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EMIR Margin Rules for Uncleared OTC Derivatives

New EU regulatory technical standards as part of the European Markets Infrastructure Regulatory body (Regulation (EU) No. 648/2012 on OTC derivatives, central counterparties and trade repositories) came into force on 4 January 2017 with implementation of new margin obligations commencing during Q1 2017.

For all uncleared OTC derivatives transacted by certain parties, the new regulations will require parties to exchange variation margin (VM) and initial margin (IM) on these transactions.

These new uncleared margin rules are the final pieces of the EMIR risk mitigation plans for OTC derivatives and are part of the EU implementation of commitments made by the G20 group of countries to reduce derivative market risks. Whilst these margin rules have been implemented in the US, Canada, and Japan from 1 September 2016, the EU delayed implementation until this year.

Who must comply?

Post relevant phase in dates, counterparties to uncleared OTC derivatives must comply with these new rules subject to the categorisations used by EMIR – a Financial Counterparty (FC) or a Non-Financial Counterparty having non-hedging activity above certain clearing thresholds e.g. EUR3bn in interest rate derivatives or EUR3bn in FX derivatives (NFC+). In practice these rules will apply to only the larger bank counterparties to uncleared derivatives with the very biggest counterparties having over EUR3 trillion in uncleared OTC derivatives commencing new margining obligations from 4 February 2017 for both VM and IM. Thereafter there is a phased approach over 4 years with part of the obligations (VM only) applying to other counterparties from 1 March 2017 and all obligations (as IM is phased in) applying to all counterparties having over EUR8bn of uncleared OTC derivatives from 1 September 2020.

Which transactions are affected?

The new rules apply to all newly transacted OTC derivatives contracts that are not cleared by a central counterparty (CCP) and are transacted after that individual (bank) counterparty’s relevant phase-in date. New transactions will include any novation or restructuring of existing contracts.

Examples of contracts that currently cannot be cleared and will be subject to these rules are FX transactions including Cross Currency swaps (but excluding any spot FX) – note that the requirements for IM are only on interest rate components of CCIR swaps – and certain structured rates products including PAYG inflation swaps.

Impact on smaller Non-Financial end-users

The types of instruments and magnitude of activity required will mean these rules do not apply to any but the largest financial, and very largest non-financial, entities – we understand that, so far, only a handful of active (more commodity based) NFCs are caught. There is, however, still a potential indirect impact on end corporate users due to the additional costs involved in the banking community adhering to these new rules – costs which the banks will obviously wish to pass on – linked to the interbank hedging associated with such contracts.

The main change over existing interbank Credit Support Annex (CSA) arrangements that already exchange the MTM of the instruments under the CSA is the requirement for Initial Margin. New regulatory compliant CSAs are currently being put in place between bank counterparties to cover new transactions caught by the implementation of these rules – including the ability to deal with both IM and VM under the new CSA. The costs involved in this are not readily transparent but are based on:

  • The new Initial Margin requirement being a gross (non-netted against the other counterparty’s IM calculation) assessment of 99th percentile volatility over a 10-day period
  • Use of a calculation model to calculate IM, developed by either counterparty or a third party to be calibrated by agreed characteristics and data
  • Assumptions on any “portfolio” approach to the transactions existing between interbank counterparties

Much like credit charges and CVA DVA calculations that vary between counterparties depending on assumptions made and types of modelling used, the costs associated with application of these new rules can vary significantly from one counterparty to another and now need to be considered as part of all other execution costs.

The last point above in particular around portfolio assumptions can be a key difference especially when limiting a bank group or choosing specific counterparties to work with each other such as a bond swap / currency swap credit auction or a novation. To the extent a significant portfolio exists between interbank counterparties, and a greater degree of portfolio offset can be considered then assumptions around the IM requirement can be moderated by those counterparties. If no portfolio offset assumptions can be made, the difference can be many basis points of additional charges. Since a number of institutions currently need to execute interbank transactions under these new (regulatory compliant) CSAs, the portfolio under the new CSA may not be extensive.

Centrus has seen these indicative charges range from a fraction of a basis point and upwards potentially reaching double digit basis points in the worst cases.

Conclusion

Although ISDA have developed a Standard Initial Margin Model (SIMM) that is intended to assist in resolving disputes over the required amount of IM, counterparties still need to use their own parameters and refer to any existing / portfolio information between them and the other counterparty which can lead to significant additional costs for the end-user depending on type and tenor / risk / volatility of instruments and the relationship between interbank counterparties.

Centrus can assist its clients in navigating any new transactions, novations or restructurings that may lead to additional costs as described in order to mitigate yet another form of regulatory costs that inevitably must be borne by the end user.

Sources

  • Recent Centrus transactional experience
  • Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories
  • Margin Regulatory Technical Standards – Regulation (EU) 2016/2251 – published in the EU Official Journal
  • ISDA SIMM Methodology, version R1.0 – effective Date: September 1, 2016