The Australian Prudential Regulation Authority (APRA) has released a consultation package for APRA-regulated institutions on margining and risk mitigation requirements for non-centrally cleared derivatives.
In recent years the G20, through the Basel Committee on Banking Supervision and the International Organization of Securities Commissions, has instituted reforms which aim to reduce systemic risk and contagion effects by ensuring the availability of collateral (margin) to offset losses that may be caused by the default of a derivative counterparty. These reforms are also aimed at promoting central clearing.
APRA proposes to apply margin and risk mitigation requirements to authorised deposit-taking institutions (ADIs), general insurers, life insurers, and RSE licensees of registrable superannuation entities that transact in non-centrally cleared derivatives. APRA’s proposals generally follow the internationally-agreed standards, although it has modified them in some areas to avoid placing undue cost on regulated entities with relatively small levels of non-centrally cleared derivative activity.
Released today, APRA’s draft Prudential Standard CPS 226 Margining and risk mitigation for non-centrally cleared derivatives (CPS 226), proposes to require APRA-regulated institutions that transact in non-centrally cleared derivatives to:
- meet new risk mitigation requirements that are intended to increase the transparency of bilateral positions between counterparties, promote legal certainty over the terms of non-centrally cleared derivative transactions and facilitate the timely resolution of disputes; and
- exchange margin (i.e. collateral) to mitigate counterparty credit risk associated with their derivative activities, when the level of this activity exceeds minimum qualifying levels.
While the risk mitigation standards apply to all APRA-regulated institutions (excluding private health insurers), APRA expects only a small number of institutions will exceed the proposed minimum qualifying levels and therefore be subject to the new margin requirements.
In proposing APRA’s margining and risk mitigation framework, Chairman Wayne Byres said: ‘APRA has sought to find an appropriate balance between the objectives of the global reforms, and the requirements of the Australian financial system. Importantly, the design of the requirements in Australia needed to have regard to supporting the ongoing efficient access to derivatives markets for APRA-regulated institutions.’
APRA invites written submissions on the draft prudential standard by 20 May 2016. A discussion paper and draft CPS 226 can be found on the APRA website.
Q: What is a non-centrally cleared derivative?
A: A non-centrally cleared derivative is a bilateral derivative transaction that is not cleared by a central counterparty. This does not include any exchange traded derivatives, securities financing transactions, or derivatives that are cleared indirectly through a clearing member on behalf of a non-member client. Examples of non-centrally cleared derivative transactions may include interest rate swaps, foreign exchange forwards and swaps, commodity swaps, options or forward contracts.
Q: What is margining and what is its purpose?
A: Margining is the process of exchanging collateral to protect against counterparty credit risk for financial contracts, such as non-centrally cleared derivatives. APRA proposes to require the exchange of both variation margin and initial margin. Variation margin is collateral that is collected to reflect the current mark-to-market exposure resulting from changes in the market value of a non-centrally cleared derivative. Initial margin protects against the potential future exposure that may arise from future changes in the mark-to-market value of a non-centrally cleared derivative during the period of time that is assumed to be required to close-out and replace the position following a counterparty default.
Q: What APRA-regulated institutions will be subject to these new requirements?
A: APRA proposes to directly apply its new requirements to all APRA-regulated institutions, other than private health insurers. Within this, it is proposed that the margin requirements will only apply to institutions that have group-level non-centrally cleared derivative activity in excess of certain qualifying levels. APRA expects that only a small number of institutions in each industry will exceed the proposed minimum qualifying levels.
Q: When do these requirements take effect?
A: APRA proposes that CPS 226 is effective on 1 September 2016. However, variation margin requirements are proposed to be phased-in from 1 September 2016 to 1 September 2017, and initial margin requirements from 1 September 2016 to 1 September 2020. The risk mitigation requirements are proposed to take effect from 1 September 2016. APRA expects the margin requirements to commence for the largest domestically-headquartered APRA-regulated institutions from March 2017, while smaller market participants will phase-in later.
Q: What are the minimum qualifying levels?
A: An APRA-regulated institution will be subject to the margin requirements where its consolidated group’s notional amount of non-centrally cleared derivatives exceeds the relevant minimum qualifying level. The margin requirements apply only in transactions with counterparties that also have consolidated group-level activity in excess of the relevant qualifying level.
In September 2016, these qualifying levels will be set at AUD 4.5 trillion for both variation and initial margin requirements. The qualifying levels will progressively reduce over the phase-in period. From September 2017, variation margin will be required for APRA-regulated institutions that are in a margining group with non-centrally cleared derivative activity that exceeds AUD 3 billion. From September 2020, initial margin will be required for APRA-regulated institutions that are in a margining group with non-centrally cleared derivative activity that exceeds the minimum qualifying level of AUD 12 billion.