Initial Margin and Benchmark Reform: Take-aways from the ISDA® Conference in Johannesburg
This year’s ISDA® conference highlighted the enormous task that will be required from a documentation point of view to ensure compliance with the initial margin requirements. The EMIR regulations are approaching phase 4 (September 2019) and phase 5 (September 2020) of their initial margin phases. This will see approximately 60 new entities being in scope for 2019 and up to 1 200 new entities being in scope in phase 5. As initial margin only applies when both parties to a trade are considered in scope of the regulations, and as each new phase of initial margin is implemented – all those entities that are already in scope have to ensure they have documentation in place with the newly phased-in entities. The documentation requirement therefore grows exponentially as more counterparties find themselves subject to the initial margin requirements. The latest draft of South African initial margin regulations anticipate phase 1 initial margin rules applying from 1 September 2019 for the very largest market players, with most of the local South African banks being impacted in phase 2 (September 2020).
Initial margin rules require posted collateral to be segregated. As a result, security interest or pledge-style credit support documentation needs to be put in place. In addition, custodians will need to be appointed, and documentation to govern relationships with custodians will need to be completed. Different custodians have different custody agreements, which also vary according to the jurisdiction of the custodian, to ensure that the assets are held and transferred validly in terms of the jurisdiction of the custodian. Again, adhering to the initial margin rules requires multiple legal agreements to be put in place, not all of which are market standard. It is therefore not too soon to start putting in place a process and strategy plan for your documentation.
Benchmark reform was the other major topic at the conference with very insightful presentations on how the market is preparing the transition to more risk-free rates. IOSCO has urged users of financial benchmarks to have robust fallback provisions in their contracts in the event that a benchmark ceases to exist. LIBOR, for example, is due to be phased out and will not be assured from December 2021. The EU has published regulation to codify these IOSCO principles into law, with high penalties possible (up to 10% of group global annual turnover) for failure to comply with the benchmark regulation. In order to assist the market with this, ISDA® is currently working on amending the 2006 ISDA® definitions by way of a supplement, to make provision for these fallback provisions. Once this supplement to the 2006 ISDA® definitions is published, all new transactions entered into which reference the 2006 definitions will automatically incorporate the supplement. For existing transactions, it is likely that parties will need to sign-up to a protocol which ISDA® is planning to publish to facilitate the inclusion of the benchmark fallbacks into existing transactions. Whilst there is certainly going to be a need to amend documentation to reference the new fallbacks and reference any new benchmarks that arise, the operational impact in terms of updating trading and pricing systems should not be underestimated.