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Discussion Paper on Margin Requirements for non-Centrally Cleared Derivatives

News and Press Release - Dated:- 3-5-2016 - Derivatives are an integral risk management tool for most of the business entities and financial institutions. Most of the bigger and mid-size companies in India use derivatives to manage foreign currency, interest rate and commodity price risks. Derivatives foster financial innovation and contribute to the completeness of financial markets. However, if not regulated and supervised appropriately, derivatives markets can also be a source of systemic ris .....

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es markets are contained. Following were the major reform measures taken in this regard: All standardised OTC derivatives should be traded on exchanges or electronic platforms, where appropriate; All standardised OTC derivatives should be cleared through central counterparties (CCPs); Non-centrally cleared derivatives should be subjected to higher capital requirements and also these derivatives should attract margin requirements. 2. RBI has taken a number of initiatives to implement these global .....

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on-centrally cleared OTC derivative is not widely prevalent. 3. Basel Committee on Banking Supervision (BCBS) along with International Organisation of Securities Commissions (IOSCO), in March 2015, finalised policy framework which establishes minimum standards for margin requirements for non-centrally cleared derivatives. This policy framework is contained in the document titled Margin Requirements for Non-centrally Cleared Derivatives. These requirements will be implemented in a phased manner o .....

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with above mentioned BCBS-IOSCO standards. 5. RBI invites feedback/comments on the policy proposals contained in this document, especially on the specific questions raised in the document. Feedback/Comments may be submitted to the following address by June 3, 2016 (electronic submission is encouraged): The Principal Chief General Manager Department of Banking Regulation Reserve Bank of India, Central Office Mumbai 400 001. Please click here to send email. Introduction 1. Counterparty credit ris .....

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t present, centrally cleared derivatives attract significantly lower capital charge; however, they are subjected to margin requirements by CCPs. Introduction of margin requirements for non-centrally cleared derivatives will help in removing this disparity between these two segments of derivatives markets and would promote central clearing of derivatives markets. 3. At present, the practice of exchange of variation and initial margins for non-centrally cleared derivatives is not widely prevalent .....

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tion is a scheduled bank, or other agency falling under the regulatory purview of the RBI. However, only variation margin requirements will be applicable to foreign exchange forward and swaps which are physically settled. These physically settled foreign exchange forwards and swaps will not attract initial margin requirements. Physically settled foreign exchange forwards and swaps have been excluded from initial margin requirements because these contracts are mostly used for hedging underlying e .....

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forex forward and swap contracts from initial margin requirements? Are there any other products which may be considered for exclusion from margin requirements? Entities which would be covered under margin requirements 6. As has been discussed earlier, the objective of introducing margin requirements is twofold: reduction of systemic risk and promotion of central clearing. In line with these objectives, those counterparties which do not pose significant systemic risk or may not be in a position .....

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sed for any category or all categories of the related entities, if it is considered desirable to do so. For the time being, it is proposed to apply the margin requirements, in a phased manner, to all financial entities (like banks, insurance companies, mutual funds, etc.) and certain large non-financial entities. Large non-financial entities will, for this purpose be entities having aggregate notional amount of outstanding non-centrally cleared derivatives at or more than INR 1000 billion, at a .....

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entities are considered risk free from the perspective of default risk and therefore do not require any capital charge for default risk. Types of Margins required to be exchanged 8. An OTC derivative exposure gives rise to two kinds of exposure to a counterparty. The first is current exposure which is reflected in the mark-to-market value at a particular time. Variation Margin (VM) protects the transacting parties from the current exposure. As VM depends on the mark-to-market value of the deriva .....

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ract is revalued and variation margin exchanged, the volatility of the underlying instrument, and the expected duration of the contract closeout and replacement period, and can change over time, particularly where it is calculated on a portfolio basis and whether transactions are added to or removed from the portfolio on a continuous basis. 9. All entities to which margin requirements will apply have to exchange the variation margin bilaterally on a regular basis. The frequency of computation of .....

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ent computed based on standardised schedule given in this document is INR 500 crore. The requirement to exchange initial margin will then be INR 150 crore (500-350). This threshold will be made applicable on a consolidated group level which will consider all non-centrally cleared derivatives between the two consolidated groups. The requirement that the threshold be applied on a consolidated group basis is necessary to ensure that arbitraging of the requirements by way of affiliates and other leg .....

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extending the threshold. 11. Initial margin requirements will be implemented in a phased manner as described in paragraph 35. At the end of the phase-in period, all entities within the ambit of application of margin requirements must have at least INR 55,000 crore of notional amount of non-centrally cleared derivative transactions outstanding for initial margin requirements to be made applicable. 12. Initial margin would be exchanged on a bilateral basis by both the counterparties in a gross man .....

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te for Indian conditions? Computation of margin requirements 13. There may be two approaches for computation of initial margin requirements. One approach may be a standardised method in which RBI given factors are multiplied by notional amount of the derivative transaction. The other approach may be use of quantitative risk models. RBI intends to mandate the use of the standardised method. Nevertheless, since use of risk models with appropriate governance structure have their utility in improvin .....

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and initial margins have to be applied on a contract by contract basis. Portfolio margining models can be used only when RBI specifically permits computation of margins on a portfolio basis. 15. Computation of initial margin based on model based approaches has to follow requirement of para 16 and 17. Initial margin has to be computed by estimating potential future exposure of a non-centrally cleared derivative which should reflect an extreme but plausible estimate of an increase in the value of .....

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ress may be separate for each broad asset class. For example, period of significant stress may be different for a forex forward transaction and an interest rate swap transaction. 16. The use of initial margin models would be subject to entities meeting certain conditions. Banks which want to use their own margin computation model can do so after it has been validated by the RBI. Initial margin models must be subject to an internal governance process that continuously assesses the value of the mo .....

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andardised based approach for computation of initial margin is also required. Further, smaller market participants may not wish or may not be able to develop and maintain a quantitative model and also may be unwilling to rely on a counterparty s model. In addition, some market participants may value simplicity and transparency in initial margin calculations, without relying on complex calculations. From regulatory perspective, there is a need for a conservative alternative for calculating initia .....

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n 10 Foreign exchange 6 Interest rate: 0-2 year duration 1 Interest rate: 2-5 year duration 2 Interest rate: 5+ year duration 4 Other 15 18. Banks using model based approach would also be required to compute initial margin based on the above schedule and for these banks initial margin requirement cannot be less than 80% of the amount computed based on using above schedule. Model based approaches may enhance the capabilities of market participants to compute potential future exposure of a transac .....

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in case of other derivatives. 19. Counterparties to derivative transactions should have rigorous and robust dispute resolution procedures in place before contracting the transactions. In the event that a margin dispute arises, both parties should make all necessary and appropriate efforts, including timely initiation of dispute resolution protocols, to resolve the dispute and exchange the required amount of initial margin in a timely fashion. 20. Derivative transactions which do not attract coun .....

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should also be collected on a transaction-by-transaction basis. The amount of variation margin to be collected is dependent on the mark-to-market value of a derivative transaction. The valuation of a derivative s current exposure may be subject to question or dispute by one or both parties. Lack of agreement on current exposure for variation margin purposes may lead to delay in exchange of the required margin in some cases. It is, therefore, required that parties to the derivative contracts sho .....

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e highly liquid and should after accounting for haircut be able to hold their value in a time of financial market stress. In addition to having good liquidity, eligible collateral for margin purposes should not be exposed to credit, market and FX risk. To the extent that the value of the collateral is exposed to these risks, appropriate haircuts should be applied. The collateral collected should not be exposed to wrong way risks, i.e., the value of collateral should not decline when the counterp .....

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and above. Issue for feedback/comments: Should certain other assets also be considered for inclusion in the list of eligible collaterals for margining purpose? Haircuts for the collateral 24. To the extent that the value of the collateral is exposed to the risks outlined in paragraph 22, appropriate haircuts should be applied. As in the case of initial margin models, risk sensitive quantitative models may also be used to establish haircuts provided the risk model has been approved by RBI for the .....

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for haircuts must also compute haircuts based on this table and minimum haircuts for such entities would be 80 per cent of the haircuts computed using the table. The values of haircuts mentioned in the below mentioned table are based on Basel III capital regulations for credit risk mitigation. Asset Class Haircut (% of market value) Cash in the currency of settlement of the derivative transaction 0 Central and State Government securities with residual maturity less than one year 0.5% Central an .....

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than one years and having rating between A and BBB 2% Corporate bond with residual maturity between one and five years and having rating between A and BBB 6% Corporate bond with residual maturity more than five years and having rating between A and BBB 12% Additional (additive) haircut on asset in which currency of the derivatives obligation differs from that of collateral asset 8% Treatment of provided/collected initial margin 25. Bilateral exchange of initial margin can protect the counterpart .....

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o its counterparty if the counterparty defaults. The risk would be exacerbated if the counterparty re-hypothecates, re-pledges or re-uses the provided margin which could result in third parties having legal or beneficial title over the margin. Due to these considerations, it has to be ensured that the initial margin collected should not be commingled with other assets of the collecting party and legal arrangements should authorise its use only for the specific purpose of meeting the losses arisi .....

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it has to be ensured that there are no legal challenges in accessing the assets held by these custodians in times of need. It has also to be ensured that all kinds of collateral arrangements are effective under the relevant laws and should be supported by periodically updated legal opinions. Issue for feedback/comments: What are the views on the proposed legal arrangement for treatment of assets received as initial margin? Would Indian laws be able to provide mechanism to ensure legally enforce .....

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l complications, delaying or denying the return of re-hypothecated/re-used assets in the event the collecting party defaults. Due to these reasons, all kinds of collateral collected as initial margin should not be re-hypothecated, re-pledged or reused. Issue for feedback/comments: What are the views on the proposal of not allowing re-hypothecation, re-pledge or re-use of assets received as initial margin? Treatment of provided variation margin 28. Regular and timely exchange of variation margin .....

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oup derivative transactions would be exempted from the scope of margin requirements if these transactions do not transfer risks in or out of a banking group. Group entities for this purpose are meant to be entities belonging to the same group where the financial statements of these entities are consolidated upon preparation of the group consolidated financial statements. Treatment of cross border transactions 30. Margin requirements as established in this document will be applicable to legal ent .....

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ulators/supervisors of other jurisdictions with respect to appropriate treatment of cross border derivative transactions. 31. For derivative transactions booked in foreign jurisdictions by foreign branches/subsidiaries of entities incorporated in India, following requirements would be made applicable: If the concerned foreign jurisdiction has implemented margin requirements for non-centrally cleared derivatives which are consistent with global standards, these host requirements would be made app .....

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ents will call for operational enhancements and additional amounts of collateral for which liquidity planning will have to be done. Hence, the new requirements will be implemented in a phased manner in India. The implementation schedule of these requirements is given in below mentioned paragraphs. Implementation of variation margin 33. From 1 September 2016, all entities within the scope of margin requirements and which belong to a group whose aggregate month-end average notional amount of non-c .....

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017, all entities within the scope of margin requirements will be required to exchange variation margin. Subject to paragraph 33 above, the requirement to exchange variation margin between entities only applies to new contracts entered into after 1 March 2017. Exchange of variation margin on other contracts is subject to bilateral agreement. Implementation of initial margin 35. The requirement to exchange two-way initial margin with a threshold of up to INR 350 crore will be phased in follows. F .....

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gin requirements and which belongs to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives for March, April, and May of 2017 exceeds INR 150 trillion will be subject to the requirements when transacting with another entity within the scope of margin requirements (provided that it also meets that condition). From 1 September 2018 to 31 August 2019, any entity within the scope of margin requirements and which belongs to a group whose aggregate month-end av .....

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l, and May of 2019 exceeds INR 50 trillion will be subject to the requirements when transacting with another entity within the scope of margin requirements (provided that it also meets that condition). On a permanent basis (ie from 1 September 2020), any entity within the scope of margin requirements and which belongs to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives for March, April, and May of the year exceeds INR 550 billion will be subject to t .....

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subject to the initial margin requirements described in this document. 36. For the purposes of calculating the group aggregate month-end average notional amount for determining whether or not an entity within the scope of margin requirements will be subject to the initial margin requirements described in this document, all of the group s non-centrally cleared derivatives, including physically settled FX forwards and swaps, should be included. Initial margin requirements will apply to all new con .....

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liates and other legal entities. This example provides an illustration of how the threshold of INR 350 crore will be applied at group level and not at individual legal entity level within the group. Suppose that an entity within the scope of margin requirements engages in separate derivative transactions with three counterparties, A1, A2, and A3. All these three entities belong to larger consolidated banking group. Suppose further that initial margin requirement computed based on the requirement .....

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