Derivatives Regulation Douglas Donahue Partner +1 212 506 2562 ddonahue@mayerbrown.com Jerome Roche Partner +1 202 263 3773 jroche@mayerbrown.com Ed Parker Partner +44 20 3130 3922 EParker@mayerbrown.com
How did we get here? The financial crisis of 2008 led to widespread examination of possible root causes by the Group of Twenty Finance Ministers and Central Bank Governors (G20) The September 2009 G20 meeting in Pittsburgh culminated in the issuance of a leaders statement of goals to address cooperatively the crisis Improving over-the-counter derivatives markets Central clearing Exchange trading of standardized contracts Trade reporting Higher capital requirements for uncleared trades Margin requirements for uncleared trades (added in 2011 Cannes G20 meeting)
From these little acorns, mighty oaks have grown To meet the G20 goals, Title VII of the Dodd-Frank Act amends the Commodity Exchange Act and the Securities Exchange Act of 1934 to create Registration requirements for swap dealers and major swap participants Substantive regulation of swaps activities In the European Union, we have European Market Infrastructure Regulation (EMIR) Regulation (EU) No 648/2012 of the European Parliament and of the Council of July 4, 2012 on OTC derivatives, central counterparties and trade repositories
Margin Regulation
Phase-in of US + EMIR Margin Requirements: 1 March 2017** VM for all other CPs 4 February 2017 IM and VM for CPs both above 3 trillion 1 Sep 2017 IM for CPs both above 2.25 trillion 1 Sep 2018 IM for CPs both above 1.5 trillion 1 Sep 2019 IM for CPs both above 0.75 trillion 1 Sep 2020 IM for CPs both above 8 billion 2016 2017 2018 2019 2020 1 Sep 2016 IM and VM for CPs IM for CPs both both above $3 trillion above $2.25 trillion EU 1 March 2017** EU* * NB EU delays * NB EU delays 1 Sep 2017 VM for all other CPs US 1 Sep 2018 IM for CPs both above $1.5 trillion 1 Sep 2019 IM for CPs both above $0.75 trillion 1 Sep 2020 IM for CPs that are both swap dealers 1 Sep 2020 IM for swap dealer and an FEU > $8 billion
Brief Overview of US Margin Regulations for Uncleared Derivatives VM Compliance Date: March 1, 2017** Overview: Regulators Entity types Who is directly regulated? Scope: Trading Relationships Products Basis between European and US regulations Consider cross-border application of the US regulations CFTC NAL 17-22 Prudential Regulators = swaps + security based swaps / CFTC = swaps only Basis between European and US regulations
Brief Overview of US Margin Regulations for Uncleared Derivatives Focus on Variation Margin Summary of VM Requirements for In-Scope Trading Relationships/Products: Two-way Zero Threshold (exposure is fully collateralized) CSAs Valuation Frequency and Transfer Timing Daily valuation T+1 transfer timing (T = date of calculation, not date of demand) (European/Canadian/Japanese regs are more generous) Eligible Collateral and related haircuts are strictly prescribed by regulation Only specified liquid collateral within the possession/control of the in-the-money party will satisfy the requirements VM may be held directly and may be rehypothecated Minimum Transfer Amounts Netting permitted with adequate documentation and diligence as to enforceability in bankruptcy No netting = collect gross/post net or gross Development of Margin Financing Solutions
Brief Overview of US Margin Regulations for Uncleared Derivatives Focus on Initial Margin Summary of IM Requirements for In-Scope Trading Relationships/Products: Calculation of Aggregate Average Notional Amount Two-way Initial Margin required Thresholds Collateral must be delivered to an unaffiliated third party custodian Collateral cannot be rehypothecated Cash may only be posted temporarily Eligible Collateral + Haircuts and prescribed by the regulations Calculation of Initial Margin amounts Regulatory approval of financial model
Regulatory Margin Self-Disclosure Letters ISDA has published Regulatory Margin Self-Disclosure Letters for Australia, Canada, the EU, Hong Kong, Japan, Singapore, Switzerland and the United States. All of which are available on ISDA s website and ISDA Amend. The purpose of the Regulatory Margin Self-Disclosure Letters is to provide market participants with a market standard way in which to provide each other with the information that is necessary to determine if, and when, the margin regulations in a relevant jurisdiction are applicable to their trading relationship. ISDA may publish additional Regulatory Margin Self-Disclosure Letters for other jurisdictions that adopt margin regulations for uncleared derivatives. A draft of the letter for Korea is currently being reviewed.
ISDA 2016 Variation Margin Protocol ISDA has published the 2016 Variation Margin Protocol ( VMP ). The purpose of the VMP is to assist market participants with the amendment of their existing credit support documentation, or the creation of new credit support documentation, to comply with relevant margin regulations for uncleared derivatives. The VMP currently allows parties to select the margin regimes of the following jurisdictions as being applicable to their trading relationship: Australia; Canada; the EU; Japan and the United States (CFTC and Prudential Regulators). ISDA will publish a supplement to the VMP to add the Swiss margin regime and may do the same for other jurisdictions in the future. ISDA has also published issue specific supplements to the VMP, including, the Japanese Notification Time supplement, the Non-Netting supplement and the Segregation Amendments supplement. The VMP, including the supplements, are available on ISDA Amend. ISDA also published AEJ bilateral templates.
2016 ISDA CSAs for Variation Margin + 2016 Phase-One CSAs for Initial Margin (and related docs) New VM Collateral Documentation ISDA 2016 CSA for Variation Margin (Security Interest New York Law)/(Title Transfer English Law)/(Loan Japanese Law) + various recommended addendums and amendments to the foregoing for particular circumstances. New IM Collateral Documentation ISDA 2016 Phase One Credit Support Annex for Initial Margin (IM) (Security Interest New York Law) ISDA 2016 Phase One Credit Support Deed for Initial Margin (IM) (Security Interest English Law) ISDA 2016 Phase One Credit Support Annex for Initial Margin (IM) (Loan Japanese Law) ISDA/Euroclear documents: Collateral Transfer Agreement (New York Law), Collateral Transfer Agreement (English Law), Security Agreement (Belgium Law) ISDA/Clearstream documents: Collateral Transfer Agreement (New York Law), Collateral Transfer Agreement (English Law), Security Agreement (Luxembourg Law) IM Custodial Documents not ISDA published documents Tri-party vs. Third-party ISDA SIMM
Cross-border impact of the European Market Infrastructure Regulation (EMIR)
EMIR Parties: Who Does EMIR Apply to? EMIR applies to any entity established in the EU that is a legal counterparty to a derivative contract, even when that entity is trading with non-eu firms Parties Financial counterparties ( FC ) Criteria Firms, institutions and undertakings authorised or managed pursuant to MiFID, the Capital Requirements Directive, the Direct Insurance Directive, the Life Assurance Directive, the Reinsurance Directive, the UCITS IV Directive, the Institutions for Occupational Retirement Provision Directive and the AIFM Directive Qualifying non-financial counterparties ( NFC+ ) Non-financial counterparties ( NFC ) Undertakings established in the EU other than, Central Counterparties ( CCPs ) and Financial Counterparties, which exceed certain thresholds for derivatives activity ( the Clearing Threshold ), as measured over a 30 day period Undertakings established in the EU other than, CCPs and Financial Counterparties, which do not exceed the Clearing Threshold
EMIR: What Does It Require? FC NFC+ Clearing obligation Risk mitigation techniques Reporting obligation Clearing obligation Risk mitigation techniques (save in relation to the increased capital requirements and the reporting of unconfirmed trades) Reporting obligation NFC Certain risk mitigation techniques (timely confirmation, portfolio reconciliation and compression, dispute resolution) Reporting obligation
EMIR: Requirements and Timetable Report all derivative contracts to Trade Repositories Minimum operational standards daily valuation, timely confirmation, portfolio reconciliation and compression, and dispute resolution Timing in Europe: Phase I: 2013 Reporting and operational standards Operational standards: from March 2013 and Sep 2013 Reporting: from 12 Feb 2014 (and 11 Aug 2014 for exposure and collateral) Specific contracts to which it applies determined by ESMA Requirement to clear certain derivative transactions Exemptions for intra-group transactions and pension schemes Timing in Europe: Phase II: 2016 Mandatory clearing Clearing obligation for IRS Clearing obligation for CDS Clearing obligation for NDFs and equity derivatives on hold Bilateral collateralisation requirements for FCs and NFCs+ Initial and variation margin requirements Timing in Europe: Phase III : 2017 New collateral requirements for non-cleared trades Legislation for margining uncleared swaps came into force in 2017 4-year phase-in period originally scheduled to start in Sep 2016, but pushed out until March 2017 VM requirements come into force before March 2017
Clearing Obligation in the EU: Current State of Play
Clearing Obligation: RTS on Interest Rate Swaps Type of counterparty Category 1: Existing clearing members (FCs and NFCs+) Start date for the clearing obligation 21 June 2016 (for G4 currencies) 9 February 2017 for additional currencies Category 2: FCs and AIFs classified as NFCs+ provided their notional aggregate OTC volume exceeds EUR 8 billion Category 3: FCs and AIFs classified as NFCs+ which do not exceed threshold for Category 2 Category 4: Other NFCs+ 21 December 2016 (for G4 currencies) 9 August 2017 for additional currencies 21 June 2019 (for G4 currencies and additional currencies) 21 December 2018 (for G4 currencies) 9 October 2019 (for additional currencies) No frontloading
Collateral Requirements Under EMIR Art. 11 (3) EMIR provides for the requirement to exchange margins on non-centrally cleared OTC derivatives Counterparties are required to ensure: the timely, accurate and appropriately segregated exchange of collateral with respect to non-cleared OTC derivatives contracts Pursuant to Art. 11 (15) EMIR, European Supervisory Authorities (ESAs: EBA, EIOPA and ESMA) are required to develop regulatory technical standards specifying risk-management procedures, including levels and type of collateral and segregation arrangements required with regard to EMIR
The Margin RTS RTS on risk mitigation techniques (i.e. Margining/for OTC derivative contracts not cleared by a CCP came into force on 4 January 2017 19 Institutions were Phase 1 / Phase 1.5 Dealers 7 to 10 dealers expected to be Phase 2 institutions 4 February 2017 Variation Margin Requirements apply where both counterparties exceed a VM notional amount of EUR 3 trillion 1 March 2017 Variation Margin Requirements apply to all other covered FCs and NFC+
Covered Entities and Non-Covered Entities (Examples) EU IM FC >8bn EU FC >8bn EU FC VM IM VM VM EU or Non-EU FC >8bn EU or Non-EU NFC+ >8bn EU or Non-EU NFC+ EU FC EU NFC+ N.A. N.A. EU or Non-EU EU or Non-EU NFC- NFC-
Risk Management Obligations access to collateral where it is held in third party custody Objectives (art. 23 RTS) cash accounts for IM maintained at institutions unaffiliated with both parties transferability of margin in a timely manner
EMIR II: Overview Commission published proposal to amend EMIR on 4 May 2017 Principal proposed changes in 4 main areas: 1) Expanding scope of definition of Financial Counterparties 4) Enhanced supervision of margining of uncleared derivatives 2) Adjustment to the clearing thresholds, barriers to clearing, exemptions and suspension 3) Reporting to Trade Repositories
Expanding Scope of Financial Counterparties Inclusion of AIFs managed by non-eu managers and thirdcountry AIFs that would be FCs if established in EU No proposed transitional period Inclusion of securitisation SPEs Challenges of margining/clearing for SPEs Conflicts with proposed Securitisation Regulation? No impact on Covered Bond exemption
Adjustments to Clearing Obligation I Promotion of access to clearing on fair, reasonable and nondiscriminatory commercial terms Harmonising threshold calculation with margin threshold Application of obligation on perclass basis (based on whether clearing threshold exceeded for that class of derivative) New clearing threshold for smaller FCs (same as NFC thresholds) but no per-class clearing and assessed on entity level (with no group aggregation)
Adjustments to Clearing Obligation II Extension of pension scheme exemption for further 3 years from entry into force of new Regulation Removal of frontloading requirement ESMA may request Commission to temporarily suspend clearing obligation for up to 12 months if: - Class no longer suitable for clearing - CCP ceases to clear and alternate CCP cannot adequately take over - Necessary to avoid threat to financial stability
Changes to Trade Reporting CCPs required to report details of exchangetraded derivatives Access rights to data by non-eu regulators (if reciprocated) New obligations on TRs and increased fines FCs obliged to report both sides of trade on behalf of NFC-s Relaxation or reporting of intra-group transactions No back-loading of transactions terminated before 12 Feb 2014
Changes to Margin Rules Increased supervision over level and type of collateral posting and segregation arrangements Initial and ongoing validation of initial margin models by regulators
Next steps Proposals to enhance supervision of CCPs also expected in June Most changes take effect 20 days after publication in OJ but 18 month phase-in period for obligations on clearing firms, regulation of TRs and technical standards on margin Consultation for feedback closes 29 June 2017 Amendments will require a new Regulation (Parliament and Council approval) and some changes require new RTSs (e.g. new access to clearing obligations) Possible adoption late-2018
The Extraterritorial Effect of EMIR It applies to EU firms even when trading with non-eu firms It has extraterritorial effect in some circumstances: The clearing obligation applies to contracts entered into by a EU FC / NFC+ and a third country entity that would be a FC or NFC+ in the EU The clearing obligation and risk mitigation requirements apply to contracts between third country entities that would be a EU FC or NFC+ in specified circumstances EMIR applies to any entity established in the EU that is a legal counterparty to a derivative contract
EMIR and Extraterritoriality Clearing obligation Article 4(a)(iv)-(v) EU + non-eu applies if non-eu would be subject to clearing if in EU Non-EU + non-eu applies if (1) entity would be subject to obligations if established in EU and (2) if contract has direct, substantial and foreseeable effect within the EU or where such an obligation is necessary or appropriate to prevent evasion of provisions of EMIR Risk mitigation Article 11(12) Non-EU + non-eu applies if (1) entity would be subject to obligations if established in EU and (2) if contract has direct, substantial and foreseeable effect within the EU or where such an obligation is necessary or appropriate to prevent evasion of provisions of EMIR
EMIR: What is Equivalence? Mechanism to: 1. avoid duplicative or conflicting rules on clearing, reporting and risk mitigation requirements caused by extraterritorial effect; 2. permit non-eu CCPs to provide clearing services to clearing members which are established in the EU; and 3. enable EU counterparties to satisfy their reporting obligation under EMIR by reporting to a third country trade repository
EMIR and Extraterritoriality: Recognition Decisions Recognition of non-eu CCPs Article 25 Non-EU CCPs are prohibited from providing clearing services to entities in EU unless recognised by ESMA. Commission must declare equivalence of CCP s jurisdiction On 15 March 2016, the European Commission adopted an equivalence decision for CCPs in USA Recognition of non-eu TRs Article 77 Non-EU TRs must apply to ESMA for recognition Commission must declare equivalence of TR s jurisdiction
Extraterritorial Application of the Margin RTS EU entities will be obliged to post and collect margins regardless of whether they face NFCs- from third countries are outside of the scope of the regulation If segregation agreements are not enforceable in a third country jurisdiction, EU firms should identify alternative processes to post collateral (such as third party banks and custodians) When that is not possible either, only the non-eu counterparty is obliged to post collateral or, in very limited circumstances, neither counterparty is required to post Intra-group transactions
Questions?
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