The Bank for International Settlements (BIS) and the International Organization of Securities Commissions (IOSCO) have published their final framework for margin requirements for non-centrally cleared derivatives
. The document sets forth globally agreed standards for all financial firms and systemically important non-financial entities that engage in non-centrally cleared derivatives. Under the guidelines, these firms will have to exchange initial and variation margin commensurate with the counterparty risks arising from such transactions. The aim of this framework is to reduce systemic risks related to over-the-counter (OTC) derivatives markets, as well as to provide firms with appropriate incentives for central clearing while managing the overall liquidity effects of these new requirements.
The framework is an articulation of eight principles:
- Appropriate margining practices should be in place with respect to all derivatives transactions that are not cleared by CCPs.
- All financial firms and systemically important non-financial entities (“covered entities”) that engage in noncentrally cleared derivatives must exchange initial and variation margin as appropriate to the counterparty risks posed by such transactions.
- The methodologies for calculating initial and variation margin that serve as the baseline for margin collected from a counterparty should (i) be consistent across entities covered by the requirements and reflect the potential future exposure (initial margin) and current exposure (variation margin) associated with the portfolio of non-centrally cleared derivatives in question and (ii) ensure that all counterparty risk exposures are fully covered with a high degree of confidence.
- To ensure that assets collected as collateral for initial and variation margin purposes can be liquidated in a reasonable amount of time to generate proceeds that could sufficiently protect collecting entities covered by the requirements from losses on non-centrally cleared derivatives in the event of a counterparty default, these assets should be highly liquid and should, after accounting for an appropriate haircut, be able to hold their value in a time of financial stress.
- Initial margin should be exchanged by both parties, without netting of amounts collected by each party (ie on a gross basis), and held in such a way as to ensure that (i) the margin collected is immediately available to the collecting party in the event of the counterparty’s default; and (ii) the collected margin must be subject to arrangements that fully protect the posting party to the extent possible under applicable law in the event that the collecting party enters bankruptcy.
- Transactions between a firm and its affiliates should be subject to appropriate regulation in a manner consistent with each jurisdiction’s legal and regulatory framework.
- Regulatory regimes should interact so as to result in sufficiently consistent and non-duplicative regulatory margin requirements for non-centrally cleared derivatives across jurisdictions.
- Margin requirements should be phased in over an appropriate period of time to ensure that the transition costs associated with the new framework can be appropriately managed. Regulators should undertake a coordinated review of the margin standards once the requirements are in place and functioning to assess the overall efficacy of the standards and to ensure harmonisation across national jurisdictions as well as across related regulatory initiatives.
The final requirements take into account a number of comments critical of the first draft. The framework exempts physically settled foreign exchange (FX) forwards and swaps from initial margin requirements. According to BIS, the variation margin on these derivatives should be exchanged in accordance with standards developed after considering the Basel Committee supervisory guidance for managing settlement risk in FX transactions. The framework also exempts from initial margin requirements the fixed, physically settled FX transactions that are associated with the exchange of principal of cross-currency swaps. However, the variation margin requirements that are described in the framework apply to all components of cross-currency swaps. "One-time" re-hypothecation of initial margin collateral is permitted subject to a number of strict conditions. These conditions are intended to help to mitigate the liquidity effects associated with the requirements.
Recognizing that margin requirements should not remain static in the face of changing circumstances, BIS and IOSCO have set up a group charged with monitoring the effects of the framework over time, and suggesting necessary refinements and changes. In addition, the group will ensure that the framework does not conflict with regulatory initiatives under way in a number of countries.
The actual impact of margin requirements is subject to various factors and uncertainties, including, among others, the ratio of cleared to non-centrally cleared derivatives and changes in market volatility over time. Moreover, a number of the framework’s design elements could have impacts that may change over time depending on changes in market structure and market conditions.
The BCBS and IOSCO will set up a monitoring group to evaluate these margin standards in 2014. The evaluation will focus on the relation and consistency of the margin standards with related regulatory initiatives such as changes to standardised approaches for trading book and counterparty credit risk capital, potential minimum haircuts on repurchase and reverse repurchase transactions, implementation of the LCR, and capital requirements on centrally cleared derivatives that may develop alongside these requirements between now and 2014.
The monitoring group will also explore efforts to establish a global framework for cross-border margin requirements.
The monitoring group will consider developments in the effort to establish a global framework for cross-border interactions across an array of regulatory initiatives including margin. These developments will be reviewed to ensure that the interactions between differing jurisdictions in the context of margin requirements are compatible with the goals of this framework.
The framework proposes a gradual phase-in period to provide market participants with sufficient time to adjust to the requirements. The requirement to collect and post initial margin on non-centrally cleared trades will be phased in over a four-year period, beginning in December 2015 with the largest, most active and most systemically important derivatives market participants.