James Okarimia - The New Margin Requirements For Non Centrally Cleared Derivatives

1. James Okarimia - Publication
New margin requirements for non-centrally cleared derivatives
The global financial crisis has raised important questions regarding the regulation of
derivatives trading. Policymakers and market participants have sought to develop an
enhanced framework for financial activity. This newsletter aims to provide insight on the
different requirements implemented through the latest derivative trading regulations along
with their implications.
Context
In September 2009, the G20 Pittsburgh summit committed to improving transparency
in the derivatives markets, mitigating systemic risk, and preventing market abuse.
Three major strategic initiatives resulted from this consensus:
1. Reporting of all derivatives transactions to centralized trade repositories, allowing
regulators to have a greater insight over the market.
2. Centralization of OTC derivatives clearing made mandatory for standardized transactions
and incentivized through capital requirements for others, in order to reduce systemic risk in
the markets. Essentially, clearing houses will spread the risk of any one member’s default
among all the other members.

2. 3. New margin requirements for non-centrally cleared derivatives, defined in order to
minimize the risk of market contagion.
 The initial margin protects the transacting parties from the potential future exposure from
future changes in the mark-to-market value of the contract during the time it takes to
close out and replace the position in the event that the counterparty defaults.
 The variation margin protects the transacting parties from the current exposure from
changes in the mark-to-market value of the contract after the transaction has been
executed.
While the reporting and central clearing requirements have been largely enforced by
Regulators (especially in the U.S.), the new margin requirements for uncleared swaps are
yet to be finalized and enforced (as required under sections 731 and 764 of the Dodd-Frank
Act in the U.S.).
On October 22, 2015, the Office of the Controller of the Currency (OCC), Federal Deposit
Insurance Corporation (FDIC), Federal Reserve Board (FRB), Farm Credit Administration
(FCA), and the Federal Housing Finance Agency (FHFA) have adopted a joint rule to
establish capital requirements, initial margin, and variation margin requirements on all non-
cleared swaps and non-cleared security-based swaps. On December 16, 2015, the
Commodity Futures Trading Commission (CFTC) has also published its final rule.
A final rule from the Securities and Exchange Commission (SEC) is still expected.
The next chapters of this newsletter intend to give an overview of the requirements adopted
by the regulators on October 22, and anticipate their impact.
Overview of new margin requirements
Scope of requirements
The adopted requirements apply to swap and security-based swap transactions that are not
cleared. The “non-cleared swap” definition includes any swap that is not cleared by a
Derivatives Clearing Organization (DCO) registered with the CFTC or by a clearing
organization that the CFTC has exempted from registration by rule or order. The “non-
cleared security-based swap” definition includes any security-based swap that is not,
directly or indirectly, submitted to and cleared by a clearing agency registered with the SEC
or by a clearing agency that the SEC has exempted from registration by rule or order.

3. Such a definition will allow covered entities to exclude transactions made with non-U.S.
clearing organizations that are subject to “comparable, comprehensive supervision and
regulation” in their home country, if, as expected, the CFTC and SEC grant relief from
registration to these DCO.
The requirements apply to all Covered Swap Entities (CSE).
These include:
 Persons/entities that have registered with the CFTC or the SEC as Swap Dealers (SD) or
Major Swap Participants (MSP)
 Financial End Users: entities whose business is financial in nature (e.g. insurance
companies, State-licensed or registered credit or lending entities and money services
businesses, real estate investment companies, securitization vehicles…).
*This includes U.S. Intermediate Holding Companies.
Excluded from this definition:
 Financial end users without material swaps exposure (any entities whose average daily
aggregate notional amount of non-cleared derivatives including covered swaps, covered
security-based swaps, foreign exchange forwards and foreign exchange swaps) with all
counterparties for June, July and August of the previous calendar year, aggregated at
the highest consolidation level, below $8 billion, will be exempted to comply with these
new margin requirements.
 Non-financial end users (any entity that is not an SD, an MSP, nor a financial end user);
 Supervised institutions with assets of $10 billion or less.
 Sovereigns and multilateral development banks.
Baseline minimum amounts and methodologies for initial and variation margin
Initial and variation margin payments or collections would not be required to be made if the
payments were below the Minimum Transfer Amount ($500,000). This statement aims at
reducing transaction costs.
The CSE is required to collect Initial Margin (IM) from and to post Initial Margin to, each
covered counterparty, on or before the business day following the day of execution, and
until the swap expires or is terminated. The required amount of IM can be calculated using
either a model-based method or a standardized table-based method.
 The required amount of IM would be the amount computed minus a threshold amount of
$50 million. This threshold is calculated at the highest consolidation level of both parties
and is based on all non-exempted non-cleared swaps between the two consolidated
groups (see picture 1).

4.  IM have to be fully exchanged.
 For transactions of a portfolio subject to the same netting agreement:
* under the model-based method, IM may be netted per "broad risk category", but not
across broad risk categories. The four broad risk categories are: commodities, credit,
equity, and foreign exchange/interest rates.
* Under the standardized method, IM may be netted across all asset classes.
*Initial Margin
requirements don’t apply to the portion of a cross-currency swap that is the fixed exchange
of principal.
The CSE is required to collect Variation Margin (VM) from, and to post Variation Margin to,
each counterparty that is a swap entity or a financial end user, on or before the end of each
business day following the day of execution of the swap and until the swap is terminated or
expires.
 A bilateral threshold requirement applies to all financial end users regardless of whether
the entity had material swaps exposure.
 VM may be netted across swaps if executed pursuant to an eligible master netting
agreement (which creates a single obligation for all covered transactions upon an event
default of the counterparty following any permitted stays in insolvency).
Eligible collateral
The OCC and FDIC provide a clear definition of the eligible collateral for IM and VM.
Eligible collateral for IM includes cash, certain domestic debt securities (issued or
guaranteed by the U.S. Department of Treasury or by any other U.S. government agency,
the International Monetary Fund, the European Central Bank, Multilateral Development
Banks certain U.S. GSE), certain foreign government debt securities, certain corporate debt
securities, certain listed equities, and gold.
Eligible collateral for VM depends on the type of counterparty.
 When facing another swap entity, only immediately available cash (denominated in USD,
another major currency, or the swap settlement currency) can be used.
 When facing financial end user counterparty, any collateral eligible to IM can be used.
Treatment of collateral

5. A CSE that collects or posts IM shall require that one or more custodians, who are in no
way affiliated with either party, hold such collateral.
The custodian agreement must prevent rehypothecation or repledging and must be
enforceable, including in bankruptcy. However, the custodian agreement may permit
reinvestment of the funds into assets that would qualify as eligible collateral.
Affiliate transactions
The adopted requirements include a few special rules that can potentially affect the
requirements when applied to affiliate transactions:
 A covered swap entity is not required to post IM to an affiliate that is not also a covered
swap entity.
 Each affiliate may be granted an IM threshold of $20 million.
 A covered swap entity, or an affiliate, that collects non-cash collateral can serve as the
custodian.
 A holding period of five business days or the maturity of the portfolio may be used in the
margin model for any swaps with an affiliate, provided that the IM is calculated
separately from the other swaps.
Phase In
In the final rule, the Regulators have slightly loosened the terms of the phase-in period.
The requirement to exchange variation margin will become effective on September 1,
2016 for when both the covered swap entity and its counterparty have an average daily
aggregate notional amount of covered swaps for March, April and May of 2016 that exceeds
$3 trillion. Any other covered swap entities with respect to covered swaps with any other
counterparty will have to comply with the variation margin requirement by March 1, 2017.
The initial margin requirement will apply in priority to the largest, most active and most
systemically important derivatives market actors. To that intent, the application
threshold (defined as the month-end average notional amount of non-centrally cleared
derivatives computed at the highest consolidation level) will be gradually lowered, starting
from $3 trillion. To be identified as a covered entity, the average daily application threshold
should be exceeded over March, April and May. If so, the entity will be subject to these new
margin requirements during the one-year period from September 1 of that year to October
31 of the following year.

6. The new
requirements will only apply to new contracts entered after these dates. Treatment of prior
contracts will be agreed as per private bilateral negotiations.
Impacts
According to the FDIC, following the implementation of this new rule, financial institutions
and their counterparties are expected to be required to post an additional $315 billion of
collateral to cover their non-cleared swaps.
The degree of impact will mostly depend on the type of entity
The new margin requirements will influence differently the activity of the different market
players. Swap Dealers will be the earliest and most significantly impacted by the regulation.
Globally, they will require more capital, as the operational and financial costs of transactions
will rise. Depending on their organization, Swap Dealers may opt to review their corporate
structure, in order to optimize their affiliate transactions.
Major Swap Participants and Financial End Users, as they face many of the same
requirements as Swap Dealers, are expected to follow the same activity review as Swap
Dealers. However, it is worth noting that under these new constraints, small market players
and new market entrants may develop competitive advantages and therefore address niche
markets.
Finally, although non-financial and commercial end users are excluded from capital and
margin requirements, they will likely be impacted by the rise in end-user prices reflecting the
cost increases induced by this new regulation in the overall value chain.
Application and Initial Margin materiality thresholds
Strategic arbitrage opportunities in activities might be available based on the application
calendar and Initial Margin thresholds. Daily margining may be onerous for smaller

7. participants, as some do not have the infrastructure and capacity to manage such
process. Additionally, many buy-side portfolios are directional and will therefore require
high margin requirements. Finally, the requirement to compute these thresholds at the
highest consolidation level and on a daily basis may require structural evolutions in the
underlying systems and lead to a rationalization and reconsideration of activities.
Initial Margin exchange and collateral eligibility
The costs of assets considered eligible for collateral are likely to significantly increase due
to a rise in the demand reinforced by the full two-way collect-and-post regime imposed on
Initial Margin.
Given that the two-way exchange is not a current common market practice, market
participants are expected to have to make significant investments in their collateral
infrastructures and capabilities (legal and operational).
Management of multiple agreements
These new requirements only apply to trades executed after the application date, thus
allowing participants to support both pre and post eligible master netting agreement
(EMNA), as the current standards are less punitive. This will further increase systems’
complexity. Additionally, the legal impact will also be quite significant, as it may require
repapering a huge amount of contracts and agreements.
Restrictions on re-hypothecation
The restrictions on the rehypothecation of customers’ collateral will require entities to review
their business and technology models. These limitations will also reduce the pool of eligible
collateral, further pressuring a potential collateral squeeze.
Segregation rule
As participants are required to segregate received Initial Margin from their assets and other
clients’ assets, the operational complexity of custody will rise significantly (multiple legal
agreements with different custodians, new enhanced reporting on collateral, less flexible
substitution mechanisms).
James Okarimia Publication