Responding to the implementation of Margin Requirements for non-centrally cleared OTC derivatives

Transcription

1 Responding to the implementation of Margin Requirements for non-centrally cleared OTC derivatives Margin Requirements for non-centrally cleared OTC derivatives took effect for the first time in the world on September 1 st, 2016 in three countries: Japan, the U.S. and Canada. Although these requirements are also scheduled to be implemented in Europe and other countries/regions, the application in these remaining territories is currently delayed. In Japan, several major financial institutions have already begun complying with the requirements since last September ( Phase 1 counterparties ). However, almost all financial institutions are required to comply with the Variation Margin ( VM ) requirements, which will become effective on March 1st, 2017 ( VM Big Bang ). The scope of entities subject to the Initial Margin ( IM ) requirements will also expand sequentially until September 1st, 2020, based on the group aggregate month-end average notional amount of non-centrally cleared OTC derivatives. This report presents a summary of the Margin Requirements and identifies key points that counterparties in the scope of these requirements should consider to be prepared for the changes ahead, based on the PwC s experience of providing support to Phase 1 counterparties that have already taken measures to comply ahead of others. 1. The Scope of the Margin Requirements The Margin Requirements took effect on September 1 st, 2016 as planned Japan, the U.S. and Canada, and to date no significant confusion has been observed after the effective date. The Margin Requirements impose an obligation to exchange two types of collateral: 1)IM, to be exchanged for the purpose of preparing against fluctuations in the market value of derivatives in the event of bankruptcy of a counterparty, and 2)VM, to be exchanged in accordance with the market value of derivatives. The financial institutions in scope are defined by the Cabinet Office Ordinance in Japan. The IM requirements will be applied sequentially, starting with those financial institutions that hold larger aggregate notional volumes of OTC derivatives, whereas the VM requirements will be applied to most counterparties from March 1st, 2017 (see the table below). In the case that one of the counterparties is not an entity in the scope of the requirements, the Margin Requirements are in principle not applied, however there is a possibility that the out

2 of scope counterparty may be required to take certain measures in order for the in scope entity to comply with its obligations (see the figure below). Going forward, the Margin Requirements are scheduled to take effect sequentially in other major markets, and regulators in each country/jurisdiction are finalizing their country-specific margin rules, other than Europe where implementation has currently been postponed. Table 1. Effective Dates of the Cabinet Office Ordinance/Notification/Guideline and the group aggregate month-end average notional amounts Effective Date Aggregate notional amount of the noncentrally cleared OTC derivatives (at group level) Phase 1: Sep. 1, 2016 JPY 420 trillion JPY 420 trillion VM Big Bang: Mar. 1, 2017 Below JPY 420 trillion Phase 2: Sep. 1, JPY 315 trillion Phase 3: Sep. 1, JPY 210 trillion Phase 4: Sep. 1, JPY 105 trillion Phase 5: Sep. 1, JPY 1.1 trillion VM IM Major counterparties in scope Mega banks Major securities companies - Almost all financial institutions Mega banks Major securities companies Major securities companies Major insurance companies Major local banks (Created by PwC Consulting based on the information from JFSA s website and Disclosure magazines issued by each entity) Figure 1. The Margin Requirements for non-centrally cleared OTC derivatives

3 2. Measures to be taken by Financial Institutions The IM requirements to be applied sequentially from September 1st, 2016 (as described above) can be calculated using either the Standardized Margin Schedule ( SMS ), which is to calculate the IM based on a haircut specified by the regulators in accordance with the notional amount, or using the Standard Internal Model Method ( SIMM ), which is to calculate the IM by aggregating margins based on the sensitivity of each risk factor for each derivative transaction by product class. When using SIMM, the methodology for calculating the sensitivities is left to the discretion of each entity. Subject to regulatory approval, it is also permitted to apply existing internal riks management models. Due to the difference in the required margin amount between SMS and SIMM, it is generally more advantageous for counterparties to adopt SIMM rather than SMS, and in fact, many Phase 1 counterparties have chosen to adopt SIMM. IM needs to be exchanged after mutually agreeing the calculated amount with the other counterparty. If there is any discrepancy in the result of this verification process, both parties should analyze the cause and make efforts to resolve the discrepancy in a mutually agreeable manner. If any material discrepancy or issue remains after a certain period of time, each counterparty needs to report this fact to the International Swaps and Derivatives Association, Inc. ( ISDA ). To avoid such discrepancies, ISDA has been recommending that counterparties adopt a Standardised Initial Margin Model calculation, and many Phase 1 counterparties have adjusted their internal models in line with this approach. Even with a Standardised Initial Margin Model calculation, a discrepancy may occur due to the differences in the methodologies used for sensitivities and risk factors associated with in scope derivatives. The Phase 1 counterparties that have already begun complying with the Margin Requirements have found that they are reconciling the calculated sensitivities of both counterparties on a daily basis, as well as working to analyze the cause of discrepancies, and continuing to consider ways to improve the IM calculation model in the future. In addition, ISDA plans to review and update the risks to be captured on an ongoing basis. For example, ISDA has recently proposed a calculation method for currency basis risk that was not included in the initial requirements. In scope counterparties are now required to complete additional tasks to adopt this additional methodology before it is applied in April, While the Phase 1 counterparties are still looking for right answer for the IM calculation in their daily trading activities, the counterparties that will become subject to the requirements after entering Phase 2 and subsequent phases are also required to incorporate the market s right answer into their own internal models. As well as model-related discrepancies that can occur every day, discrepancies in the IM amount can also be caused by rapidly exchange-rate fluctuations, such as those observed after the recent U.S. presidential election. However, to date, neither of these types of discrepancies have resulted in significant confusion or a dispute.

4 As with IM, counterparties will be required to exchange VM collateral after mutually agreeing the calculated amount with the other counterparty. This will apply to most financial institutions from March 1, In preparation for compliance with the requirements, in scope counterparties that intend to adopt internal models should take measures in the following areas: 1. Verification and improvement of the sensitivity calculation methodology applied to target derivatives 2. Development of a methodology for the calculation of IM 3. Validation and improvement of the methodology for calculating the market value for the VM calculation 4. Connection tests with a platform for IM/VM reconciliation 5. Selection of counterparties to continue to enter into transactions with, and the execution of CSA after the implementation date 6. Establishment of model governance/collateral management structures in line with the regulatory requirements 7. Notification to the regulators (if necessary) 3. Key Points for future consideration and PwC s services Over the past 12 months, PwC has been supporting Phase 1 counterparties, both in Japan and overseas, with their compliance efforts for IM. PwC has also been supporting and advising in scope counterparties on the additional enhancements required to comply with VM requirements, even after the Margin Requirements came into force. Based on our extensive experience and accomplishments, PwC has identified a number of key areas for consideration where we can provide support and advisory services to help counterparties subject to Phase 2 and subsequent phases prepare for the Margin Requirements. Support on the establishment of IM/VM calculation model (support area: 1, 2 & 3) As described above, many Phase 1 counterparties have adopted SIMM. In this case, the methodology of calculating the sensitivities and the market value of derivative transactions which are the base of the margin calculation in this case is left to the discretion of each counterparty. It is also permitted to adopt an existing methodology used for risk management operations. As a result, it is essential to develop a model that does not result in a critical discrepancy in the margin calculation value compared to that calculated by each counterparty. PwC has a broad experience and can provide project management support as well as support on technical aspects, from model validation to preliminary back-testing required by ISDA. Project management support Support for internal modeling

5 Technical documentation and numerical validation support Back-testing support Support on the introduction of an industry standard platform (support area: 4) From a practical perspective, it is necessary to implement a common industry standard platform to perform margin reconciliation. PwC has extensive knowledge of the main points to be considered as well as how to eliminate errors during implementation, based our experience working with counterparties who are already complying with Margin Requirements. With these findings, insights and expertise, PwC can help with the avoidance and timely resolution of deficiencies. Support for connecting to the platform Operational support for taking measures to correct errors or eliminate malfunctions, etc. Support on the establishment of governance arrangements to comply with Margin Requirements (support area: 5 & 6) If adopting the internal model, the following requirements must be met: - Establish a model management division independent from the division that uses the internal model. - Develop, operate and maintain documentation including policies and procedures. - Conduct back-testing. - Perform validation and maintenance of the internal model. - Confirm the appropriateness of model management process with major counterparties. - Implement internal audit review. This model governance framework as recommended by ISDA has been developed and adopted by financial institutions in the U.S. and Europe, and PwC has the benefit of our support experiences in these territories. Support for development of a model governance framework (establishment of a model management division, development of policies and procedures, etc.) Support for improvement of supproting business processes Support for selection of counterparties to continue to enter into transactions with and the selection of custodians Support for establishment of internal audit review processes

6 Support on the submission of applications to regulators for the use of internal models (support area: 7) The Margin Requirements do not provide explicit information on what is to be included as part of the application to the regulators. A notification or application to regulators in other jurisdictions to that where the counterparty was established may also be required, because many counterparties are also subject to the Margin Requirements of the country/jurisdiction where an office or a branch is present. PwC has been supporting counterparties with the model application process, identifying and organizing necessary documents and information and providing support communicating with regulators both in Japan and overseas. Support for communication with regulators (regulatory communication) Support for preparation of the application form Support on the internal audit pertaining to Margin Requirements (Co-sourcing / Outsourcing) PwC brings together collaborative expertise in consulting, audit, and assurance services. In addition to the above consulting services, PwC can provide internal audit services including co-sourcing / outsourcing by leveraging our professional services network around the globe. Internal audit on risk management and compliance Internal audit on the status of regulatory compliance Internal audit on risk model validation Contacts PwC Consulting LLC Financial Services Marunouchi Park Building, Marunouchi, Chiyoda-ku, Tokyo , Japan Tel: Koji Yamamoto Partner +81 (0) koji.yamamoto@pwc.com Yumi Mitsuhashi Senior Manager +81 (0) yumi.mitsuhashi@pwc.com Hirotada Komatsu Senior Manager +81 (0) hirotada.komatsu@pwc.com 2017 PwC Consulting LLC. All rights reserved. PwC refers to the PwC network member firms and/or their specified subsidiaries in Japan, and may sometimes refer to the PwC network. Each of such firms and subsidiaries is a separate legal entity. Please see for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.