Basel Committee and IOSCO Release Framework for Uncleared Derivatives Margin

The Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) on September 2 released their final policy framework on margin requirements for uncleared derivatives (the “Framework”). The Framework, which follows two proposals on the topic from BCBS and IOSCO (the “Proposals”), is intended to establish minimum standards for uncleared derivatives margin rules in the jurisdictions of BCBS and IOSCO’s members, which includes the United States.

The Framework is designed to provide guidance to national regulators in implementing G-20 commitments for uncleared derivatives margin requirements. In the United States, the Dodd-Frank Act, reflecting the same G-20 commitments, requires the SEC, CFTC and banking regulators to adopt initial and variation margin requirements for swap dealers and major swap participants (“MSPs”) under their supervision. [1] The U.S. regulators have proposed rules to implement these requirements (the “U.S. Proposals”), but have not yet adopted final rules, in part due to the ongoing BCBS/IOSCO efforts. The Framework is similar in concept to the U.S. Proposals, but differs in a number of significant respects. Appendix A summarizes the Framework and the three U.S. Proposals, highlighting a number of the key differences.

With the Framework finalized, we expect that U.S. regulators will work to issue final rules implementing uncleared swap margin requirements in the coming months.

The Framework: Key Principles 1 Through 8

The margin requirements in the Framework are presented as eight key principles, with related commentary and high-level standards for national regulators to incorporate into their rules.

1. Appropriate margining practices should be in place with respect to all uncleared derivatives transactions.

Under the Framework, most OTC derivatives, including those that are not “swaps” or “security-based swaps” under Title VII of the Dodd-Frank Act, by unaffiliated “covered entities” (as defined below), are subject to initial and variation margin requirements. However, in a change from the Proposals, the Framework requires variation margin, but not initial margin, for physically-settled foreign exchange swaps and forwards.

2. Financial firms and systemically important non-financial entities (“covered entities”) must exchange initial and variation margin.

The Framework requires bilateral exchange of both initial and variation margin for uncleared derivatives between “covered entities.” The precise definition of “covered entity” would be determined by each national regulator in implementing the Framework. The Framework only applies to uncleared derivatives between two covered entities, and the Framework’s margin requirements therefore do not apply to transactions involving non-financial entities that are not systemically important. The Framework also does not apply margin requirements to transactions involving sovereigns, central banks, multilateral development banks or the Bank for International Settlements.

Covered entities must exchange the full amount of variation margin, with no threshold, on a daily basis, and must exchange initial margin subject to a €50 million threshold applied on a consolidated group basis. [2] In both cases, covered entities may use a minimum transfer amount up to €500,000, which was increased from €100,000 in the Proposals. This scope of coverage differs significantly from the U.S. Proposals, including that the U.S. Proposals (i) require swap dealers and MSPs to collect, but not necessarily post, initial and variation margin (unless facing another swap dealer or MSP), (ii) provide for thresholds for both initial and variation margin, (iii) limit the availability of thresholds from posting margin to certain enumerated types of entities and (iv) calculate the thresholds on a legal entity, rather than group consolidated, basis.

3. The methodologies for calculating initial and variation margin should (i) be consistent across covered entities, and (ii) ensure that all counterparty risk exposures are covered with a high degree of confidence.

Initial margin must be calculated based on a 99% confidence interval over a 10-day horizon (or longer, if variation margin is not collected daily) based on historical data that incorporates a period of significant financial stress.

Market participants may choose to base initial margin calculations on either internal models approved by a covered entity’s national regulator or on a standardized schedule, but may not “cherry pick” between the two for all derivatives in the same well-defined asset class. Models may allow for portfolio risk offsets where there is an enforceable netting agreement in effect, subject to approval by the relevant supervisory authority. However, the portfolio risk offsets may only be within, and not across, well-defined asset classes including currency/rates, equity, credit or commodities. The Framework sets out a recommended standardized schedule providing for initial margin requirements, as provided in the sidebar.

The Framework provides that a covered entity using the standardized schedule may apply the type of “net-to-gross ratio” that is used in bank capital rules to incorporate some netting efficiencies to all derivative positions in the same class that are subject to an enforceable netting agreement. [3]

Netting of notional amounts may be permissible for contracts having the same terms but that move in opposite directions.

Derivatives for which a firm faces no counterparty risk (e.g., where the seller of an option has collected the full option premium) may be excluded from initial margin calculations.

4. To ensure that assets collected as collateral can be liquidated in a reasonable amount of time to generate proceeds that could sufficiently protect covered entities from losses 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 Framework requires national supervisors to specify eligible collateral types. The Framework suggests possible collateral types that are broader than those contemplated in the U.S. proposal (including, for example, gold and certain corporate bonds and equities). The Framework also indicates that model-based haircuts for collateral should be permissible but also proposes a list of standardized haircuts that may be applied in the alternative to different types of collateral, as set forth in the sidebar on the following page.

5. Initial margin should be exchanged 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.

Unlike the Proposal, the Framework allows re-hypothecation of customer collateral, but only for the purpose of hedging customer positions and only subject to restrictive conditions. Since, for this purpose, “customers” include only “buy-side” financial firms and nonfinancial entities, but not dealers or market makers in derivatives, margin collected in the interdealer market may not be re-hypothecated.

Customer collateral collected as initial margin must be segregated from the initial margin collector’s proprietary assets and the collector must give its customer the option to have its initial margin individually segregated. To the extent that the customer consents to re-hypothecation, the margin collector and the third party to which customer collateral is re-hypothecated would need to comply with additional requirements, including that:

• the re-hypothecation must be in connection with hedging positions arising out of transactions with customers (or where a customer’s collateral is individually segregated, hedging positions arising out of transactions with that specific customer);
• the collateral may be re-hypothecated, re-pledged, or reused only once;
• collected collateral must be treated as customer assets and segregated from the initial margin collector’s proprietary assets until re-hypothecated to a third-party and, once re-hypothecated, the third-party must segregate the collateral from its own proprietary assets;
• collateral of customers who have consented to re-hypothecation must be segregated from customers who have not so consented;
• collateral must only be re-hypothecated to, and held by, an entity that is regulated under similar rules and that is not an affiliate of the customer;
• the customer must provide express written consent to the rehypothecation; and
• the level and volume of re-hypothecation must be disclosed to the authorities.

6. Transactions between affiliates are not subject to mandatory margining.

The Framework leaves the treatment of interaffiliate derivatives to national regulators. The U.S. Proposals do not discuss the treatment of interaffiliate swaps, other than a request for comment from the SEC.

7. Requirements for margining uncleared derivatives should be consistent and non-duplicative across jurisdictions. The Framework provides that a home-country supervisor may permit a covered entity to comply with the margin requirements of a hostcountry’s margin regime, provided that the home-country supervisors consider the host-country margin regime to be consistent with the Framework. A branch may be subject to margin requirements of either the jurisdiction where the headquarters is established or the hostcountry requirements.

8. Margin requirements should be phased in over an appropriate period of time.

The Framework includes a compliance schedule that (i) provides a de minimis level of uncleared derivatives exposure under which initial margin requirements would not apply and (ii) phases in margin requirements between December 2015 and December 2019.

Covered entities must begin exchanging variation margin on December 1, 2015 with respect to new contracts entered into on or after that date. The date on which a given covered entity will be required to exchange initial margin depends on the notional amount of uncleared derivatives (including deliverable foreign exchange swaps and deliverable foreign exchange forwards) entered into by its consolidated group and that of its counterparty, as provided in the sidebar. Specifically, two covered entity counterparties to uncleared derivatives will be required to exchange initial margin if the consolidated group to which each belongs has an aggregate month-end average notional amount of uncleared derivatives exceeding a de minimis level that will decrease each year from 2015 through 2019. For 2019 and beyond, the de minimis level will remain at €8 billion. In all cases, the aggregate month-end average notional amount of uncleared derivatives is to be measured for June, July and August of each year. Initial margin requirements apply to all new contracts entered into during the periods described in the sidebar.

The Framework represents BCBS/IOSCO’s final recommendations and public comment has not been solicited. However, BCBS and IOSCO plans to establish a monitoring group to evaluate the margin standards against related regulatory initiatives that may develop alongside these requirements between now and 2014.

Endnotes:

[1] References in this post to “swap dealers” and “MSPs” are intended to encompass both those regulated by the CFTC as well as SEC-regulated security-based swap dealers and major security-based swap participants.
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[2] The Framework clarifies that investment funds will not be considered to be part of a consolidated group so long as the funds are distinct legal entities that are not collateralized by or are otherwise guaranteed or supported by other investment funds or the investment advisor in the event of fund insolvency or bankruptcy.
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[3] Under this approach, standardized initial margin = 0.4 * gross initial margin + 0.6 * (net current replacement cost ÷ gross current replacement cost) * gross initial margin.
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