EMIR Newsflash: Consultation Paper on Initial Margin Model Validation

On 4 November 2021, the European Banking Authority (EBA), in consultation with ESMA and EIOPA (the other two bodies that comprise the European Supervisory Authorities (ESAs)), published the long-awaited consultation paper on draft regulatory technical standards (RTS) on the proposed requirement on in-scope firms to obtain regulatory approval for initial margin models that they use (called Initial Margin Model Validation, or IMMV, in the consultation paper). The consultation is open until 4 February 2022, with a public hearing on 15 December 2021.

The genesis of this consultation paper was the EMIR Refit in 2019, which referred to the need for competent authorities to validate risk-management procedures that involve the use of margin models and requires the ESAs to develop RTS with details of the supervisory procedures in respect of that validation. Since then, there have been concerns about how the new regulatory requirement under EMIR for approval of initial margin models (such as ISDA SIMM) would operate in practice and, in particular, how buy-side firms that are directly in-scope would comply with it. Although the US margin regime already requires regulatory approval of initial margin models, introducing such a requirement under EMIR could impose a significant additional regulatory burden on buy-side firms because, unlike the US margin regime, EMIR applies directly to in-scope buy-side firms as well as to sell-side firms.

The draft RTS attempts to deal with that concern by distinguishing between “large, sophisticated institutions”, on the one hand, and “medium-small institutions” on the other hand. The former group would be required to follow a more detailed and prescriptive “standard” IMMV process, whilst the latter group would be permitted to follow a “simplified” IMMV process. The draft RTS proposes that in-scope firms that are either: (i) non-banks or (ii) below an AANA threshold for March, April and May of the preceding year of EUR 750 billion on a group basis would be permitted to follow the simplified IMMV process, with other in-scope firms being required to follow the standard IMMV process. The EBA estimates that approximately 20 institutions would therefore be required to comply with the standard IMMV process.

Both the standard and simplified IMMV processes would involve an initial submission by firms to their competent authority, followed by an assessment and decision by the competent authority on the IM model application. There are also requirements for ongoing assessment of model changes. The consultation paper recognises that many firms will be using the same model (ie SIMM), but discards the possibility of a centralised approval process for the whole market. Instead, the draft RTS propose that each firm be required to make an application for its own use of the IM model but that efficiencies for the assessment and approval process be gained through firms being able to rely on some general documentation in their application (eg publications from industry bodies such as ISDA on how SIMM works) and the competent authority being permitted to leverage off the results and findings from previous approvals given to other firms.

In terms of timing, the draft RTS also propose a phased implementation of the commencement of the IMMV requirements, with:

• Phase 1 commencing 1 year after the entry into force of the RTS (capturing in-scope firms required to follow the standard IMMV process)
• Phase 2 commencing 2 years after the entry into force of the RTS (capturing in-scope firms which are permitted to follow the simplified IMMV process but which are above a AANA threshold of EUR 50 billion for March, April and May of the year preceding the entry into force of the RTS)
• Phase 3 commencing 3 years after the entry into force of the RTS (capturing all other in-scope firms permitted to follow the simplified IMMV process)

The draft RTS also propose a transitional solution for firms already using an IM model, pursuant to which such firms would be permitted to continue using that IM model for up to 2 years, as long as they make their initial validation application within 1 month of the relevant commencement date, during which 2 year period the relevant competent authority can raise any issues on the IM model. In other words, the proposal is for a transitory non-objection approval.

Finally, whilst UK EMIR also includes the same requirement for regulatory approval of initial margin models, no proposals have yet been published by the UK FCA or PRA.