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Impact of the Margining Reforms on Asia

Jing Gu

Senior Counsel, ISDA

October 11, 2016

Contents

• WGMR framework and implementation timing

• Application to cross-border counterparty parings

• Preparation Steps

• ISDA SIMM™

2

WGMR Framework

• In September 2013, the Basel Committee on Banking

Supervision and the International Organization of Securities

Commissions published a framework for margin

requirements for non-centrally cleared derivatives (“BCBS-

IOSCO Framework”) that was intended to be used by G-20

regulators in adopting their own rules.

• In March 2015, BCBS IOSCO updated the implementation

timetable.

• The BCBS-IOSCO Framework needs to be implemented by

national regulators.

3

WGMR Key Requirements

• Margin requirements should apply to all uncleared transactions

• Some FX carved out of framework

• Financial firms and systemically important non-financial entities to

exchange initial margin (IM) and variation margin (VM)

• Precise definition of financial firms, non-financial firms and

systemically important non-financial firms to be determined by

appropriate national regulation

• Limits on use of thresholds, minimum transfer amounts

• Threshold limit applied at group level

• IM to be calculated using model meeting specified requirements, or

standard schedule

• VM to be exchanged to cover full amount of exposure with sufficient

frequency (eg daily)

4

WGMR Key Requirements

• Collateral should be limited to highly liquid assets and subject to

haircuts

• National supervisors should develop their own list of eligible

collateral assets

• IM should be exchanged on a gross basis, and held in a way that

protects each party from the other’s insolvency risk

• Requirements to be phased in

5

WGMR National Rules Current Status

Country/Region Regulator/Authority Rules Status

USA Prudential Regulators Final rules November 2015

Switzerland Federal Council Final rules November 2015 (Financial Market Infrastructure Ordinance).

Update expected to harmonize with EU

USA CFTC Final substantive rules January 2016, final cross-border rules May 2016

Canada OSFI Final rules February 2016 (Guideline E 22)

Japan JFSA Final rules March 2016

South Africa NT Draft rules June 2015

Hong Kong HKMA Draft rules December 2015 and consultation conclusions August 2016

Australia APRA Draft rules February 2016

EU European Supervisory

Authorities Draft rules March 2016

Singapore MAS Draft rules May 2016

India RBI Discussion paper May 2016

6

Uncleared Margin Rules - Implementation

Timetable Sept 2017 March 2017

– VM phase in

complete

Sept 2016

– First wave VM

and IM

implemented

in the US,

Canada and

Japan

First Wave

– Exchange of VM and IM if

average aggregate

notional amount of non-

centrally cleared

derivatives for group for

the March, April and May

prior to September

(AANA) exceeds €3

trillion

Sept 2017 - 2020

– IM AANA threshold

decreases annually;

– Sept 2017 – € 2.25 trillion

– Sept 2018 – €1.5 trillion

– Sept 2019 – €0.75 trillion

– Sept 2020 – €8 billion

March 2017

– VM requirements

apply to all other

covered entities

Sept 2018

Sept 2019

Sept 2020

7

Application to Cross-Border

Counterparty Parings

8

Dodd-Frank Act: US Regulators

In general, the Dodd-Frank Act

vests primary responsibility for:

• swaps (interest rate, FX,

commodity, etc.) in the US

Commodity Futures Trading

Commission (“CFTC”)

• security-based swaps (single

name CDS, narrow based

security index swaps, etc.) in

the US Securities Exchange

Commission (“SEC”)

However, for prudential requirements (margin and capital), primary responsibility for banks and other institutions with existing “Prudential Regulators” is vested in those Prudential Regulators

9

Applicable US Rules by Product and Swap Entity Type

• PR: (any of the OCC, Board, FDIC, FCA or FHFA)

• SD: Swap Dealer

• MSP: Major Swap Participant

• SBSD: Security-based Swap Dealer

• MSBSP: Major Security-based Swap Participant

Party Rules applicable to Swaps Rules applicable to Security-Based Swaps

SDs and SBSDs with a PR PR rules PR rules

MSPs and MSBSPs with a PR PR rules PR rules

SDs (no PR) CFTC rules None

MSPs (no PR) CFTC rules None

SBSDs (no PR) None SEC rules (when adopted)

MSBSPs (no PR) None SEC rules (when adopted)

10

US Rules: counterparty classification

Covered swap

entities and swap

entities (CSE and

SE):

Financial end

user:

• Broader than “financial entity” (the analogous definition for mandatory

clearing) and intended to pick up essentially all entities that engage in

activities that require state or federal charters or licenses (lending, deposit

taking, dealing, investment advice) or that are professional investors.

• Divided into two categories: financial end users with “material swaps

exposure” financial end users without “material swap exposure.” SDs and

MSPs must collect initial margin from, and post initial margin to, financial

end users that have “material swaps exposure.”

• US rules apply indirectly to these entities.

Non financial end

users and exempt

entities:

• Covered swap entities do not have to collect or post minimum regulatory

margin amounts with these entities under US rules.

• SDs and MSPs subject to the particular rules of the relevant regulator are

“covered swap entities” and SDs and MSPs subject to another US

regulator’s rules are “swap entities.”

• US rules apply directly to these entities.

11

Financial End Users

Defined by a long list of enumerated entity types, including:

• bank and bank-like entities

• GSEs

• money service businesses

• brokers and dealers

• insurance companies

• investment advisers

• employee benefit plans

• securitization vehicles

• public and private funds, commodity pools, family offices etc. that raise funds or

use their own money primarily to invest in financial assets

• non-U.S. entities that would be financial end users if organized under U.S. or

state law

12

Entity Scope: US Rules

CSE/SE Financial End User

Non-Financial End User

CSE/SE

Financial End User

Non-Financial End User

Margin Rules generally apply Margin Rules generally do not apply

13

Cross-border application of PR Rules:

Offshore Exclusion

• Prudential regulators exclude “foreign non-cleared swaps” of a “foreign covered swap

entity” from the scope of the margin requirements.

Foreign Non-Cleared Swap

Neither the counterparty nor any party that provides a guarantee of either party’s obligations under the uncleared swap is–

1. Organized under the laws of the United States or any State (including a U.S. branch, agency, or subsidiary of a foreign bank) or a resident of the United States;

2. A branch or office of an entity organized under the laws of the United States or any State; or

3. A swap entity that is a subsidiary of an entity that is organized under the laws of the United States or any State.

Foreign Covered Swap Entity

Any covered swap entity that is not–

1. Organized under the laws of the United States or any State, including a U.S. branch, agency or subsidiary of a foreign bank;

2. A branch or office of an entity organized under the laws of the United States or any State; or

3. A subsidiary of an entity that is organized under the laws of the United States or any State.

A company is a “subsidiary” of another company if:

• The company is consolidated by the other company on financial statements under GAAP, IFRS or other similar standards, or would be if any such standards had applied; or

• A U.S. banking regulator has determined that a company is a subsidiary of another company because the regulator has concluded that either company provides significant support to, or is materially subject to the risks or losses of, the other company.

“US branch” determination:

• Note: The Prudential Regulators stated that they “would generally consider the entity to which the swap is booked as the counterparty.”

14

Cross-border application of PR Rules:

Full Substituted Compliance

Full substituted compliance may be available to (if no U.S. guarantor):

• Substituted compliance determinations: For substituted compliance the Prudential

Regulators must jointly make a “comparability” determination in the form of a public

order.

• A foreign covered swap entity;

• A U.S. branch or agency of a foreign bank; or

• A subsidiary of a depository institution, an Edge corporation or an agreement corporation that is not organized under the laws of the United States or any State,

• An entity organized under the laws of the United States or any State, unless it is a U.S. branch or agency of a foreign bank;

• A natural person who is a resident of the United States; or

• A branch or office of an entity organized under the laws of the United States or any State.

provided that its

obligations are not

guaranteed by

15

Cross-border Application of EMIR Rules

Entities that are not “established” in the EU. Obligation applies to a TCE where

the contract is:

• Between a FC or NFC+ and a TCE that would be subject to the obligation

(i.e., an FC or NFC+) if it were established in the EU; or

• Between two TCEs that would be subject to the obligation if they were

established in the EU provided the contract has a direct, substantial or

foreseeable effect within the EU or where the obligation is necessary or

appropriate to prevent evasion of the Regulation.

• An investment firm, credit institution, insurance undertaking, assurance

undertaking, reinsurance undertaking, undertaking for collective investments

in transferable securities (UCITS) and its managers, institution for

occupational retirement provision and alternative investment fund managed

by AIFMs (in each case authorised pursuant to relevant EU directives).

• An undertaking established in the EU other than a financial counterparty or

a central counterparty.

Third country

entities (TCEs):

Financial

counterparties

(FC):

Non-financial

counterparties

(NFC):

16

Entity Scope: EMIR Rules

FC/NFC+ NFC- TCE

(FC/NFC+) TCE (NFC-)

FC/NFC+

NFC-

TCE (FC/NFC+)

TCE (NFC-)

Margin Rules apply Margin Rules do not apply

Margin Rules apply if there is a ‘direct, substantial and foreseeable effect’

17

Cross-border application of AEJ rules

Hong Kong

Substituted compliance available if an AI’s counterparty is subject to a

foreign regulatory framework for which HKMA has made a comparability

determination.

Exemption for transactions with counterparties from jurisdictions where

netting and/or collateral arrangement is not enforceable.

Singapore

Deemed compliance available if (i) the margin requirements in the foreign

jurisdiction are comparable; and (ii) the MAS Covered Entity can

demonstrate that it has complied with the margin requirements of that

foreign jurisdiction;

Exemption for transactions with counterparties from jurisdictions where

netting is not enforceable.

Australia

Substituted compliance available subject to APRA approval and automatic

deference regime for a foreign ADI, Category C insurer or EFLIC in

Australia;

Exemption for transactions with counterparties from jurisdictions where

netting and/or collateral arrangement is not enforceable 18

VM Margin Requirements Table Relevant Foreign

Jurisdiction (RFJ) Counterparty

Is Counterparty required to collect VM under RFJ when trading

with FIs in a jurisdiction with no margining rules?

N/A Domestic counterparty No

Korea/China etc Counterparty in a jurisdiction with no margin regulation No

US (PR)

US-based swap dealer (SD) Yes unless certain exemptions are available

Onshore branch of US-based SD Yes

Onshore subsidiary registered as SD (i.e. non-US

SD)…….

No unless it has a US parent/guarantor or acting through a US

branch

Subsidiary guaranteed by a SD No assuming subsidiary is not an SD

EU

Offshore EMIR-compliant bank Yes unless certain exemptions are available *

Onshore branch of EMIR-compliant bank Yes unless certain exemptions are available *

Onshore subsidiary guaranteed by EMIR-compliant bank Yes if meet certain conditions **

Stand-alone subsidiary of EMIR-compliant bank No

Japan

Offshore Japanese bank Yes ***

Onshore branch of Japanese bank Yes ***

Onshore subsidiary of Japanese bank No

HK

Offshore HK bank Yes

Onshore branch of HK bank Yes

Onshore subsidiary guaranteed by HK bank Yes if meet certain conditions #

HK branch of overseas bank Yes if trades booked in Hong Kong

Stand-alone subsidiary of HK bank No

Singapore Offshore Singapore bank Yes

Onshore branch or subsidiary of Singapore bank No

Australia

Offshore Australian bank Yes ##

Onshore branch of Australian bank Yes ##

Onshore subsidiary of Australian bank Yes if subsidiary is a Level 2 group entity ##

* If independent legal review (i) does not confirm that the netting agreement in the relevant third country can be legally enforced with certainty at all times; or (ii) confirms that no

segregation arrangement with such third country party can meet the requirements under the draft RTS, then the EU party does not need to POST any VM/IM (such jurisdictions

being “Non-Netting Jurisdiction”). The EU party does not need to COLLECT or POST VM/IM if (A) the third country is a Non-Netting Jurisdiction; (B) the independent legal review

concludes that collecting collateral in accordance with the draft RTS is not possible; and (C) the exemption ratio is lower than 2.5%.

** Pursuant to Art 11(12) of EMIR, VM/IM requirements apply to transactions between two non-EU entities that would be subject to those requirements if they were established in the

EU, provided that those transactions have a "direct, substantial and foreseeable effect" within the EU OR where such obligation is necessary or appropriate to prevent the evasion of

any provisions of EMIR. An OTC derivative is deemed to have a "direct, substantial and foreseeable effect" within the EU where a non-EU subsidiary benefits from a guarantee

provided by an EU financial counterparty if the guarantee: (a) covers (i) the entire liability of the non-EU subsidiary for an aggregated notional amount (ANA) of at least €8 billion or

(ii) part of the liability of the non-EU subsidiary for an ANA of at least €8 billion divided by the percentage of the liability covered; AND (b) is at least equal to 5% of the sum of current

exposures in OTC derivatives of the EU guarantor.

*** VM applies to a person who enters into OTC derivatives “as a business” who (i) has an average notional amount of non-cleared OTC derivatives (on a non-consolidated basis) equal

to or more than JPY 300 billion; and (ii) is based in a netting-friendly jurisdiction.

# VM applies if: (i) the guarantee is booked in HK; (ii) legal obligation of the guarantor is explicitly documented; (iii) guaranteed uncleared derivative exposure exceeds HK$60 billion.

## VM is only required if both parties exceed AUD 12 billion threshold. The threshold is reduced to AUD 3 billion from Sept 2017.

19 The above does not constitute legal advice or purport to be a guide to/an explanation of all relevant issues/considerations.

Preparation steps

20

WGMR – What is Being Done?

The ISDA Working Group on Margin Requirements has several

workstreams in place to help the market prepare for the implementation

of uncleared derivatives margin requirements.

• Model – the SIMM

• Operational build out

• Collateral documentation

• Templates to address new initial and variation margin

requirements

• Protocol to provide scalable solutions for industry transition to

regulatory VM

21

Preparation Steps I

• Determine own status for rules applicable to you and

other rules

• Party type

• Aggregate notional volume

• Sort/Anticipate counterparties by

• Type

• Geography (rule applicability)

• Assess current margin documentation against rules

• Credit support documentation

• Custody documentation

22

Preparation Steps II

• Analyse need to re-document:

• Counterparties where no margin is required

• Counterparties where margin is required

• VM/IM/Both

• New document needs:

• Do I need a new ISDA Master?

• Do I need new credit support documents?

• Do I need new IM segregation documents?

• Consider - historical trades

23

Preparation Steps III

• Analyse operational needs and capabilities

• Daily calculations and deliveries

• Ability to run multiple CSAs and collateral flows

• Ability to deliver and receive margin

• IM modelling

24

Documentation – Architecture and Approach

• Classification: ISDA self disclosure form • http://www.isda.org/publications/pdf/35345836_14_WGMR_Self_Disclosure_Letter_T

emplate.pdf

• VM • New bookstore CSAs for VM under English / New York /

Japanese law

• VM Protocol

• IM • New bookstore CSD for IM under English law / CSA for IM

under New York or Japanese law

• 2 versions: Phase One and non-Phase One (latter to be

published soon)

• Custodial arrangements – ISDA Euroclear / Clearstream

Documentation

• Legal Review

25

ISDA SIMM™

26

ISDA SIMM™ : Model overview and motivation

SIMMTM avoids unnecessary complexity – an important element for the

global Initial Margin project

The Initial Margin project is very different from regulatory capital

projects.

The margin calculated by the model is not paid by the calculating firm, but by

its counterparty. This is a crucial and a unique difference.

Because of this, the counterparty has a very strong interest in understanding

the firm’s calculation and needs to have confidence in it.

For that reason, ISDA members were very keen to have a standard model that

could be widely adopted across the industry.

27

ISDA SIMM™ : Model overview and motivation

The key advantages of this approach are:

• Operational simplicity, compared with every bank making its own IM

model

• Banks do not have to implement all their counterparties’ models in

order to check correctness of margin calls

• Consistent regulatory governance and oversight

• Reduction of the number of disputes as well as timely and transparent

dispute resolution

• Enhanced predictability of future liquidity requirements

• Supports the use of derivatives by a wide range of counterparties, and

reduces exclusion from the market

28

ISDA SIMM™: Nature • SIMMTM is based on the existing regulatory-mandated “Sensitivity Based

Approach” from FRTB.

• Some modifications and improvements have been made to adapt it for

Initial Margin use.

• Model is based on risks, which are already calculated by banks. It includes

all major and material risks, vega and convexity, as well as spread risk,

basis risk and term structure.

• Based on standard variance-covariance ideas

• Allows netting and diversification within an asset class, but not between

asset classes.

• Calculation scheme is simple to implement and fast to run.

• Based on calibrated parameters, but has light-weight data requirements.

• Like all models, it is an approximation to the truth, but the approximation is

good-quality and has been tested by extensive backtesting.

29

Documentation

Trades Trade

Bundling

Margin

Results Calculator

Margin Calls &

Dispute

Management

Margin

Analysis and

Explanation

Risk

Mapping, or

other data

logic

Risk inputs:

Sensitivities,

Time Series,

etc.

• Consistency in

trade population

designation by

asset

• Trade feed timing

to match margin

calculation

process needs

• Timing and

availability of risk

data

• Data quality

• Standardized risk

definitions

• Common risk factors

• Number of risk factors

consistent with aims of

transparency and

reconciliation concerns

• Common mapping logic

• Ease in identifying margin

result drivers

• Analysis and results

conducive to dispute

resolution

• Common product

definition

• Common bundling

rules

• Common agreement

rule handling

• Transparent, predictable

and replicatable

methodology

• Readily available and

common inputs

• Batch timings, processing

times consistent with

margin needs

• Reruns in case of errors or

disputes

• Scale and speed

• Definition of

monitoring criteria

• Exception and

override handling

• Recalculation needs

• Exception, escalation

and supervision rules

• Clearly defined

process and data

sharing protocols

Firm Level Application

17