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Crunch Time for Initial Margin Webinar Q&A

05 April 2019

On March 28, IHS Markit held a webinar to discuss "Crunch Time for Initial Margin: Challenges and Solutions for the Uncleared Margin Rules," the latest report from Celent's Head of Risk, Neil Katkov. The webinar covered key findings from the report, and discussed recent regulatory relief efforts, including the most recent guidance published by BCBS/IOSCO. The discussion prompted multiple comments and questions from our audience. The following Q&A summarizes the audience's inquiries with collaborative responses from IHS Markit, Celent and our industry partners.

View the webinar replay.

1. Do we have to calculate Aggregate Average Notional Amount (AANA) each year even once we fall into scope for Phase 4 or 5?

You need to distinguish between AANA that drives compliance dates (Phase 4 AANA is $0.75 trillion, Phase 5 AANA is actually zero), and AANA that drives whether you are a financial end user with material swaps exposure (MSE AANA is $8 billion). Note they have different testing periods too. Once a covered swap entity and its counterparty must comply with the margin requirements for uncleared swaps based on the compliance dates, they remain subject to the margin requirements. However, if the counterparty's status changes from a financial end user with material swaps exposure to a financial end user without material swaps exposure, then the covered swap entity may cease complying with Initial Margin requirements for any uncleared swaps entered into with that counterparty after the counterparty changes its status as well as for any outstanding uncleared swap entered into after the applicable compliance date and before the counterparty changed its status.

2. Is there any relevant guidance on how to calculate AANA?

AANA is calculated for a counterparty together with its affiliates. It looks at the average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, foreign exchange forwards, and foreign exchange swaps. Note therefore that it includes foreign exchange forwards and foreign exchange swaps despite the fact that they are not themselves in scope for margin. For Phase 4 compliance dates AANA, you look at March, April and May 2019 daily averages. For material swaps exposure calculation, you look at June, July and August daily averages of the previous calendar year e.g. for Initial Margin in Sep 2020, you would look at June, July and August of 2019. Only look at business days. An entity must count the average daily aggregate notional amount of a swap between the entity and an affiliate only one time. The calculation does not include a swap or security-based swap that is exempt pursuant to TRIPRA.

3. What does 'group' actually mean? How do we determine which funds we group together to do the AANA calculation?

A group includes all affiliates. A company is an affiliate of another company if:

(1) Either company consolidates the other on a financial statement prepared in accordance with US Generally Accepted Accounting Principles, the International Financial Reporting Standards, or other similar standards,

(2) Both companies are consolidated with a third company on a financial statement prepared in accordance with such principles or standards, or

(3) For a company that is not subject to such principles or standards, if consolidation as described in paragraph (1) or (2) of this definition would have occurred if such principles or standards had applied.

In the context of the Prudential Regulators (PR) Rules, an affiliate can also catch any company that the relevant regulator has determined is an affiliate, based on its conclusion that either company provides significant support to, or is materially subject to the risks or losses of, the other company.

Investment funds generally are not consolidated with the asset manager other than during the seeding period or other periods in which the manager holds an outsized portion of the fund's interests although this may depend on the facts and circumstances. Some accounting standards, such as the GAAP and IFRS variable interest standards, sometimes require consolidation between a sponsor or manager and a special purpose entity created for asset management, securitization, or similar purposes, under circumstances in which the manager does not hold interests comparable to a majority equity or voting control share.

4. Will regulators increase the AANA threshold to help firms?

BCBS/IOSCO recently issued guidance to remove documentation requirements for firms under the Initial Margin exchange threshold of US$50M. While the realization of this relief may depend on action by regulators in each jurisdiction, the intent of the guidance was to provide relief for those firms under the threshold. Neither BCBS/IOSCO nor regional regulators have indicated there will be further relief in the form of raising the AANA threshold for Phase 5.

5. If you are doing AANA at Group level, how do you know which jurisdiction you fall into? Especially if you are a global firm?

ANNA must be calculated for every potentially relevant regime.

6. Any traction with regulators to allow cash to be used as collateral instead of securities?

Eligible collateral for initial margin includes ''immediately available cash funds'' that are denominated in a major currency or the currency of settlement for the uncleared swap. However, permitting initial margin collateral to be held in the form of a deposit liability of the custodian bank is inconsistent with the rule's prohibition against rehypothecation of such collateral. In addition, employing a deposit liability of the custodian bank—or another depository institution—is inconsistent with the final rule's prohibition against use of obligations issued by a financial firm. On the other hand, as a practical matter, the regulators acknowledged it would have been very difficult to eliminate cash entirely (because of timing of transfer of collateral and because income generated by non-cash assets in custody will be paid in cash. Therefore, the rules in the US allow cash where the posting party directs the custodian to reinvest the deposited funds into eligible non-cash collateral of some type, or the posting party delivers eligible non-cash collateral to substitute for the deposited funds. This reinvestment must occur within a reasonable period of time after the initial placement of cash collateral to satisfy the initial margin requirement, and the amount of eligible collateral must be sufficient to cover the initial margin amount in light of the applicable haircut on the non-cash collateral. Investment in a money market fund is a possible route where the investment criteria of the MMF only permit otherwise eligible collateral.

7. Is the eligible collateral schedule not included in the Initial Margin Credit Support Annex (CSA)? Is this a separate agreement?

There are two approaches to the Eligible Collateral Schedule (ECS). In the triparty model, the posting of collateral is delegated to your custodian who will select assets for posting from your long box, based on the eligibility criteria and any portfolio optimization instructions you have provided. In that case the ECS is a primarily operational document that constitutes instructions to the Custodian as to what the parties have agreed to be eligible and the haircuts applicable. It exists separately from the CSA and is expressed in the format required by the Custodian. By contrast, third party custodians are more passive and operate the account but do not manage the selection of collateral. In that case, the eligible collateral schedule will be set out in, or as an annex to, the CSA, and does not need to be in any Custodian-dictated format.

8. What are netting sets?

In response to concerns that swaps entered into before the compliance dates would need to be documented under a different eligible master netting agreement e.g. master agreement, than swaps entered into after the compliance dates in order for the margin requirements not to apply to the pre-compliance dates swaps, the rules allow an eligible master netting agreement to identify one or more separate netting portfolios to which the requirements of the final rule apply on an aggregate net basis. Thus, under the final rule, pre-compliance date swaps in the same Eligible Master Netting Agreement (EMNA) as post-compliance date swaps would be subject to the requirements of the final rule unless they are treated under the EMNA as separately identified netting portfolio.

9. Do Phase 4 and 5 firms have to do back testing? Is it mandatory?

If using a risk-based model to calculate Initial Margin, the covered swap entity's risk control unit shall validate its initial margin model prior to implementation and on an ongoing basis. The covered swap entity's validation process shall include an outcomes analysis process that includes back testing the model. This analysis shall recognize and compensate for the challenges inherent in back testing over periods that do not contain significant financial stress.

10. If you are in scope for Variation Margin (VM), does that mean you are automatically in scope for Initial Margin?

No, if you are a financial end user but you do not have "material swaps exposure" then you do not need to post or collect Initial Margin. See questions 1-3 for how to calculate this.

11. My clients are typically large corporate entities that will never post Initial Margin. What is he regulatory requirement to provide an annual/election notice regarding the posting of Initial Margin?

The Uncleared Margin Rules do not change your responsibility to offer segregation by notice to your counterparty, and if a counterparty elects segregation the account must be held at a custodian that is independent of both the counterparty and the you.

12. Please discuss your views on the recent BCBS/IOSCO guidance on the timelines for compliance:

We will refer to the announcement regarding the USD$50M threshold. The BCBS/IOSCO announcement does not itself change the terms or interpretation of any Initial Margin rules. That will be down to individual regulators - and it seems likely that they will make their own announcements, but they haven't done so yet. If regulators do make announcements that go no further than BCBS/IOSCO, this would not be the "regulatory relief" that the industry has been lobbying for. If regulators go no further than the statement, it doesn't give any grace period to put documents in place following an unexpected spike in Initial Manager, meaning the dealer risks immediately being in breach in such a scenario. It would not clearly scale down the universe of in-scope entities in the way that dealers and industry bodies had been hoping. It would require dealers to form a judgment as to how (if at all) it impacts on their plans for Initial Margin repapering - and it is likely that different dealers will have different views on this.

13. Is the $50M threshold a given or must be negotiated with each counterparties?

EMIR Region:

The EUR€50M threshold is a maximum permissible threshold for Initial Margin. It is open to parties to agree a lower threshold. The threshold applies across the group entities on both sides.

US Region:

The US$50M threshold is a regulatory maximum that once breached requires the posting of Initial Margin. It is a maximum starting point but can be reduced between counterparties for reasons such as credit risk, FX conversion buffers, or firm by firm preference. The US$50M threshold is aggregated across all entity relationships represented by a CSA or multiple CSAs between affiliates and the counterparty.

14. For the $50M threshold, if there are multiple investment managers for an entity is the $50M threshold applied at the higher entity/counterparty level or would it be applied for the positions an Initial Margin would have vs a specific counterparty?

EMIR Region:

You would look through the investment manager to the entity and apply the EUR€50MM threshold to all of your (and your group's) dealings with that entity, regardless of the different investment managers through which that entity acts.

US Region

You would look through the investment manager to the entity and apply the US$50MM threshold to all of your (and your group's) dealings with that entity, regardless of the different investment managers through which that entity acts

15. Is it correct that the $50M threshold is technically only applicable to new trades?

It is available to be applied across your initial margin obligations, which (assuming you have a separate CSA for these) will just be your new trades. There is nothing stopping counterparties from agreeing a lower threshold. Arguably applying it to legacy trades as well as new trades may mean that less benefit is had in reducing the amount of regulation Initial Margin.

16. Is the $50M "per counterparty" or total for a firm?

The total for an entity and its affiliates across all relationships with a particular counterparty group.

17. If a firm builds their own model based on SIMM, does that have to be approved by regulators?

In the US, the calculation obligation falls on the dealer rather than the financial end user. SIMM needs to be approved by regulators.

18. Are uncleared swaps grandfathered in to the SIMM framework?

Legacy swaps do not require margining provided they are part of a distinct netting set and they are not amended in a way that would bring them in scope.

19. Do you see/foresee in the market new clearing solution for OTC products?

We are aware of a number of initiatives including Swap Agent. Also aware of a number of initiatives that aim to reduce initial margin, including Quantile and Bilateral Risk Management.

20. How do I ensure my counterparty has lodged the initial margin they agree to lodge? Similarly, how do I ensure that the counterparty doesn't take any Initial Margin assets back without my agreement?

Protections in this regard include the fact that initial margin is subject to legal agreements between the counterparties; that posted margin is held in segregated, third-party custodial accounts; and that the custodians are also bound by legal agreements.

21. Would amending an existing trade - for example, if LIBOR goes away - then make it subject to Initial Margin?

It is not entirely clear what kinds of amendments will bring a legacy swap into scope. However, the CFTC and the Prudential Regulators have issued relief in the context of amendments made to swaps to comply with the US QFC Stay rules. BCBS/IOSCO has stated that any changes made to legacy derivative contracts "solely for the purpose of addressing interest rate benchmark reforms" should not be required to adhere to the margin requirements for non-cleared swaps. However, as of 2 April 2019 the CFTC and the Prudential Regulators have made no such clarification.

22. What is the relevant date for Phase 5 that new uncleared transactions will be in scope for Initial Margin?

1 September 2020

23. Are FX forwards in scope?

Physically settled FX forwards are not in scope for initial margin. They are in scope for variation margin in the US, EU, and Japan. FX forwards are in scope for the AANA calculation despite not being part of the Initial Margin calculation for margin exchange.

24. For sensitivity for a basket equity swap. Do you calculate value change of the instrument with respect to a 1% change in the price of the equity?

SIMM asks for delta sensitivity with regard to each underlying in the basket, exactly as you describe, but for reporting the risks are mapped into SIMM buckets for sectors, etc. so the risks may all be aggregated together depending on what's in the basket.

DISCLAIMER: The information provided does not constitute, and may not be relied upon as, legal advice and is given without liability or responsibility. You are required to consult your own legal advisers with respect to the matters discussed.

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