market

data as possible– Validated and monitored

independently


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What do you need to do?S&S DRS Collaboration

Derivatives Risk Solutions (DRS) DocHub

Margin Solutions Product– Assists with documentation and regulatory compliance needs– Outsourcing service staffed by teams of experience lawyers and paralegals– Pre-agreed fixed price per agreement– Flexible and scalable


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Summary


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Summary

This seminar should have covered:– Comparative analysis of margin rules in the US, the EU, HK and Singapore– Approaches to documenting new Initial Margin and Variation Margin

arrangements for existing relationships– Likely challenges that may be faced in implementing new margin

arrangements for non-G-SIB counterparties

Things have not yet been finalised…


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BiographiesSimon McKnight – Hong [email protected] is a derivatives and structured products specialist whose work spans awide range of products, including equity, credit and commodity linked productsin OTC, loan and notes format. His most recent work has focused oncorporate equity derivatives such as margin loans and collar financings.Before that he worked on all forms of credit derivatives, equity derivatives,stock loans/repos and repackagings and spent a year working on the Lehmanadministration.

Jason Valoti – [email protected] acts for international investment banks in relation to structured and OTCderivative transactions, synthetic and cash CDOs, CLOs and repackagedsecurities and other asset and fund backed structures, including Shariahcompliant transactions. Jason also advises international investment banks inrelation to equity and commodity linked note, warrant and certificate issues. Inaddition, he advises investment managers on structured debt capital marketstransactions.


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CPD Day 2016 - files.simmons-simmons.com

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