Legal issues involved with initial margin are the part of the broader spectrum of the collateral management under the EMIR Regulation.
Initial margin is defined in the Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council 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 as "the collateral collected by a counterparty to cover its current and potential future exposure in the interval between the last collection of margin and the liquidation of positions or hedging of market risk following a default of the other counterparty" (Article 1(1)).
Recital 3 of the said Regulation underlines "initial margin protects counterparties against potential losses which could stem from movements in the market value of the derivatives position occurring between the last exchange of variation margin before the default of a counterparty and the time that the OTC derivative contracts are replaced or the corresponding risk is hedged".
The definition of initial margin did not rise major controversies, as the early drafts of the aforementioned Regulation contained the analogous wording (see the draft RTS proposed by the ESAs' Second Consultation on margin RTS for non-cleared derivatives of 10 June 2015 (JC/CP/2015/002) - the initial margin "protects against expected losses which could stem from movements in the market value of the derivatives position occurring between the last exchange of variation margin before the default of a counterparty and the time that OTC derivative contracts are replaced or the corresponding risk is hedged" (Recital 5)).
Also the document of the Basel Committee on Banking Supervision, Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives, September 2013 indicates that initial margin protects the transacting parties from the potential future exposure that could arise from future changes in the mark-to-market value of the contract during the time it takes to close out and replace the position in the event that one or more counterparties default.
As follows, the economic sens of the initial margin is rather clear, though literary wording of the definition varies to reflect different aspects of the same business model.
The amount of initial margin reflects the size of the potential future exposure.
It depends on a variety of factors, including how often the contract is revalued and variation margin exchanged, the volatility of the underlying instrument, and the expected duration of the contract closeout and replacement period, and can change over time, particularly where it is calculated on a portfolio basis and transactions are added to or removed from the portfolio on a continuous basis.
The above approach was consequently upheld by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) in the document: "Margin requirements for non-centrally cleared derivatives" adopted in March 2015.
When it comes to the economic significance in the macro scale, the value of total initial margin collected among financial institutions in the EU is estimated by the Impact Assessment attached to the draft RTS of 10 June 2015 (JC/CP/2015/002) in the range of EUR 40 billion. The figure is about 40% of the global value.
See below the contemplations on the initial margin contained in the above Consultation Paper of 14 April 2014:
"The EMIR requires financial counterparties to have risk management procedures in place that require the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts. Similarly, non-financial institutions must have similar procedures in place, if they are above the clearing threshold. Consistent with this goal, to prevent the build-up of uncollateralised exposures within the system, the RTS require the daily exchange of variation margin between counterparties.
Subject to the provisions of the RTS, the entities mentioned above, i.e. both financial and non-financial counterparties, will also be required to exchange two-way initial margin to cover the potential future exposure resulting from a counterparty default. To act as an effective risk mitigant, initial margin recalculations should reflect changes in both the risk positions and market conditions. Consequently, counterparties will be required to recalculate initial margin, at least when the portfolio between the two entities has changed, or the underlying risk measurement approach has changed. In addition, to ensure current market conditions are fully captured, initial margin is subject to a minimum recalculation period of 10 days.
In order to align with international standards, the requirements in the RTS will apply only to key OTC derivative market participants. The provisions of the RTS on initial margin will therefore apply to entities that have an OTC derivative exposure above a predetermined threshold, defined in the RTS as above EUR 8 billion in gross notional outstanding. This reduces the burden on smaller market participants, while still achieving the principle objective of a sizable reduction in systemic risk. The RTS impose an obligation on EU entities to collect margin in accordance with the prescribed procedures, regardless of whether they are facing EU or non-EU entities. EU entities would have to collect margin from all third-country entities, unless explicitly exempted by the EMIR or under the EUR 8 billion threshold, even from those that would be classified as non-financial entities below the threshold if they were established in the EU.
During the development of the RTS, the issue of the risks posed by physically-settled foreign-exchange contracts was carefully considered. There appears to be a risk involved in these transactions. However, to maintain international consistency, entities subject to the RTS may agree not to collect initial margin on physically-settled foreign exchange forwards and swaps, or the principal in currency swaps. Nevertheless, the counterparties are still expected to post and collect the variation margin associated with these contracts, which is assessed to sufficiently cover the risk and ensure a proportionate approach.
Yet it is also recognised that the exchange of collateral for only minor movements in valuation may lead to an overly onerous exchange of collateral and that initial margin requirements will a measurable impact. Therefore, the RTS propose a threshold to limit the operational burden and a threshold for managing the liquidity impact associated with initial margin requirements. Both thresholds are fully consistent with international standards.
The first threshold ensures that the exchange of initial margin does not need to take place if a counterparty has no significant exposures to another counterparty. Specifically, it may be agreed bilaterally to introduce a minimum threshold of up to EUR 50 million, which will ensure that only counterparties with significant exposures will be subject to the Initial Margin requirements.
The second threshold ensures that, when market valuations fluctuate, new contracts are drawn up or other aspects of the covered transactions change; an exchange of collateral is only necessary if the change in the margin requirements exceeds EUR 500 000. Similarly to the first threshold, counterparties may agree on the introduction of a threshold in their bilateral agreement as long as the minimum exchange threshold does not exceed EUR 500 000. Therefore, the exchange of collateral only needs to take place when significant changes to the margin requirements occur. This will limit the operational burden relating to these requirements."
Frequency of calculation and determination of the calculation date
According to the Regulation 2016/2251, counterparties must calculate initial margin no later than the business day following one of these events:
(a) where a new non-centrally cleared OTC derivative contract is executed or added to the netting set;
(b) where an existing non-centrally cleared OTC derivative contract expires or is removed from the netting set;
(c) where an existing non-centrally cleared OTC derivative contract triggers a payment or a delivery other than the posting and collecting of margins;
(d) where the initial margin is calculated in accordance with the standardised approach and an existing contract is reclassified in terms of the asset category as a result of reduced time to maturity;
(e) where no calculation has been performed in the preceding 10 business days.
For the purpose of determining the calculation date for initial margin, the following rules, moreover, apply:
(a) where two counterparties are located in the same time-zone, the calculation is to be based on the netting set of the previous business day;
(b) where two counterparties are not located in the same time-zone, the calculation is to be based on the transactions in the netting set which are entered into before 16.00 of the previous business day of the time zone where it is first 16.00.
Provision of initial margin
The initial margin must be provided by the posting counterparty within the same business day of the calculation date.
Iin the event of a dispute over the amount of initial margin due, counterparties must provide within the same business day of the calculation date at least the part of the initial margin amount that is not being disputed).
Calculation of initial margin
The amount of collected initial margin is to be calculated using either:
(a) the standardised approach (the rules thereof are stipulated in Annex IV to the Regulation) or
(b) the initial margin models (referred to in Section 4 the Regulation);
or both (Section 4 and Annex IV to the Regulation 2016/2251 see below).
According to the Regulation 2016/2251, the collection of initial margin is performed without offsetting the initial margin amounts between the two counterparties.
Where counterparties use both the standardised approach and the initial margin models in relation to the same netting set, they must use them consistently for each non-centrally cleared OTC derivative contract.
Counterparties calculating the initial margin in accordance with the initial margin models must not take into account any correlations between the value of the unsecured exposure and the collateral in that calculation.
Counterparties are required to agree on the method each counterparty uses to determine the initial margin it has to collect but are not required to use a common methodology.
Where one or both counterparties rely on an initial margin model they must agree on the model developed.
"A mandate for initial margin models to be endorsed by authorities could promote certainty for market participants and authorities alike" (Report from the Commission to the European Parliament and the Council under Article 85(1) of 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 COM(2016) 857 final of 23.11.2016).
Ban on initial margin reuse
According to Article 20 of the Regulation 2016/2251 the collecting counterparty is not allowed to rehypothecate, repledge nor otherwise reuse the collateral collected as initial margin.
The only exclusion from this restriction is a situation where a third-party holder uses the initial margin received in cash for reinvestment purposes.
Initial margin management and segregation
Counterparties' internal procedures, legal arrangements and a collateral holding structure must ensure:
(a) daily valuation of the collateral;
(b) access to the received collateral where it is being held by a third party;
(c) where initial margin is held by the collateral provider, that the collateral is held in insolvency-remote custody accounts;
(d) the availability of unused collateral to the liquidator or other insolvency official of the defaulting counterparty;
(e) that the initial margin is freely transferable to the posting counterparty in a timely manner in case of the default of the collecting counterparty;
(f) that non-cash collateral is transferable without any regulatory or legal constraints or third-party claims, including those of the liquidator of the collecting counterparty or third-party custodian, other than liens for fees and expenses incurred in providing the custodial accounts and other than liens routinely imposed on all securities in a clearing system in which such collateral may be held;
(g) that any unused collateral is returned to the posting counterparty in full, excluding costs and expenses incurred for the process of collecting and holding the collateral.
Cash collected as initial margin must be maintained in cash accounts at central banks or credit institutions, which fulfil all of the following conditions:
(a) they are:
- authorised in accordance with Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms or
- authorised in a third country whose supervisory and regulatory arrangements have been found to be equivalent in accordance with Article 142(2) of the CRR Regulation;
(b) they are neither the posting nor the collecting counterparties, nor part of the same group as either of the counterparties.
The counterparties must assess the credit quality of the credit institution at issue, by using a methodology that does not solely or mechanistically rely on external credit quality assessments.
Any collateral posted as initial margin may be substituted by alternative collateral where all of the following conditions are met:
(a) the substitution is made in accordance with the terms of the agreement between the counterparties;
(b) the alternative collateral is eligible, as set out in the Regulation 2016/2251;
(c) the value of the alternative collateral is sufficient to meet all margin requirements after applying any relevant haircut.
Initial margin must be protected from the default or insolvency of the collecting counterparty by segregating it in either or both of the following ways:
(a) on the books and records of a third-party holder or custodian;
(b) via other legally binding arrangements;
Counterparties must ensure that non-cash collateral exchanged as initial margin is segregated as follows:
(a) where collateral is held by the collecting counterparty on a proprietary basis, it must be segregated from the rest of the proprietary assets of the collecting counterparty;
(b) where collateral is held by the posting counterparty on a non-proprietary basis, it must be segregated from the rest of the proprietary assets of the posting counterparty;
(c) where collateral is held on the books and records of a custodian or other third-party holder, it must be segregated from the proprietary assets of that third-party holder or custodian.
Where non-cash collateral is held by the collecting party or by a third-party holder or custodian, the collecting counterparty must always provide the posting counterparty with the option to segregate its collateral from the assets of other posting counterparties.
Counterparties must perform an independent legal review in order to verify that the segregation arrangements meet the above requirements. That legal review may be conducted by an independent internal unit, or by an independent third party.
Counterparties are required to provide evidence to their competent authorities of compliance with the requirement of the independent legal review in relation to each relevant jurisdiction and, upon request by a competent authority, must establish policies ensuring the continuous assessment of compliance.
European Commission Proposal of May 2017 for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories (COM(2017)208) goes even further than that and envisions new requirement that risk-management procedures for exchange of collateral of counterparties, or any significant change to those procedures, must be approved by supervisors before they are applied.
EMIR reporting for initial margin
Companies are required to indicate in their EMIR transaction reports the value of the initial margin posted - Field 24 of the Table 1 of the Annex to the Commission Implementing Regulation (EU) 2017/105 of 19 October 2016 amending Implementing Regulation (EU) No 1247/2012 laying down implementing technical standards with regard to the format and frequency of trade reports to trade repositories according to Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories (initial margin received - Field 28).
Initial margin in the CCP framework - margin simulation tool
Legal definition of initial margin for the purposes of the central counterparties' CCP's framework is also contained in Article 1(5) of Commission Delegated Regulation No 153/2013 of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on requirements for central counterparties pursuant to which 'initial margin' means margins collected by the CCP to cover potential future exposure to clearing members providing the margin and, where relevant, interoperable CCPs in the interval between the last margin collection and the liquidation of positions following a default of a clearing member or of an interoperable CCP default (this is connected with the definition of 'margins' as a broader category, which is set out in the Article 1(4) of the said Regulation, stipulating that 'margins' are 'margins as referred to in Article 41 of Regulation (EU) No 648/2012 which may include initial margins and variation margins').
European Commission Proposal of May 2017 for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories (COM(2017)208)
In Article 38 of EMIR the following paragraphs 6 and 7 are added:
“6. A CCP shall provide its clearing members with a simulation tool allowing them to determine the amount, on a gross basis, of additional initial margin that the CCP may require upon the clearing of a new transaction. That tool shall only be accessible on a secured access basis and the results of the simulation shall not be binding.
7. A CCP shall provide its clearing members with information on the initial margin models it uses. That information shall meet all of the following conditions:
(a) it clearly explains the design of the initial margin model and how it operates;
(b) it clearly describes the key assumptions and limitations of the initial margin model and the circumstances under which those assumptions are no longer valid;
(c) it is documented."
The said draft Regulation of May 2017 foresees that CCPs should provide their clearing members with tools to simulate their initial margin requirements on a gross basis and with a detailed overview of the initial margin models they use (this is "to increase transparency and predictability of the initial margins and to restrain CCPs from modifying their initial margin models in ways that could appear procyclical").
FIA Response of 18 July 2017 to the European Commission EMIR Review Proposal – Part 1 (REFIT Proposals) supports this proposal and underlines that understanding margin models and being able to scrutinize them will help participants to gain comfort with the risk management models of a CCP, and increase their confidence that the default of a clearing member can be managed using initial margin without recourse to mutualised resources in the waterfall under most market conditions.
The usefulness of this disclosure in the FIA opinion will depend on the level of detail and comprehensiveness of the information provided.
FIA argues that documentation of the margin model should also include all add-ons for risks not covered by the core margin model, for instance concentration, liquidity, seasonality, procyclicality, basis or idiosyncratic risks.
Overall, the documentation should allow members to fully replicate base margin and all add-ons.
Additionally, the documentation should also capture rationale for assumptions made/parameters used – particularly Margin Period of Risks (MPOR) – in the margin framework.
FIA observes that many CCPs already offer margin simulation tools to their members, but making this a requirement mandatory for all EU CCPs is welcomed.
Such a simulation tool should be able to produce several measures:
- the initial margin for a given portfolio;
- the additional initial margin required to clear additional trades; and
- the initial margin required to clear a given trade on a standalone basis.
It would be useful, albeit not essential for the simulation also to provide incremental default fund contributions for the above cases, which would then be used to estimate additional default fund contributions for new client portfolios on changes in the house portfolio.
FIA would welcome more clarity on what is meant by “on a gross basis” and indicated that most CCPs calculate initial margin as one net figure across a whole portfolio, taking portfolio benefits into account if applicable.
Simulation of new trades will only yield meaningful results if the net initial margin across the whole portfolio (including the added transaction) is part of the result.
According g to the FIA, the result of the simulation cannot be binding, as the margin models might react to new market data, or the CCP will make use of their right to ask for additional margin.
When it comes to group entities, in the USA house and affiliates accounts' margins are posted together in a house account, while in the EU affiliate accounts are margined as clients (ESMA Discussion Paper of 26 August 2015, Review of Article 26 of RTS No 153/2013 with respect to client accounts (ESMA/2015/1295), p. 12).