Collateral Damage: New Margin Rules Set to Shake up the Derivatives Industry

Starting March 1, many derivatives counterparties will be subject to new margin rules. The impact of mandatory margining will be significant: higher transaction costs, new collateral documentation and more ground for disputes.  

What You Need To Know

  • Mandatory posting of both initial and variation margin will be required, to be phased in under separate timetables.
  • The regulatory landscape covering the new margin regime is complex, with similar but not equivalent rules potentially applying to the same trades within Canada. Trades with a cross-border element may be eligible for substituted compliance under the margin requirements of a qualifying foreign jurisdiction.
  • Legacy trades will be grandfathered, but covered transactions entered into after March 1, 2017 will need to be documented under regulatory-compliant collateral documentation.
  • The new rules are intended to make Canada a "protocol eligible regime" under the International Swaps and Derivatives Association’s (ISDA) documentation framework, and ISDA has published a self-disclosure letter to help counterparties determine which trades will be subject to the new margin regime, and when compliance will be required.

Background

The economic and political fallout from the financial crisis nearly a decade ago ignited a widespread push for global financial reform. Derivatives were high on the list for regulatory oversight given their perceived role in exacerbating market instability. In particular, over-the-counter (OTC) derivatives were singled out for their hand in fuelling excessive leverage on the balance sheets of the largest financial firms. The ever-increasing complexity and interconnectedness of global derivatives activities contributed to a concentration of risk among the major dealers on what was then a largely unregulated market.

In the wake of the global economic crisis, G-20 countries committed in 2009 to implement a series of reforms to bolster oversight of the OTC derivatives markets and reduce systemic risk. Hallmarks of the reforms included new rules requiring standardized OTC derivatives to be traded on exchanges and cleared through central counterparties, higher capital and margin requirements on uncleared trades, and mandating reporting of derivatives trades to designated entities.

The G-20 commitments laid the foundation for a policy framework developed jointly by the Basel Committee on Banking Supervision and International Organization of Securities Commissions (BCBS-IOSCO Framework) which evaluated margin requirements for non-centrally cleared derivatives. This bulletin focuses on Canada’s implementation of the principles outlined in the BCBS-IOSCO Framework in relation to new margin rules that apply to derivatives trades that are not centrally cleared.

In Canada, the new margin regime is implemented for certain financial institutions through Guideline E-22 – Margin Requirements for Non-Centrally Cleared Derivatives (the Guideline), which was published in its final form on September 2016 by The Office of the Superintendent of Financial Institutions (OSFI). A parallel regime has been outlined by the Canadian Securities Administrators in CSA Consultation Paper 95-401 – Margin and Collateral Requirements for Non-Centrally Cleared Derivatives (the CSA Proposal). This regime would apply to qualifying trades not otherwise covered by OSFI’s Guideline, but not yet in force.

Scope of the New Margin Rules

OSFI's Guideline

Under the Guideline, margin requirements apply to uncleared derivatives trades between federally regulated financial institutions (FRFIs) and their counterparties where both entities have a sufficiently large uncleared derivatives book to qualify as "Covered Entities."1

A Covered Entity is a financial entity belonging to a consolidated group having an aggregate month-end average notional amount (AANA) of non-centrally cleared derivatives (excluding inter-affiliate trades) for each of March, April and May of any calendar year exceeding C$12 billion.2 If the AANA threshold is met on those three months in a particular calendar year, margin must be exchanged under the Guideline beginning on September 1st of that year.  An FRFI that is a Covered Entity is referred to as a "Covered FRFI."

With the exception of FX forwards and FX swaps (and the FX component of cross-currency swaps), the margin requirements are triggered when a particular counterparty meets the "Covered Entity" criteria described above and apply to any trades between a Covered FRFI and a counterparty. If a counterparty’s status changes such that it can no longer be deemed to be a "Covered Entity," then the margin rules will cease to apply to all trades between the counterparty and the Covered FRFI, regardless of when those trades were entered into.

CSA Proposal

The CSA Proposal, which is also modelled on the BCBS-IOSCO Framework, is intended to regulate uncleared derivatives to which the Guideline does not apply. Accordingly, FRFIs that are subject to, and compliant with, the Guideline would be relieved from the requirements contemplated by the CSA Proposal. The CSA Proposal will likely apply to only a narrow band of trades given the further relief available under the proposal on the basis of substituted compliance with a foreign jurisdiction (discussed below). 

In circumstances where the CSA Proposal is not pre-empted by the Guideline or the rules of a foreign jurisdiction, it would require the exchange of margin in circumstances where both counterparties to a non-centrally cleared derivative are financial entities with an AANA exceeding C$12 billion of non-centrally cleared derivatives (excluding inter-affiliate trades) for each of March, April and May of any calendar year. Consistent with the Guideline, if the AANA threshold is met on those three months in a particular calendar year, margin must be exchanged beginning on September 1 of that year. 

While the portfolio size threshold is the same under both the Guideline and the CSA Proposal, the definition of "financial entity" in the CSA Proposal differs slightly.3 The margin requirements under the CSA Proposal would apply to all OTC derivatives, except that FX forwards and FX swaps which would be excluded from initial margin requirements (in contrast to the Guideline, which excludes FX forwards and FX swaps from both initial and variation margin requirements).

Exemptions for Substituted Compliance

Guideline

Trades between a Covered FRFI and a foreign (non-Canadian) Covered Entity will be exempt from the margin requirements under the Guideline if (1) the Covered FRFI is subject to, and has complied with, the margin requirements of the foreign Covered Entity that is not subject to OSFI’s oversight and (2) the Covered FRFI has documentary evidence that the margin rules of that foreign jurisdiction are comparable to the BCBS-IOSCO Framework.

CSA Proposal

The CSA Proposal also provides for substituted compliance where a foreign counterparty—which would otherwise be in-scope under the CSA Proposal—is subject to and compliant with the margin rules of that counterparty's home jurisdiction and which are assessed to be equivalent to the CSA Proposal’s requirements and meet the standards outlined by the BCBS-IOSCO Framework. If substituted compliance were available on that basis, the counterparties would elect whether the derivatives trades between them would be subject to the CSA Proposal (as it may be enacted) or the rules of the foreign jurisdiction.

When do the New Margin Rules Take Effect?

Guideline

The requirements for initial margin and variation margin, which are being phased in on separate timelines, are both based on the size of the counterparties’ uncleared derivatives book (including physically settled FX forwards and FX swaps, but excluding inter-affiliate trades). The margin requirements will apply to all new derivatives contracts entered into during the periods specified in the table below. Novations of grandfathered trades and—so long as they are undertaken for a genuine legal or commercial purpose (i.e., not for the purpose of avoiding the margin rules)—amendments to existing derivatives contracts do not qualify as new derivatives contracts.

Initial Margin

The requirement to exchange two-way initial margin will apply to trades between a Covered FRFI and a Covered Entity where both parties have an aggregate month-end AANA for March, April and May of the applicable calendar year exceeding the corresponding amounts below for the related phase-in period:

Phase-in Period

AANA Exceeding

September 1, 2016 to August 31, 2017

C$5 trillion

September 1, 2017 to August 31, 2018

C$3.75 trillion

September 1, 2018 to August 31, 2019

C$2.5 trillion

September 1, 2019 to August 31, 2020

C$1.25 trillion

September 1, 2020 and thereafter

C$12 billion

Variation Margin

The requirement to exchange variation margin will be phased-in in two stages. From September 1, 2016 to February 28, 2017, trades between a Covered FRFI and a Covered Entity where both parties have an AANA of non-centrally cleared derivatives exceeding C$5 trillion are required to post variation margin. Thereafter, all other Covered FRFI’s and Covered Entities will be subject to the variation margin requirements beginning on March 1, 2017.

CSA Proposal

Specific details regarding timing have not yet been published, but the CSA Proposal states that a similar phase-in approach would be adapted from the BCBS-IOSCO Framework. 

What are the New Margin Requirements?

Guideline

Variation Margin

The purpose of variation margin is to protect transacting parties from current exposure arising due to daily fluctuations in the mark-to-market value of their underlying trades. The animating principle is that posting variation margin to collateralize trade exposure would reduce adverse liquidity shocks and mitigate counterparty credit risk. If a trade moves out-of-the-money for one party, then that party will be required to fully cover that exposure by posting collateral to its in-the-money counterparty in the same amount (subject to a minimum transfer amount of C$750,000 for all margin transfers, both initial and variation).

Like initial margin, variation margin must be calculated and called within two business days of entering into a trade, and calculated and called on a daily basis thereafter. Following each call for variation margin, the requisite amount of margin must be posted within two business days.

The Guideline provides that variation margin should be calculated and exchanged pursuant to a single, legally enforceable netting agreement. If a legally enforceable netting agreement is not in place, variation margin must be exchanged on a gross basis.

Initial Margin

The purpose of initial margin is to provide a collateral buffer to protect transacting parties against future exposure from adverse changes in the mark-to-market value of the underlying trades between the time of default and the date on which the trade is subsequently closed-out or replaced.

Initial margin must be calculated and called within two business days of entering into a trade, and calculated and called on a daily basis thereafter. Upon receiving a call for initial margin, the receiving party must post the specified margin on or before the second business day following each such call. The exchange of initial margin between counterparties is subject to a maximum threshold of C$75,000,000; i.e., only initial margin in excess of the threshold is required to be exchanged. The threshold is determined on a consolidated group basis based on all outstanding non-centrally cleared derivatives between the two counterparties’ respective consolidated groups.

The required amount of initial margin may be calculated by using either (i) a counterparty’s internal "quantitative portfolio margin model" (Internal Model) or (ii) the standardized margin schedule set forth in the Guideline (Standardized Model). A counterparty’s election to use an Internal Model is subject to meeting a number of conditions informing the standards for building a suitable model, such as prescribing certain risk factors and stress-testing parameters which must be incorporated. Covered FRFIs are required to review their Internal Models no less frequently than annually in light of prevailing market conditions and modelling practices.

In recognition of the complexity involved in calculating initial and variation margin and the potential for valuation discrepancies between counterparties, the Guideline requires counterparties to have dispute resolution procedures in place prior to entering into derivatives transactions with each other.

CSA Proposal

The requirements for posting both initial and variation margin under the CSA Proposal are substantially similar to those of the Guideline. Under the CSA Proposal: (i) initial margin will be required to be calculated using either a quantitative margining model or a standardized schedule to be prescribed by the CSA (and the same model should be applied consistently across each class of derivatives); (ii) any quantitative models employed must be recalibrated and reviewed at least annually; (iii) margin must be calculated and called within two business days of entering into a trade, and daily thereafter; (iv) initial margin would only need to be exchanged over and above a threshold not to exceed C$75,000,000 (determined on a consolidated group basis consistent with the Guideline); (v) margin transfers are also subject to a minimum transfer amount not to exceed $750,000 (combined for both initial and variation margin); and (vi) counterparties which are both covered by the CSA Proposal must establish dispute resolution procedures to deal with potential disputes relating to initial and variation margin.

Eligible Collateral

The types of collateral eligible for posting as margin under the Guideline and CSA Proposal are similar, although some differences are apparent, as illustrated by this side-by-side comparison:

Guideline

CSA Proposal

Cash

Cash

Gold

Gold

Debt Securities

Debt securities rated at least:

  • ≥ BB- when issued by sovereigns
  • ≥ BBB- when issued by other entities
  • ≥ A-3/P-3 for short-term debt instruments

Debt securities that are:

  • Issued or guaranteed by the Government of Canada, Bank of Canada or a provincial government of Canada
  • Issued and fully guaranteed by the Bank for International Settlements, the International Monetary Fund or a multilateral development bank with a rating of at least BB-
  • Debt securities issued and guaranteed by foreign governments  with a rating of at least BB-
  • Debt securities issued by corporate entities with a rating of at least BBB-
Unrated Debt Securities

Unrated debt securities where all of the following apply:

  • Issued by a bank
  • Listed on a recognized exchange
  • Classified as senior debt
  • All rated issues of the same seniority issued by the issuing bank must be rated at least BBB- or A-3/P-3 by a recognized external credit assessment institution
  • The institution holding the securities as collateral has no information to suggest that the issue justifies a rating below BB- or A-3/P-3

N/A

Equities

Equities (including convertible bonds) included in a main index

Equities included in major Canadian stock indices;

Equities (including convertible bonds) not included in a main index but which are listed on a recognized exchange

N/A

Transferable Securities and Mutual Funds

Undertakings for collective investments in transferable securities (UCITS) and mutual funds where:

  • a price for the units is publicly quoted daily; and
  • the UCITS/mutual fund is limited to investing in the instruments listed above.

Mutual funds, where:

  • a price for the fund’s units is publicly quoted daily; and
  • (ii) the mutual fund is limited to investing in the assets above.

Implications

From a commercial perspective, mandatory margin requirements can generally be expected to increase the transaction costs of covered trades, and we anticipate a surge in demand for liquid collateral that satisfies the criteria described above. There will also be significant implications from a documentation perspective as existing Credit Support Annexes will need to be either amended or replaced for trades falling under the new rules. 

In that regard, ISDA has published new forms of Credit Support Annexes for both initial and variation margin designed to be compliant with the regulations. Given the grandfathering rules discussed above, it is possible that two counterparties might have three different Credit Support Annexes in effect between them (one for legacy trades not subject to the margin rules, one for initial margin and one for variation margin). 

Fortunately, ISDA has also developed an online "protocol" to facilitate amending existing Credit Support Annexes to be compliant with the new margin regime. Consequently, counterparties to derivatives trades can expect to receive a request from their FRFI counterparties to complete the ISDA Regulatory Margin Self Disclosure Letter, which is designed to help market participants determine if and when compliance with one or more of the new regulatory margin regimes will be required.

_________________________

1 For purposes of the Guideline, the term "FRFIs" refers to banks, foreign bank branches, bank holding companies, trust and loan companies, cooperative credit associations, cooperative retail associations, life insurance companies, property and casualty insurance companies and insurance holding companies.

2 A "financial entity" as defined in the Guideline means a legal entity whose main business includes: the management of financial assets, lending, factoring, leasing, provision of credit enhancements, securitisation, investments, financial custody, proprietary trading and other financial services activities. This group would include deposit-taking institutions, insurance companies, pension funds, hedge funds, and asset managers.

3 Under the CSA Proposal, "financial entity" includes cooperative credit associations, central cooperative credit societies, banks, loan corporations, loan companies, trust companies, trust corporations, insurance companies, treasury branches, credit unions, caisses populaires, financial services cooperatives, pension funds, investment funds, and any person or company that is subject to registration or exempted from registration under securities legislation of a jurisdiction of Canada, in any registration category, as a result of trading in derivatives.

To discuss these issues, please contact the author(s).

This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

For permission to republish this or any other publication, contact Janelle Weed.

© 2017 by Torys LLP.
All rights reserved.

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