In brief
APRA has released its long-awaited Prudential Standard CPS 226 Margining and risk mitigation for non-centrally cleared derivatives. While these rules are based on the Draft released in February of this year, and address some of the concerns raised during the consultation process, there are still a number of questions which remain unanswered. Partner Tom Highnam and Senior Associate Rod Aldus consider the new standard and some of the potential pitfalls for Australian and international derivative counterparties.
Background
Following the fallout from the global financial crisis, the G20 nations determined that the risks posed by unsecured OTC derivatives should be better managed in order to avoid a repeat of the Lehman Brothers collapse. Part of the proposed management was to introduce mandatory margining between counterparties to non-centrally cleared OTC derivative transactions.
While the G20 nations tasked the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (BCBS-IOSCO) with setting up a framework for mandatory margining, it was left up to the individual regulators in each jurisdiction to implement the rules.
In February this year, APRA released its draft Prudential Standard CPS 226, along with a request for consultation, to the market with a proposed start date of 1 September. Following a substantial number of responses, many of which raised concerns about the proposed start date, APRA delayed releasing the final version of Prudential Standard CPS 226 pending further industry consultation.
Until now. We have examined some of the potential traps arising from the implementation of these rules.
Inadvertent application
The parties who are bound by Prudential Standard CPS 226 are the following APRA covered entities:
- authorised deposit-taking institutions (ADIs), including foreign ADIs, and authorised banking non-operating holding companies (NOHCs);
- general insurers, including Category C insurers, authorised insurance NOHCs and parent entities of a Level 2 insurance group;
- life companies, including friendly society and eligible foreign life insurance companies, and registered life NOHCs; and
- registrable superannuation entities.
However, on the basis that this is intended to apply to cross-border as well as domestic transactions, APRA covered entities must post, collect and exchange margin on qualifying transactions with covered counterparties. Covered counterparties are defined to be any institution, except sovereign entities and some special purpose vehicles, engaged substantively in one or more of the following activities:
- banking;
- leasing;
- issuing credit cards;
- portfolio management (including asset management and funds management);
- management of securitisation schemes;
- equity and/or debt securities;
- futures and commodity trading and broking;
- custodial and safekeeping services;
- insurance; and
- similar activities that are ancillary to the conduct of these activities,
For the avoidance of doubt, hedge funds, trading firms, and foreign deposit-taking institutions are considered to be covered counterparties (subject to the exceptions listed above).
The drafting in respect of this is, presumably, intended to capture entities that would be caught by similar rules to those set out in Prudential Standard CPS 226 but is not an APRA covered entity. However, this begs the question: what happens when an entity is not covered by Prudential Standard CPS 226 or any equivalent margining rules but is a covered counterparty?
The practical effect is that the APRA covered entity will be unable, without an exemption from APRA, to trade with that covered counterparty unless the covered counterparty agrees to post, collect and exchange margin. Due to the breadth of the entities captured under the definition of covered counterparty, this means that many entities that would otherwise be out of scope for Prudential Standard CPS 226 will suddenly find themselves on the receiving end of margining requests.
Cross-border rules
Although each jurisdiction has, broadly, based its rules upon the BCBS-IOSCO framework, each will have its own eccentricities. Prudential Standard CPS 226 does provide for cross-border relief, but only where APRA has approved substituted compliance or the APRA covered entity would be caught by the rules of the other jurisdiction directly.
Additionally, APRA has provided a very wide exemption from exchanging or posting margin with a counterparty that is domiciled in a jurisdiction where there is doubt around bankruptcy remoteness and enforceability of netting or the enforcement upon default is questionable. However, it is unclear how in practice this would play out if the relevant counterparty’s regulator requires the exchange or posting of margin.
Timing uncertainty
The BCBS-IOSCO framework proposed a phased-in application from 1 September 2016 for initial margin and 1 March 2017 for variation margin, including the thresholds for when entities needed to start complying. This timeline was replicated in the draft Prudential Standard CPS 226, but has been replaced in the final version with a note stating that the implementation date is to be notified. The effect of this is that while these are stated to be the final rules, there is a risk that further changes may be made when the implementation date is notified to the public, causing some degree of uncertainty in the market.
How does it affect you?
For the majority of Australian counterparties, the short answer is that, at the moment, it doesn’t with the timetable still to be finally determined. However, for all counterparties, both Australian and international, the release of Prudential Standard CPS 226 does remove a lot of the uncertainty in the market around the approach that APRA would take and enables these entities to start planning for the future. We expect to see a lot more credit support documents tailored towards compliance with Prudential Standard CPS 226 start to appear in the market place.