On August 16, 2016, the International Swaps and Derivatives Association, Inc. (ISDA) published the ISDA 2016 Variation Margin Protocol (VM Protocol). The VM Protocol will help market participants implement the new variation margin requirements set to come into force in the U.S., Canada and Japan for all except the very largest financial market participants beginning on March 1, 2017. Through the use of exchanged questionnaires, the VM Protocol allows swap dealers and their counterparties to identify applicable regulatory regimes and make changes to existing collateral agreements to bring their variation margin arrangements into compliance.
What entities are in scope for the VM Protocol?
In the U.S., final rules implementing the requirement to margin non-cleared swaps (the Margin Rules) were published in October 2015 for entities subject to the jurisdiction of U.S. prudential regulators and in December 2015 for entities regulated by the U.S. Commodity Futures Trading Commission (and not by a U.S. prudential regulator). Under the Margin Rules, swap dealers are required to post and/or collect variation margin for non-cleared swaps entered into with “financial end users.” Financial end users are defined under the Margin Rules by reference to an enumerated list of financial market participants, including, in part, banks, savings and loans, insurance companies, broker-dealers, registered investment advisors and collective investment vehicles. The list encompasses a wide range of activities in the financial sector, so it is important that firms that are potentially in-scope understand whether they will be in-scope under the financial end user definition.
What is the timeline for the requirement to exchange variation margin?
Under the Margin Rules, the requirement to exchange variation margin will be phased in over two dates in the U.S. The first compliance date begins September 1, 2016, and covers swaps between swap dealers and financial end users, where the financial end user and its affiliates have in excess of $3 trillion in daily average aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, FX forwards and swaps for March, April and May of 2016.
The second compliance date begins March 1, 2017, and covers swaps between swap dealers and other financial end users. The VM Protocol targets this March 1, 2017, “big bang” implementation that will pick up the vast majority of financial end users in the U.S. While other jurisdictions, including Singapore, Hong Kong, Switzerland and the EU, recently announced a delay in the implementation of the margin requirements of those jurisdictions, there is no indication as yet that regulators in the U.S. will similarly delay current compliance dates.
What does the VM Protocol do?
Determination of Applicable Regimes
First, the VM Protocol enables parties to determine which regulatory regimes might be applicable to their swap trading relationship by eliciting the exchange of certain information. In this respect the VM Protocol largely replicates the Regulatory Margin Self Disclosure Letter published by ISDA on June 30, 2016. Currently, the VM Protocol allows parties to amend documentation to comply with margin requirements in the U.S., Canada and Japan. As a result of delays in implementation of final margin rules in the EU and Switzerland, the VM Protocol contains a placeholder mechanism that will allow the VM Protocol to expand to cover these regimes once the final rules and compliance dates are in place for these jurisdictions.
The VM Protocol applies a “strictest of” procedure where a counterparty pair is subject to multiple regimes and the applicable rules under each regime are different. For example, if a swap dealer selects both U.S. and Canadian margin regimes as applicable to a particular swap trading relationship, then even if the swap dealer’s counterparty only selects U.S. rules as applicable, the VM Protocol will apply the stricter of the two regimes to the extent U.S. and Canadian regulations are different. This is because the VM Protocol applies all regimes selected as applicable by either counterparty.
Upgrading Documentation
Second, the VM Protocol facilitates the amendment of derivatives documentation to address the requirements of the Margin Rules. Counterparty pairs are able to amend or create documentation, and make related elections, for their non-cleared swaps that produce contractual results that comply with the margin requirements. For instance, for counterparty pairs subject to the U.S. Margin Rules that have New York law-governed Credit Support Annexes (CSAs), the VM Protocol effectively permits the amendment of existing CSAs or the creation of new CSAs that align with the regulatory-compliant 2016 Credit Support Annex for Variation Margin (NY Law) that ISDA published on April 13, 2016. Click here for an analysis of the impact of this new regulatory-compliant CSA on existing variation margin arrangements.
Parties have four options when upgrading existing documentation or creating new documentation to comply with the Margin Rules.
- Creation of Master Agreement and CSA. Under this option the parties enter into a new ISDA 2002 Master Agreement (2002 Master) with a new regulatory-compliant CSA. The terms of the new 2002 Master are determined by the VM Protocol and the parties’ matched questionnaires. This option is similar to other ISDA protocols that permit the parties to opt into a deemed 2002 Master. The terms of the new CSA are determined by the New CSA Method (see below).
- New CSA Method. Under this option, the parties have an existing ISDA 1992 or 2002 Master Agreement and add a new CSA for variation margin on terms that are determined by the VM Protocol and the parties’ matched questionnaires. The new CSA covers new transactions while legacy transactions remain under the parties’ existing CSA, if any.
- Replicate-and-Amend Method. Under this option the parties amend an existing master agreement and CSA by creating a replica of the parties’ existing CSA. The existing CSA is then amended to the extent required to comply with the Margin Rules. The replica CSA covers only new transactions; legacy transactions remain under the existing CSA.
- Amend Method. Under this option, the parties amend an existing CSA so that it complies with the Margin Rules. The amended CSA covers all trades between the parties (both new transactions and legacy transactions).
When electing these methods, if the parties treat new transactions separately from legacy transactions, they will be creating separate netting sets for each group. As a result, new transactions will not be netted against legacy transactions automatically. This presents a significant change for market participants. The grandfathering of legacy transactions means that, unless the parties voluntarily elect to bring pre-compliance date swaps into compliance anyway, multiple CSAs will exist under a single ISDA Master Agreement, at least until legacy transactions roll off. Collateral management systems will need to be modified to accommodate this split in netting sets.
The VM Protocol generally does not amend any initial margin amounts, other than certain technical amendments needed in the Replicate-and-Amend Method to avoid any initial margin in an existing CSA from being double counted when the replica CSA is created, and an option to allow the parties to reset their initial margin to zero (if both parties agree) under the Amend Method or the Replicate-and-Amend Method. Otherwise, the VM Protocol does not amend regulatory requirements for the exchange of initial margin. In the U.S., the initial margin rules are subject to a separate phase-in timeline.
How can I comply with the VM Protocol?
The VM Protocol is open for adherence on ISDA’s website and will be available electronically on ISDA Amend beginning in October 2016. ISDA Amend is a service that facilitates the amendment of multiple ISDA Master Agreements for counterparties to comply with derivatives regulations implemented since the 2008 financial crisis. To complete the process, financial end users will need to exchange questionnaires with their applicable swap dealer counterparties.
Next Steps
The VM Protocol has broad implications for the derivatives market and the margin relationship for non-cleared swaps that exists between swap dealers and their counterparties. Financial end users will also need to consider potential changes in operational practices to facilitate compliance with the new requirements.
For additional action points and context on the Margin Rules and similar requirements in other jurisdictions, see our series evaluating the proposed margin regulations. Please contact one of the authors or another McGuireWoods lawyer if you have questions regarding the VM Protocol and its impact on your firm’s swap trading activities.