On August 16, 2016, the International Swaps and Derivatives Association, Inc. (ISDA) published the ISDA 2016 Variation Margin Protocol (VM Protocol). The VM Protocol will help market participants implement the new variation margin rules for non-cleared swaps that are set to come into force in the U.S., Canada and Japan. Through the use of exchanged questionnaires, the VM Protocol allows swap dealers and their counterparties to identify applicable regulatory regimes and make changes to existing collateral agreements to bring their variation margin arrangements into compliance.
Compliance dates and entities in scope
Under these rules, the requirement to exchange variation margin will be phased in over two dates. The first compliance date begins September 1, 2016, and covers swaps between swap dealers and “financial end users,” where the financial end user and its affiliates have in excess of $3 trillion in daily average aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, FX forwards and swaps for March, April and May of 2016. Financial end users include banks, savings and loans, insurance companies, broker-dealers, registered investment advisors and collective investment vehicles. The list encompasses a wide range of activities in the financial sector, so it is important that firms that are potentially in-scope understand whether they will get caught by the definition.
The second compliance date begins March 1, 2017, and covers swaps between swap dealers and all other financial end users. The VM Protocol targets this March 1, 2017, “big bang” implementation that will pick up the vast majority of financial end users in the U.S. While other jurisdictions, including Singapore, Hong Kong, Switzerland and the EU, recently announced a delay in the implementation of the margin requirements of those jurisdictions, there is no indication as yet that regulators in the U.S. will similarly delay current compliance dates.
Initial margin rules are subject to a separate phase-in timeline, ranging from September 1, 2016 for swap dealers and other large financial end users, to September 1, 2020 for the smallest financial end users.
What does the VM Protocol do?
- First, the VM Protocol enables parties to determine which regulatory regimes might be applicable to their swap trading relationship by eliciting the exchange of certain information. Currently, the VM Protocol allows parties to amend documentation to comply with margin requirements in the U.S., Canada and Japan. As a result of delays in implementation of final margin rules in the EU and Switzerland, the VM Protocol contains a placeholder mechanism that will allow the VM Protocol to expand to cover these regimes once the final rules and compliance dates are in place for these jurisdictions. The VM Protocol applies a “strictest of” procedure where a counterparty pair is subject to multiple regimes and the applicable rules under each regime are different. For example, if a swap dealer selects both U.S. and Canadian margin regimes as applicable to a particular swap trading relationship, then even if the swap dealer’s counterparty only selects U.S. rules as applicable, the VM Protocol will apply the stricter of the two regimes to the extent U.S. and Canadian regulations are different.
- Second, the VM Protocol facilitates the amendment of derivatives documentation to address the margin requirements. Counterparty pairs are able to amend or create documentation, and make related elections, for their non-cleared swaps that produce contractual results that comply with the margin requirements. F or instance, for counterparty pairs subject to the U.S. margin rules that have New York law-governed Credit Support Annexes (CSAs), the VM Protocol effectively permits the amendment of existing CSAs or the creation of new CSAs that align with the regulatory-compliant 2016 Credit Support Annex for Variation Margin (NY Law) that ISDA published on April 13, 2016.
Click here for a deeper dive on the impact of this new regulatory-compliant CSA on existing variation margin arrangements.
Importantly, parties may choose how to treat legacy transactions. New transactions can be bifurcated from legacy transactions, thereby creating separate netting sets for each group. As a result, new transactions will not be netted against legacy transactions automatically. This presents a significant change for market participants. Grandfathering of legacy transactions means that unless the parties voluntarily elect to bring pre-compliance date swaps into compliance anyway, multiple CSAs will exist under a single ISDA Master Agreement, at least until legacy transactions roll off. Collateral management systems will need to be modified to accommodate this split in netting sets and track multiple CSAs with different terms.