A summary of the challenges to be faced by buy-side firms with respect to regulatory initial margin.
Whilst largely dormant for some time, EMIR will shortly be raising its head again in the form of mandatory initial margin (IM) requirements for uncleared OTC derivatives. Phase 4 will bite in September 2019, with Phase 5 coming a year later. In a case of saving the best for last, this final sting in the tail provides perhaps the most significant EMIR implementation challenge for buy-side firms.
In particular, buy-side firms will need wholly new arrangements with their dealer counterparties and custodians in order to comply with the IM requirements. In addition, those buy-side firms that have existing non-regulatory-compliant segregated IM or Independent Amount structures in place will need to revisit such arrangements in order to bring them into compliance with the IM requirements.
Firms who will be caught by the new IM requirements should grasp the nettle now and begin implementation planning.
To whom and when do the obligations apply?
The IM requirements will apply, subject to the thresholds and phase-in set out below, where both parties to an uncleared OTC derivative fall into one of the following classifications:
- financial counterparties (FCs) (including UCITS, AIFs with an authorised AIFM and most EU pension schemes)
- non-financial counterparties above the EMIR clearing threshold (NFC+s), and
- if they are facing an FC or an NFC+, third country entities (TCEs) that would be an FC or an NFC+ if established in the EU.
The IM requirements can also apply where each party is a TCE that would be an FC or NFC+ if established in the EU and there is a “direct, substantial and foreseeable effect” in the EU.
The table below sets out the two remaining phase-in dates under both the EU and the US rules and the aggregate average notional amount (AANA) thresholds which apply to each phase-in date. The AANA threshold must be breached by both counterparties in order for the IM requirements to apply.
However, since the major dealers will have already breached the AANA thresholds for one of the earlier Phases 1 to 3, when facing one of those dealers, as a practical matter the AANA determination for Phases 4 and 5 needs to be performed primarily for buy-side firms.
| AANA of uncleared OTC derivatives for March, April and May of relevant year of over1
|| EU/US phase-in date
| USD/EUR 750 billion (Phase 4)
|| 1 September 2019
| USD/EUR 8 billion (Phase 5)2
|| 1 September 2020 and annually thereafter
What are the key EMIR IM requirements?
Many of the requirements imposed by the Margin RTS will be new for buy-side firms and will therefore introduce fresh legal and operational challenges. The most significant of these is that buy-side firms will be required both to post IM to dealers and to receive IM from dealers. Such IM posting/receiving must be performed on a gross basis so cannot be offset against each other and the IM that is posted and received must be segregated from the insolvency risk of the party that is receiving the IM.
In addition, the Margin RTS prescribes both the frequency at which IM must be calculated (i.e. upon the occurrence of certain events and at least every 10 business days) and the methodology that must be used (eg. ISDA SIMM). Although IM is subject to the same eligibility and haircut requirements as the variation margin (VM) requirements introduced in early 2017, IM is also subject to concentration limits in respect of the assets that may be provided as collateral.
Buy-side firms that are directly subject to EMIR will also be required to undertake further monitoring and assessment of their margining arrangements. Such buy-side firms will have to perform validation, back-testing and auditing assessments on the IM model that they use. In addition, they will have to obtain an independent legal review/opinion of both the compliance of the segregation arrangements and the enforceability of the new IM documentation.
What legal documentation is required?
In contrast to the VM requirements, the legal documentation upgrade necessary for compliance with the IM requirements is both significant in number and challenging in complexity. In particular, while the VM requirements led to minor technical uplifts to the documentation, establishing effective and enforceable security and segregation arrangements, often on a cross-border basis, is inherently more involved from a legal perspective.
The diagram below sets out the documentation required between a buy-side firm and a dealer. As can be seen, while compliance with the VM requirements were met with a single upgrade to an existing Credit Support Annex, compliance with the IM requirements could mean up to 5 additional agreements per dealer relationship, including potential onboarding with unfamiliar triparty custodians such as Euroclear and/or Clearstream.
When should new documentation be put in place?
Although dealers have the implementation experience of Phases 1-3, this experience has been confined to implementing in the inter-dealer market. There was only one buy-side firm that was caught during those earlier phases and the implementation of that buy-side firm’s IM arrangements with its dealers gave rise to fresh legal, documentary and operational challenges that the dealer community had not previously anticipated.
Such challenges are compounded by the fact that buy-side firms will not know with certainty whether they will be caught by Phase 4 or Phase 5 until the relevant period for measuring AANA in 2019 and 2020. The three-month window between AANA measurement and the start date of IM requirements will not provide sufficient time to put the necessary documentation in place, so parties will need to consider in advance of these measurement windows whether they are likely to be subject to the IM requirements.
Furthermore, with the majority of affected buy-side firms falling within Phase 5, there is likely to be a significant bottleneck in 2020, with both dealers and custodians being squeezed for time and capacity. Buy-side firms wishing to influence terms and negotiate substantively to reach the best outcome for their funds or clients may therefore consider not waiting that long and instead voluntarily put regulatory-compliant arrangements in place early.
The final crucial factor to be considered is the timing deadlines that will be imposed by the custodians, which will be some months in advance of the relevant September start date. The diagram below sets out a suggested approximate timeline to which buy-side firms should consider working.
The impact of Brexit and EMIR Refit
Assuming that the IM requirements set out in the Margin RTS will not start to apply to firms in Phase 4 and Phase 5 prior to the EU exit date, the UK will need (absent any transitional Brexit deal) to provide new technical standards endorsing the timetable set out in the Margin RTS in order for the September 2019 and September 2020 deadlines to apply to buy-side firms either caught directly by the UK’s version of EMIR or indirectly caught through a trading relationship with a UK dealer. Although the application of the current phase in timetable has not yet been endorsed by the UK, in light of the UK’s stated goal of equivalence with the EU regime, parties should expect requirements to follow the timetable currently set out in the Margin RTS.
The EMIR Refit will also bring some changes to the scope of the IM requirements, principally through the proposed expansion of the definition of “financial counterparties” to include EU AIFs, irrespective of whether they have an authorised AIFM.
Buy-side firms with segregated/managed account clients will need to obtain information from such clients on their status against the IM thresholds on an annual basis, especially where the client’s assets are managed by more than one manager. Firms may wish to prepare an upgrade to their existing client questionnaires or letters to cover this off. Depending on timings, it may make sense to do this in conjunction with the updates required to reflect categorisation changes under the EMIR Refit.
Phases 4 and 5 of the implementation of the IM requirements present substantial challenges to the buy-side. Buy-side firms caught by the IM requirements will need to arrange new relationships, documentation and processes on a demanding timetable. If it is possible that you will be included in Phase 4 or 5 of IM, the time to act is now.
Simmons & Simmons acted for the sole buy-side firm that has, to date, been in-scope for the IM requirements (in Phase 3).
1 In the EU, AANA will be determined as of last business day of each month, while under the US regime AANA will be determined as of each business day in each month.
2 The USD threshold for Phase 5 and beyond is for Financial End User to determine whether they are “without Material Swaps Exposure” and is determined over June, July, August of the preceding year.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.