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Buy-side perspective: Preparing for the initial margin ‘big bang’

  • United Kingdom
  • Financial services and markets regulation
  • Financial institutions

05-02-2019

In this briefing we summarise the initial steps that in scope buy-side entities should now be taking in order to prepare for the initial margin ‘big bang’.

Initial margin requirements

In-scope buy-side entities will be required to deliver and receive initial margin in relation to their uncleared OTC derivatives transactions and to make arrangements for the segregation of that margin. Initial margin is intended to protect parties against future adverse movements in the value of their derivatives transactions.

The amount of initial margin to be delivered must be determined using a regulatory compliant calculation methodology. The methodology used may be either:

  1. a grid methodology – a methodology based on the standardised schedules published in the applicable uncleared margin rules; or
  2. an internal model – a methodology developed by a counterparty or a third party agent (such as ISDA).

Buy-side entities that are accustomed to the variation margin requirements may not be familiar with regulatory segregated initial margin requirements. There are a number of differences between the regulatory requirements for variation margin and initial margin. For example, unlike variation margin, which is a one-directional payment, regulatory initial margin is a two-way gross payment with liquidity and funding implications. Due to these differences, it is likely that material operational enhancements will be required in order for in-scope buy-side entities to comply with the regulations.

Application

Whether or not entities are within the scope of the initial margin requirements is determined with reference to the average notional amount of the non-centrally cleared OTC derivatives transactions (calculated at group level) that were outstanding on the latest business day of March, April and May of the preceding year (the “AANA”). All non-centrally cleared OTC derivatives transactions are included for this purpose, including intragroup transactions. The requirements have been staged in over five phases.

The requirements already apply to the most active participants in the derivatives market which were subject to the requirements during phases one to three. The initial margin requirements will be staged to apply to the buy-side of the market in phases four and five. The ANNA threshold for these phases is set out below.

 

AANA Threshold

 

Phase

EU 

US

Canada

Switzerland

Implementation date

Phase four

€750 billion

US$750 billion

C$ 1.25 trillion

CHF 750 billion

1 September 2019

Phase five

€8 billion

All1

C$ 12 billion

CHF 8 billion

1 September 2020


Immediate action points

Establishing arrangements for the delivery and receipt of initial margin is more time consuming and the documentation involved is more complex and more heavily negotiated than was the case with variation margin. All in scope entities should therefore identify whether they will be subject to the initial margin requirements and, if so, the applicable implementation date as soon as possible.

Buy-side firms should disclose if they are likely to be in-scope of the initial margin requirements to their counterparties now. This disclosure can either take place by way of the standard ISDA Regulatory Margin Self Disclosure Letter or by less formal discussions with counterparties.

This disclosure should where possible take place 12 to 18 months prior to the relevant implementation date to allow sufficient time to establish the necessary arrangements.

Documentation

The precise documentation that is required will depend upon the law that is chosen to govern the security arrangements, the custodian or central securities depositary selected by the parties and the location of the collateral assets.

ISDA has published a standard suite of documentation that can be used. The documentation will include a security document (such as the ISDA 2018 Credit Support Deed for Initial Margin (IM) (English Law) and the ISDA 2018 Credit Support Annex for Initial Margin (IM) (New York Law)) and, usually, an account control agreement.

Each of the custodians and central securities depositaries that provide collateral services to support initial margin will have a preferred form of account control agreement which may differ depending upon the types of entity involved and the relevant jurisdiction.

Counterparties may decide to handle the process through a documentation platform. Platforms are available on the market that are intended to allow parties to negotiate agreements more efficiently. It is not yet clear whether these platforms will be used by buy-side entities and the use of a platform alone will not be sufficient.

Parties may wish develop playbooks and/or template documentation to assist with negotiations.

Custodial relationships

Buy-side entities that have not utilised custodians previously, or who are expanding their custodial relationships to accommodate the new requirements, will need to set up infrastructure pipelines with custodians or central securities depositaries to communicate collateral exchange and status.

Brexit

Brexit may create an added level of complexity for buy-side entities located in the UK, non-UK buy-side entities facing UK counterparties or parties to documentation which is subject to the laws of England and Wales. In the event that the UK and the EU find a way to agree the withdrawal agreement, a transitional and implementation period (“TIP”) will apply to the UK for a period of at least 21 months and possibly up to a further two years after that. During the TIP EU legislation will continue to apply in the UK and the TIP will extend beyond the phase five implementation date for initial margin.

The position is less clear in the event that the withdrawal agreement is not agreed. Please see our briefing “The impact of a no-deal Brexit on derivatives entered into by UK buy-side entities” for further on the impact of a no-deal, including in relation to the margin requirements, available here.

Managed accounts

Particular considerations will apply to multi-managed accounts. As the requirements will apply at entity level, they may necessitate co-operation and data sharing across data managers. This might cause added complexity to the arrangements.

How can Eversheds Sutherland assist?

Our global derivatives team has been advising clients regarding the initial margin requirements since the requirements were first introduced. As a buy-side focused derivatives practice, we have a deep understanding of the requirements of buy-side entities including insurance companies, pension schemes, commodities firms and investment funds.

We have worked with clients to scope the requirements and to develop standardised initial margin documentation. We can also produce a formal review of the enforceability the collateral arrangements if required under the relevant margin regime.

Members of our global derivatives practice have been active participants in industry working groups in relation to the new regulations including the ISDA Working Group on Margin Requirements (WGMR).


1. Note that (a) non-financial commercial end users hedging commercial risk and (b) financial end users who do not have a ‘material swaps exposure’ (i.e. an AANA below the $8 billion threshold) are excluded.

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