The Complete Handbook of the Uncleared Margin Rules: What You Must Know

The Uncleared Margin Rules Explained

The uncleared margin rules for non-centrally cleared derivatives (the "Rules") became effective on September 1, 2016 for the largest market participants and are being introduced in phases over time in line with each jurisdiction’s implementation timeline. The Rules have already been adopted in numerous jurisdictions, including the United States, Canada and the European Union ("EU"). Each jurisdiction has implemented the Rules with some specific inconsistencies; however, the following is a high-level overview of the regulations.
The Rules were established by the Basel Committee on Banking Supervision (the "Basel Committee") and the International Organization of Securities Commissions ("IOSCO"). The Rules are intended to mitigate counterparty credit risk through counterparty credit risk provisions. Overall, the objective of the Rules is to set minimum standards for margin requirements for non-centrally cleared derivative transactions. In other words, commercial end users, SMEs, pension plans and sovereigns make up a distinct group within the broad category of market participants that are directly impacted by the rollout of the Rules. Market participants that are not required to adhere to the Rules may be indirectly impacted as other market participants may pass these costs along to their counterparties. Therefore, all derivatives market participants must be aware of the Rules.
Focusing on the Rules from a Canadian perspective, there have been certain distinctions regarding the adoption of the Rules between Canada, the US and the EU. For example, Canadian firms will not need to compute or exchange variation margin with, or obtain a credit rating from, unaffiliated third-party custodians. In addition, the scope of the Rule does not cover foreign currency hedging transactions in Canada. It should also be noted that the "Bucks" refer to Canadian dollars in the context of the US dollar conversion rate when determining the scope of the Rules for Canadian participants.
The Rules are intended to be implemented in three phases. Phase 1, which applied as of September 1, 2016, applies to the largest market participants ("Group 1"). Phase 2, which will apply as of March 1, 2017, will apply to the remaining larger market participants ("Group 2"). Finally, Phase 3, which will begin on September 1, 2018, will apply to SMEs, pension plans, sovereigns and other end users ("Group 3").
The Basel Committee and IOSCO jointly issued their final report on margin requirements for non-centrally cleared derivatives on September 2 , 2013. The report recommends that the regulatory margin framework: The Basel Committee and IOSCO developed the final report in response to the G-20 commitments to implement robust measures to improve transparency and decrease the risk and systemic implications that resulted from the 2008 global financial crisis. The G-20 commitments include the following: Although the Basel Committee and IOSCO developed the rules in response to the G-20 commitments, the Basel Committee and IOSCO deviate from the G-20 commitments as follows: The G-20 commitments to implement margin requirements for non-centrally cleared derivatives involve the establishment of minimum requirements related to the initial and variation margin requirements and the timing of the collection and maintenance of such margin. The G-20 commitments also involve establishing minimum frequency and timing for the exchange of margin; however, end users with low aggregate month-end notional amounts (i.e., less than $3 trillion) who trade certain types of non-centrally cleared derivatives and who can avail themselves of a cash flow bar are exempt from the initial margin requirements until September 1, 2020. The Basel Committee and IOSCO published additional guidance on the appropriate timeframe for the implementation of minimum initial margin requirements in light of the significant negative impact the implementation of margin requirements may have on liquidity in fixed income markets and on the ability of clearinghouses to manage risk. The implementation of minimum initial margin requirements for non-centrally cleared derivatives should follow the final phase of implementation of the global standard on margin requirements by no later than September 1, 2020. Under the Rules, counterparties must obtain and analyze certain information from their counterparts in determining the initial margin requirement. These counterparties will also be required to provide certain information to their counterparties. Certain disclosures are only required in the initial margin proposal. In addition, the requesting party will not be required to provide additional disclosures. Focusing on variation margin and initial margin, variation margin will be calculated and exchanged on a daily basis throughout the life of the transaction, while initial margin will be calculated and exchanged at least on a one-time-per-day basis. The Rules will also present a number of other changes that require tracking and analysis.

Uncleared Margin Rules – Definitive Components

The margin requirements for uncleared swaps and non-cleared credit derivatives (the "uncleared margin rules") are designed to reduce systemic risk in the swap markets by requiring covered swap entities and their affiliates to collect and post collateral with each other. These rules mandate bilateral exchange of margin based on the type and risk profile of the swap, a methodology for calculating initial and variation margin amounts, procedures, documentation and an overall process for exchanges of margin over the life of the transaction.
Generally, the uncleared margin rules will apply to covered swap entities if they meet threshold amounts of aggregate average notional amount of non-cleared swaps and non-cleared credit derivatives. Specific thresholds in the U.S. regulations vary depending on the entity type and category of swap or non-cleared credit derivative, but they turn on whether the entity has $3 trillion or $1 billion of average average notional amount over a 36 month period. Excluded from the calculation are non-U.S. persons dealing with non-U.S. persons.
Initial margin (IM) is defined as the amount calculated per schedule above, with the applicable threshold, multiplied by the IM percentage. IM can be collected in the form of cash and/or non-cash margin, but must be collected in certain jurisdictions. Variation margin (VM) is the amount determined by multiplying the 10-day average of the notional value of all non-cleared swaps by the percentage applicable to the swap category as shown above.
Covered swap entities must enter into written documentation to set forth when and how IM and VM is collected, as well as how collateral can be substituted, the right to declare an event of default and terminate transactions under specified circumstances, rights to set-off and keepers of operational arrangements. There is also an industry standard template for a margin custodial agreement, plus various other arrangements that must be executed by covered swap entities and their counterparties for the purposes of posting and collecting margin.

Untangling Compliance in Financial Organizations

Compliance with uncleared margin rules can be particularly challenging for financial institutions. Margin rules typically require firms to calculate their risk exposures, identify any affected trades and determine appropriate margin, all of which tends to be repetitive and labor intensive. It is not uncommon for firms to have different policies and procedures in place for different jurisdictions. Then, there is the question of post-trade and trade documentation, which can be quite difficult to implement. To top it off, some jurisdictions do not require a trade confirmation but expect that a trader or dealer will calculate the margin after the trade is executed. Plus, firms are still having to deal with transitioning well-established uncleared swaps portfolios if they have not already had to move to a central clearing regime for certain swaps trades. On top of all that, the cost of compliance can be quite large. As a result, many firms are left frustrated.

How the Global Financial Market Will be Affected

The global impact of the uncleared margin rules will be felt across all market participants. Although designed to mitigate systemic risk, what is clear is that the rules will have a significant impact on the way businesses trade, finance their operations and manage their liquidity. There are obvious costs related specifically to compliance, but there are wider impacts across a number of areas.
Liquidity pressures
Companies will have to think carefully about their liquidity management as the new rules will create greater demand for cash, whereas certain recent changes in regulation (particularly Basel III) have introduced the need for banks to hold greater reserves of cash.
For clients that are covered by the rules, there is a risk that bilateral trading relationships may be adversely impacted by the costs of compliance; to contain their costs, some clients may seek to move their trades to other entities, or market participants may withdraw from uncleared derivatives activity altogether. Clients are expected to pressurize their bank relationships in order to keep their trading costs to a minimum, and it is therefore possible that customers covered by the regulations could find that banks become less willing to provide certain trading services .
Market stability
There remains a significant question-mark around the degree to which the implementation of the uncleared margin rules may now impact market stability. The key ability of financial institutions to withstand a future market crisis is thought to be related to their ability to absorb risk. Central clearing aids this absorption of risk, as clearing houses are generally better capitalized and more resilient than the market participants themselves. Uncleared OTC derivatives, however, introduce the risk of counterparty default and the remaining market participants must consequently step up to cover that risk should a participant fail.
International trading practices
The timing of the implementation of the uncleared margin rules across jurisdictions has not always been synchronized, which has created uncertainty and complexity for those marketing participants that do business on a cross-border level. It is expected that third country regulators will expect the full cooperation of foreign regulators in meeting all requirements under the rules, regardless of the location of counterparties. Unfortunately, this does not seem likely in practice, particularly given the spread of the rules across jurisdictions; as such, it will be very interesting to see an impact analysis once the full scope of the rules is finally known.

Practical Risk Mitigation Strategies

In keeping with the overarching principles embedded in the uncleared margin rules—that requirements must be scalable in relation to the size and complexity of the relevant institution’s activities—such institutions should consider comprehensive rules-based and process-driven risk management strategies that incorporate the following best practices:
Given the potential for collateral disputes and service disruptions that non-compliant activity may cause in the industry, an institution failing to implement a sound margin management strategy likely will be challenged by market participants, regulators and the wider industry. Appropriate risk management practices are essential to the long-term survival of all affected firms in this new regulatory environment.

What Could be the Next Development

As time progresses, industry participants can expect to see further clarifications and updates to the uncleared margin rules to reflect comments received from market participants and to continue to align the rules with relevant international standards. Technology providers can also expect continuing developments, both in the regulatory compliance space and in market infrastructure standards. The effective date for the Phase 6 initial margin margin requirements (September 1, 2021) is approaching, and will likely lead to some revisions or amendments to the rules to address timing, extensions, substitutions , and similar issues. Several other issues also will receive further consideration as the Phase 5 and Phase 6 initial margin requirements come into force.
With respect to information technology, recent developments in peer-to-peer technology, blockchain, and other automated data management systems are likely to impact how regulatory technology services are provided and how technology providers impact the market. As with all regulatory changes, there are opportunities for regulatory technology providers, both by providing regulation-aware core software systems that enable compliance, but also by offering services that provide regulators a view into transactions that previously weren’t possible.