24 June, 2016
What you need to know
- On the 25th of February 2016, the Australian Prudential Regulation Authority (APRA) commenced a consultation process on margining and risk mitigation requirements for non-centrally cleared derivatives by releasing the draft Prudential Standard CPS 226 Margining and risk mitigation for non-centrally cleared derivatives (Draft CPS 226)1.
- APRA proposes to apply the margining requirements under Draft CPS 226 to certain APRA regulated institutions, such as authorised deposit taking institutions, general insurers, life companies and registrable superannuation entities with non-cleared derivatives > AUD 3 billion.
- The proposed margining requirements will also have implications for other buy-side participants, such as financial institutions including managed funds, hedge funds, private equity funds, trading firms, foreign deposit taking institutions, credit card issuers, leasing companies and custodians with non-cleared derivatives > AUD 3 billion as well as non-financial institution participants with non-cleared derivatives > AUD 50 billion.
Draft Prudential Standard CPS 226 Margining and risk mitigation for non-centrally cleared derivatives
Draft CPS 226 is based on the recommendation of the International Organization of Securities Commissions (IOSCO) to reduce systemic risk associated with non-cleared derivatives. These are derivatives transacted on the OTC market that are not cleared through a central clearing house. Unlike cleared derivatives were counterparty risk is reduced through the use of a central clearing agent, non-centrally cleared derivatives retain the element of counterparty risk. To mitigate this risk, in September 2013 IOSCO proposed a two-pronged approach to reform the global derivatives framework, by introducing margining and risk mitigation requirements, to be adopted by APRA through the proposed regulations.
This article focuses on the margining proposals under Draft CPS 226.
Margining proposals
What is margin?
Margin is the collateral held by a party to cover counterparty credit risk, so that in the event the counterparty defaults on its obligations to that party there will be collateral to protect that party against losses due to the counterparty's default. APRA propose two types of margin requirements to reduce counterparty credit risk, being initial margin and variation margin (see table below).
Who will be required to exchange margin?
APRA proposes to require an "APRA covered entity" to exchange margin in a non-centrally cleared derivative transaction with a "covered counterparty" where both counterparties have a group-wide portfolio of non-centrally cleared derivatives that exceeds the qualifying levels2.
APRA covered entities
As noted above, the proposed margining requirements under Draft CPS 226 directly apply to APRA covered entities.
APRA covered entities include:
- authorised deposit taking institutions;
- general insurers;
- life companies; and
- registrable superannuation entities.
Initial margin
Collateral held to cover potential future exposure due to future changes in the market value of the derivative over the close-out period.
Variation margin
Collateral held to reflect the current mark-to- market exposure resulting from changes in the market value of the derivative.
APRA also proposes to apply the margin requirements to certain subsidiaries of these types of entities3 and to exempt certain intra-group transactions from the margin requirements.
APRA noted in Draft CPS 226 that private health insurers will not be considered to be an APRA covered entity but that APRA will consider extending Draft CPS 226 to private health insurers in due course.
Covered counterparties
If an entity is a "covered counterparty", such entity can still be indirectly caught by the Draft CPS 226 proposed margin requirements to exchange margin with an APRA covered entity.
Draft CPS 226 defines a covered counterparty as a "financial institution" or "systemically important non-financial institution", excluding sovereigns, central banks, multilateral development banks, public sector entities, the Bank for International Settlements, certain covered bond special purpose vehicles and certain securitisation special purpose vehicles.
The definition of "financial institution" under Draft CPS 226 is broad and includes any institution "engaged substantively" in one or more of the following activities (domestically or overseas):
- banking;
- leasing;
- issuing credit cards;
- portfolio management (including asset management and funds management);
- management of securitisation schemes;
- equity and/or debt securities, futures and commodity trading and broking;
- custodial and safekeeping services;
- insurance and similar activities that are ancillary to the conduct of these activities.
It appears that APRA has adopted a broad approach to capture all institutions that normally fall within the meaning of the term "financial institution"4. This can potentially capture certain buy-side participants, for example:
- managed funds;
- hedge funds;
- private equity funds;
- trading firms;
- foreign deposit taking institutions;
- credit card issuers;
- leasing companies; and
- custodians.
APRA proposes to define a "systemically important non-financial institution" as an entity that is not a financial institution and that belongs to a margining group whose aggregate month-end average notional amount of non- centrally cleared derivatives for the preceding March, April and May exceeded AUD 50 billion. APRA appears to be driven by the need to capture non-financial institutions that are significant users of non-centrally cleared derivative
transactions (and therefore are considered to be systemically important)5. This can again potentially capture certain buy-side participants, such as very large non-financial institutions that engage in very high volumes of non-centrally cleared derivatives.
APRA proposes that variation margin is calculated on a daily basis whereas initial margin is proposed to be calculated at the outset of a transaction and on a consistent and regular gross basis, and in each case, the calculations are to be conducted promptly.6 To the extent an entity is caught by the margin requirements, that entity will need to consider establishing collateral arrangements to allow for the calculation and exchange of margin.
What will constitute eligible collateral?
It is proposed that liquid assets will constitute eligible collateral for this purpose, and may include cash, certain debt securities, certain covered bonds, senior securitisation exposures, equities included in a major stock index and gold. This reflects IOSCO's recommendation that assets for the purposes of collateral should be able to be liquidated in a reasonable amount of time.
When are the margining requirements proposed to start?
APRA proposes to phase in the margin requirements from 1 September 2016. Variation margin requirements will be phased in until September 2017, whereas initial margin has a phase in period that will extend to September 2020. APRA may also grant substituted compliance where an entity is required to comply with a foreign regulator to the extent that the framework is comparable to Draft CPS 226.
APRA has invited written submissions on Draft CPS 226 by 20 May 2016. It will be an important step in the development of the Australian margining landscape to see how the margining rules will be shaped after the consultation process. The new rules can have material costs and compliance implications for APRA regulated institutions and certain buy-side participants.
1 Draft CPS 226 is supported by the APRA Discussion Paper "Margining and risk mitigation for non-centrally cleared derivatives" http://www.apra.gov.au/CrossIndustry/Documents/160225-CPS-226-discussion-paper-FINAL.pdf (Discussion Paper). 2 Broadly speaking, the qualifying level for variation margin (after conclusion of the phase-in period) is AUD 3 billion and the qualifying level for initial margin (after conclusion of the phase-in period) is AUD 12 billion, in each case measured by reference to the aggregate month-end average notional amount of non-centrally cleared derivatives of the relevant margining group.
3 On a "Level 2" basis as defined in the APRA Prudential Standard APS 001 Definitions. 4 Refer to page 14 of the Discussion Paper.
For further information, please contact:
Jamie Ng, Partner, Ashurst
jamie.ng@ashurst.com
