The regulatory requirements for posting and collecting initial margin (IM) currently apply principally to the uncleared over-the-counter (OTC) derivatives of swap dealers and other large banking organizations. Starting as soon as later this year, and then continuing next year and the year after, the IM requirements will also apply to uncleared OTC derivatives of end-users (Buy Side Firms) that have significant uncleared OTC derivative portfolios. The most important phase-in dates for such Buy Side Firms are likely to be September 1, 2019 and September 1, 2020.
Uncleared OTC derivatives between swap dealers and such Buy Side Firms are already subject to variation margin (VM) requirements; however, the requirements and related arrangements for posting and collecting IM will be substantially more burdensome than those for VM. Thus, although the September 2019 and September 2020 dates may seem distant, Buy Side Firms that expect to be in scope for the IM requirements should engage in several different kinds of advance planning. And even Buy Side Firms that conclude that they will not likely be in scope for the IM rules will soon have work to do: they are likely to be asked by swap dealers for documentation to confirm their conclusions in that regard, which will require them to undertake related quantitative analyses that may be time consuming, particularly for Buy Side Firms that trade through multiple investment managers.
To assist with the phase-in process, the International Swaps and Derivatives Association, Inc. (ISDA) recently published a form of self-disclosure letter (IM Letter). The IM Letter is designed to enable a Buy Side Firm to notify its dealer counterparties whether it expects to be in scope for purposes of the September 2019 or September 2020 phase-in date or, alternatively, not to be in scope for purposes of either date.1 Dealer counterparties may request Buy Side Firms to complete the IM Letter (or documentation similar to it) in the near term, as the dealers begin their own preparations for the next phases of IM compliance. Many Buy Side Firms will therefore need to determine soon whether and when the IM rules are likely apply to them. Thus, Buy Side Firms are encouraged to begin gathering the necessary data now, in order to undertake the calculations that will need to be undertaken to determine how to complete the IM Letter. Note that, although those calculations can be complex, the IM Letter itself does not provides substantive guidance regarding how to complete it.
Buy Side Firms that will be in scope for the IM rules will also need time to prepare for implementation of the requirements. This will likely entail amending existing documentation (or entering into new regulatory IM compliant documentation), establishing new custodial relationships for the collection and holding of IM, determining the amount of IM that will be required, considering the consequences of such requirements on the Buy Side Firm’s liquidity, and implementing methods to monitor relevant threshold calculations set forth in the rules.
The purpose of this Sidley Derivatives Update is to provide general guidance to Buy Side Firms about what to expect with respect to the implementation of the IM rules in the EU and the United States (respectively, the EU Rules2 and the U.S. Rules3 and, together, the IM Rules)4 and what Buy Side Firms should consider when responding to requests to complete the IM Letter.
What are the margin rules for uncleared OTC derivatives?
Regulators in the United States, the EU and other jurisdictions have adopted rules requiring market participants to exchange IM and VM for uncleared OTC derivatives. Those rules were adopted following a commitment made by G20 leaders in 2011,5 and they are based on the September 2013 international policy framework for margin requirements issued by the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions.6 The specific regulatory margin regime (or regimes) applicable to an uncleared OTC derivative between a Buy Side Firm and a given counterparty will depend on, among other factors, where the Buy Side Firm and the counterparty are organized and operating.
What are the IM requirements for uncleared OTC derivatives in the United States and the EU?
In the United States and the EU, the IM Rules require IM to be posted and collected, subject to a permitted threshold of up to US$50 million under the U.S. Rules and €50 million under the EU Rules.7 In both the United States and the EU, the requirement marks a change from current market practice, under which many Buy Side Firms post IM to their dealer counterparties, but do not collect it.
Collateral posted as IM must be in a form that is prescribed, and it must be posted in a manner that is also prescribed, by the IM Rules. Under the U.S. Rules, collateral posted as IM must be held by an independent third-party custodian that is not affiliated with either counterparty. Under the EU Rules, cash collateral must be held by an independent third-party custodian that is a bank and that is not affiliated with either counterparty; however, non-cash collateral may be held via other legally binding arrangements that protect the posting counterparty from the default or insolvency of the collecting counterparty, and any non-cash collateral held by the posting counterparty must be held in insolvency-remote custody accounts. Those requirements also represent a significant departure from current market practice, under which only a small percentage of Buy Side Firms have custodial arrangements in place for the collection and holding of IM.
How does a Buy Side Firm determine if it will be in scope for the IM Rules?
The U.S. Rules impose requirements on registered swap dealers both to post and to collect IM from any counterparty that is a “financial end user”8 with “material swaps exposure.” Buy Side Firms that are covered by those definitions will be required to exchange IM with their swap dealer counterparties as a result of the swap dealers’ regulatory obligations.
By contrast, under the EU Rules, certain Buy Side Firms will be directly subject to the EU Rules. Thus, a Buy Side Firm that is either (i) a financial counterparty9 (FC) under the European Market Infrastructure Regulation10 (EMIR) or (ii) a non-financial counterparty that exceeds the EMIR clearing threshold11 (an NFC+) and that exceeds the applicable EU margin thresholds will be required both to post and to collect IM when transacting with other FCs and NFC+s, as well as when transacting with non-EU entities that are similar to FCs and NFC+s (including non-EU dealers).12
What are the relevant average aggregate notional amount thresholds for purposes of the IM Rules?
Both the U.S. Rules and the EU Rules will measure a Buy Side Firm’s uncleared OTC derivatives activity by reference to the average aggregate notional amount (AANA) of the Buy Side Firm’s uncleared OTC derivatives. The AANA calculations under both sets of rules are applied on a gross basis (i.e., without the Buy Side Firm netting exposures with a given counterparty); however, trades between affiliates are counted only once. Despite these basic similarities, there are important differences between the U.S. Rules and the EU Rules.
Under the U.S. Rules, a Buy Side Firm has “material swaps exposure” if it and its “affiliates” had a daily AANA of uncleared OTC derivatives, measured across all counterparties for June, July and August of the previous calendar year that exceeded US$8 billion. For that purpose, uncleared OTC derivatives include CFTC-regulated swaps, SEC-regulated security-based swaps and foreign exchange derivatives and forwards, in each case, that are not cleared through a central clearing counterparty.
Under the EU Rules, the threshold for determining whether an FC or an NFC+ is in scope for the EU Rules is €8 billion, measured by reference to its, and each member of its group's, AANA of uncleared OTC derivatives on the last business day of March, April and May of the prior calendar year. For purposes of calculating AANA under the EU Rules, a Buy Side Firm must include uncleared OTC derivative contracts that may otherwise be exempt from the requirements of the EU Rules, including certain FX derivative transactions and certain temporarily exempted equity options.
What is an “affiliate” or a “group” for purposes of calculating AANA under the IM Rules?
In both the United States and the EU, affiliation is generally determined by reference to accounting consolidation principles.
Under the U.S. Rules, an entity generally will be deemed an “affiliate” of another entity for purposes of calculating material swaps exposure if: (i) either entity consolidates the other entity on its financial statements prepared in accordance with applicable accounting principles (or would be required to consolidate the other entity on its financial statements if such applicable accounting principles were applied); or (ii) both entities are consolidated with a third entity on financial statements prepared in accordance with applicable accounting principles (or would be consolidated on the financial statements of a third entity if such accounting principles were applied).
In the context of investment funds, two separate funds managed by the same investment manager will not be affiliates for purposes of calculating material swaps exposure unless the financial statements of the two funds are (or would be) consolidated.
It is important to note that because AANA, for the purposes of the U.S. Rules, is measured on a principal-by-principal basis, a Buy Side Firm that uses multiple investment managers will need to aggregate applicable derivatives activity across all its accounts in order to calculate its AANA. The Buy Side Firm will need to take into account not only the uncleared OTC derivatives that it has entered into directly (including through various managers), but also the uncleared OTC derivatives entered into by any sub-advised funds or accounts for which it is the sole investor. It will also need to aggregate any uncleared OTC derivatives entered into by its affiliates on a similar principal basis (i.e., across all of the given affiliate’s managers and relevant sub-advised funds or accounts).13 Thus, an investment manager for a small managed account of a large institutional investor group may be surprised to find that uncleared OTC derivatives traded for that account will be subject to IM requirements. Accordingly, investment managers acting as subadvisors to large institutional investors (through managed accounts, single investor funds or otherwise) are advised to contact their sub-advisory clients in the near term to discuss the logistics of making the necessary AANA calculations.
Under the EU Rules, the “group” by reference to which IM thresholds are applied is generally determined by reference to accounting consolidation principles set out in the EU Accounting Directive.14 Under the EU Accounting Directive, “group” means “a parent undertaking and all its subsidiary undertakings.” “Parent undertaking” means “an undertaking which controls one or more subsidiary undertakings,” while “subsidiary undertaking” means “an undertaking controlled by a parent undertaking, including any subsidiary undertaking of an ultimate parent undertaking.”
With respect to investment funds, funds will not be considered to be part of the same group for the purposes of the EU Rules if they are distinct segregated pools of assets for the purposes of the fund’s insolvency or bankruptcy, and if they are not collateralized, guaranteed or otherwise financially supported by other investment funds or their managers.
With respect to any sub-advised funds or accounts for which a Buy Side Firm is the sole investor, a result similar to that described above for the U.S. Rules may apply under the EU rules, and Buy Side Firms will need to consider whether uncleared OTC derivatives entered into via managed accounts need to be included in the calculation of AANA for the purposes of applying the EU thresholds.
When will the IM Rules start to apply?
The IM Rules are being phased in for all market participants according to a schedule tied to recent levels of their uncleared OTC derivatives activity. For a given phase-in date to apply to a given derivative, both counterparties to the swap must have uncleared OTC derivatives activity exceeding the stated threshold for that date. Thus, the two phase-in dates that have already occurred resulted in IM requirements only for swaps between the largest market participants, particularly swap dealers (i.e., those market participants having AANAs exceeding US$2.25 trillion in the United States or €2.25 trillion in the EU).15 The IM phase-in dates for remaining market participants, including Buy Side Firms that will be in scope for the IM Rules, will be determined as follows, by reference to the AANA for the given Buy Side Firm (and all of its affiliates or group members) for the preceding March, April and May:
- September 1, 2018, if the AANA exceeds US$1.5 trillion for purposes of the U.S. Rules or €1.5 trillion for purposes of the EU Rules (Phase 3).
- September 1, 2019, if the AANA exceeds US$750 billion for the U.S. Rules or €750 billion for purposes of the EU Rules (Phase 4).
- September 1, 2020, for all other Buy Side Firms that are in scope for the IM Rules (Phase 5).
Note that, under the U.S. Rules, the AANA that determines whether a Buy Side Firm has exceeded the US$8 billion material swaps exposure threshold (and is thus in scope if it is a financial end user) is calculated over a different period from the period used to calculate the AANA that then determines the Buy Side Firm’s phase-in date. In the former case (material swaps exposure), AANA is calculated for the months of June, July and August of the previous calendar year. However, for the phase-in dates, as described above, AANA is calculated for the months of March, April and May of the current year. Similarly, under the EU Rules, the phase-in dates are determined using the AANA of the current year (March, April and May), but the €8 billion threshold that triggers application of the IM requirements uses AANA for each of March, April and May of the preceding year.16
How will the amount of required IM be calculated?
Under both the U.S. Rules and the EU Rules, IM must be calculated using either a risk-based IM model or a look-up table of standardized minimum amounts set out in the applicable IM Rules. Under the U.S. Rules, risk-based IM models must be approved by a swap dealer’s relevant U.S. regulator. At the time of this Sidley Derivatives Update, there is no similar requirement in the EU.
ISDA has developed the ISDA Standard Initial Margin Model (ISDA SIMM) to provide a common IM calculation methodology that can be used by market participants globally. Most dealers have already implemented the ISDA SIMM for purposes of earlier phases of the IM Rules’ implementation, and it is expected that dealers will continue to rely on that model.
Any party using the ISDA SIMM to calculate IM, regardless of whether such party, such party’s counterparty or a third party vendor is the party that actually calculates the IM amount, will need to consider ISDA’s licensing requirements for use of the ISDA SIMM.17
What documentation will be required to prepare for compliance with the IM Rules?
In most cases, Buy Side Firms that are in scope for the IM Rules will be required to amend the terms of their existing collateral documentation (or to enter into new collateral documentation that is compliant with the IM Rules) and to enter into two triparty custodial arrangements: one for the custody of IM posted by the Buy Side Firm; and a second for custody of IM collected by the Buy Side Firm. There must be two separate triparty arrangements because, under both the U.S. Rules and the EU Rules, regulatory IM posted and collected must be segregated.
ISDA is currently working with its members to draft a template Credit Support Annex governed by New York law (2018 NY IM CSA) that parties can use to comply with the IM requirements in the United States, the EU and certain other jurisdictions. The 2018 NY IM CSA is based on the “ISDA 2016 Phase One Credit Support Annex for Initial Margin (Security Interest–New York Law),” which was used by dealers during earlier IM compliance phases. ISDA intends to publish the 2018 NY IM CSA in the near term. ISDA plans to work with its members to produce template IM credit support documentation that is governed by English law.
ISDA is also working to develop an online tool called “ISDA–Create IM,” which is intended to facilitate the negotiation and execution of IM documentation. The online tool is being designed with the intention of making the negotiation process for IM documentation more efficient, and, according to ISDA, the tool will allow firms both to make standard elections and to negotiate customized terms. It is anticipated that ISDA Create–IM will be launched in early 2019, with a beta version available starting in September 2018. It is not known yet which dealers will utilize the new online tool.
What custodial relationships are required under the IM Rules?
To comply with the segregation requirements under the IM Rules, one or more custodial relationships must be in place with custodians that are not affiliates of either counterparty. That requirement will necessitate Buy Side Firms’ negotiating triparty segregation arrangements with dealer counterparties and entering into new account control agreements or amending existing account control agreements with eligible custodians.
For in-scope Buy Side Firms that are not already segregating IM, the requirement will result in new costs and will require operational changes to their collateral management processes. It will also require such Buy Side Firms to manage risk exposures to custodian banks.
What does the IM Letter do?
The IM Letter invites a Buy Side Firm to check one of three boxes to identify if and when the Buy Side Firm expects to be required to post and collect IM, so that its dealer counterparties can be prepared to comply with the IM Rules from the required compliance date. The Buy Side Firm may need to confirm with its dealer counterparties whether they are subject to the U.S. Rules, the EU Rules and/or the rules of any other jurisdiction in order to determine whether the Buy Side Firm is required to undertake the calculations required by one or more IM regimes. As noted above, the calculations can be different across regimes (e.g., because the kinds of derivatives that determine AANA for the U.S. Rules are not exactly the same as the kinds of derivatives that determine AANA for the EU Rules).
The alternative elections in the IM Letter for the “Notifying Entity” (i.e., the Buy Side Firm) are as follows:
- Notifying Entity wishes to prepare IM documentation for use with Recipient (i.e., the dealer counterparty) on and after September 1, 2019, in anticipation that Notifying Entity may be in scope for IM requirements applicable to Recipient (or otherwise applicable to the trading relationship between Notifying Entity and Recipient) on that date.
- Notifying Entity wishes to prepare IM documentation for use with Recipient on and after September 1, 2020, in anticipation that Notifying Entity may be in scope for IM requirements applicable to Recipient (or otherwise applicable to the trading relationship between Notifying Entity and Recipient) on that date.
- Notifying Entity does not anticipate being in scope for IM requirements applicable to Recipient or to Notifying Entity’s trading relationship with Recipient beginning on either September 1, 2019 or September 1, 2020.
Because determining which phase-in date (if any) will apply is based on a Buy Side Firm’s AANA over a period of time that will occur in the future, a Buy Side Firm may not know, or have the relevant information to determine, which election applies. However, helpfully, the IM Letter clearly specifies that notifications made with the IM Letter are for planning purposes only and are not representations.
For Buy Side Firms that will be in scope for the IM Rules, posting and collecting IM will likely entail significantly greater changes and challenges than posting and collecting VM. The most important phase-in dates for Buy Side Firms—September 1, 2019 and September 1, 2020—are still a year or two away; however, Buy Side Firms are encouraged to act well in advance of that date. Not only are the necessary arrangements likely to present challenges to many individual Buy Side Firms, but the derivatives industry will be challenged as a whole, particularly as the phase-in dates approach. Thus, Buy Side Firms should consider taking steps early in order to avoid the additional pressures and difficulties that may arise for those waiting until the deadlines are at hand.
Moreover, as noted above, even Buy Side Firms that do not expect to be in scope should act early to confirm their status under the IM Rules. In order to ensure that existing trading relationships are not unduly interrupted, they will need to undertake the AANA calculations, and to inform dealer counterparties, regarding their status.
1 The IM Letter is available on ISDA’s website at https://www.isda.org/book/isda-regulatory-margin-self-disclosure-letter-july-11-2018/.
2 See Regulation (EU) No. 648/2012 available at https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32012R0648&from=EN and Commission Delegated Regulation (EU) 2016/2251 , available at https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=uriserv%3AOJ.L_.2016.340.01.0009.01.ENG.
3 In the United States, there are currently two sets of applicable IM regulations: (i) one adopted by the Federal Reserve Board, the Office of Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Finance Agency (Prudential Regulators), which applies to swap dealers registered with the U.S. Commodity Futures Trading Commission (CFTC) and security-based swap dealers registered with the U.S. Securities and Exchange Commission (SEC), in each case, that are subject to prudential regulation by one of the Prudential Regulators; and (ii) one adopted by the CFTC, which applies to CFTC-registered swap dealers that are not prudentially regulated, including non-bank affiliates of banks. See Margin and Capital Requirements for Covered Swap Entities; Final Rule, 80 Fed. Reg. 74840 (November 30, 2015), and Margin Requirements for Covered Uncleared Swaps for Swap Dealers and Major Swap Participants; Final Rule, 81 Fed. Reg. 636 (January 6, 2016), available at http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2015-32320a.pdf. The SEC is expected to issue its own margin rules for SEC-registered security-based swap dealers that are not prudentially regulated, but it is not clear when those rules will be finalized.
4 A number of other countries are also in the process of phasing in their uncleared OTC derivatives IM rules. Rules other than those in the United States and the EU are not addressed in this Sidley Derivatives Update.
5 See G20, Cannes Summit final declaration, available at https://in.ambafrance.org/IMG/pdf_Cannes_Summit_final_declaration.pdf?4507/8aa7bb503ad2b268a3f781b220c4cd4bbcfee9f4.
6 See Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions, Margin Requirements for Non-Centrally Cleared Derivatives (as revised in March 2015), available at http://www.bis.org/bcbs/publ/d317.pdf.
7 The $50 million/€50 million threshold is the highest threshold that the IM Rules allow. It is possible some parties will agree to lower thresholds for commercial reasons.
8 Many Buy Side Firms will have already determined whether they are “financial end users,” as swap dealers are required to post VM to, and collect VM from, counterparties only if they are financial end users under the U.S. Rules with respect to VM, which took effect in 2017.
9 The term “financial counterparty” includes certain banks, investment firms, insurance undertakings, UCITS, pension funds and alternative investment funds with managers authorized or registered under the EU Alternative Investment Fund Managers Directive.
10 Regulation (EU) No. 648/2012 available at https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32012R0648&from=EN.
11 See Sidley Derivatives Update, The ISDA 2013 EMIR NFC Representation Protocol. Should you adhere? (March 13, 2013).
12 Many Buy Side Firms will have already determined that they are FCs or NFC+s under the EU Rules, as only FCs and NFC+s have been required to exchange VM under the EU Rules, which took effect in 2017.
13 While the managed account itself may fall well below the relevant AANA thresholds, the client may reach the AANA thresholds after taking into account (i) all of the positions the underlying investor has entered into directly and through other sub-advised accounts and (ii) any positions of that investor’s affiliates.
14 See Directive 2013/34/EU, available at https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A32013L0034.
15 The IM Rules were phased in on September 1, 2016 for market participants with AANAs exceeding US$3 trillion in the United States or €3 trillion in the EU (Phase 1). The next phase-in date was September 1, 2017, covering market participants with AANAs exceeding US$2.25 trillion in the United States or €2.25 trillion in the EU (Phase 2).
16 The EU Rules suggest that if a Buy Side Firm's AANA, determined by reference to March, April and May of 2020, exceeds €8 billion, the Buy Side Firm's AANA must also have exceeded €8 billion determined by reference to March, April and May of 2019 in order for the EU Rules to apply in 2020. Accordingly, it would appear that a "two-step" determination is required by virtue of the application of Article 28 and 36(1) of the EU Rules.
17 See ISDA, ISDA SIMM Licensed Vendors (updated July 11, 2018) (listing licensed vendors and stating that “[a]ny party which offers commercial services based on the [ISDA SIMM] . . . is required to enter into a licensing agreement with ISDA.”), available at https://www.isda.org/2016/09/15/isda-simm-licensed-vendors/.
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