Finally some clarity on impending margin requirements for OTC derivatives
On 8 August 2017, the South African Financial Services Board (“FSB”) released for comment the second draft of the Board Notice entitled “Margin Requirements for OTC Derivative Transactions” (the “Second Draft Board Notice”). The first draft of the Board Notice had been released in 2015, together with the second draft of the Regulations under the Financial Markets Act, 2012 (the “Regulations”), and market participants were surprised that the third draft of the Regulations was released in 2016 without an accompanying further draft of the Board Notice.
Interestingly, the file of the Second Draft Board Notice that was distributed by the FSB is entitled “Final Draft Margin Requirements Notice for Public Comment”, and paragraph 4.2 of the Second Draft Board Notice contemplates the phasing in of the margin requirements to commence from 1 January 2018. It is therefore reasonable for market participants to anticipate that the final Board Notice will be substantially similar to the Second Draft Board Notice and will, after a number of delays, finally come into effect from 1 January 2018.
The Second Draft Board Notice is a vast improvement on the first draft of the Board Notice in a number of ways. For example, it no longer contemplates the bilateral exchange of margin (ie, cash or securities as collateral) with clients (which, as defined in the Regulations, could have included individuals and small businesses executing once-off trades); it includes exemptions for intra-group transactions under a certain threshold; it provides guidelines for margining requirements in respect of cross-border trades; and it contemplates the phasing-in of the margin requirements.
As evidenced by the evolution of the title “Margin Requirements for Non-Centrally Cleared OTC Derivatives” to “Margin Requirements for OTC Derivative Transactions”, the Second Draft Board Notice seems to acknowledge that the margin requirements have been prioritised by the FSB and will be in place well before central clearing commences in South Africa.
Market participants should note the following requirements:
- the margin requirements will apply from 1 January 2018 to any covered entity (defined roughly to include financial institutions such as banks, collective investment scheme managers, insurers, authorised users of an exchange, etc), in respect of which the aggregate month-end average gross notional amount of OTC derivatives for July, August and September 2017 of the covered entity’s group exceeds ZAR30-trillion;
- spot FX and physically settled commodity trades are excluded for purposes of posting initial margin, but are included for purposes of calculating aggregate month-end average gross notional amounts of OTC derivatives and for purposes of posting variation margin;
- initial margin may be rehypothecated (ie, on-transferred by the initial margin collector to a third party) only once, and only for purposes of hedging the initial margin collectors’ positions arising from the trades for which the initial margin was collected;
- variation margin may be rehypothecated; and
- cash and gold constitute eligible collateral – market participants will have to wait and see if the registrar specifies any securities as eligible collateral.
Finally, we note that there remains room for improvement and clarification in the Second Draft Board Notice. Some examples are the following:
- the definition of “counterparty” lists a number of types of financial entities, including banks, insurers and authorised users. The list notably excludes pension funds, but oddly includes managers of collective investment schemes, rather than the portfolios of the schemes themselves; and
- the definition of “covered entity” includes a counterparty and an OTC derivatives provider (as defined in the Regulations). Paragraph 2.1, entitled “General application”, states that the notice is binding on “covered entities”. Paragraph 3, entitled “General requirements”, then goes on to state that a provider (not a covered entity) must adhere to certain requirements.
Paragraph 4, entitled “Initial margin”, clarifies that the initial margin aims to protect providers and their relevant counterparties. It is therefore unclear whether the margin requirements apply to covered entities even in transactions where neither covered entity is an OTC derivatives provider, or only to transactions where one of the parties is an OTC derivatives provider and the other is a covered entity.
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