The new requirement to post variation margin for non-centrally cleared derivatives is expected to present significant challenges to financial institutions, particularly the sell side, which may lack the right collateral, liquidity and operational capability.
Variation margin is posted daily to cover mark-to-market positions in derivatives price movements. The mandatory requirement for market participants to post variation margin has become a market-wide issue largely because it applies to all financial counterparties including asset managers, pension funds, insurance companies and hedge funds. Corporates which trade significant volumes of derivatives with banks will also be caught by the variation margin requirements.
With the 1 March 2017 variation margin rule implementation deadline looming, this has given rise to concerns about whether financial institutions are ready in terms of their legal documentation, operational infrastructures, their ability to meet the strict requirements on the type of collateral that can be posted and the required timing for settlement.
"The scale of the task is massive, and firms [financial institutions] need to take action now in order to stand a chance of being ready in time," the International Swaps and Derivatives Association said in a commentary posted on its website on 3 November.
One of the immediate impacts of the new margin requirement for non-centrally cleared derivatives is on credit support annexes which would require market participants to amend existing ones or negotiate new ones if they did not exist previously, said Tasos Zavitsanakis, consulting director, advisory services at PwC in Hong Kong.
Credit support annexes describe the type and frequency of collateral which counterparties would need to exchange to protect the mark-to-market positions in derivatives movements. It also requires collateral to be settled on a T+1 basis.
If market participants are unable to provide collateral on a T+1 basis because they do not have either the liquidity or the operational capability, this would make them effectively non-compliant under the US Commodity Futures Trading Commission ("CFTC") rules, Zavitsanakis said. The European margin rules are still being finalised, while some Asian jurisdictions have finalised their rules, all of which are expected to be implemented by end of this year.
Zavitsanakis said the industry is less concerned about banks not meeting the margin requirements, but rather whether their clients, mainly the sell side such as asset managers, fund managers and insurance companies, would be compliant. The concerns lie in whether the sell side has the right collateral, liquidity and operational capability.
"If the sell side needs to create liquidity, they can ask banks to do asset transformation to create the liquidity but there will be cost involved. The sell side may not have the operational infrastructures as well," he said.
To ensure that they comply with the new margin rules, banks need to know whether their clients are able to trade on a T+1 basis, and they will only transact with counterparties with such capability, Zavitsanakis said.
"The issue [for banks] then becomes: how can I be compliant? The only way to be compliant is to use US government bonds, UK government bonds, euro bonds and Canadian government bonds, all of which are able to settle on a T+1 basis. Most other bonds settle on a T+2 or T+3 basis," he said.
The different requirements under the margin rules in different jurisdictions will affect market participants in different ways, said Terry Yang, consultant at Clifford Chance in Hong Kong. Depending on the rules in which country market participants will be subjected, this will in turn determine the kind of collateral they can use to post as variation margin, Yang said.
"If a bank is subject to the T+1 requirement under the CFTC rules and it is trading with a counterparty that is not able to satisfy the T+1 requirement, then it will not be able to trade with such a counterparty," he said.
European and Asian Margin Rules
The European margin rules for non-centrally cleared derivatives, which are in the process of being finalised, have a slightly different requirement. The market generally interprets the European rules as requiring instructions for delivery of collateral to be given by T+1, according to Yang.
Asian rules, which vary among jurisdictions, are generally less strict, he said. The Australian regulator, for instance, only requires collateral to be delivered promptly without setting a cut-off time. Hong Kong regulator has set a more generous timeframe for collateral to be exchanged compared to the US and European regulators; it has also set T+3 as the maximum amount of time allowed for collateral to be posted.
Implications Go Beyond Legal
ISDA pointed out that revising and setting up new documentation is a necessary step in the run-up to the margin rule implementation. It has published a variety of revised credit support documents under various legal regimes. The challenge, it said, is how to make those changes without having to negotiate bilaterally with every single counterparty.
Zavitsanakis said legal documentation would need to be dealt with to ensure compliance with the new margin rules, and would require negotiations among the counterparties.
"If the old and new agreements are very different, there may be terms that one counterparty does not want to give up, but banks will just want to simplify the agreement. It would need some kind of negotiation," he said.
The new requirements to post variation margin go beyond legal implications, Yang said. Financial institutions would have to comply with a very strict timeframe; operational infrastructures that are unable to do T+1 settlements would need to be changed; and treasury would need to source for liquidity, he said.
"The variation margin requirement affects different aspects of a non-cleared derivative trade," he said.
The valuation of position is another aspect of non-centrally cleared derivatives which financial institutions and their counterparties would need to agree upon, said Tom Jenkins, partner, financial services at KPMG China.
"As part of the new regulations, market participants are required to ensure that they agree with the valuation methodology and they need to have a dispute resolution mechanism to resolve any disagreement on the valuation," he said.
Given the impending deadline, it would be challenging for market participants to put in place all the necessary arrangements by March 1, 2017, including sorting out the legal documents, making changes to their operational systems, and ensuring there is sufficient liquidity for the collateral, Yang said.
Market participants may end up focusing their efforts on a few key counterparties initially to meet the March 1, 2017 implementation date and then work with other counterparties to remediate outstanding issues relating to the implementation of the margin requirements.
"It is difficult to see how regulators would be willing to push back the 1 March 2017 deadline," he said.