This article was written by Scott Farrell, Max Allan and Roslyn Hinchliffe.
The Australian Prudential Regulation Authority (APRA) has released the final rules which will impose margin and risk mitigation requirements on participants in Australian risk management markets. This is one of the final steps in the Australian regulatory journey in complying with the G20’s post-crisis reform agenda. Although the new rules give market participants a clearer picture of the derivatives counterparties with whom they will be required to exchange initial and variation margin, market participants will be left searching for the implementation date and phase-in timetable. However, the effort needed to comply is significant and it is now the time to engage with the potential for margining obligations to apply. In this Alert, we summarise who is caught, and what has changed since the last draft of the rules was seen.
The margin and risk mitigation requirements are to be imposed through Prudential Standard CPS 226 Margining and risk mitigation for non-centrally cleared derivatives (CPS 226). The prudential standard, and the supporting response to submissions, can be found here. There have been some significant changes between the consultation draft and the final rules, including as to who the rules apply to.
The finalisation of the Australian margin requirements follows the legislative reforms introduced to facilitate Australian entities complying with the Australian and the other global derivatives margin requirements. Our alerts which describe some of the reforms and the new laws themselves can be found here and here.
Do the rules apply to me?
It is important to understand that derivative counterparties can be caught by the rules either directly or indirectly. The universe of APRA-regulated entities (other than private health insurers) are directly caught by the rules if the relevant thresholds (described later) are met. These covered entities are all:
- authorised deposit-taking institutions (ADIs) (including foreign ADIs) and non-operating holding companies authorised under the Banking Act;
- general insurers, including Category C insurers, non-operating holding companies authorised under the Insurance Act and parent entities of Level 2 insurance groups;
- life companies, including friendly societies and eligible foreign life insurance companies (EFLICs), and non-operating holding companies registered under the Life Insurance Act; and
- registrable superannuation entities (RSE) licensees
A covered entity will be required to post and collect variation margin and initial margin when it trades with covered counterparties. This means that the margin rules apply indirectly to the counterparties that these covered entities have to exchange margin with. This is because a covered counterparty dealing with a covered entity needs to comply because otherwise the covered entity can’t trade with it.
A covered counterparty is a financial institution. Financial institutions are inclusively defined to include 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, but not where the portfolio manager is acting as agent); 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. Authorised NOHCs, registered life NOHCs, any overseas equivalents, hedge funds, trading firms, and foreign deposit-taking institutions are considered to be financial institutions. However, the following financial institutions are excluded from being covered counterparties:
- sovereigns, central banks, multilateral development banks, public sector entities and the Bank for International Settlements; or
- any of the following which enter into derivative transactions for the sole purpose of hedging:
- covered bond special purpose vehicles;
- securitisation special purpose vehicles in traditional securitisations; or
- special purpose vehicles or collective investment vehicles established for the sole purpose of acquiring and holding or investing in real estate or infrastructure assets. This exclusion is an important change from the consultation draft.
However, not all transactions between all covered entities and covered counterparties are caught. There is a threshold which must be met first. For example, APRA has maintained the AUD 3 billion threshold for the application of variation margin requirements to an APRA covered entity (based on the entity’s group’s aggregate month-end average notional amount of non-centrally cleared derivative transactions). This means that unless the covered entity AND the covered counterparty both satisfy this threshold, the transactions between them will not be caught by the margin requirements.
By when do I need to care?
We don’t know when these requirements will start to apply. APRA has announced that it will advise the market of the implementation date and phase-in timetable in due course.
In this regard, APRA has stated that it continues to support internationally harmonised implementation of the requirements and is monitoring the progress of implementation in other jurisdictions. If implementation is to be in line with the internationally agreed timeframe, March 2017 could still be a critical date.
Market participants should not be too quick to draw comfort from the uncertainty of the Australian implementation due to the close proximity of some of the international timetables. They are likely to need to quickly progress the significant amount of work that compliance will entail.
Only marginally different to the consultation draft? Think again
There are some significant changes from the consultation draft released in February. Many of these changes will be well-received by the Australian derivatives industry. For those who are already focussing on the details, here are just a few things to think about when taking a look at the final rules and comparing them to the consultation draft:
- exclusion of FX trades from IM and VM - physically settled foreign exchange (FX) forwards and swaps, and the fixed physically settled FX transactions associated with the exchange of principal in cross-currency swaps, have been excluded from the requirement to exchange variation margin (as well as initial margin, as was the case in the consultation draft)
- exclusion of real estate or infrastructure vehicles and non-financial institutions - real estate and infrastructure special purpose vehicles and collective investment vehicles are excluded from the scope of the rules if they enter into derivatives for the sole purpose of hedging. Similarly, non-financial institutions are no longer included as covered counterparties
- self-disclosure as due diligence - self-declaration or public disclosure from a counterparty is an acceptable way to verify that the counterparty is a covered counterparty exceeding qualifying levels. Where a covered entity is of a preliminary view that a counterparty is not a covered counterparty or doesn’t exceed qualifying levels, the covered entity must undertake a reasonable level of due diligence to ensure that there is no reason to believe otherwise
- Australian booked transactions only for foreign regulated entities – for foreign ADIs, Category C insurers and EFLICs, the rules only apply to transactions booked in accounts of the Australian branch of that entity
- clarity on cross-border application – the final rules provide greater detail on the cross-border application of the rules
- exclusion of level 2 group members which are not covered counterparties - a member of a Level 2 group is now only going to be subject to the rules if the member is a covered counterparty (ie a financial institution not otherwise excluded from the scope of the rules)
Also, the focus of the risk mitigation requirements has been shifted to mandate the establishment and implementation of appropriate policies and procedures for determining appropriate risk mitigation rules for all its non-centrally cleared derivatives transactions.
It is now too late to say it’s too early
The excuses to avoid implementing the systems required to comply with margining are evaporating. The margin requirements will necessitate significant changes to credit support documents and the commercial, operational, legal and compliance processes which support collateralisation. APRA itself has emphasised that institutions should continue to actively prepare for the implementation of requirements.
We expect that participants in the Australian market will be keenly looking for the announcement by APRA of the implementation date and phase-in timetable. However, the finalisation of the Australian rules mean that market participants need to consider the impact on their business of the implementation of margining and risk mitigation requirements and prepare for a significant documentation exercise in order to comply with the impending requirements.
Put simply, it is a relief to get the final rules, but now the real work starts. And we don’t know when it is due.