1. Second Consultation paper on the draft regulatory technical standards on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012
18 June 2015, London

2. Content International and legal framework Mandate
Structure of the draft RTS
References
Annex

3. Introduction
The scope of these draft RTS Regulation covers banks, investment firms, insurance companies , alternative investment fund managers and non-financial counterparties that are considered systemically important (i.e. above the clearing threshold)
For this reason, the Legislators mandated the ESAs to work together developing a joint draft RTS
In the broader effort of the derivatives reform, the EMIR and these draft RTS implement the international agreed principles (BCBS-IOSCO framework) in the European Union. These principles were issued on September 2013, and reviewed in March 2015
These draft RTS further specify aspects, requirements and processes that the BCBS-IOSCO framework left open to local implementation

4. International and legal framework
The two main references:
Regulation (Eu) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (EMIR)
Margin requirements for non-centrally cleared derivatives, issued by BCBS and IOSCO on September 2013 and reviewed on March 2015

5. Next steps 10 July 2015 End of second consultation
September/October ESAs to submit the final draft RTS to the European Commission (expected)
Immediately Application of the provisions related to
after publication intragroup exemptions
in the Official Journal
of the EU
1 September Application of the risk management procedures (including the requirement to collect collateral) in the modalities set by these RTS
New phase-in Phase-in of the requirements for VM and IM in line with the updated BCBS IOSCO framework

6. Structure of the draft RTS in the 2nd consultation paper
Recitals
Chapter 1 Counterparties’ risk management procedures
Chapter 2 Procedures concerning the exemptions for intragroup derivative contracts
Chapter 3 Applicable criteria for applying exemptions for intragroup derivative contracts
Chapter 4 Final provisions
Annexes

7. Main changes from the first Consultation Paper
Treatment of non-EU non-financial counterparties (Art. 2 GEN)
Exchange of margins with third country entities (Art. 3 GEN)
Treatment of derivatives associated to covered bonds for hedging purposes (Art. 8 GEN)
Timing for the collection of variation margin (Art. 1 VM)
Requirements concerning initial margin models (Art. 1 – 5 MRM)
Alignment of minimum CQS for collateral between IRB and ECAI ratings (Art. 3 LEC)
Concentration limits (Art. 7 LEC)
Haircut for FX mismatch (Art. 1 HC and Annex II)
Trading documentation (Art. 2 OPD)
Re-use and re-hypothecation (treatment of cash collateral for IM) (Art. 1 REU)
Intragroup exemptions: definition of practical and legal impediments (Art. 3 and 4 IGT)
Amended IM and VM phase-in (Art. 1 FP)

8. 1) Treatment of non-EU non-financial counterparties (Art. 2 GEN)
Third countries non-financial counterparties below the clearing threshold (NFC-) should be treated as EU NFC-
The identification of the status of a non-financial counterparty and whether that counterparty is above/below the clearing threshold is left to the European Counterparty.

9. 2) Exchange of margins with third country entities (Art. 3 GEN) (1/2)
In the first consultation paper, the RTS were developed on the concept that EU counterparties are required to collect margins (‘collect only’)
The implicit assumption was that the same entities that are in the scope of the EMIR and BCBS-IOSCO framework would also be covered by the margin rules in third countries.
As this is not the case, the requirement for the EU counterparties to only collect margins has been extended to also post margins.
Art. 3 GEN “Where a counterparty referred to in Article 1(1) GEN, which is established in the Union enters into a OTC derivative contract with a counterparty that is established in a third country and would be subject to the requirements of this Regulation if it was established in the Union, the risk management procedures shall include that initial and variation margin are exchanged between the counterparties and that the collateral is maintained and protected, in accordance with this Regulation”.

10. 2) Exchange of margins with third country entities (Art. 3 GEN) (2/2)
Exchange IM when dealing with third country counterparties, including the requirement of posting IM to counterparties domiciled in non-netting jurisdiction (i.e., where bankruptcy laws, netting and segregation agreements are not enforceable)
European counterparties have the obligation to assess the legal enforceability of the netting and segregation agreements.
Where this assessment turns out to be negative, counterparties will have to rely on alternative arrangements

11. 3) Treatment of derivatives associated to covered bonds swaps for hedging purposes (Art. 8 GEN)
At least in some jurisdictions, covered bond issuers/cover pools are not able to collect IM because the resulting claim of the posting counterparty on the collateral would be considered a claim ranking senior to the bond-holders
This special treatment is only available for covered bond programmes that fulfil certain restrictions similar to those in the first Consultation Paper apply
Similar requirements were introduced to guarantee an exemption for covered bonds swaps from clearing obligations in the RTS on Interest Rates derivatives
These requirements include the 2% regulatory over-collateralisation as alternative to margin requirements.
The current proposal includes:
two-way exemption from IM; and
one-way exemption for the covered bond issuer/cover pool from posting VM
The covered bond issuers/cover pools would be required to collect VM and required to return the cash VM previously collected

12. Treatment of swaps related securitisation vehicles
No legal basis for introducing similar exemptions for SPVs
Many SPVs might be exempted anyway when classified as “NFC-”
However, as the clearing threshold works at group level, some of the SPVs classified as NFC- might be captured (i.e. required to exchange margins) because of consolidation requirements

13. 4) Timing for the collection of variation margin (Art. 1 VM) (1/2)
As in the first Consultation Paper, the timing for the exchange of initial and variation margin is set to ‘T+1’, i.e. the business day following the trade date.
Respondents to the first consultation noticed that:
real-world constraints, such as different time zones, might impede the implementation of this requirement
portfolio reconciliation issues, time to settle cash payments or to transfer securities may justify extending this time
Completing the transfer at T+1 is considered a fundamental pillar of the whole margin framework.

14. 4) Timing for the collection of variation margin (Art. 1 VM) (2/2)
Flexibility in the time for the exchange of margins:
“T” might be subject to further specification in the final rules to allow for time-zone differences to be taken into account
The current draft RTS allow that variation margins are not collected at ‘T+1’ as long as the margin period of risk for the calculation of the IM is increased of a number of days equal to the extension
T+3 is only allowed for VM and under those conditions

15. 5) Requirements concerning initial margin models (Art. 1 – 5 MRM)
The draft RTS includes detailed requirements for developing initial margin models
As in the first consultation paper:
main non-linearities have to be captured
collateral should be modelled as distinct from the OTC derivative portfolio
Different from first consultation paper:
use of a ‘primary risk factor’ is dropped as the BCBS-IOSCO requirement to avoid risk offsetting among asset classes can be achieved in other ways
correlations and basis risk have to be captured by a conservative calibration

16. 6) Alignment of the CQS between IRB and ECAIs (Art. 3 LEC)
In the current draft, the minimum credit quality level for collateral for counterparties using IRB models and counterparties using ECAI ratings have been aligned to CQS 3

17. 7) Concentration limits (Art. 7 LEC)
Concentration limits: The ESAs have carefully considered this issue, and concluded that the concentration limits are necessary to limit systemic risks. Collateral diversification is also an explicit requirement of the BCBS-IOSCO principle
Current proposal:
concentration limits for non-sovereign debt securities apply to all counterparties (by issuer and type)
concentration limits for sovereign debt securities (EU and non-EU) apply only to systemically important counterparties:
GSIIs
OSIIs and
those collecting (in a single netting set) more than EUR 1bn collateral
concentration limits (in a single netting set) for sovereign debt securities (EU and non-EU) apply to collateral above EUR 1 bn

18. 8) Haircut for FX mismatch (Art. 1 HC and Annex II)
The haircut for currency mismatch is maintained for IM and VM but removed for VM posted in cash in any currency
The reasoning behind this choice:
it would interfere with the current market practices and
the haircut on cash would increase the credit risk for the posting party, as it would not be segregated and posted in excess to the change in market value of the derivatives
For VM posted in securities, the FX haircut and all the other haircuts apply in line with the CRR volatility adjustments. In this case, the FX haircut for VM has to be calculated with respect to the transfer currency
The FX haircut for IM is calculated with respect to the termination currency
Where transfer currency and/or termination currency are not foreseen in the agreements, the FX haircut applies to the entire collateral for that netting set

19. 9) Trading documentation (Art. 2 OPD)
Proper trading relationship documentation is required
Legal assessment on the enforceability of the netting agreement and the segregation requirements is also required
Requiring all the market participants to have a legal opinion on all bilateral agreements was considered excessively burdensome
The requirements requiring a written agreement from non-covered counterparties were dropped

20. 10) Re-use and re-hypothecation (treatment of cash collateral for initial margin) (Art. 1 REU)
Considering:
No intention of the ESAs to ban cash as eligible collateral for IM
Requirements on segregation of IM may clash with the actual possibility to segregate cash
Cash for IM ‘un-economical’ and therefore use of cash for IM should be a uncommon event
In the current draft: initial margin collected in cash can be re-invested in eligible collateral as long as the collateral is used to secure the exposure that the custodian or the collecting party has with respect to the posting party

21. 11) Intragroup exemptions: practical and legal impediments (Art
11) Intragroup exemptions: practical and legal impediments (Art. 3 and 4 IGT) (1/2)
Under the EMIR, intragroup transactions for non-centrally cleared OTC derivatives are exempted from margin requirements as long as “there is no current or foreseen practical or legal impediment to the prompt transfer of own funds or repayment of liabilities between counterparties”
The following current or foreseen restrictions have to be considered:
currency and exchange controls;
the regulatory, administrative, legal or contractual framework in which the counterparties operate is such as to prevent mutual financial support or significantly affect the transfer of funds within the group;
any of the conditions on the early intervention, recovery and resolution are met, as a result of which the supervisor foresees an impediment to the prompt transfer of own funds or repayment of liabilities;
the existence of minority interests that limit decision-making power within entities that form the group;
the purpose or the legal structure of the counterparty undertaking, as defined in its statutes, instruments of incorporation and internal rules.

22. 11) Intragroup exemptions: practical and legal impediments (Art
11) Intragroup exemptions: practical and legal impediments (Art. 3 and 4 IGT) (2/2)
Current restrictions of a practical nature have to be considered including any of the following:
Insufficient availability of unencumbered or liquid assets to the relevant counterparty when due; or
there are operational obstacles for such transfers or repayments when due

23. 12) Amended IM and VM phase-in (Art. 1 FP)
A new phase-in for the margin requirements was issued by the BCBS and IOSCO in March 2015
The current draft RTS updates the timeline according to BCBS-IOSCO framework
The new date of implementation:
1 September 2016 for VM and IM for the major participants
VM is phased-in in the following six months and
IM is phased-in over the following four years
To note that the permanent exemption from IM (EUR 8 bn) does not apply to VM

24. Most significant aspects unchanged from first consultation paper (1/2)
Definitions of Termination and Insolvency,
Definition of counterparty
Voluntary collateralisation
Scope of Coverage - Instruments Subject to the Requirements
Novation and Portfolio Compression
FX derivatives
Others (non EU – CCP)
Scope of Coverage – Counterparties
UCITS and other Investment Funds
IORPS
Sovereigns, central banks and multilateral development banks (in Level 1)
Microfinance, real estate and other specialised funds

25. Most significant aspects unchanged from first consultation paper (2/2)
Operational Process for the exchange of collateral
EUR 8 bn notional threshold - Calculation and Implementation (redraft)
EUR 50 mln threshold (redraft)
Minimum Transfer Amount (redraft)
Collateral Eligibility - Wrong Way Risk
Haircuts
Standard Haircuts (clarification on currency mismatch)
Haircut models

26. Annexes

27. The mandate under Article 11(15) of the EMIR
“In order to ensure consistent application of this Article, the ESAs shall develop common draft regulatory technical standards specifying:
the procedures for the counterparties and the relevant competent authorities to be followed when applying exemptions under paragraphs 6 to 10;
the risk - management procedures, including the levels and type of collateral and segregation arrangements, required for compliance with paragraph 3;
the applicable criteria referred to in paragraphs 5 to 10 including in particular what should be considered as practical or legal impediment to the prompt transfer of own funds and repayment of liabilities between the counterparties”.
the level of capital required for compliance with paragraph 4; (1)
(1) As amended by Article 520 of the CRR

28. References
Regulation (Eu) No 648/2012 of the European Parliament and of the Council of 4 July on OTC derivatives, central counterparties and trade repositories (EMIR) [link]
Consultation Paper: Draft regulatory technical standards on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012 [link]
Joint Discussion Paper on Draft Regulatory Technical Standards on risk mitigation techniques for OTC derivatives not cleared by a CCP under the EMIR (JC/DP/2012/1) issued by EBA, EIOPA and ESMA on 6 March 2012 [link]
Margin requirements for non-centrally cleared derivatives – final document, issued by BCBS and IOSCO on March 2015 [link]
Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions, issued by BCBS on February 2013 [link]