[Arav and Dev are students at Maharashtra National Law University, Mumbai.]
Recently, the Reserve Bank of India (RBI) notified the RBI (Margining for Non-Centrally Cleared OTC Derivatives) Directions (Directions) in May 2024, which will come into force from November 2024. These have come in furtherance of the RBI’s mandate to implement Group of 20’s (G20) Reform Programme declared in the Pittsburgh Summit 2009 that aimed to reduce systemic risks in over-the-counter (OTC) derivative markets.
The 2008 Financial Crisis exposed the inherent capacity of OTC derivatives to topple major financial markets. G20 recognized the severe economic global crisis and agreed to implement strong international standards to improve the OTC derivative regulatory framework. In the 2011 Cannes Declaration, G20 added margin requirements for non-centrally cleared OTC derivatives (NCCD) to the reform and called upon the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commission (IOSCO) to develop policy frameworks establishing minimum standards.
One of the essential elements of an OTC transaction is ‘clearing’, which is the process of settling transactions between the parties. It can be done centrally, i.e. by adding a legal counterparty that settles the contract or, it can be done non-centrally, wherein the parties settle the contract themselves. In centrally cleared derivatives, the parties are required to post margins to a central counterparty (CCP) for mitigating the CCP’s risk exposure. However, due to the absence of CCPs in NCCDs, there was no requirement for posting margins until the RBI (Variation Margin) Directions 2022. This will now be repealed by RBI (Margining for Non-Centrally Cleared OTC Derivatives) Directions 2024 which includes both initial and variation margin requirements.
Necessities of Margining
Margining requires market players to set aside collateral, known as ‘margin’, to cover their obligations, reducing counterparty default risk. Margins are of two kinds: initial margin (IM) and variation margin (VM). IM addresses future exposure during close-out, which is only used if VM, which covers daily fluctuations, falls short. This layered approach enhances risk management in OTC derivatives.
Margining requirements are expected to limit systemic risk by ensuring the availability of collateral, thereby offsetting losses in the event of a counterparty default. Requiring margins prevents large uncollateralized positions that could trigger financial stress, as was the case of Lehman Brothers. Moreover, it promotes market discipline by raising the cost of taking excessive risks. It is also essential to minimize spill-over effects from interconnected financial institutions. Hence, margining requirements promote predictability and risk management, ultimately enhancing the confidence of OTC market participants.
Calculating and Exchanging Collateral
RBI directs that IM is to be calculated at the outset of a transaction either on a standardized approach (Annex I of the Directions) or quantitative portfolio margin model (Annex II of the Directions) outlined in the directions. The market participants have followed the International Swaps and Derivatives Association (ISDA) SIMM Model for the calculation of margins before the release of the Directions. Market participants can avoid following the standardized approach and move forward with the ISDA SIMM Model as it fulfils all requirements of the quantitative portfolio margin model.
RBI specifies various instruments, including government securities, that could be exchanged as collaterals under paragraph 10 of the Directions. According to Section 13 of the Government Securities Act 2006, all rights concerning government securities are to be exclusively decided in Indian courts. While Paragraph 12 of the Directions allows the parties to mutually decide on the procedure for dispute resolutions, ISDA recommends arbitration to resolve derivative disputes. This makes the disputes involving government securities non-arbitrable as per the four-fold test laid down in Vidya Drolia v. Durga Trading Corporation.
Non-arbitrability of government securities would make their use as collateral undesirable, given the market’s inclination towards arbitration as the preferred mode of dispute resolution. The eligible instruments in the Directions to be used as collateral are fairly limited when compared to BCBS-IOSCO framework. The issue of undesirability of government securities as collateral further aggravates the problem of limited options.
Gaps in CSP Infrastructure
Protection of the exchanged IM through segregation is an essential BCBS-IOSCO principle. The posting party faces risks of losing the margin once it has exchanged margins if there are no safeguards for its treatment. Although the party will be protected to some extent in case the counterparty defaults, the risk exponentially increases if the counterparty re-uses the collected margin, as it may lead to the creation of third-party rights. This might delay or even make the IM inaccessible to the posting party. To solve this, collected margins should be segregated, making them immediately available in cases of counterparty defaults. Paragraph 8 of the Directions mandates segregation of IM from collector’s proprietary assets. One of the most accepted forms of segregation is including a ‘Collateral Service Provider’ (CSP) in the transaction to hold the exchanged margins.
However, a regulatory framework and infrastructure regarding CSPs is absent in the Indian OTC market, unlike the ETD market. The ETD market has an established infrastructure for CSPs, majorly scheduled commercial banks. While RBI has allowed scheduled commercial banks to act as CSPs, it fails to provide a comprehensive framework for their governance. Since there is no local capability for providing third-party collateral services, RBI has allowed the participants to use foreign CSPs.
Operational Strain of Timelines
While RBI had codified VM requirements in 2022, it never brought regulations for IM. This is presumably due to its lack of application to a large number of transactions across the market. The BCBS-IOSCO report (Report) acknowledged that the implementation of IM requirements will necessitate large sums of collateral, liquidity planning, and operational improvements. To ease the high transitional costs, the BCBS-IOSCO framework advises that the requirements should be brought in a phased manner, to equitably balance the benefits of incentives and the reduction of systemic risk against the costs of transition, operations, and liquidity.
The Report has divided the implementation into one to two-year-long phases based on valuations of the Average Aggregate Notional Amount (AANA) of NCCDs of three preceding months. The phases began at 3 trillion Euros and ended at 8 billion Euros within a span of 6 years. On the other hand, RBI has not phased in the implementation of the Directions on varying AANA of NCCDs. This will harm smaller players as they will require additional time as compared to larger players, given the difference in resources. Hence, a blanket implementation is inequitable and against the BCBS-IOSCO principles.
Additionally, the ISDA in its response to RBI consultation on draft Directions for NCCDs, suggested RBI give at least 18 months from the date of release of final directions for market players to comply with the requirements . However, the Directions have given a mere 6 months to all the participants, which will certainly pose a challenge to them due to the absence of custodial arrangements and other operational challenges as discussed above.
Addressing Duplicity of Compliances
Duplicity of margining requirements in different jurisdictions results in extra work and costs without any additional safeguards. USA’s Commodity Futures Trading Commission under the Dodd-Frank Act introduced substituted compliance. This allowed market participants to satisfy compliances in the host jurisdiction by fulfilling a comparable jurisdiction’s requirements. To facilitate this, it is necessary to resolve inconsistencies between cross-border regulations as they directly affect the comparability of the rules.
A majority of OTC transactions follow standardized documents created by the ISDA. ISDA generally uses English or New York Law as the governing law for ease in dispute resolution and compliance. It is pertinent to note that substituted compliance will enable compliance of the Directions and the governing law of the documents concurrently and hence, the use of ISDA standard documents can continue unhindered. The principal beneficiaries of substituted compliance are domestic branches of foreign banks as they would not have to ensure compliance with multiple jurisdictions.
Conclusion
The RBI has taken steps towards creating a safer OTC market in compliance with most BCBS-IOSCO principles and ISDA practices. However, some deficiencies must be redressed for an efficient margining infrastructure. ISDA has strongly called for an exemption of procedural requirements such as stamp duty, registration of documents and charges, in margining documents to ensure ease of business. The absence of local CSPs and the undesirability of Indian government securities as collateral would push all market participants to use foreign CSPs, which would be detrimental to the nascent local CSP infrastructure. The short implementation period may cause severe hardships and jeopardise a smooth transition, which will be antithetical to the RBI’s mandate of creating a safer OTC market. Lastly, the limited options of eligible collaterals need to be resolved.
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