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 Wednesday 21 July 2021

Threshold Monitoring

In just over one month’s time regulatory initial margin (“IM”) requirements for uncleared derivatives will apply to Phase 5 entities.  Some entities are considering using a threshold monitoring approach rather than putting in place full IM documentation and custodial arrangements.

Background

From 1 September 2021, in-scope entities within a group whose aggregate average notional amount (“AANA”) is above EUR 50 billion (“Phase 5”) will be caught by regulatory initial margin requirements when facing in-scope entities within another group whose AANA is also above EUR 50 billion.

The AANA values above relate to EU EMIR Margin Rules and UK onshored EMIR Margin Rules. Similar requirements apply with respect to other uncleared margin rules (e.g. for US margin rules the equivalent AANA level is USD 50 billion).

Please note that Phase 5 parties will not only have to put in place IM arrangements with other Phase 5 entities but also with any counterparties with whom they have in-scope uncleared OTC derivative transactions in Phases 1-4. 

Following a one year extension (as a result of Covid), in-scope entities are now working tirelessly to have IM requirements in place to allow trading of in-scope IM products to continue from 1 September 2021.

In March 2015, the Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) published the Margin requirements for non-centrally cleared derivatives “final” policy framework.  Note: BCBS/IOSCO published updates to the policy framework in July 2019 and April 2020.

Regulators in various jurisdictions have since set about creating their own rules based on these global recommendations especially in the USA, European Union, UK, Canada, Switzerland, Japan, Australia, Hong Kong and Singapore.

In March 2019, BCBS/IOSCO issued a press release stating:

The Basel Committee and IOSCO note that the framework does not specify documentation, custodial or operational requirements if the bilateral initial margin amount does not exceed the framework's €50 million initial margin threshold. It is expected, however, that covered entities will act diligently when their exposures approach the threshold to ensure that the relevant arrangements needed are in place if the threshold is exceeded.

Many regulators have issued statements in line with this BCBS/IOSCO press release.

What is Threshold Monitoring?

Regulation allows for a threshold of EUR 50 million to apply across in-scope entities within a group before they are required to exchange IM when facing in-scope entities within another group.

Many entities have been assessing trading relationships with their counterparties to determine if they expect to reach the IM threshold either in the mid to long term or not at all.

This may be of particular interest to entities that are in-scope for Phase 5 due to their AANA calculation but do not trade in-scope IM products with their counterparties.  The AANA calculation includes physically-settled FX forwards and swaps but these products are not in-scope for IM.

Parties are required to “act diligently” to ensure they put in place full IM documentation and custodian arrangements by the time that the threshold is reached.  Monitoring the IM threshold usage is a mechanism to ensure this is done. 

Often the parties will agree a sub-threshold lower than the regulatory threshold.  If this sub-threshold is reached then the parties will start negotiation to put in place full IM documentation and custodial arrangements with a view to completing this process before the regulatory threshold is actually reached.

The population of Phase 5 groups is larger than the Phase 1-4 groups combined.  In addition, while Phases 1-4 typically covered banks and insurance companies, Phase 5 also includes more diverse entity types including pension funds, hedge funds and asset managers.

For some trading relationships, a threshold monitoring approach could be an appropriate solution (either in the short to medium term or permanently) to ensure that trading can continue before regulatory thresholds are reached.

Posted by Abigail Harding

Category: ISDA negotiation

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