It is worth taking a step back as we reach this milestone. This is the final phase in the clearing & margin story that started in the aftermath of the 2008 financial crisis with the G20’s goal of bringing greater stability to the derivatives market. Who remembers “Cat 1 Counterparties” under Dodd Frank Mandatory Clearing back on 11 Mar 2013?

Since those heady days there has been a huge shift in the market – the vast majority of derivatives traded are now cleared, and of those that remain bilateral, almost all post-variation margin and now almost all are subject to initial margin rules. IM Phase 6 is the last step (well, maybe not quite the last – see below) in a regulatory change programme which has been running now for some 11 years!

But enough dwelling on the past. As far as Phase 6 goes, the main points are:

• Ready or not? per our last article and summer wrap up, there has been a scramble to get IM docs and custodian accounts in place by 1 Sep to exchange IM – and many will have missed the deadline. For those that didn’t make it, Threshold Monitoring is the ‘fallback’. Though watch out as there will likely be some operational disruption as levels are checked to ensure counterparties do not breach internally set thresholds as new trades are put on. And if thresholds are breached, then there will be no trading.
• The tail: expect the legal negotiations for IM repapering to continue on until at least the end of the year, as people play catch-up, and try to get their trading documentation amended and operational processes set-up, such that they are no longer reliant on Threshold Monitoring (or more to the point, run the risk of breaching limits). 
• The future: and we’re afraid it is not over then. IM will be the gift that keeps on giving, as counterparties come in and out of scope of the published levels in the annual reviews in years to come. And to make things a little more fun, the measurement periods and compliance dates are not aligned globally (see table below).

So AANA, the Average Aggregate Notional Amount, gets calculated annually, across a designated 3-month period. Then if you exceed the amount specified you are in scope from the next compliance date. 

But here’s a catch...the observation periods are not the same everywhere (they are not even the same within the US between the Fed and CFTC²). And neither are the subsequent compliance dates. And actually neither are the currencies. Add to that you might drop out of scope as well as into scope, and it is going to make for a rather confusing framework.

In the table below we list the original phases and compliance dates for the main jurisdictions, then the annual cycle that will start post-Phase 6. For a more complete list see ISDA³ calendar on the AANA page of their Margin InfoHub. 

You only have to actually exchange Initial Margin if you exceed the €50m/$50m collateral threshold, assuming both parties are above their AANA thresholds. But it is possible to imagine a situation in the future where a counterparty drops back below the €8bn/$8bn AANA for Mar-Apr-May 2023 say, but still has a collateral amount in excess of €50m/$50m facing certain counterparties. 

In that case they may well wish to stop posting margin (to save margin costs), however, to do so they will have to revoke the margin agreements and custodian arrangements they have put in place. Equally mergers, demergers or changing jurisdictional rules (see note on China below) may change the picture.

It is also not entirely clear how previous postings for in-scope products may be treated when entities drop out of scope. In the US previous postings can be returned, though under EU & UK rules it is not so clear. 

Note that when exchanging IM, there may be increased xVA⁴ implications as Margin Valuation Adjustments (MVA) are now relevant as part of pricing for any trades/packages that are not cleared. Whilst this is already well understood for larger counterparties caught in earlier phases, it will be new to counterparties which have more recently come into scope.

If counterparties start to see an increase in total costs to trade bilaterally with banks given potential additional capital charges, perhaps this will be a driver for institutions that are currently exempt from central clearing (or institutions transacting exempt asset classes) to consider moving away from transacting bilaterally. For example the posting of initial margin will mean more capital will be locked-up and collateral sufficiency for affected pension schemes will be reduced. As discussed in this piece from our Pensions team, now more than ever, pension schemes must make sure they have a well-defined and well-understood collateral risk management plan.

On 1 August ISDA published a new legal opinion that recognises the enforceability of close-out netting under Chinese law. They have not yet published their collateral opinion, but it is expected soon. In the fullness of time this may result in counterparties revising their treatment of margin requirements with entities based in this jurisdiction. EMIR⁵ (both EU and UK) allows for the ‘2.5% Exemption’ currently for non-netting jurisdictions – i.e. EMIR permits EU/UK counterparties to exempt entities in non-netting jurisdictions from margin requirements (both VM⁶ and IM) under certain conditions.

If you are uncertain on the requirements here and whether it impacts you, please get in touch through your usual contacts. And if you have specific questions around the legal or operational set-up for Phase 6, email our team.

1 - AANA: Average Aggregate Notional Amount

2 - CFTC: Commodity Futures Trading Commission

3 - ISDA: International Swaps and Derivatives Association Inc

4 - xVA: X-Value Adjustment

5 - EMIR: European Market Infrastructure Regulation

6 - VM: Variation Margin