ISDA News and Documentation

On February 23, 2017, the European Supervisory Authorities (ESAs) announced that neither the ESAs nor competent authorities (CAs) would provide over-the-counter (OTC) derivatives dealers subject to European Market Infrastructure Regulation (EMIR) with relief from the March 1, 2017 deadline to implement variation margin (VM) requirements. However, due to difficulties faced by small counterparties, and for consistency with the guidance issued by the U.S. banking agencies, the ESAs expect CAs to generally apply a risk-based approach in their day-to-day enforcement of VM requirements after March 1.  CAs will require European dealers to take into account counterparty exposures and risk of default, document their steps taken toward full compliance and put in place alternative arrangements to contain risk, such as using existing Credit Support Annexes to exchange VM.  The ESAs and CAs make clear that their risk-based approach does not entail a general forbearance, but that CAs will make a case-by-case assessment on the degree of a dealer’s compliance and progress.  In any case, the ESAs and CAs expect EU derivatives dealers to finalize all necessary documentation before September 1, 2017 and that OTC transactions entered into on or after March 1, 2017 will remain subject to VM obligations for non-centrally cleared derivatives under the EMIR Regulatory Technical Standards.

The European regulators made their announcement on the same day as the Federal Reserve Board (FRB) and Office of the Comptroller of the Currency (OCC) issued guidance for U.S. swap dealer banks.  On February 23, 2017, the FRB and OCC required U.S. swap dealer banks to be in full compliance with their VM requirements by March 1, 2017 for counterparties with significant exposures.  But for swap counterparties without significant exposures, the FRB and OCC expect swap dealer banks to make good faith efforts to comply with the final rule by September 1, 2017.  The FRB and OCC didn’t provide any definitions for significant exposures.

With guidance from the ESAs, CAs, FRB and OCC, as well as the announcement by the Japanese Financial Services Agency that it will delay VM requirements for Japanese dealers applicable to cross-border trades with counterparties in jurisdictions where VM requirements have not yet been implemented, only the Canadian regulators have yet to announce transitional measures or no-action relief.  The U.S. Commodities Futures Trading Commission, plus regulators in Australia, Hong Kong and Singapore elected to provide no-action relief from VM requirements until September 1, 2017 for dealers under their jurisdiction.  Let’s hope global regulators can use the next six months to agree on a consistent framework for VM requirements.  Without such harmonization, global markets could further fragment and liquidity in key OTC derivative products, such as foreign exchange swaps and forwards, could be reduced.  Risk-based approaches are good, but harmonized regulation is better.

U.S. swap dealer banks received much needed breathing room, but not complete relief from the March 1, 2017 variation margin (VM) deadline for swaps and security-based swaps. On February 23, 2017, the Federal Reserve Board (FRB) and Office of the Comptroller of the Currency (OCC) recognized that, considering the scope and scale of documentation and operational changes necessary for swap dealer banks to achieve effective compliance for each of its non-cleared swap transactions, FRB and OCC examiners will focus on the bank’s good faith efforts to comply with the VM requirements, as soon as possible, but in no case later than September 1, 2017.

Significant Exposures

However, for swap counterparties that present significant exposures, the FRB and OCC expect swap dealer banks to be full compliance with the VM requirements by March 1, 2017. The FRB and OCC didn’t define what may constitute significant exposures.  For swap counterparties without significant exposures, the FRB and OCC expect swap dealer banks to make good faith efforts to comply with the final rule by September 1, 2017.  Swap dealer banks should prioritize compliance efforts based on the size of and risk inherent in the credit and market risk exposures presented by each counterparty.  Furthermore, banks must establish governance processes that assess and manage their current and potential future credit exposure to non-cleared swap counterparties, as well as any other market risk arising from such transactions.   The FRB and OCC indicated that their examiners will consider the bank’s implementation plan, including actions taken to update documentation, policies, procedures and processes, as well as its training program for staff on how to handle technical problems or other implementation challenges.

Impact on the Buy Side

The FRB and OCC announcement is important because the largest swap dealers are affiliated with U.S. banking institutions and most counterparties should not present significant exposures to banks affected by the guidance. While the FRB and OCC elected not to provide complete relief, the bank regulatory announcement is critical because the six-month VM rule grace period from the Commodity Futures Trading Commission only covered smaller non-bank and energy swap dealers.  Hopefully, European and Canadian regulators will follow their colleagues in the United States, Australia, Singapore and Hong Kong in postponing their VM deadlines to September 1, 2017.  Without global coordination of VM rules and deadlines, market participants could suffer from decreased liquidity and market fragmentation.  To prevent such trading disruptions, financial end users and other buy-side counterparties must continue to work diligently to establish VM compliant documentation with their dealers as soon as possible.

On February 13, 2017, the U.S. Commodity Futures Trading Commission (CFTC) issued time-limited no-action relief providing a six-month grace period for certain swap dealers to come into compliance with the variation margin rules that are set to come into force March 1, 2017.  As CFTC Acting Chairman Giancarlo noted, as much as 90 percent of financial end-users in-scope under the rules are not ready to meet the new requirements.

Global systemic risk is not reduced by the abrupt cessation of risk hedging activity by American life insurance companies and retirement funds at a time of enormous changes in financial rates and global asset values. This action by the CFTC does not change the scheduled time of arrival for the agreed margin implementation. It just foams the runway to ensure a safe landing.”  – CFTC Acting Chairman Giancarlo

The CFTC’s relief will primarily benefit smaller swap dealers and energy companies registered as swap dealers.  While the relief contains certain conditions, these are not generally onerous. The relief is similar to that provided by regulators in Australia, Singapore and Hong Kong.

However, U.S. prudential regulators and European regulators have yet to issue similar relief.  Given that many of the largest swap dealers are subject to rules issued by the U.S. banking agencies, the Federal Reserve Board, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency, the relief issued by the CFTC will do little to prevent last-minute trading disruptions or market fragmentation if the U.S. banking regulators do not follow suit.  Further, European dealers are subject to variation margin rules promulgated by European regulators under EMIR.  European regulators have yet to issue any final relief, although they have made noises indicating that such relief is being considered.  In short, the CFTC’s relief will have limited benefit to impacted market participants if these other regulators do not follow suit before March 1.

Derivatives traders and lawyers are focused on March 1. Not for any basketball tournaments, but for the variation margin (VM) big bang.  From March 1, 2017, swap dealers and financial end-users will be required to exchange VM on uncleared swaps.  To comply with the applicable VM rules, swaps dealers and financial end users will need to amend their derivatives documentation, including credit support annexes (CSAs).  ISDA created the 2016 VM Protocol (the VM Protocol) to provide a documentation solution that complies with the U.S. banking prudential regulator and Commodity Futures Trading Commission (CFTC) VM rules, as well as similar rules in Canada, Japan and under European Market Infrastructure Regulation (EMIR).  In addition to selecting the relevant jurisdictions required for compliance, counterparties can elect to:

  1. Amend existing master agreements to add new CSAs for VM on terms determined by the VM Protocol.
  2. Amend existing master agreements and CSAs to cover new transactions (but not trades entered into before March 1, 2017) by creating a replica of their existing CSA and then amending it to comply with the jurisdictions selected.
  3. Amend existing CSAs in order to comply with the jurisdictions selected (which would cover all transactions under the master agreements).
  4. Create new ISDA 2002 Master Agreements (using agreed-upon boilerplate terms) with new compliant CSAs.

While the VM Protocol is quite flexible and can satisfy applicable VM requirements in the US, Canada, Europe and Japan, many market participants have elected to not use the VM Protocol. Rather, many participants have decided to negotiate new or amended CSAs on a bilateral basis. Considering that it often takes months to negotiate a single CSA, and that thousands of counterparties will be required to exchange VM on March 1, derivatives lawyers for swap dealers and investment managers are working diligently to finish the new documentation in time.

But, What If…?

If a substantial number of counterparties have not executed bilateral compliant CSAs or adhered to the VM Protocol by March 1, they will not be able to trade uncleared swaps. This could disrupt global swap markets by reducing liquidity and increasing risk by preventing market participants from hedging existing positions.  The easiest solution would be for the CFTC and other global regulators to postpone the March 1 deadline.  Hong Kong and Singapore have already announced a six month phase-in period for counterparties to continue to negotiate compliant documentation.  Australia has also postponed the deadline to September 1, so long as all transactions executed from March 1 are subject to VM requirements by September 1.  Unfortunately, the European Commission may be unwilling or unable to push back the March 1 effective date for the EMIR VM standards.  This could put acting CFTC Chairman Christopher Giancarlo in a difficult position. Chairman Giancarlo has emphasized the importance of harmonizing global derivatives regulation, particularly to prevent market fragmentation.

I am especially concerned that smaller firms, including American pension and retirement funds, may not be able to get their documentation done in time. If they do not, they will be abruptly forced to stop hedging their portfolios at a time of enormous changes in financial rates and global asset values.” – Acting CFTC Chairman Christopher Giancarlo


The CFTC could decide not to provide relief in order to maintain consistency with the EMIR VM standards.  The CFTC elect to provide short-term transitional period of relief, much as it did on September 1, 2016 for large swap dealers to complete the custodial arrangements needed to comply with the initial margin requirements applicable to dealers (the 2016 Relief).  However, the 2016 Relief was implemented at the last minute and offered only a 30-day period for a small number of dealers to complete less complex documentation.  Given that the VM rules have a global impact and the upcoming March 1 deadline will affect a much larger set of counterparty relationships, the most practical way forward would be for the CFTC to work with European and Asian regulators to push-back the March 1 deadline to September 1, 2017, or implement a six-month phase-in period.  Hopefully, with the post-election changes at the CFTC, U.S. regulators will have more flexibility to harmonize derivatives regulation than they did under the prior administration.  Let’s hope that U.S. and global regulators can agree on a consistent approach.  Otherwise, the March 1, 2017 VM big bang will cause March madness.

On September 1, 2016, the largest derivatives dealers started complying with initial margin and variation margin requirements for non-cleared swaps, which came into force in the U.S., Japan and Canada. Similar rules have been delayed in the E.U., Australia, Hong Kong, and Singapore, creating the potential for market fragmentation and complexity (especially for entities that trade on a cross-border basis).

Stock market graph and bar chart price displayGenerally the September 1 rollout date came and went with little fanfare, although it appears that some dealers were unable to set up third party custodial accounts in order to comply with the requirement to segregate initial margin amounts. By the end of the day the CFTC had issued a 30-day time limited, no-action letter in order to provide conditional relief to dealers that were unable to set up segregated custody accounts. CFTC Chairman Massad issued a related statement, acknowledging that “CFTC staff has been made aware that some dealers have not been able to complete all documentation required to comply with the custodial arrangements required by CFTC rules, due to the limited number of providers of such services and the volume of custodial agreements that market participants are requesting.”

One takeaway from this first compliance date for financial end users or smaller banks that may get caught in future IM phases is that segregated IM arrangements can take time to implement. As anyone who has had the pleasure (or pain) of negotiating a custody agreement knows, there are a limited number of large custodians in the market. Negotiating changes to a custodian’s standard terms can also be a time-consuming process. As we noted in November of 2015 , a primary action item for financial end users that must comply with the IM requirements (i.e. they have material swaps exposure), is to implement and test segregated IM lines. As regulatory margin requirements are phased in, the IM rollout dates will act as pressure points on custodial capacity – which may limit the opportunity to negotiate custody agreements and test the facilities if they are implemented at the eleventh hour.

It's all in the formula...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.

Many swaps markets participants that actively trade large swap notionals are aware that the CFTC and U.S. banking regulators are set to begin phasing in requirements to exchange margin on non-cleared swaps, starting September 1, 2016. As a result of these new margin rules, ISDA published on April 13, 2016, a new variation margin rule-compliant Credit Support Annex (CSA). Understanding key differences between this new regulatory-compliant CSA and any existing CSAs that you have in place will be an important action item for any financial market participants caught by the rule.

In particular, swaps market participants should pay careful attention to the following areas that are most impacted by the new variation margin CSA.

  • Transaction scope and netting across multiple transactions
  • Scope of margining
  • Minimum transfer amounts
  • Eligible collateral
  • Valuation of collateral and haircuts
  • Transfer timing
  • Treatment of negative interest
  • Offset of credit support due under other CSAs
  • Dispute resolution timing

Please click here for a detailed elaboration of these issues and how the new variation margin CSA differs from many existing CSAs.

The new CSA has broad implications for the derivatives market and the margin relationship for non-cleared swaps. Swap market participants will need to consider potential changes in operational practices to facilitate compliance with the new CSA, which are a response to the CFTC and banking regulators’ rulemaking requiring the exchange of margin, as mandated by Dodd-Frank.