Upload
others
View
4
Download
0
Embed Size (px)
Citation preview
Evan Koster and James Doyle
What You Need to Know The Swap Margin Rules
| 2 Hogan Lovells
• 2,500 lawyers • Six continents • 47 offices
About Hogan Lovells
| 3
About Quaternion
Hogan Lovells | Quaternion Risk Management
1 Who We Are Partner-owned firm specializing in quantitative risk analytics with a global presence in New York, Boston, London, Dublin, and Dusseldorf.
Our Clients Investment banks, institutional investors, and asset managers, including a number of top 10 global financial institutions in developed markets.
Our Vision Accelerate model development at reduced cost and enhance our clients’ connectivity across the financial system through an improved global standard for transparent risk analytics.
Our People Employ 35 professionals globally with deep in-business and risk management experience within the financial industry.
Our Community Industry practitioners and thought leaders, active contributors to open source pricing and risk analytics development; academic partnerships with leading universities and data science centers, published textbooks, and research papers.
On September 30, 2016 Quaternion will release its free Open Risk Engine to the financial community.
2
3
4
5
6
Implementation of Margin Requirements in the U.S. & EU
| 5 Hogan Lovells
UNITED STATES (amounts are notional) EUROPEAN UNION (amounts are notional)
1 Sept 2016: VM applies if ˃ USD 3 trillion*
1 Mar 2017: VM applies to all other entities
1 Sept 2016: IM applies if ˃ USD 3 trillion for Mar – May 2016
1 Sept 2017: IM applies if ˃ USD 2.25 trillion for Mar – May 2017
1 Sept 2018: IM applies if ˃ USD 1.50 trillion for Mar – May 2018
1 Sept 2019: IM applies if ˃ USD 0.75 trillion for Mar – May 2019
1 Sept 2020: IM applies to all other entities
Final and permanent IM annual threshold: USD 8 billion *The CFTC on September 1 issued a time-limited, no-action letter stating that it will not recommend an enforcement action against a swap dealer subject to the September 1, 2016 compliance date for the CFTC’s uncleared swap margin rules, subject to certain conditions, for failing to fully comply with the custodial arrangement rule prior to October 3, 2016.
1 month after the entry into force of the margin regulatory technical standards : VM applies if ˃ EUR 3 trillion
The later of 1 Mar 2017 or 1 month after the entry into force of the final regulatory technical standards: VM applies to all other entities
1 month after the entry into force of the margin regulatory technical standards IM applies if ˃ EUR 3 trillion for Mar – May 2016
1 Sept 2017: IM applies if ˃ EUR 2.25 trillion for Mar – May 2017
1 Sept 2018: IM applies if ˃ EUR 1.50 trillion for Mar – May 2018
1 Sept 2019: IM applies if ˃ EUR 0.75 trillion for Mar – May 2019
1 Sept 2020: IM applies if ˃ EUR 8 billion for Mar – May 2020
Final and permanent IM annual threshold: EUR 8 billion
Upcoming Timeline for Implementation
| 6 Hogan Lovells
EUROPEAN UNION 28 July 2016 The European Commission endorsed with amendments the
final regulatory standards (RTS) on the margin requirements under EMIR, proposing an adjusted implementation timeline.
Jurisdiction -- Margin Requirements
• The new timeline pushes back the start date for the initial margin requirements until 1 month after the entry into force of the final RTS (likely to be February/March 2017), so no longer following the international compliance dates
• On 8 September 2016, the European Supervisory Authorities issued an opinion rejecting some of the proposed amendments from the European Commission
| 7 Hogan Lovells
UNITED STATES • The Prudential Regulators and the CFTC have issued their own final rules in respect of margin
requirements
• The Prudential Regulators include:
Department of the Treasury
Board of Governors of the Federal Reserve System
Federal Deposit Insurance Corporation
Farm Credit Administration
Federal Housing Finance Agency
• The Prudential Regulators’ rules apply to swap entities that are prudentially regulated by a U.S prudential regulator, while the CFTC rules apply to swap entities that are regulated by the CFTC and that are not prudentially regulated
• They are generally similar, but there are a few differences: (i) the anti-evasion provision in the definition of “margin affiliate;” (ii) the model approval process; (iii) the calculation of variation margin and related documentation requirements, and the (iv) treatment of inter-affiliate trades
Jurisdiction -- Margin Requirements
| 8 Hogan Lovells
UNITED STATES EUROPEAN UNION • Margin requirements impose the obligations on
“Covered Swap Entities (CSE)” • Covered Swap Entities
Any Swap Dealer, Major Swap Participant, or Security-Based Swap Participant that is registered with the CFTC and/or the SEC
• Financial End User A bank, Fannie Mae, Freddie Mac or a Federal Home
Loan Bank, registered investment company or a private fund, state licensed lender, market intermediary, non-US entity that would be a financial end user if it were organized under the laws of the U.S. or any state, catch-all provision (see below)
• Financial End Users with Material Swaps Exposure If a financial end user and its affiliates, on a consolidated
basis, have an average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, foreign exchange forwards and foreign exchange swaps for June, July and August of the previous calendar year that exceeds $8 billion
• EU margin requirements apply to EU Financial Counterparties (FCs) and EU non-financial counterparties whose aggregated positions in derivatives exceed certain clearing thresholds (NFC+s)
• Financial counterparties (FCs) include (if established in the EU): banks investment firms insurers and reinsurers occupational pension schemes certain UCITS funds and, where relevant, their managers certain Alternative Investment Funds (AIF) managed by
an EU authorized or registered AIF manager
Entities Within Scope of the Margin Requirements
| 9 Hogan Lovells
UNITED STATES EUROPEAN UNION • Transactions between entities and their affiliates
should only be counted once
• Swaps with end users that are exempt from the clearing requirement under Dodd-Frank also are not required to be included for the purpose of calculating this threshold
• What is an “Affiliate” for the purpose of these rules? The CFTC uses a financial accounting test as a trigger for affiliation rather than a “control test.” A Margin Affiliate is:
Either entity consolidates the other on a financial statement prepared in accordance with GAAP, the IFRS or other similar standards, or
• NFC+: non-financial counterparty established in the EU that is not a FC whose aggregate OTC derivative positions of its group on a worldwide basis exceed any of the clearing thresholds below:
OTC credit derivatives= EUR 1 billion OTC equity derivatives= EUR 1 billion OTC interest rate derivatives= EUR 3
billion OTC foreign exchange derivatives= EUR 3
billion OTC commodity derivatives and any other
derivatives= EUR 3 billion
Entities Within Scope of the Margin Requirements Cont.…
| 10 Hogan Lovells
UNITED STATES EUROPEAN UNION
• Both entities are consolidated with a third entity on a financial statement prepared in accordance with such principles or standards, or
• For an entity that is not subject to such principles or standards, if consolidation as described in paragraph (1) or (2) of this definition would have occurred if such principles or standards had applied
• Non-EU entities: Initial margin (IM) and variation (VM)
margin apply where a FC or NFC+ subject to margin requirements trades with a non-EU counterparty that would be subject to margin requirements if it was established in the EU
IM and VM will also apply to trades between two non-EU entities if such entities would be subject to the EU margin requirements if they had been established in the EU and the transaction has a “direct, substantial and foreseeable effect” within the EU
Entities Within Scope of the Margin Requirements Cont.…
| 11 Hogan Lovells
UNITED STATES EUROPEAN UNION • What does “Consolidated” indicate in this
context ?
The CFTC uses an accounting consolidation analysis
The Prudential Regulators, unlike the CFTC, reserve the right to include any other entity as an affiliate or a subsidiary based on a conclusion that either entity provides significant support to, or is materially subject to, the risks or losses of the other entity
• Non-EU entities: Initial margin (IM) and variation (VM)
margin apply where a FC or NFC+ subject to margin requirements trades with a non-EU counterparty that would be subject to margin requirements if it was established in the EU
IM and VM will also apply to trades between two non-EU entities if such entities would be subject to the EU margin requirements if they had been established in the EU and the transaction has a “direct, substantial and foreseeable effect” within the EU
Entities Within Scope of the Margin Requirements Cont.…
| 12 Hogan Lovells
UNITED STATES • Treatment of Investment Funds, Investment Managers and Family Office entities under
the Rules
Investment Funds and Investment Managers
− Investment funds are generally are not consolidated with the asset manager unless the manager holds an “outsized portion of the fund’s interests”
− The CFTC has stated that treatment of the investment fund as an affiliate is warranted when an entity may own up to 100 percent of the ownership interest of an investment fund
− The approach is similar to that of the Basel Committee on Banking Supervision
Family Offices
− Application of “Catch-all” under definition of Financial End User
− “A person, entity or arrangement that is, or holds itself out as, raising money from investors, accepting money from clients or using its own money primarily to invest, trade or facilitate the investing or trading in loans, securities, swaps, funds or other assets for resale or other trading”
Entities Within Scope of the Margin Requirements Cont.…
| 13 Hogan Lovells
EUROPEAN UNION
• Treatment of AIFs and UCITs funds UCITs and AIFs managed by authorised or registered AIF managers will be
considered distinct entities and treated separately when applying the thresholds to determine the applicable phase-in date of the margin requirements, provided that:
− the funds are distinct segregated pools of assets for the purposes of the fund's insolvency or bankruptcy; and
− the segregated pools of assets are not collateralized, guaranteed or otherwise financially supported by other investment funds or their managers.
Entities Within Scope of the Margin Requirements Cont.…
Hogan Lovells | 14
UNITED STATES
• Financial End Users without Material Swaps Exposure Is a financial end user that is not a CSE and whose aggregate
average daily notional amount is equal to or less than $8 billion Not subject to initial margin requirements A CSE’s swaps with a financial end user that does not have material
swaps exposure would continue to be subject to the variation margin requirements of the final rule
Entities Within Scope of the Margin Requirements Cont.…
Hogan Lovells | 15
EUROPEAN UNION • From 1 September 2020, an FC/NFC+ entity belonging to a group whose
aggregate month-end average notional amount of non-centrally cleared derivatives (including all physically settled FX forwards and swaps) for March, April and May of that year: exceeds EUR 8 billion – will be subject to the initial margin requirements is less than EUR 8 billion – will not be subject to the initial margin
requirements • Variation margin requirements will still apply
Entities Within Scope of the Margin Requirements Cont.…
| 16 Hogan Lovells
UNITED STATES EUROPEAN UNION • A Non-financial end user means a counterparty
that is not a swap dealer, a major swap participant, or a financial end-user
• Non-financial end users that enter into swaps to hedge and mitigate commercial risk
• Affiliates who enter swaps on behalf of non-
financial entities that use swaps to hedge and mitigate commercial risk in respect of itself or another affiliate
• Trades with NFCs below the clearing thresholds (NFC-) are not subject to initial or variation margin requirements
• EU, US and Japanese sovereigns and central banks
• Multilateral development banks • Public sector entities and the Bank for
International Settlements • Covered bond issuers, under certain
conditions • An EU counterparty may not need to post or
collect IM or VM for trades with a non-EU counterparty located in a jurisdiction where the enforceability of netting agreements or protection of collateral cannot be supported by an independent legal assessment, subject to certain conditions being met
Entities Exempt from the Margin Requirements
| 17 Hogan Lovells
UNITED STATES EUROPEAN UNION
• For Variation and Initial Margin Under the CFTC Rules, the only products
within scope for the purpose of collecting margin are uncleared swaps
Under the rules promulgated by the Prudential Regulators, this includes uncleared security-based swaps as well
The SEC has yet to release its own set of rules regarding margin requirements
• Variation Margin EMIR: All uncleared OTC derivatives Exempt:
− Until 31 December 2018 or when defined under MIFID II, physically settled FX forwards
− Equity options and options on equity indices (exempt for 3 years)
• Initial Margin All uncleared OTC derivatives Exempt:
− Physically settled FX forwards and swaps
− Equity options and options on equity indices (exempt for 3 years)
Products Covered by the Margin Rules
| 18 Hogan Lovells
UNITED STATES EUROPEAN UNION
• Variation Margin A threshold of Zero
• Initial Margin Threshold A maximum of USD 50 million between all
entities in a consolidated group facing all entities in the counterparty’s consolidated group
Prudential regulators lower threshold with affiliates (see below)
• Minimum Transfer Amount USD 500,000 Final Rules provide for a minimum
transfer amount for the collection and posting of margin by Covered Swap Entities
• Variation Margin A threshold of Zero
• Initial Margin A maximum of EUR 50 million between
all entities in a consolidated group facing all entities in the counterparty’s consolidated group
• Minimum Transfer Amount EUR 500,000
Margin Thresholds & Minimum Transfer Amounts
| 19 Hogan Lovells
UNITED STATES EUROPEAN UNION • Inter-affiliate trades are subject to variation margin
requirements
• Inter-affiliate trades are those that occur between a Covered Swap Entity and its non-CSE affiliates
• Neither prudentially regulated Covered Swap Entities or CFTC regulated Covered Swap Entities must post initial margin with affiliates that are Financial End Users with Material Swaps Exposure
• A prudentially regulated Covered Swap Entity must collect initial margin from an affiliate, subject to a $20 million maximum threshold
• CFTC Covered Swap Entities are exempt under certain circumstances from collecting initial margin from affiliates
• These exemptions do not apply to variation margin
• There is an exemption for intragroup transactions, which are subject to certain conditions being met
• Intragroup trades have an initial margin threshold of EUR 10 million
• There is a delayed application of the margin requirements to intragroup transactions with non-EU counterparties.
Affiliate Trades
| 20 Hogan Lovells
UNITED STATES EUROPEAN UNION • Variation Margin for CSE’s
USD cash Currency of underlying swap Major currency for Covered
Swap Entities • Initial Margin and VM between
CSE and Financial End User Cash Gold Certain government bonds Certain corporate bonds Certain equities and debt
• Variation Margin & Initial Margin Cash Gold Certain government debt
securities Certain corporate securities Certain equities and convertible
bonds *Concentration limits may apply
to initial margin collateral including custodian concentration limits for cash
Eligible Collateral
| 21 Hogan Lovells
UNITED STATES EUROPEAN UNION • The rules promulgated by the CFTC
and the Prudential Regulator provide for the use of standardized models to calculate initial Margin
• Goal: 99% confidence interval over a 10-day horizon (or time to maturity, if shorter) calibrated to a time period of between 1 and 5 years
• There should be no cross-margining with other products with respect to the model
• 99% confidence interval over a 10-day horizon calibrated to a period of between 3 and 5 years
• No cross-margining with other products
What is a Regulatory-Compliant Margining Model?
| 22 Hogan Lovells
United States
• Netting– the rules permit limited netting for uncleared swaps under an “Eligible Master Netting Agreement” The rules permit limited netting for uncleared swaps under an EMNA but do not
permit netting across other products • Netting Agreements must be “Qualifying”– they must create a single legal obligation,
provide the Covered Swap Entity with a right to accelerate, terminate and close out on a net basis, no walkaway clause, and be subject to sufficient legal review
• Separate netting portfolios under a single EMNA is permitted
What is a Regulatory-Compliant Margining Model—Netting Issues?
Hogan Lovells | 23
• Both the CFTC and the Prudential Regulators have adopted rules setting forth the cross-border application of the margin rules; the cross-border rules are largely the same except for minor differences “U.S. Person” definition in this case is different from the definition promulgated by the CFTC with respect
to the cross-border application of the Dodd-Frank requirements. The main differences are: – Addition of concept of a non-U.S. CSE whose operating results, financial position and statement of cash
flows are consolidated, in accordance with U.S. GAAP, with those of an ultimate parent entity that is a U.S. person (a “Foreign Consolidated Subsidiary” or “FCS”) and whose obligations are not guaranteed by a U.S. person (a “Non-Guaranteed FCS”);
– Removal of “including, but not limited to” language – With respect to funds and collective investment vehicles, there is no longer a concept of “U.S. majority
ownership” which will apply to such determination – For U.S. persons who own a legal entity and are responsible for such entity’s liabilities, the requirement
that these U.S. persons are also majority-owned by 1 or more U.S. persons is removed
U.S. CSEs and U.S. Guaranteed CSEs Under the CFTC Final Rules, all non-cleared swaps of U.S. CSEs and U.S. Guaranteed CSEs are subject
to the CFTC Margin Rules, regardless of the counterparty. However, U.S. CSEs and U.S. Guaranteed CSEs may rely on substituted compliance with respect to their initial margin posting obligations to (but not collecting obligations from) non-U.S. persons (including non-U.S. CSEs, U.S. branches of CSEs and FCSs) whose obligations are not guaranteed by a U.S. Person.
Cross-Border Application
Hogan Lovells | 24
• Non-Guaranteed FCSs and Non-Guaranteed U.S. Branches The CFTC Final Rules subject a Non-Guaranteed FCS and a Non-Guaranteed U.S. Branch to the CFTC Margin
Rules to the same extent as a U.S. CSE and a U.S. Guaranteed CSE (i.e., with respect to each non-cleared swap, regardless of counterparty).
However, the CFTC Final Rules permit a Non-Guaranteed FCS and a Non-Guaranteed U.S. Branch to rely on substituted compliance for all margin requirements, unless the counterparty is a U.S. CSE or U.S. Guaranteed CSE (in which case substituted compliance would only be available with respect to the initial margin collection requirements of the Non-Guaranteed FCS or Non-Guaranteed U.S. Branch).
• Excluded Non-U.S. Covered Swap Entities The CFTC Final Rules provide a limited exclusion from the CFTC Margin Rules (the “Exclusion”) for a swap
between a non-U.S. CSE that is neither an FCS nor a U.S. branch and whose obligations are not guaranteed by a U.S. person (an “Excluded Non-U.S. CSE”) and a non-U.S. person (including a non-U.S. CSE, other than an FCS or a U.S. branch of a non-U.S. CSE) whose obligations under the relevant swap are not guaranteed by a U.S. person.
With respect to non-cleared swaps with other types of entities, the CFTC Final Rules permit an Excluded Non-U.S. CSE, like a Non-Guaranteed FCS and a Non-Guaranteed U.S. Branch, to rely on substituted compliance with respect to all margin requirements, unless the counterparty is a U.S. CSE or U.S. Guaranteed CSE (in which case substituted compliance would only be available with respect to the Excluded Non-U.S. CSE’s initial margin collection requirements).
Cross-Border Application
Preparing for Regulatory Compliance: Counterparty Classification
Hogan Lovells | 26
• Determine if you are covered by the rules and any applicable phase-ins • Identify and classify each counterparty to determine if and when the margin requirements
will be applicable to the trading relationship between the parties ISDA Regulatory Margin Self-Disclosure Letter (SDL) • Published on 30 June 2016 The SDL allows counterparties to disclose information necessary to determine if and when their trades would be subject to the margin rules by allowing counterparties to disclose information including: entity status – FC, NFC+ and availability of any exemptions
cross-border status – third country entity etc.
whether the relevant notional thresholds are crossed in a particular year for the purposes of determining phase-ins (annual requirement)
threshold tracking, to be done on a group/affiliated basis due to aggregation requirements
The SDL is structured in a modular fashion. Market participants can choose to complete only those modules that they are required/willing to complete.
Preparing for regulatory compliance: counterparty classification
Documentation Issues
| 28 Hogan Lovells
• A Covered Swap Entity must execute trading documentation with each swap entity or financial end user counterparty regarding credit support arrangements, provided that the credit support arrangements:
Provide the Covered Swap Entity and its counterparty with a contractual right to collect and post initial and variation margin in amounts and in the forms required by the final rules;
Specify the methods, procedures, rules and inputs for determining the value of each uncleared swap for calculating variation margin;
Specify the dispute resolution procedures concerning the valuation of uncleared swaps or assets collected or posted as initial or variation margin; and
Describe the methods, procedures, rules and inputs used to calculate initial margin for uncleared swaps entered into between the covered swap entity and its counterparty
Regulatory Documentation Requirements-United States
| 29 Hogan Lovells
• Compliance with rules will require counterparties to make amendments to existing collateral documentation or put in place new collateral documentation
• ISDA has recently published the ISDA 2016 Variation Margin Protocol (VM Protocol) What is the purpose of the VM Protocol? An efficient means of updating collateral documentation to comply with VM margin
requirements for uncleared derivatives in the US, Canada and Japan. The VM Protocol can be supplemented to allow counterparties to agree to further updates
to their collateral documentation to comply with the margin requirements in Europe and Switzerland.
The VM Protocol offers market participants the option to select in its questionnaire, which margin regimes (addressed by the VM Protocol) with which it wishes to comply.
Delivers to the market a new form of Variation Margin CSA that is published by ISDA in 2016 (see below). There are several forms including the New York law CSA, English law CSA and Japanese law CSA.
The VM Protocol does not address the initial margin requirements.
ISDA 2016 Variation Margin Protocol
| 30 Hogan Lovells
Allows counterparties, through the exchanging of Questionnaires during a match process, to make four types of documentation changes:
1. Add a new CSA for variation margin by amending an existing master agreement (“Option 1”). The New CSA governs new transactions while the legacy transactions remain governed by the existing CSA.
2. Create a “replica” CSA that amends both the existing master agreement and CSA so that it can comply with the new margin requirements the CSA would apply to new transactions only (“Option 2”).
3. Amend an existing CSA so that it complies with the new margin requirements. This CSA would apply to new and legacy transactions (“Option 3”).
4. Enter into a new ISDA 2002 Master Agreement that includes a new CSA for variation margin (“Option 4”).
ISDA 2016 Variation Margin Protocol Cont.…
| 31 Hogan Lovells
• Consequences of selecting Option 1 and Option 2– create separate netting sets for new and legacy transactions
New transactions will not be netted against legacy transactions automatically– a change from current practice for many market actors
Grandfathering of legacy transactions means that, unless the parties voluntarily elect to bring pre-compliance date swaps into compliance, multiple CSAs will exist under a singe ISDA Master Agreement at least until legacy transactions roll off
− Collateral management systems will need to be modified to accommodate this split in netting sets
ISDA 2016 Variation Margin Protocol Netting Sets
| 32 Hogan Lovells
• The VM Protocol consists of 8 parts, which includes:
VM Protocol + Adherence Letter;
Questionnaires that will be exchanged between the counterparties; and
Six substantive Exhibits:
– three of which correspond to each of the New York law, Japanese law and English law forms for those who select Option 1; and
– three additional exhibits, each of which correspond to the New York law, Japanese law, and English law forms for those counterparties who select either Option 2 or Option 3
• As for initial margin, the VM Protocol does not cover this, but counterparties would continue to post their “Independent Amounts” established under their existing CSAs
Architecture: ISDA 2016 Variation Margin Protocol
| 33 Hogan Lovells
• The VM Protocol opened to the market on August 16, 2016 and remains open. In other words, there is not “cut-off” for adherence
• The Protocol Questionnaire should be available through ISDA Amend in October 2016
• First, an adhering party must execute an Adherence Letter that can be found in the “Protocol Management” section of the ISDA website at http://www2.isda.org. Each adhering party must print, sign and upload the Adherence Letter as a PDF. An authorized
signatory must sign the letter, such signatory being a person who has the legal authority to bind such entity. Once ISDA has approved the document, the adhering party will receive notice of such acceptance via e-mail confirmation
The adhering party must include its name, legal entity identifier (LEI), contact name and address
• Second, the adhering party must exchange questionnaires with its counterparty
How to Adhere to the VM Protocol
| 34 Hogan Lovells
• Matching Questionnaires The Questionnaires contain each party’s elections with the ultimate aim of
communicating how the VM Protocol will apply to the counterparties
The Questionnaires can be delivered online to designated counterparties using ISDA Amend
Under the VM Protocol, certain conditions must be met in order for a pair of exchanged questionnaires to be considered “matched”
Some of the important terms on which the parties must agree include the following:
− Whether to create a new Protocol Master Agreement or use an existing one
− If a new Protocol Master Agreement is being created, then the governing law for the document must be agreed upon
− If an existing Protocol Master Agreement is being used, then the parties must designate whether they are choosing Option 1, Option 2 or Option 3
How to Adhere to the VM Protocol Cont.…
| 35 Hogan Lovells
• Matching Questionnaires The parties may agree to use more than one of Option 1, Option 2 or Option 3, and if
this is the case, then a hierarchy established by the VM Protocol will dictate which of such methods shall apply
If the parties select Option 1, the VM Protocol provides “default settings” for three commercial terms. However, the parties can agree between themselves whether such a default setting will apply. The three commercial terms include:
− Minimum Transfer Amount
− Applicability of Negative Interest; and
− Notification time (this only applies where a party has selected 1 pm London time for an English law CSA)
How to Adhere to the VM Protocol Cont.…
Hogan Lovells | 36
• This CSA is designed to assist those “Phase 1” entities whose compliance date for initial margin requirements is September 1, 2016
• A New York law security interest is still created under this CSA • Variation margin, unlike in the 1994 CSA, is excluded from the terms of
this agreement because the phasing in of the initial margin requirement occurs first (but this may not apply in the EU)
• Nothing in this CSA impacts or affect the rights of the parties with respect to variation margin
• The initial margin due with regard to new transactions will specifically be excluded in the calculation of “Exposure” with respect to any legacy CSA
• Provides an option for parties to elect whether an alternate regulator-approved margin calculation method will apply
2016 Phase One CSA for Initial Margin (IM)
Hogan Lovells | 37
• Intended for use with New York law ISDA Master Agreements • This is an updated CSA that enables compliance with the new requirements
governing the exchange of variation margin • Creates a New York law security interest over all the collateral • Excludes from its scope any “independent amount” or initial margin in
addition to any transactions that are specified by the parties in Paragraph 13 • This CSA reduces the time in which either party can make transfers of
collateral to the other pursuant to a demand. The time previously allotted to parties was 2 business days, but not such time is 1 business day
• With respect to the collateral, parties may adjust “downward” for negative interest in this new CSA if “Interest Adjustment” is so specified in Paragraph 13
2016 CSA for Variation Margin (NY Law)
I. OTC derivative market overview
II. Financial management challenges
III. IM calculation and input requirements
IV. Optimization, MVA, and capital management
Risk Management Implications of Initial Margin
I. OTC derivative market overview
II. Financial management challenges
III. IM calculation and input requirements
IV. Optimization, MVA, and capital management
Risk Management Implications of Initial Margin
| 40
• OTC Derivative Market ~$493 trillion notional 2015 (BIS)
• Basel Committee on Banking Supervision (BCBS)-International Organization of Securities Commissions (IOSCO) estimates (for US banks only): – ~$315 Bn initial margin under ISDA SIMM™
– ~$3,600 Bn initial margin under Standard Rules (BCBS 261 appendix )
• Notes on BCBS-IOSCO
– Applies to the most complicated instruments with non-standard pricing models
– Agreeing mark-to-market between banks is difficult, agreeing IM (VaR) is very difficult
– Fundamental change to the operation and economics of the derivative market
Initial Margin By the Numbers
Hogan Lovells | Quaternion Risk Management
| 41
Derivative Margining: Overview
Hogan Lovells | Quaternion Risk Management
I. OTC derivative market overview
II. Financial management challenges
III. IM calculation and input requirements
IV. Optimization, MVA, and capital management
Risk Management Implications of Initial Margin
| 43
Challenges of BCBS-IOSCO
Hogan Lovells | Quaternion Risk Management
1. Legal and Contractual 2. Operational
3. Quantitative Model approval,
SIMM™ attribution, MVA and cost of funding
4. Financial Management Operating model, Capital impacts, B/S optimization
Initial Margin
| 44
• Operating Model – Management of IM, Collateral, Funding
– Measure to Manage: cost and benefit attribution to affected desks
• Capital Impacts
– Capital models need to be changed to take account of IM risk mitigation
– Gives rise to Dynamic IM models (DIM) under Basel III
• Balance Sheet Effects
– Own Balance Sheet optimization (SIMM™ reduction)
– Collective SIMM™ optimization
Financial Management Challenges
Hogan Lovells | Quaternion Risk Management
| 45
• Reduce SIMM™ between 8 institutions with two constraints: 1. Trading restrictions
between certain counterparties
2. “Reduce-only” requirement for certain counterparties
• Next step: explore additional constraints and other optimization functions (e.g. MVA)
Example: Collective SIMM™ Optimization
Hogan Lovells | Quaternion Risk Management
I. OTC derivative market overview
II. Financial management challenges
III. IM calculation and input requirements
IV. Optimization, MVA, and capital management
Risk Management Implications of Initial Margin
| 47
• Agreement on IM amount is paramount – Equal for both counterparties at trade inception, though varies over time – Methodology must be transparent, otherwise no agreement and exchange
• Regulation requires VaR-style approach (99% C.I., 10-day, one tailed)
– Internal models vary → backtested on unique historical data – BCBS 261 defines standardized bucketing schedule as % of notional by asset class and tenor
• ISDA created a more risk-sensitive approach (Standard Initial Margin Model)
– Inputs based on risk sensitivities (“greeks”), easier to reconcile than VaR results – More conservative than VaR due to “one size fits all” (~2-4x larger than true VaR) – Permitted to use alternative models (internal VaR) w/ regulatory approval
Initial Margin Calculation
Hogan Lovells | Quaternion Risk Management
| 48
• Primary inputs: sensitivities grouped across currencies, tenors, underlying – Delta – change in position value based on 1bp move in reference asset
– Vega – change in position value based on 1bp move in reference asset volatility
– Curvature – intended to capture cross effects of simultaneous risk factor moves
• System performance is crucial for regular sensitivity calculation – Brute force “bump and revalue” approach
– Adjoint algorithmic differentiation for larger portfolios
• Even with similar methodologies, reconciliation can be burdensome – Creation of industry consortium (AcadiaSoft) for dealer reconciliation and exchange
Trade Data and Input Requirements
Hogan Lovells | Quaternion Risk Management
I. OTC derivative market overview
II. Financial management challenges
III. IM calculation and input requirements
IV. Optimization, MVA, and capital management
Risk Management Implications of Initial Margin
| 50
• Opportunities for global reduction of IM posted among counterparties – Net risk position remains identical, with considerations for capital, risk limits, funding, etc.
• Multilaterally (across many counterparties) likely provides largest savings
• Bilaterally (between numerous legal entities of only two counterparties)
• Internally (among various legal entities of a single holding company) – Allows use of internal models, leading to less conservative IM exchange
Optimization via Trade Compression
Hogan Lovells | Quaternion Risk Management
A1 (X)
B1 (-X)
B2 (X)
A2 (-X)
A1 (X)
B1 (-X)
B2 (X)
A2 (-X) Compression
State 1 State 2
Margin Savings
| 51
• Posting IM dramatically decreases counterparty credit risk (CVA) – Must be reflected in trade pricing
(MVA) and capital calculations (PFE)
– Requires simulation of forward IM amounts over full life of each trade
– Computationally difficult, leading to nested Monte Carlo under brute force
– IFRS 13 fair value implications
• Alternative analytic solutions – Regression using polynomials
– Forward SIMM and AAD
MVA & Dynamic Initial Margin (DIM)
Hogan Lovells | Quaternion Risk Management
| 52
1. Independent IM Model Benchmarking and Validation – Preparation for Regulatory Submissions / Approval
– Software to calculate and benchmark SIMM™
2. Software and services for SIMM™ Attribution and Cost Allocation
3. Capital Model Design and Implementation (DIM)
4. Software for MVA Calculation
5. IM Optimization and Trade Compression
6. Balance Sheet Optimization
7. CSA Valuation Services for Specific / Bespoke Features
How Can Quaternion Help?
Hogan Lovells | Quaternion Risk Management
| 53
Panel Discussion and Q&A
Hogan Lovells | Quaternion Risk Management
"Hogan Lovells" or the "firm" is an international legal practice that includes Hogan Lovells International LLP, Hogan Lovells US LLP and their affiliated businesses.
The word “partner” is used to describe a partner or member of Hogan Lovells International LLP, Hogan Lovells US LLP or
any of their affiliated entities or any employee or consultant with equivalent standing.. Certain individuals, who are designated as partners, but who are not members of Hogan Lovells International LLP, do not hold qualifications equivalent
to members.
For more information about Hogan Lovells, the partners and their qualifications, see www.hoganlovells.com.
Where case studies are included, results achieved do not guarantee similar outcomes for other clients. Attorney advertising. Images of people may feature current or former lawyers and employees at Hogan Lovells or models not
connected with the firm.
© Hogan Lovells 2016. All rights reserved
www.hoganlovells.com