During the 5th session of the 13th National People’s Congress (“NPC”) held on 8 March 2022, the Chairman of the Standing Committee of the NPC (“NPCSC”) announced that the PRC Futures and Derivatives Law (“FDL”), among other legislation, has been included in its 2022 annual legislative plan. The market anticipates and welcomes the passing of the FDL within this year.
As summarised in our article “To the Future and Beyond – Thoughts on the PRC Futures and Derivatives Law (Second Reading)”, it is highly likely that the FDL (once finalised and effective) will confirm, for the first time, legislative recognition of the “Single Agreement” and “Close-out Netting” concepts contained in international and PRC domestic OTC derivatives documentation. This will provide a robust legal framework for the PRC to be regarded by foreign counterparties as a “clean” netting jurisdiction.
We will now briefly consider the impact of regulatory margin rules on OTC derivatives transactions with PRC counterparties. Currently, we understand that a number of international firms may be relying on certain exemptions (for example, Article 31(1) of the Regulatory Technical Standards for risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty under EMIR) from posting and collecting margin when trading with PRC-based counterparties, or they may be collecting margin collateral from PRC-based counterparties on a gross basis.
When the PRC becomes a clean netting jurisdiction, the above exemption from regulatory margin requirements may well become inapplicable. Unlike close-out netting issues, regulatory margin requirements may be less familiar to PRC counterparties for the following reasons:
(a) the PRC has not issued or implemented any mandatory margin rules that align with the BCBS-IOSCO’s Margin Requirements for Non-centrally Cleared Derivatives;
(b) the international margin requirements and documentation are highly technical and complex and some PRC counterparties may be unfamiliar with the relevant legal and technical concepts;
(c) international firms have been reluctant to accept onshore collateral to satisfy margin requirements and PRC counterparties do not hold that many offshore eligible assets, and may in any event be reluctant to post offshore collateral.
As a result of these foregoing factors, some PRC counterparties may need time to familiarize themselves with regulatory margin requirements. With the anticipated passing of the PRC Futures and Derivatives Law in 2022, now is the time for international firms to actively focus on regulatory margin requirements for OTC derivatives with PRC counterparties and related legal documentation issues. It is also the time for PRC counterparties to get prepared because if they do not, international firms will have to quit trading non-centrally cleared OTC derivatives with them (or still charge higher margin on a gross basis).
Based on KWM’s extensive experience in advising major international and Chinese financial institutions and corporates on these issues, below are our answers to some frequently asked questions on this important topic.
1. What are regulatory margin requirements?
After the global financial crisis in 2008, the G20 leaders committed to develop and implement series of regulatory requirements (including margin requirements) in their respective jurisdictions to reduce systemic risk and create a level playing field across the globe.
Under regulatory margin rules, counterparties to OTC derivatives are required to post and collect margin (also referred to as collateral) to and from each other. This is designed to reduce counterparty credit risk because the collateral (usually in the form of high quality liquid assets (“HQLA”, including cash or highly liquid debt securities) is available to offset losses following the default of a derivatives counterparty.
Fast toward to today, most major jurisdictions have adopted and implemented regulatory margin requirements. While there are important differences in the detailed rules in each jurisdiction, the broad requirements are similar because they are largely based on the global regulatory margin standards established jointly by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (“Global Margin Standards”).
Like most financial regulations, the Global Margin Standards and the local regulatory margin rules implemented in each jurisdiction (“Local Margin Rules”) are highly complicated and full of technical jargon. In this article, we will try to explain some of the key concepts and related legal documentation issues in plain language.
2. What is initial margin (“IM”) and variation margin (“VM”) and what is the difference between the two?
Regulatory margin requirements distinguish between IM and VM.
Variation margin (“VM”) is collateral that protects derivatives counterparties from the current exposure that one counterparty has to the other. The amount of VM reflects the size of the current exposure, which can change regularly due to market movements. Therefore, VM is generally required to be exchanged daily to track changes in the mark-to-market value of derivatives and to fully collateralise the mark-to-market exposure.
Initial margin (“IM”) is collateral that protects derivatives counterparties from the potential future exposure that can arise from future changes in the mark-to-market value of the derivatives during the time it takes to close out and replace the derivatives following a counterparty default. The amount of IM reflects the size of the potential future exposure.
3. Who is subject to regulatory margin requirements?
Generally speaking, regulated financial institutions are directly subject to Local Margin Rules issued by the relevant financial regulator(s). These rules generally require a regulated financial institution to both post and collect VM and IM to and from certain types of counterparties. In this article, we shall refer to the posting and collecting of margin between two counterparties as “exchanging” margin.
To comply with the regulatory requirement to exchange margin, a regulated financial institution will negotiate and enter into margin documents with each of its counterparties, which will impose contractual obligations on each side to exchange margin. Therefore, even if a counterparty to a regulated financial institution is not directly subject to regulatory margin rules (e.g., because it is not financially regulated), the counterparty becomes indirectly and contractually subject to margin requirements by virtue of entering into margin documents with a regulated financial institution. Many PRC counterparties will likely be in this situation in the absence of any PRC regulatory margin rules.
Financial and non-financial counterparties: It is important to note that a regulated financial institution is not required to exchange margin with all types of counterparties. Generally speaking, a regulated financial institution is only required to exchange margin with “financial counterparties” or certain “systemically important non-financial counterparties”. The Local Margin Rules in each jurisdiction contain detailed definitions of these key terms, which are all slightly different from each other.
It is important to note that the definition of financial counterparty can be quite broad under certain Local Margin Rules and can capture any domestic or foreign entity that mainly engages in one or more financial activities (such as banking, lending, insurance, securities, derivatives or asset management activities) – even if that entity is not regulated. Therefore, it is crucial for an entity (including a PRC counterparty) to make accurate communications about its status and catagorisation under the applicable Local Margin Rules. Otherwise, its regulated financial institution counterparty may be exposed to regulatory risks as a result of relying on inaccurate communications, which may in turn expose the entity in question to potential risks and liabilities.
A regulated financial institution is generally not required to exchange margin with a counterparty which is a sovereign, central bank, public sector entity or multilateral development bank. Again, these key terms are defined somewhat differently in each jurisdiction’s Local Margin Rules.
4. What kind of derivatives are subject to regulatory margin requirements?
Regulatory margin requirements generally apply to all non-centrally cleared derivatives. For cleared derivatives, the central counterparty or clearinghouse will impose its own margin requirements.
Regulatory margin requirements generally do not apply to transactions such as repos and securities lending transactions that are not themselves derivatives but share some common features with derivatives.
In addition, the Local Margin Rules in many jurisdictions exclude physically settled FX forwards and FX swaps as well as certain other categories of OTC derivatives from the scope of regulatory margin requirements.
5. What legal documents are needed to comply with regulatory margin requirements?
To comply with regulatory margin requirements, regulated financial institutions need to enter into a large number of new legal documents with their counterparties. These legal documents impose, among other things, detailed VM and IM calculation and exchange obligations on both parties.
The International Swaps and Derivatives Association (“ISDA”) has developed industry standard margin documents that are designed to comply with applicable Local Margin Rules. Since VM and IM are calculated differently and are required to be held in different ways, there are separate sets of legal documents for VM and IM.
Despite the development and widespread use of standard margin documents, these legal documents are highly complicated and heavily negotiated, because each document allows the parties to make a large number of elections and further amendments to tailor for their specific commercial and regulatory circumstances.
The process of negotiating margin documents is comparable to negotiating an ISDA schedule or the elections and variables paragraph of a Credit Support Annex (“CSA”). However, the process can be much more complicated because, as explained below, multiple margin documents are required to comply with the VM and IM requirements. Accordingly, many financial institutions and their counterparties engage external law firms to assist with margin documentation, negotiation and related legal and compliance issues.
Overview of standard VM documents: To help parties comply with VM requirements, ISDA has published, among other things, the English law governed ISDA 2016 Credit Support Annex for Variation Margin (“VM CSA”). The VM CSA is based on the ISDA 1995 English law CSA and is an annex to the ISDA Schedule. Like the 1995 CSA, the VM CSA involves the outright transfer of legal and beneficial title in the collateral from the transferor to the transferee, while the transferee has a contractual obligation to deliver equivalent credit support to the transferor in certain circumstances. The elections and variables paragraph of the VM CSA allows parties to specify eligible collateral types (subject to regulatory restrictions) and make other elections or amendments to meet applicable commercial and regulatory requirements.
Overview of standard IM documents: The Local Margin Rules in most jurisdictions generally require IM to be held in a segregated account and not to be rehypothecated, repledged or reused (“Segregation Requirement”). Specifically, IM should be held in an account with an independent third-party custodian which is segregated from the proprietary assets of the collateral taker and custodian, and adequately protected from insolvency of the collateral provider, collateral taker and custodian. The Segregation Requirement which applies to IM (but not VM) means that IM arrangements are documented separately from VM arrangements.
To help parties comply with IM requirements, ISDA has developed a wide range of standard IM documents designed to work with different types of custodians and governing laws. For example, ISDA has developed IM documents for circumstances where the custodian is a bank and where the custodian is an international central securities depository (“ICSD”) such as Euroclear or Clearstream.
As far as the English law documents are concerned, ISDA’s ‘flagship’ IM document is the 2018 Credit Support Deed (“CSD”) for Initial Margin (“IM CSD”). The IM CSD is based on the ISDA 1995 English law CSD and is therefore a separate security document executed as a deed and not forming part of the ISDA Master Agreement. Instead of relying on title transfer, the IM CSD involves creating a security interest over the segregated account and the collateral held in it. Significantly, pursuant to regulatory margin requirements, IM must generally be transferred on a two-way gross basis, which means that each counterparty must transfer collateral to the other counterparty’s segregated account and these two separate transfer obligations cannot be netted or set off against each other. The elections and variables paragraph of the IM CSD allows parties to make various elections and amendments to meet applicable commercial and regulatory requirements.
Bank custodian IM documents: Besides the IM CSD, ISDA has published the Bank Custodian Collateral Transfer Agreement for IM (“Bank Custodian CTA”) and separate corresponding Bank Custodian Security Agreements (each a “Bank Custodian SA”) governed by the laws of different jurisdictions. In essence, the Bank Custodian CTA and Bank Custodian SA represent the two halves of the IM CSD: (1) the Bank Custodian CTA governs the mechanical and operational aspects of the margin exchange process and is subject to the same governing law as the relevant ISDA Master Agreement; and (2) the Bank Custodian SA relates to the creation and enforcement of the security interest and is governed by the law where the segregated account is located.
In addition to the Bank Custodian CTA and SA, the collateral provider, collateral taker and bank custodian will also need to enter into an account control agreement (“ACA”). The ACA governs, among other things, the circumstances and manner in which the collateral provider or collateral taker can exercise exclusive control over the segregated account and instruct the custodian to transfer collateral out of the account. Major custodians have published standard form ACAs, which are subject to certain elections that the parties can make to reflect their commercial and regulatory needs. Also, the collateral provider will enter into a custody agreement governing the terms of the custody account it has with the bank custodian. To comply with regulatory margin requirements, IM will be transferred from the collateral provider’s custody account into the segregated account.
Euroclear and Clearstream IM documents: Where the custodian is not a bank but Euroclear or Clearstream, the parties would enter into (1) the ISDA Euroclear CTA and SA or (2) the ISDA Clearstream CTA and SA, as the case may be. The credit support document is split into a CTA and SA for similar reasons as in the bank custodian context. The Euroclear and Clearstream IM documents are designed to specifically work with the Euroclear and Clearstream membership documents, respectively. Therefore, the elections and variations provisions in the Euroclear and Clearstream IM documents are somewhat different to those found in the bank custodian IM documents. In addition, Euroclear or Clearstream (as the case may be) may also enter into a Collateral Management Services Agreement with parties. We can revisit the Euroclear and Clearstream IM documents in details in the following series.
6. Where can I learn more about regulatory margin requirements and legal documentation issues?
We at KWM are here to help you. KWM regularly assists international and PRC-based financial institutions and corporates with ISDA/NAMFII, CSA, VM and IM margin document negotiations, as well as with designing and documenting innovative and complex cross-border derivatives products. We also regularly advise international and PRC-based clients on margin and other regulatory requirements that apply to derivatives transactions.
KWM is ISDA’s legal counsel in the PRC and has been actively participating in legal developments relating to the enforceability of close-out netting, collateral segregation and title transfer arrangements in the PRC. We are familiar with the unique issues faced by PRC-based financial institutions and their counterparties and would be pleased to share our insights with you. Please feel free to contact our core team members below.
Important Note: “margin” and “collateral” used in this Article are not equal to security interest over cash margin, moveable assets or rights under PRC law.
Thanks to Dolores Xie for her contribution to this article.
