Uncleared OTC Derivatives: ESAs Propose Initial Margin Relief Below the €8 Billion Threshold

The European Supervisory Authorities—the EBA, EIOPA and ESMA—have published a Final Report proposing targeted amendments to the bilateral margin requirements for uncleared OTC derivatives.

The proposed changes are intended to simplify the treatment of counterparties that fall below the €8 billion initial margin threshold. Most importantly, the exemption from exchanging initial margin would be extended from new transactions to existing uncleared OTC derivative contracts.

This would allow affected counterparties to release initial margin already collected for outstanding contracts, subject to their contractual arrangements and operational readiness.

The proposed amendments represent targeted regulatory relief, but they have not yet entered into force.

The existing bilateral margin framework

Commission Delegated Regulation (EU) 2016/2251 establishes risk-mitigation requirements for OTC derivative contracts that are not cleared through a central counterparty.

Among other matters, the Regulation establishes requirements concerning:

• the calculation and exchange of variation and initial margin;

• the types of collateral that may be used;

• collateral valuation and haircuts;

• segregation of initial margin;

• risk-management procedures; and

• operational and legal arrangements between counterparties.

Initial margin protects counterparties against potential future exposure arising between the default of a counterparty and the close-out or replacement of the relevant derivative portfolio.

Unlike variation margin, which reflects changes in the current market value of a contract, initial margin is intended to cover potential changes in exposure during the period required to close out or replace positions following a default.

What is the €8 billion threshold?

The initial margin requirements apply by reference to a counterparty’s aggregate month-end average notional amount, commonly referred to as AANA, of non-centrally cleared OTC derivatives.

The calculation is based on the month-end amounts for March, April and May.

Where a counterparty belongs to a group, the calculation is performed at group level. This means that entities cannot consider only their individual derivative portfolios where the applicable rules require the exposures of the wider group to be included.

The €8 billion threshold is separate from the EMIR clearing thresholds. The two regimes cover different transaction populations and serve different regulatory purposes.

What is the problem with the current rules?

Under the existing framework, where one of the two counterparties falls below the €8 billion threshold, the counterparties may stop exchanging initial margin for new uncleared OTC derivative contracts entered into during the relevant period.

However, the exemption does not extend to contracts already outstanding. Consequently, counterparties must continue:

• calculating initial margin for existing contracts;

• exchanging or maintaining collateral;

• operating segregation arrangements;

• maintaining custodial accounts and relationships; and

• supporting the related legal, reconciliation and operational processes.

This may continue for the remaining duration of the outstanding contracts, even though new transactions between the same counterparties are no longer subject to initial margin.

The ESAs consider this outcome unnecessarily complex and burdensome. It is also inconsistent with the approach followed in certain other jurisdictions, potentially affecting the international level playing field.

The principal proposed change

The draft RTS would extend the initial margin exemption to both new and existing contracts.

Where one of the two counterparties has an AANA below €8 billion for March, April and May of a given year:

• initial margin would not be collected for uncleared OTC derivative contracts between the two counterparties; and

• initial margin already collected for outstanding contracts would be released.

The exemption could be implemented as early as 1 June of the year in which the relevant March, April and May calculation is performed.

This would allow counterparties to benefit from the exemption shortly after demonstrating that one of them is below the applicable threshold.

What happens when the threshold is exceeded?

The draft RTS also clarify the position where both counterparties have an AANA above €8 billion.

In that case, the counterparties would become subject to initial margin requirements for new uncleared OTC derivative contracts entered into between them.

The requirements would apply no later than 1 January of the following calendar year.

This preserves a preparation period for counterparties entering the initial margin regime, allowing them time to establish or update:

• collateral documentation;

• initial margin calculation processes;

• eligible collateral arrangements;

• segregation and custody structures;

• dispute-resolution procedures; and

• operational and systems capabilities.

Counterparties may nevertheless begin collecting initial margin earlier if they choose to do so.

The proposed relief is optional

The draft wording allows counterparties to provide for the exemption in their risk-management procedures. It does not prevent them from continuing to collect and exchange initial margin voluntarily.

Counterparties that become eligible for the exemption may therefore decide:

• whether to apply the exemption;

• when to stop collecting initial margin;

• how and when existing collateral should be released; and

• whether some contractual or risk-management arrangements should remain in place.

The ESAs expressly recognise that the release of initial margin should be managed in accordance with the counterparties’ contractual arrangements and operational readiness.

Eligibility for relief should therefore not result in the immediate or uncontrolled release of collateral. Affected firms will need a coordinated process covering legal documentation, internal approvals, counterparty agreement, custodian instructions, reconciliations and operational controls.

What about single-stock and equity-index options?

EMIR 3 introduced Article 11(3a) into EMIR, exempting non-centrally cleared single-stock options and equity-index options from requirements concerning the timely, accurate and appropriately segregated exchange of collateral.

The draft RTS therefore propose deleting outdated transitional provisions in Delegated Regulation (EU) 2016/2251.

This is primarily a technical alignment of the Level 2 rules with the exemption already established under the Level 1 EMIR framework. These options would continue to remain exempt from the relevant margin requirements.

Practical implications for affected counterparties

The proposed change may reduce the cost and operational burden associated with maintaining initial margin arrangements for legacy portfolios. Potential benefits include:

• release of collateral held against existing contracts;

• reduced funding and liquidity costs;

• reduced initial margin calculation and reconciliation activity;

• simplification of custody and segregation arrangements;

• reduced operational complexity for legacy portfolios; and

• greater alignment with the approach applied in other jurisdictions.

However, firms should not consider the change purely as automatic regulatory relief. Several practical issues will need to be addressed before initial margin is released.

These include:

• confirming the accuracy and scope of the AANA calculation;

• determining whether the threshold is assessed at entity or group level;

• confirming the counterparty’s threshold status;

• reviewing contractual rights and obligations;

• agreeing the timing and mechanics of collateral release;

• assessing whether custody arrangements should be amended or terminated;

• updating risk-management procedures;

• obtaining appropriate internal approvals; and

• maintaining evidence supporting the decision to apply the exemption.

What should firms do now?

The amendments are not yet legally applicable. The Final Report and draft RTS have been submitted to the European Commission for endorsement. Following Commission adoption, the Regulation will be subject to scrutiny by the European Parliament and the Council. It will then be published in the Official Journal of the European Union and enter into force on the twentieth day following publication.

In preparation, potentially affected firms should:

1. identify counterparties and portfolios currently subject to initial margin;

2. validate their AANA calculation methodology and group perimeter;

3. estimate which relationships may fall below the €8 billion threshold;

4. quantify the collateral and liquidity impact of the proposed relief;

5. review credit support documentation and custodian arrangements;

6. establish governance for deciding whether the exemption will be applied;

7. define an orderly collateral-release process; and

8. monitor the endorsement and legislative scrutiny process.

Firms approaching or fluctuating around the threshold should pay particular attention to annual monitoring, documentation and operational readiness. They may move into or out of the initial margin regime depending on the relevant AANA calculation.

Early preparation will allow affected firms to benefit from the proposed simplification in a controlled manner while maintaining appropriate legal, operational and risk-management safeguards.