New EMIR Collateral Rules for Non-Cleared OTC Derivatives: Impact for Funds
As part of the phased introduction of measures under EMIR1, a recently adopted EU Regulation2 establishes new risk mitigation requirements for trading OTC derivatives.
Of greatest significance, the Regulation introduces rules requiring the posting of daily variation margins. The Regulation came into effect on 4 January 2017 and the new variation margining rules apply from 1 March 2017. These rules will apply to all UCITS and AIFs with authorised or registered AIFMs (each categorised under EMIR as a "Financial Counterparty").
The Regulation introduces margin and collateral requirements where affected entities engage in non-cleared OTC derivative contracts (the "Relevant Transactions").
Table 1 below summarises the key requirements under the Regulation and briefly considers the impact and recommended actions for affected UCITS and AIFs.
The requirement to exchange initial margin is only applicable where gross notional exposure to non-cleared OTC derivatives is in excess of a certain significant volume.
Variation margining will be required on both sides of a Relevant Transaction from 1 March 2017.
A minimum transfer amount of up to €500,000 may be agreed between the parties before collateral will be required to be collected.
Deliverable FX forwards (i.e. the exchange of two different currencies on a specific future date at a fixed rate agreed on the trade date of the contract covering the exchange) will not be in-scope for the two way variation margining requirements until MiFID II is implemented (3 January 2018).
Non-deliverable FX forwards are in scope from 1 March 2017.
There is a delayed timeframe for implementation of initial and variation margining rules in respect of options on single-stock equities and equity indices.
If you would like further information on the Regulation or EMIR more generally and its potential implications for your business, please contact your usual Maples and Calder contact.
To exchange initial margin (including segregation and concentration rules)
|The initial margin rules may be disregarded where gross notional exposure to non-cleared OTC derivatives is less than €8bn (calculated as an aggregate month-end average amount over March, April and May of the preceding year). This is calculated at sub-fund level in respect of umbrella funds.|
To exchange variation margin to cover fluctuations in the mark-to-market value of the Relevant Transaction on both sides of the contract day-to-day
Financial Counterparties must ensure collateral arrangements for Relevant Transactions provide for two way variation margining of eligible collateral.
The application of variation margining rules to FX hedging activities poses a number of operational issues, particularly for funds where hedging is done at share class level. Assets available to the relevant share class for margining purposes must be identified and provisions in relevant contracts should limit recourse to the relevant class.
To ensure collateral meets certain qualitative criteria
|The Regulation prescribes specific types of assets as eligible collateral that Financial Counterparties will each need to consider. In a UCITS context, for example, these requirements will have to be considered in addition to/alongside existing UCITS collateral requirements.|
Haircut rules to apply in respect of the valuation of collateral
Any existing haircut policy applied by Financial Counterparties will need to be assessed against the new rules.
Where parties calculate haircuts based on volatility estimates determined internally rather than using the standardised model provided for under the Regulation, certain minimum criteria must be satisfied.
Prescribed elements to be covered in each Financial Counterparty's risk management processes
Several items concerning collateral management must be documented in risk management processes (either internal or on record), including (but not limited to) recourse to collateral in the event of counterparty's insolvency; exchange of information between parties; and adjustment of daily margin calculations in accordance with haircut provisions.
There is limited crossover between the elements to be covered in collateral risk management processes under the Regulation and the current risk management processes to be documented for AIFs and UCITS.
Collateral risk management processes are required to be reviewed as necessary and at least annually.
Specific elements to be covered in legal contracts
This will need to be assessed on a case-by-case basis looking at the particular collateral arrangement documentation.
ISDA has produced template credit support annexes implementing two-way variation margining.
|Documented legal review as to the effectiveness of netting and exchange of collateral arrangements when entering into such agreements|
This may be performed by an internal unit independent of investment activities.
ISDA has formal legal opinions on the enforceability of its netting arrangements in various jurisdictions available to members on its website that could be sourced for the purposes of an internal assessment.
1 Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories.
2 Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards for risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty.