Derivatives and pension funds: key collateralisation deadline approaching
15 February 2017
For pension funds which enter into uncleared overthecounter (OTC) derivative contracts, urgent action is required to ensure that appropriate arrangements are in place to avoid disruption to new contracts from 1 March 2017. On this date, new variation margin rules will apply to a broader range of financial counterparties and nonfinancial counterparties. More onerous, initial margin requirements could also apply to pension funds, but this would be from a later date, if at all.
Variation margin rules apply from 1 March 2017
From 1 March 2017, in a 'big bang' change to market practice, all parties classed as financial counterparties (this includes pension funds) under the European Market Infrastructure Regulation (EMIR), as well as certain nonfinancial counterparties (to the extent their outstanding OTC derivatives positions exceed certain gross notional values calculated on a group basis), will fall within scope of the obligation to collect collateral, known as variation margin (VM), in relation to uncleared trades when they transact with another inscope counterparty. The rules will also apply to crossborder transactions (ie transactions between inscope EU entities and nonEU entities) to the extent that a nonEU counterparty would be subject to the rules were it established in the EU (with the rules applying to the nonEU counterparty indirectly). In addition, the rules can apply to transactions entered into between two nonEU entities in certain limited circumstances. We note that there are no specific exemptions that apply to pension funds in a VM context.
The new VM rules are part of G20 commitments to reduce certain risks relating to derivatives. The rules mark a move away from current practice (existing derivatives collateral arrangements are not subject to regulatory requirements and parties can structure these as they see fit) to an obligation to exchange twoway collateral on a daily basis, with the terms of such exchange being prescribed by regulation. As such, certain minimum requirements must
be included in collateral documentation and existing practices must be reviewed and, if necessary, revised (for example, the regulation prescribes minimum transfer amounts, types of eligible collateral, collateral quality and haircuts).
The new rules only apply to uncleared OTC derivatives that are "entered into" after 1 March 2017. Trades entered into before that date will not be subject to the new rules unless they are novated or amended in a material way. Whether an amendment will bring a trade in scope is not straightforward and more detailed analysis will be required.
In order to determine whether the VM requirements will apply to a counterparty pairing, it is, therefore, important that each counterparty is aware of its classification for EMIR purposes as well as that of its counterparty.
Initial margin rules may also apply
In addition to new VM rules, EMIR also introduces new rules relating to initial margin (IM). IM is effectively an additional buffer to cover potential future exposures over a tenday period. The introduction of IM (not traditionally an important part of collateralisation in the OTC derivatives market) as a mandatory and substantial element of OTC derivatives collateralisation will involve significant market changes. This is primarily because IM is calculated on a gross basis and collateral must also be segregated to protect against the default or insolvency of the collateral taker and to ensure that it is freely transferable to the collateral provider on the default of the collateral taker. There is, however, an EUR8 billion threshold before the IM requirements will apply (calculated on a group basis based on the aggregate average notional amount (AANA) of noncentrally cleared derivatives entered into), which means that IM will only be relevant for the most systemically important counterparties.
IM requirements are being phased in between February 2017, and then from September 2017, and then each consecutive September until September 2020 depending on the AANA, with the AANA applicable in February 2017 being EUR3,000 billion, the AANA applicable in September 2017 being EUR2,250 billion, the AANA applicable in September 2018 being EUR1,500 billion, the AANA applicable in September 2019 being EUR750 billion and the AANA applicable in September 2020 being EUR8 billion.
For many pension funds, there is likely to be a substantial gap between the application of the VM and IM requirements, and for funds for which the AANA is less than EUR8 billion, the IM requirements will not apply at all.
How do the VM and IM rules interact with the EMIR clearing requirement?
VM and IM requirements only apply to OTC derivatives transactions which are not subject to the mandatory clearing requirement under EMIR. Although a discussion of the clearing obligation is outside the scope of this briefing, we note that pension funds still benefit from an exemption to mandatory clearing – in fact, a delegated regulation extending the existing transitional exemption to 16 August 2018 has been adopted by the European Commission. However, to the extent that a pension fund enters into a noncentrally cleared OTC derivative contract that is subject to the VM or IM requirement, the pension fund must be prepared to collateralise that transaction.
What action is required?
To the extent this process has not already begun, you will need to collect data and notify counterparties of the fund's EMIR classification and its AANA. You may already have been asked for this information by existing counterparties as they seek to work out which contracts need to be collateralised pursuant to the EU rules, and how (that is, VM only, or VM and IM).
You will also need to be ready – from a legal, operational and documentation perspective – to comply with the VM requirements by 1 March 2017 and (if applicable) the IM requirements at a later date.
ISDA has produced various tools and documentation to assist with compliance. There are a number of different approaches that can be taken to amending documentation, and pension funds should consider which route is most appropriate and feasible in their specific circumstances.
This briefing scratches the surface of a very complex regime. In addition, we note that there are also other new margin regimes which are being phased in in other G20 jurisdictions and which may equally apply to your counterparty pairing. To discuss the issues and details further, please contact your usual Allen & Overy adviser.