The March 8 publication by European supervisory authorities (ESAs) of their final rules on the margining of non-cleared derivatives marks the start of a sprint to comply ahead of the global, pre-agreed start date. ISDA and its members have been ‘in training’ for this race for the past three years, but the final draft regulatory technical standards give all entities affected by European rules the information they need to make the necessary changes to documentation, processes and systems. Many will read the rules and be relieved that some of the hurdles have been removed. But, as in any race, some challenges lie ahead.
There is certainly some good news in the 95-page release, reflecting many of the concerns raised by ISDA during the consultation process. Most significantly, many of the problematic points of difference between earlier European proposals and final rules from US prudential regulators and the Commodity Futures Trading Commission (CFTC) have either been eliminated or moderated – a welcome development that should help facilitate equivalence decisions between the US and Europe.
For example, the ESAs opted not to require initial margin exchange on physically settled foreign exchange swaps and forwards, and on the principal in cross-currency swaps, bringing their rules more in line with the approach taken in the US, and in the proposals made by other national regulators. Recognising that US rules do not cover equity options, European regulators also chose to introduce a three-year phase-in before these instruments are subject to margin requirements – a decision taken to avoid regulatory arbitrage, the ESAs said.
Action was taken to tackle practical problems highlighted by ISDA as well. A six-month delay on intragroup initial margin was included to reflect concerns that applications for intragroup exemptions may not be approved by national authorities in time for the September effective date. And a three-year phase-in was introduced for intragroup trades with non-EU affiliates to give time for equivalence determinations to be completed.
These are all good, positive steps that should help cross-border trading – an issue on which ISDA has been vocal. But there were some more challenging elements in there too. That includes a decision to stick with a requirement for margin to be collected within one day of the trade date (T+1). That’s in line with US final rules, although it differs from the approach taken in some other national proposals. Market participants had argued T+1 presents practical challenges for trades with counterparties in other time zones, particularly in Asia, where markets close early in the European day. European buy-side groups had also argued that the T+1 deadline for variation margin collection would, at best, impose significant costs on smaller financial end users, such as pension funds, for little reduction in systemic risk.
ISDA had recommended allowing more time for the calling and collection of margin. Ultimately, the ESAs made some attempt to allow more time for smaller firms to exchange variation margin, but only under strict conditions that appear to essentially involve the pre-funding of margin. This implies prohibitive extra costs.
But, as with any race, the clock is the biggest challenge. And with little time left to implement, this race has become a sprint. In the space of just six months, all outstanding collateral documents will need to be revised, technology will need to be implemented or adapted and tested, and regulatory approvals will need to be obtained. New legal documents to address segregation and collateral exchange must also be drafted and signed. That’s hefty to-do list, and a challenging timetable.
ISDA has been in training for some time to prepare the ground for implementation. Central to this initiative is the development of a standard initial margin model, known as the ISDA SIMM, which will be available for firms to use to calculate how much initial margin needs to be exchanged. ISDA has been touring the globe in recent months, showing the methodology to regulatory authorities, alongside a transparent governance structure, in order to smooth to path to implementation. Significant time and resource has also been spent to prepare for the necessary revisions to the ISDA credit support annex in each jurisdiction, as well as to develop a protocol to ensure the changes can be made to outstanding agreements as efficiently as possible. Additional initiatives include the development of a dispute resolution mechanism.
But while plenty of preparation has been done by ISDA and the industry as a whole, the nuts and bolts of implementation could not begin until final rules were published. US prudential regulators published their final rules at the end of October, and the CFTC followed two months later. The March release from European regulators fires the starting gun on the sprint to be ready for implementation in Europe.