Reference: Guideline for Banks/FBB/ BHC/T&L/CCA/CRA/Life/ P&C/IHC February 29, 2016 To: Banks Foreign Bank Branches Bank Holding Companies Trust and Loan Companies Co-operative Credit Associations Co-operative Retail Associations Life Insurance Companies Property and Casualty Insurance Companies Insurance Holding Companies Subject: Guideline E-22 Margin Requirements for Non-Centrally Cleared Derivatives OSFI is issuing the final version of Guideline E-22, which requires the exchange of margin to secure performance on non-centrally cleared derivatives transactions between covered entities. These margin requirements will mitigate systemic risk in the financial sector as well as promote central clearing of derivatives where practicable. The provisions of this Guideline are consistent with margin requirements issued by the Basel Committee on Banking Supervision (BCBS) and the Board of the International Organization of Securities Commissions (IOSCO) and support the financial stability objectives of the international framework. The Guideline applies to all federally-regulated financial institutions where they meet the definition of a covered entity, taking into consideration the potential operational burden in relation to small and medium sized institutions which may have non-material exposure. OSFI recognizes the cross-border nature of the non-centrally cleared derivatives market, and supports efforts to reduce the application of duplicative or conflicting margin requirements. The Guideline therefore permits deference to other jurisdictions and regulators when justified by the quality and comparability of the respective regulatory regime. The Guideline incorporates several revisions resulting from comments received during the public consultation process, which began in October 2015. The attached table (Annex 1) summarizes material comments received from industry stakeholders and provides an explanation of how they have been addressed. We thank all those who participated in the consultation process. The Guideline is effective September 1, 2016, consistent with the timing of the BCBS-IOSCO framework. 255 Albert Street Ottawa, Canada K1A 0H2 www.osfi-bsif.gc.ca
- 2 - Questions on the Guideline should be sent by email to Patrick Tobin, Capital Specialist, Bank Capital by email (Patrick.Tobin@osfi-bsif.gc.ca). Yours truly, Mark Zelmer Deputy Superintendent
Annex 1: Summary of Comments Received and OSFI Resolution Comment OSFI Response Overall One commenter noted that certain provisions of draft Guideline E-22 could be read to impose regulatory requirements on Covered Entities generally and not just Covered Entities regulated by OSFI. For example, draft Guideline E-22 s discussion on initial margin models makes multiple references to requirements imposed on Covered Entities such as a covered entity must have a rigorous and well-defined process and a covered entity must review. Given the context and the scope of OSFI s regulatory oversight, the commenter believes these requirements should apply to Covered FRFIs and not all Covered Entities. However, to provide clarity on the scope of applicability of the requirements in the Guideline, they requested that OSFI make clear that the affirmative obligations set forth in the Guideline apply only to Covered FRFIs and not to all Covered Entities. OSFI confirms that the requirements in Guideline E-22 only apply to FRFIs and the text has been amended to reflect this. Section 1: Scope of Coverage Several commenters requested that non-financial entities not be included in the definition of a Covered Entity. Commenters noted that non-financial entities are typically end users who use derivatives solely for hedging purposes. They also noted that non-financial entities are excluded from the definition of a Covered Entity in the margin rules of most foreign jurisdictions. Some commenters requested that trades with financial entities with less than $10 billion in assets be exempt from the margin requirements. They noted that this would be consistent with the proposed exemptions under the US prudential regulators Margin Rule 1. A commenter requested that OSFI clarify the impact of a change in a party s Covered Entity status on the obligation to exchange margin. They proposed that a party s Covered Entity status should be evaluated when the parties first enter into a transaction and that a change in that status should not result in stricter margin requirements After careful consideration, OSFI believes that it would be appropriate to exclude non-financial entities from the definition of Covered Entities. The asset size of an institution does not necessarily reflect its level of activity in the OTC derivatives market and therefore, OSFI believes that the current threshold for inclusion in the definition of a Covered Entity (using non-centrally cleared derivative notional as the indicator) is better suited than asset size to determine which financial entities are included in the definition of a Covered Entity. OSFI agrees with the comments and the proposal and has reflected this in the final Guideline. 1 These are the rules that were jointly published by the Office of the Comptroller of the Currency, the Federal Reserve Board, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Finance Agency.
applying to any pre-existing transactions (whether or not those transactions are grandfathered under paragraph 61 of the draft Guideline). Further, they propose that if there is a change in status that would result in less strict margin requirements applying (for example, a party ceases to be a Covered Entity), the parties should be permitted to agree on a bilateral basis to comply with less strict standards for all transactions. The commenter noted that this approach would be consistent with the position under the US prudential regulators' Margin Rule. Several commenters requested that all CCPs be exempted from the definition of a Covered Entity and not only QCCPs. One commenter noted that CCPs do not have the authority nor the ability to post initial margin. Several commenters noted that the definition of a financial entity was too broad and needed to be clarified. Further, commenters requested that treasury affiliates of commercial entities and special purposes entities be explicitly exempt from the definition of a Covered Entity. Some commenters noted that many special purposes entities are exempt from the definition of a Covered Entity in the US prudential regulators Margin Rule under the exemption for "captive finance companies". Several commenters requested that OSFI provide further deference to foreign rules when FRFIs are trading with foreign counterparties. Many commenters requested that credit intermediation swaps, used by institutions that cannot trade directly with the Canada Housing Trust as part of the Canada Mortgage Bond funding program, be exempt from the margin requirements. Commenters noted that if these swaps were not exempt, the cost of this funding program would increase for these institutions. Several commenters asked that physically settled commodity transactions be explicitly exempted from the definition of a derivative as it was not clear if they were captured in the current definition. Commenters noted that the inclusion of physically settled commodity transactions in the definition of derivative : (i) is not appropriate for purposes of a margin regime intended to mitigate systemic risk in the financial sector ; (ii) could have negative consequences for Canada s physical commodity markets; and (iii) could also adversely impact Canada s derivatives markets. Finally, commenters noted that this would be consistent with US prudential regulators' Margin Rule. Several commenters requested that the OSFI margin requirements not apply to foreign OSFI agrees with the proposal and has included it in the final Guideline. OSFI appreciates the comment and notes the challenges in interpreting this definition. To assist in the interpretation of this definition, OSFI is providing the following clarity: (i) a non-exhaustive list of entities that are intended to be captured by the definition is given and (ii) specific exemptions for qualifying central treasury affiliates and qualifying special purpose entities have been included in the Guideline. A process for achieving substituted compliance for foreign rules has been established and included in the Guideline. After careful consideration, these swaps will be subject to the margin requirements as they carry the same risk as similar swaps with similar counterparties. OSFI believes that such an exclusion would be consistent with other OSFI treatment of physically settled commodity transactions and therefore has provided the requested explicit exemption. A process for achieving substituted compliance for foreign rules has
bank branches in Canada. Instead, they asked that OSFI allow the margin requirements of the branch's parent to apply. been established and included in the Guideline. Section 2: Variation margin requirements Several commenters requested clarification on how to deal with "non-netting" counterparties where bankruptcy regimes or legal systems may make the enforceability of netting agreements difficult to verify. Commenters requested that the first variation margin call should be on or before the business day after execution of the trade or 2 days after if an Asian operation is involved. Afterwards, daily call and calculation of variation margin is achievable in practice. They further noted that for sophisticated counterparties, the delivery of variation margin should be required on or before the business day following the variation margin call or two business days after the call if a European or Asian counterparty is involved). For less sophisticated counterparties, up to three business days may be needed to exchange variation margin. This clarification has been provided in the final Guideline. OSFI has taken into account these comments and the Guideline allows for the first variation margin call to occur within two business days of the execution of the trade and on a daily basis thereafter. For more sophisticated counterparties, the delivery of variation margin must occur within two business days of the variation margin call. Up to three business days is permitted for less sophisticated counterparties. One commenter requested that the exchange of variation margin be permitted to occur up to three business days after the variation margin call for cross-border transactions. Finally, another commenter requested even more flexibility and requested that OSFI allow the "market convention" to determine when variation margin is calculated, call and exchanged. Section 3: Initial margin requirements Commenters requested that the first initial margin call should be two business days after execution of the trade. Afterwards, daily call and calculation of initial margin is achievable in practice. They further noted that the exchange of initial margin should occur within two business days of the initial margin call. One commenter requested that the exchange of initial margin be permitted to occur up to three business days after the initial margin call for cross-border transactions. In order to qualify to use an internal model to calculate initial margin requirements, the draft Guideline states that Covered Entities must review and, as necessary, revise the data used to calibrate the initial margin model at least monthly, and more frequently as OSFI has taken into account these comments and the Guideline allows for the first initial margin call to occur within two business days of the execution of the trade and on a daily basis thereafter. For more sophisticated counterparties, the delivery of initial margin must occur within two business days of the initial margin call. OSFI agrees with the comment and has aligned the requirement with those of the US prudential regulators Margin Rule.
market conditions warrant, to ensure that the data incorporate a period of significant financial stress" (paragraph 33). Commenters noted that they believe this requirement is excessive and potentially pro-cyclical. They suggested that an annual review with consideration of recalibration at that time is sufficient and consistent with the requirement for transparent and predictable procedures. Finally, they noted that the US prudential regulators final Margin Rule amended the corresponding provision in that rule to make the review requirement annual as opposed to monthly. One commenter noted that setting the initial margin threshold at the consolidated level will lead to operational difficulties. They asked that thresholds be set at the entity level. Together with footnote 6, paragraph 21 of the draft Guideline requires that the choice between model- and schedule-based initial margin should be made consistently over time for transactions within the same well-defined asset class. An exception is provided for more complex transactions and seldom used products such that a different method can be used for such transactions within an asset class provided that cherry picking does not occur between model-based and schedule-based margin calculations. Entity level thresholds could be arbitraged by institutions who strategically book derivatives in different legal entities to stay below the threshold and avoid initial margin requirements. Further, this requirement is part of the BCBS-IOSCO framework. For these reasons, the current requirement will be maintained. OSFI believes the exceptions provided in the draft Guideline should be sufficient, except in the instances where counterparties require margin requirements to be computed in a different manner. Language has been added to reflect this in the final Guideline. One commenter noted that there may be circumstances which legitimately warrant the use of a different method of determining initial margin calculations within the same asset class, provided the choice is consistently applied. For example, two business units within the same financial institution may offer products within the same asset class but may choose different methods for determining initial margin calculations because of different business strategies and therefore different credit considerations applicable to each business unit. Accordingly, there should be flexibility to choose different models within the same asset class, as long as the choice is consistently applied. Further, another commenter noted that this may be problematic if a counterparty request that margin be computed in a different manner than the Covered FRFI typically does. Commenters noted that paragraph 27 of the draft Guideline provides that initial margin cannot be re-hypothecated, and therefore, technically, no interest can be earned on such cash collateral. They were of the view that parties should be allowed to mutually agree to invest cash collateral and earn interest thereon. After discussions with several commenters, OSFI has amended the language to ensure that cash initial margin can be held in a deposit account with a custodian and ensure that cash on deposit can be pledged as initial margin.
Commenters further noted that the language in the draft Guideline can be read as not allowing cash on deposit to be pledged as initial margin and requested that the following sentence be added to footnote 8: "cash on deposits may be held in a general deposit account with a custodian". Section 4: Eligible collateral Under paragraph 44(d) of the draft Guideline, eligible collateral includes certain debt securities not rated by a recognized external credit assessment institution that meet enumerated criteria. One of the criteria which must be met is that OSFI is sufficiently confident about the market liquidity of the security. Commenters highlighted that such an open-ended requirement will not be workable for market participants. It would require FRFIs to include a unilateral right in their underlying collateral documentation to declare such debt securities ineligible whenever OSFI declares it is no longer sufficiently confident in the liquidity of such securities. Such uncertainty will make it difficult for market participants to price transactions and will likely mean that such debt securities will never be considered eligible collateral. Commenters suggested that this limb of paragraph 44(d) is not necessary given the other eligibility criteria in paragraph 44(d) and requested that it be deleted. The standard supervisory haircuts in the table in paragraph 57 include an additional 8% haircut on assets where the currency of the derivative differs from the currency of the collateral. While paragraph 46 provides that this additional 8% haircut does not apply to variation margin, the 8% haircut does apply to initial margin. Commenters asked that Covered FRFIs should be permitted to incorporate the foreign exchange risk into the initial margin model calculations in lieu of applying the proposed 8% haircut. Any application of the haircut should be against the termination currency of the derivatives netting contract rather than the currency of the derivative transaction, provided that, consistent with the U.S. prudential regulators Margin Rule, each counterparty should be permitted to designate a different termination currency. Commenters also believe there should be no haircut applied to cash collateral for either initial margin or variation margin. The Guideline allows for both model-based haircuts as well as standardized haircuts. One commenter requested that OSFI clarify that the table in paragraph 57 only sets forth minimum haircuts when the standardized approach is used and is not relevant when a model-based approach is used. OSFI has taken the comment under consideration and deleted the bullet in question. OSFI has taken into account the comment and discussed with other regulatory agencies. The proposed new treatment will be as follows: The additional 8% haircut for foreign exchange risk will apply only in the following circumstances: i) Non-cash variation margin posted in a currency other than the ones agreed to in the relevant contract (either for individual derivative trades or relevant master netting agreements); or ii) ii) Cash and/or non-cash initial margin collateral posted in a currency other than the termination currency that the posting party has designated in the relevant contract (either for individual derivative trades or relevant master netting agreements). Each counterparty may choose one termination currency, so that there can be two termination currencies. This clarification is included in the final Guideline.
One commenter requested that debt issued by public sector entities should count as "sovereign" debt when applying the supervisory haircuts. They noted that this would be consistent with the application of the supervisory haircuts in the Capital Adequacy Requirements. OSFI agrees with the comment and has amended the guideline accordingly. Section 5: Phase-in of requirements Paragraph 61 provides (in footnote 11) that genuine amendments to existing derivatives contracts do not qualify as a new derivatives contract for purposes of the grandfathering provisions of the draft Guideline. Commenters asked that OSFI also carve-out from the scope of the draft Guideline (i) novations of grandfathered transactions and (ii) new non-centrally cleared transactions resulting from portfolio compressions of grandfathered transactions. OSFI agrees with the comment and has reflected it in the Guideline. During discussions with some commenters, it was noted that grandfathering of legacy trades would be very difficult and complex to operationalize if grandfathered and non-grandfathered trades were novated or compressed into a single set of new derivatives. Therefore, it has also been explicitly stated that "new" derivatives arising from novation or compression of grandfathered and nongrandfathered derivatives will be subject to the margin requirements (i.e. they will not be scoped out under the grandfathering provisions).