EUROPEAN UNION: Exchange of Collateral for OTC Derivatives Contracts of Financial Counterparties to become Mandatory

Tuesday December 20 2016

New provisions on collateral posted for bilateral OTC derivatives and on other risk management procedures are included in the European Commission Delegated Regulation (EU) 2016/2251 which was published on 15 December 2016 in the Official Journal of the European Union.

The Delegated Regulation specifies the provisions of Article 11 of the Regulation (EU) No 648/2012 (EMIR). A key purpose of the new provisions is to mitigate the mutual counterparty credit risk between the parties to OTC derivatives contracts.

Counterparties have an obligation to protect themselves against credit exposures to derivatives counterparties by collecting margins where those contracts are not cleared by a central counterparty. The Regulation lays out the standards for the timely, accurate and appropriately segregated exchange of collateral. These standards will apply on a mandatory basis to the collateral that counterparties are required to collect or post pursuant to the Regulation. Counterparties which agree to collect or post collateral beyond the requirements of the Regulation can choose whether or not to exchange such collateral in accordance with the standards.

For users of OTC derivatives, the key aspects of the reform are:

• the obligation to agree on exchange of collateral in the manner laid down in the Regulation;
• the obligation to agree on the assets used as collateral prior to conclusion of new OTC derivatives contracts;
• the obligation to use the types of collateral set out in the Regulation;
• the obligation to manage the risks related to OTC derivatives and the collateral posted for them in accordance with the provisions of the Delegated Regulation.

The Regulation will particularly affect financial counterparties, such as banks, insurance companies, investment firms, investment funds and alternative investment funds. In addition to financial counterparties, the Regulation will also apply to a limited number of non-financial counterparties exceeding the clearing threshold.

Since central counterparties (‘CCPs’) might be authorised as a credit institutions according to EU legislation, non-centrally cleared OTC derivative contracts that CCPs enter into during a default management process are excluded from the requirements of the Regulation since those contracts are already subject to the provisions of Commission Delegated Regulation (EU) No 153/2013.

Initial margin requirements

When setting the level of initial margin requirements, the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions explicitly considered two aspects, as reflected in their framework, ‘Margin requirements for non-centrally cleared derivatives’ of March 2015 (‘BCBS-IOSCO framework’).

The first aspect is the availability of high credit quality and liquid assets covering the initial margin requirements. The second is the proportionality principle, as smaller financial and non-financial counterparties might be hit in a disproportionate manner from the initial margin requirements.

While the thresholds will always be calculated at group level, investment funds are treated as a special case as they can be managed by a single investment manager and captured as a single group. However, where the funds are distinct pools of assets and they are not collateralised, guaranteed or supported by other investment funds or the investment manager itself, they are relatively risk remote in relation to the rest of the group. Such investment funds are therefore to be treated as separate entities when calculating the thresholds, in line with the BCBS-IOSCO framework.

Obligation to exchange collateral

The Delegated Regulation divides collateral into variation margins and initial margins. The obligation to exchange variation margins mainly concerns all bilateral OTC derivatives contracts of financial counterparties. This obligation will apply to OTC derivatives contracts entered into on or after 1 March 2017. The obligation will apply, as early as February, to a small number of financial counterparties with a particularly high volume of OTC derivatives contracts. In practice, these are mainly international banks.

Obligation to exchange initial margins to be phased in

Large market participants with over EUR 8 billion worth of OTC derivatives contracts, calculated in terms of gross notional amounts, will be subject to an obligation to exchange initial margins. This obligation will be applied gradually on the basis of the total volume of contracts in such a way that the first counterparties will fall within the sphere of the exchange obligation in February 2017 and the last ones on 1 September 2020.

Extension of time for equity and equity index derivatives and intra-group OTC derivatives

For OTC equity and OTC equity index derivatives, the obligation to exchange collateral will not apply until the beginning of 2020. Moreover, there will be a transitional period of six months until 4th of July for the application of the collateral exchange obligation to intra-group transactions according to Article 3 of the EMIR of groups as defined in Article 2 (16) of the EMIR.

Exemptions for intra-group OTC derivatives

The obligation to exchange collateral will not be applied to bilateral OTC derivatives contracts, according to Article 3 of the EMIR, that are entered into by two counterparties belonging to the same group and established in the same Member State. Counterparties belonging to the same group and established in different Member States can also apply for exemption in accordance with Article 11 of the EMIR. More detailed provisions on applications for exemption are laid down, in addition to the Regulation now published, in the Commission Delegated Regulation (EU) No 149/2013.

Provisions relating to UCITS

A counterparty can only collect collateral from shares or units in UCITS provided that certain conditions are met. These conditions include that:

• the units or shares have a daily public price quote;
• the UCITS are limited to investing in assets that are eligible in accordance with Article 4(1) of the Regulation; and
• the UCITS meet the criteria laid down in Article 132(3) of Regulation (EU) No 575/2013 including that (i) it is managed by a company subject to EU or equivalent supervision where cooperation is sufficiently ensured; and (ii) the prospectus or equivalent document includes the categories of assets in which it is authorised to invest and the methodologies used to calculate any investment limits.

Where a UCITS or any of its underlying UCITS do not only invest in assets that are eligible in accordance with Article 4(1), only the value of the unit or share of the UCITS that represents investment in eligible assets may be used as eligible collateral.

Where non-eligible assets of a UCITS can have a negative value, the value of the unit or share of the UCITS that may be used as eligible collateral will be determined by deducting the maximum negative value of the non-eligible assets from the value of eligible assets.

Click on the above link to view the Commission Delegated Regulation.