Variation Margin - documentation and implementation

Market participants are starting to prepare, distribute or receive documentation in connection with their (or their counterparties’) regulatory margin requirements.

The purpose of this briefing is to give a short overview of the regulatory requirements giving rise to this documentation, and to look at the various ways in which the next phase of documentation for variation margin can be implemented. Documentation for initial margin is covered in a separate briefing.

One of the key pillars of the G20’s OTC derivative reform programme is the requirement to exchange margin for non-centrally cleared derivatives. The Basel Committee on Banking Supervision (BCBS) and International Organisation of Securities Commissions (IOSCO) were tasked with publishing a policy framework recommending minimum standards for margin requirements to ensure a globally consistent approach.

Two types of margin were recommended by BCBS/IOSCO: variation margin, for ongoing mark-to-market movements; and initial margin, for potential future exposure. The differences between the two are discussed later in this briefing, but the key difference is that initial margin needs to be segregated and ring-fenced from the insolvency of the margin receiver, and so cannot be provided on a title transfer basis.

The key deadline that people are currently working towards for variation margin is March 2017.

BCBS and IOSCO recommended that implementation of the margin requirements should be phased in from September 2016. The first phase focused on derivatives between the largest of derivatives users (“Phase One” institutions, being covered entities who have an aggregate month-end average notional amount of non-centrally cleared derivatives of more than €3 trillion).

The second phase, which applies to all other derivatives users (subject to certain exemptions), is scheduled to start in March 2017.

Some jurisdictions have finalised their rules implementing the margin guidelines, so “Phase One” institutions have already put in place documentation to comply with those rules amongst themselves. Industry participants are now starting to prepare the documentation for their derivatives with other trading counterparties.

Other jurisdictions have not finalised their rules implementing the margin guidelines, but nonetheless have a deadline of March 2017 to be compliant with the rules, once published. Institutions are therefore preparing documentation now so that they can comply by March 2017.

Some jurisdictions are not expected to have rules in place by March 2017, in which case institutions that are not subject to any other regulatory regime may not be looking to put documentation in place yet.

The table below summarises the current position in a number of jurisdictions.

Jurisdiction	Details of any final variation margin rules	Date on which final variation margin rules are expected to come into effect	Current status of any non-final variation margin rules	Additional info
European Union			The European Commission adopted a delegated regulation on 4 October 2016. The delegated regulation is subject to an objection period by the European Parliament and the Council, after which it will be published in the Official Journal. Implementation will begin one month after the entry into force of the delegated regulation – it is expected that implementation will be required for non-centrally cleared derivatives between Phase One entities one month after entry into force, and 1 March 2017 for all others.	The press release for the European Commission’s adoption of the delegated regulation can be found here.
United States of America	Final rules have been issued by both the “Prudential Regulators” for bank swap dealers and bank security-based swap dealers, and by the Commodity Futures Trading Commission (CFTC) for non-bank swap dealers. The Prudential Regulators include the Federal Reserve Board, Federal Deposit Insurance Corporation, Office of Comptroller of the Currency, Federal Housing Finance Agency, and Farm Credit Administration.	September 1, 2016 for non-centrally cleared derivatives between Phase One entities. March 1, 2017 for all others.	The Securities and Exchange Commission (SEC) has proposed, but not yet finalized, margin rules for non-bank security-based swap dealers.	The final rules also include provisions to implement a 2015 statute that exempts certain nonfinancial counterparties from the scope of the margin regulations for uncleared swaps that hedge or mitigate commercial risk. The adopting release for the Prudential Regulators’ rules is here; the adopting release for the CFTC is here.
Canada	Federal banking regulations will apply to federally-regulated financial institutions. Provincial securities regulations (see the fourth column opposite) will apply to other entities. Federal Banking Regulation In February 2016, the Office of the Superintendent of Financial Institutions (OSFI) published a guideline based on the BCBS/IOSCO framework and applicable to federally regulated financial institutions (FRFIs). FRFIs that are subject to and complying with the OSFI Guideline would be relieved from the requirement to comply with the proposals in the CSA consultation paper noted in the fourth column opposite when these become provincial laws administered by the provincial securities regulators. The guideline can be found here.	1 September 2016 for non-centrally cleared derivatives between Phase One entities. 1 March 2017 for all others.	Provincial Securities Regulation The Canadian Securities Administrators (CSA) published a consultation paper on July 7, 2016 outlining the Committee’s proposed policy recommendations for margin requirements for non-centrally cleared derivatives regulated by the provincial securities regulators. The comment period expired on Sept 6, 2016 and the Committee is now considering the comments received. Each province will have to implement the rules once the CSA Consultation Paper process of consultation, feedback and finalization is complete. Once that consultation period is complete, the CSA would publish a National Instrument as the next step in the legislative process. The CSA Committee has indicated that it will be 2017 before the rules will be completed. It is only at that point that the rules would be adopted across provinces, based on the final form of the CSA proposals and on the basis of a phase–in timeline set out in the National Instrument. The CSA Consultation Paper can be found here.
Hong Kong			The Hong Kong Monetary Authority (HKMA) consultation paper on margin requirements was published in December 2015 and the HKMA responded on 22 August 2016 to comments from ISDA on that consultation paper. ISDA further responded on 14 September 2016. On 22 August 2016 the HKMA also deferred implementation of margin requirements beyond 1 September 2016, noting that the final rules on margin requirements for non-centrally cleared derivatives would be issued in the coming months and that they will continue to monitor progress in the implementation schedules of other major markets and announce a revised phase-in schedule for Hong Kong in due course.	Hong Kong is not a member of the G20 (and so is not bound by the G20 commitments) but has nonetheless decided to implement rules.
Japan	The Financial Services Agency of Japan (the FSA) published a set of final regulations on margin requirements on 31 March 2016. The final regulations include the Cabinet Office Ordinance, the FSA Public Notices 15 – 17 and a number of revised supervisory guidelines.	The VM requirements are being phased in from 1 September 2016.
People’s Republic of China			There is no expectation of margin requirements being introduced in the immediate future. No draft regulations have been published and there is no expectation that there will be in the near future.
Saudi Arabia	No final rules are publicly available.	Not available	The 2016 SAMA financial stability report indicates that : “SAMA is currently implementing the Basel margining requirements for the OTC Derivatives, the new Counterparty Credit Risk rules and the rules for Central Counterparties.” There is no publicly available information regarding the status of those rules.
Singapore			The Monetary Authority of Singapore (MAS) consultation paper on margin requirements for non-centrally cleared OTC derivatives was issued on 1 October 2015. ISDA and ASIFMA jointly, amongst others, have submitted responses. The consultation paper proposed that the IM and VM requirements would be phased in from 1 September 2016 (with each phase subject to a six-month transition period to allow for smooth implementation). On 22 August 2016 the MAS announced that they would defer implementation of margin requirements beyond 1 September 2016, noting that the final rules on margin requirements for non-centrally cleared derivatives would be issued in the coming months and that they will continue to monitor progress in the implementation schedules of other major markets and announce a revised phase-in schedule for Singapore in due course.
South Africa	Final rules have not been published	It is expected that the margin requirements will be phased in for South African market participants after the Regulations have come into effect. the Regulations are expected to come into effect at the end of 2016 and accordingly, it is expected that the margin requirements will be phased in from the middle of 2017.	On 5 June 2015, the Registrar of Securities Services in South Africa issued for public comment a draft board notice which sets out the margin requirements for non-centrally cleared OTC derivative transactions.

If a derivative counterparty is subject to the regulatory requirements, they will not be permitted to enter into derivatives unless that derivative complies with those regulatory requirements.

So if you are not subject to the rules but your counterparty is, your counterparty will not be able to enter into new trades with you after the relevant deadline unless you have put in place appropriate documentation.

Because the BCBS/IOSCO framework is a set of guidelines that needs to be implemented separately in each G20 jurisdiction, the precise rules will differ on a jurisdiction-by-jurisdiction basis.

However, the general principles are that two types of margin (variation margin and initial margin) should be exchanged, and that initial margin should be exchanged in a way that is protected from the insolvency risk of the person receiving it (meaning that initial margin needs to be segregated and cannot be reused). The BCBS/IOSCO framework also sets out detailed recommendations on the frequency of margin calls, what is acceptable as eligible margin, and acceptable thresholds or minimum transfer amounts.

Variation margin and initial margin have a number of similarities, but due to their different purposes they also diverge on some key points.

The following comparison table identifies some of the similarities and differences between variation margin and initial margin. Again, the precise details will depend on the local implementing regulations.

The margin requirements applicable to derivatives between two parties will depend on the jurisdiction of each party (or their group) and the regulatory regime(s) applicable to them.

As such, institutions that are preparing the margin documentation will not be able to complete it without knowing key information regarding their trading counterparties, such as their jurisdiction, regulatory status and size of their (and their group’s) derivatives trading activity. While some institutions may have certain information concerning their counterparties, they will require their counterparties to provide additional information so that the correct margin documentation can be prepared.

ISDA has published the ISDA Regulatory Self-Disclosure Letter which is intended to assist market participants with the exchange of necessary information to determine if, and when, their trading relationship will become subject to regulatory margin requirements. The latest version (published on 30 June 2016) covers Canada, the European Union, Japan, Switzerland and the United States of America.

Institutions may also use more bespoke documentation or correspondence to help identify the appropriate margin requirements.

Protocols were developed by ISDA to enable market participants to put in place documentation on a standardised basis with multiple counterparties, reducing the need for bilateral negotiations.

On 16 August 2016 ISDA published the 2016 ISDA Variation Margin Protocol (the VM Protocol). The VM Protocol allows parties to amend their existing credit support documents, or to enter into new credit support documents, in a way which is compliant with the regulatory margin requirements. A market participant that wishes to use the VM Protocol adheres to the VM Protocol by sending a letter to ISDA, together with the applicable adherence fee.

Because of the variety of regulatory regimes that may apply to two parties (each of which may have different margin requirements), and the range of different ways in which industry participants may wish to adopt the margin requirements, the VM Protocol allows the parties to make further elections on a bilateral basis by exchanging a Questionnaire.

The margin documentation between two parties who have adhered to the VM Protocol will therefore be a combination of the VM Protocol and the Questionnaire – the VM Protocol itself will not be sufficient to put in place margin documentation. The VM Protocol will only take effect between two adhering parties if they have exchanged “matching” Questionnaires.

No. The VM Protocol is not the only way to put in place (or amend) credit support documentation to comply with regulatory margin requirements. Parties can agree documentation bilaterally.

ISDA has published various standard form documents (the ISDA 2016 Credit Support Annexes (VM)) that can be used to implement the regulatory variation margin requirements.

These include English, New York and Japanese law Credit Support Annexes, which are updated versions of the existing (non-regulatory) forms of Credit Support Annex published by ISDA, and which have been adapted to work specifically in the context of the regulatory margin requirements. By way of example, the VM versions of the Credit Support Annex provide only for the exchange of variation margin, and do not include initial margin or “Independent Amounts”.

ISDA and the FBF have also published an AFB/FBF Addendum to the ISDA 2016 Credit Support Annex for Variation Margin (VM). This allows parties to use the ISDA 2016 Credit Support Annex for Variation Margin (VM) with French-law governed AFB Master Agreements and FBF Master Agreements.

There are three main ways that you could put in place a regulatory-compliant CSA:

• “Amend”: this amends the existing CSA so that it becomes compliant with the regulatory requirements. The amended CSA will cover new trades entered into after the relevant margin phase-in date and will also apply to legacy trades in the event they are part of the same netting set.
• “Replicate-and-Amend”: the existing CSA is replicated so that two CSAs apply to the same ISDA Master Agreement. The existing CSA will continue to apply to legacy trades without amendment, and the new replicated CSA (which will apply to trades entered into after the relevant margin phase-in date) will be amended to become compliant with the regulatory requirements.
• “New CSA”: this does not rely on an existing CSA. A new CSA is entered into using one of the ISDA 2016 Credit Support Annexes (VM). The existing CSA will continue to apply to legacy trades without amendment, and the new CSA will apply to trades entered into after the relevant margin phase-in date.

These alternatives (and the terminology) are provided for in the VM Protocol, but can equally be used in bilateral documentation. ISDA has not published bilateral documentation to amend or replicate existing CSAs. Parties that wish to take this approach will either need to use the VM Protocol or to put in place bespoke documentation (which may be based on the VM Protocol).

The answer to this will depend on a number of factors, and will not be the same for everyone.

Some industry participants consider that the Amend method (amending the existing Credit Support Annex so that all trades, both legacy and new, are subject to the revised requirements) is preferable as it avoids the need for multiple Credit Support Annexes under the same ISDA Master Agreement. This is because having more than one Credit Support Annex can be difficult from an operational perspective.

Other industry participants consider that the disadvantage of the Amend method is that it applies the regulatory margin requirements to transactions that do not need to be margined. As such, there may be a commercial or pricing implication of imposing new terms on existing transactions.

While you may already have an arrangement in place for the exchange of margin, it is unlikely that the existing document is compliant with the new regulatory requirements. For example, the new requirements specify which collateral is eligible, which haircuts are required, which thresholds and minimum transfer amounts are acceptable and how frequently valuation and margin calls are required, all of which may be different to the terms that you have in place already.

The answer to this will depend on a number of factors, and will not be the same for everyone.

Institutions that have a significant volume of trading relationships that will require regulatory margin may find that the VM Protocol makes it easier to put in place the same (or similar) arrangements with multiple counterparties.

Institutions that have existing Credit Support Annexes that they wish to continue to use (and adapt) for the regulatory margin requirements will need to consider whether the amendments in the VM Protocol will work for those existing documents. If the existing documents contain bespoke provisions that are inconsistent with the VM Protocol, they may wish to consider using a bilateral agreement.

Institutions may also consider using bilateral documentation if they consider the VM Protocol to be too complex for their credit support documentation requirements or if it does not address their regional or domestic requirements.

The VM Protocol has an option which (in addition to putting in place a new CSA) will result in a new ISDA Master Agreement between the two parties.

If using bilateral documentation, then if you do not have an ISDA Master Agreement in place you will be expected to put one in place at the same time as the new CSA.

The VM Protocol consists of a number of parts:

• The VM Protocol agreement – this is similar to other protocols published by ISDA. It sets out how parties can adhere to the VM Protocol and how the VM Protocol can be used to amend or put in place a Credit Support Annex. The VM Protocol agreement does not itself contain any of the margin documentation.
• An Adherence Letter Exhibit – this is the form of letter that needs to be sent to ISDA if you wish to adopt the VM Protocol.
• The Protocol Questionnaire Exhibit - this is the form of Questionnaire that needs to be exchanged between the parties. Margin documentation will not be put in place or amended between two parties who have adhered to the VM Protocol unless they have exchanged Questionnaires and those Questionnaires “match”.
• Six CSA exhibits – these contain the operative provisions for the margin documentation. The six exhibits reflect the different models (Amend, Replicate-and-Amend or New CSA) that the parties may choose and the different types of Credit Support Annex (English, New York or Japanese) that they may have or wish to put in place. The Amend and Replicate-and-Amend exhibits are similar, since they rely on the parties’ existing Credit Support Annex and seek to amend it. The New CSA exhibit is slightly different, as it creates a new Credit Support Annex in its entirety.
• A PCA Principal Answer Sheet – this allows a manager to prepare a Questionnaire separately for each principal on whose behalf it is acting.
• A Recipient PCA Principal Annex – this allows a manager to identify those principals on whose behalf it is exchanging a Questionnaire.

The Questionnaire contains a number of elections that need to be made. Only if certain elections are “matched” will the margin documentation in the VM Protocol take effect.

You will therefore need to complete all of the fields that are relevant to you. Some of the questions will not apply, depending on which elections you have made. If you are using ISDAAmend to complete the Questionnaire, only the relevant questions will appear, and irrelevant questions will be filtered out as you continue to complete the Questionnaire.

For example, you will need to:

• identify yourself, including an identifier
• specify which regulatory regime is applicable to you
• choose whether you wish to use Amend, Replicate-and-Amend or New CSA
• choose whether you wish to use an English, New York or Japanese law CSA and
• specify whether you wish to override the default fallbacks in the VM Protocol on certain commercial terms, such as the Notification Time, Minimum Transfer Amounts and Valuation Agent.

If the regulatory margin requirements are applicable to you, you should consider how you wish to proceed. This includes:

• determining which counterparties you propose trading with, as the regulatory margin requirements will only apply to new transactions entered into after the phased-in implementation date
• determining whether you wish to use the VM Protocol or bilateral documentation
• determine which regulatory margin regime applies to you and your counterparty
• determining whether you wish to amend your existing credit support documentation to be compliant with the regulatory margin requirements, or whether you wish to put in place a new Credit Support Annex to work alongside your existing Credit Support Annex.

The Derivatives and Structured Finance team at Norton Rose Fulbright has significant experience in all of the issues associated with the regulatory margin requirements, and can assist in your preparation of, response to or understanding of the documentation for both variation margin and initial margin.

If you have any questions, please get in touch with your usual Norton Rose Fulbright contact or with any of the people listed below.

Daniel Franks, London
Nigel Dickinson, London
Hannah Meakin, London
Terry Arbit, Washington, DC
Michael Loesch, Washington, DC
Kathleen A. Scott, New York
Martin Botik, Dubai
Dale Rayner, Brisbane
Elana M. Hahn, Toronto
Shawn Barnett, Johannesburg
Colin Rice, Singapore