ISDA publishes 2016 Variation Margin Protocol

Background

Under a globally coordinated implementation schedule developed by the Basel Committee on Banking Supervision and the International Organisation of Securities Commissions (BCBS/IOSCO), financial firms with the largest derivatives portfolios globally are scheduled to exchange initial margin (IM) and VM on their uncleared derivatives trades from September 2016.

For all other firms, the IM requirements will be phased in over a four year period; however, the VM requirements are set to apply from March 2017.

Several jurisdictions including the US and Japan have adhered to this international schedule. As has been well-publicised, the EU has delayed the commencement date for the EMIR margin requirements, but the VM requirements are still currently expected to apply from March 2017 for all in-scope market participants.

The new protocol (the VM Protocol) offers one method of making the necessary changes to market participants’ collateral terms to ensure compliance with relevant margin requirements and is targeted particularly at the March 2017 commencement date.

ISDA 2016 Variation Margin Protocol

The VM Protocol caters for the margin rules for US Prudential Regulators (PR) Rules, CFTC Rules, Japan Rules, Canada (OSFI) Rules, EMIR Rules and Swiss (FMIA) Rules. However, as finalised rules for the latter two are expected only later in 2016, there are placeholders for EMIR or Swiss terms to be added in the future. It provides for the amendment or creation of an ISDA Credit Support Annex (CSA), governed by New York, English or Japanese law, and consists of the following eight documents:

• ISDA 2016 Variation Margin Protocol
• Questionnaire
• Exhibit NY-AMEND
• Exhibit NY-NEW
• Exhibit En-AMEND
• Exhibit En-NEW
• Exhibit J-AMEND, and
• Exhibit J-NEW.

VM Protocol methods

The VM Protocol provides three different methods to upgrade or create CSAs:

1. “Amend Method” - terms in existing CSAs are amended as necessary to comply with relevant VM requirements.
   1. This means that existing (legacy) transactions are also subject to the new VM requirements.
   2. However, it also means that any negotiated terms are preserved for new transactions to the extent possible under the relevant VM requirements.
   3. There will remain one margin call between the parties in respect of VM.
2. “Replicate and Amend” - this is similar to the Amend Method, except that a duplicate CSA is created from the existing CSA and then that duplicate CSA is amended as necessary to comply with relevant VM requirements.
   1. This means that legacy transactions are not subject to the VM requirements as they are maintained under the original CSA.
   2. Again, negotiated terms are preserved for new transactions to the extent possible under the relevant VM requirements.
   3. However, as there are now two CSAs dealing with VM, there will be two separate margin calls in respect of VM.
3. “New CSA” - the parties enter into a new CSA with standard terms and certain optional terms produced through questionnaire elections.
   1. This means that legacy transactions are not subject to the VM requirements and continue to be maintained under the original CSA.
   2. However, negotiated terms are not preserved for new transactions.
   3. New CSAs are constructed using the new “ISDA bookstore” versions of the NY law, English law and Japanese law CSA, where the CSA type and governing law are determined by existing documentation.
   4. In addition, as there are now two CSAs dealing with VM, there will be two separate margin calls in respect of VM.

How the VM Protocol works

The VM Protocol is more complicated than traditional ISDA protocols in that it requires a party to submit an adherence letter to ISDA and also to exchange questionnaires with a counterparty to effect substantive protocol terms with that counterparty.

Adhering parties need both to adhere to the VM Protocol with ISDA and exchange the questionnaires with their counterparties. The VM Protocol agreement then provides a set of contractual “rules” for the process of exchanging questionnaires via a “matching” process in order to determine the specific agreed terms between two adhering market participants.

The questionnaires are designed to provide the same flexibility for parties that would be available in a traditional bilateral negotiation of CSA terms. A market participant may specify which margin requirements it would like to comply with and its commercial preferences in respect of CSA terms. Then, depending on what its counterparty has specified in its own questionnaire, the “rules” in the VM Protocol will dictate what the agreed terms are between the two parties.

Those “rules” distinguish between certain core terms (called “condition precedent matching” in the VM Protocol), in respect of which there must be exact agreement between the parties’ election in their respective questionnaires, and other terms (called “additive matching” and “matching with fallbacks” in the VM Protocol), in respect of which there does not need to be exact agreement between the parties and in respect of which the VM Protocol will automatically apply certain terms to both parties.

In order to ensure full flexibility, a market participant may send different questionnaire responses to different counterparties. In addition, an asset manager may complete different questionnaire responses in respect of different underlying funds or clients.

Should you use the VM Protocol?

There is no requirement to use the VM Protocol, and it represents just one method of amending or creating CSAs in order to comply with the applicable margin requirements.

For certain market participants, the VM Protocol may offer an administratively efficient method of making the necessary amendments. However, others may find that the complexities involved with potentially numerous questionnaires and the matching process mean that they would prefer to amend CSA terms on a bilateral basis.

It is also worth noting that the vast majority of previous ISDA protocols were limited to relatively minor, straightforward or representation fixes but this new VM Protocol is designed to introduce major amendments to existing commercial and operational terms of contractual documents and even create brand new ones.

Given the looming commencement date of March 2017 for all in-scope market participants, we suggest that even those not affected by the initial wave of IM and VM requirements take steps to consider how they intend to deal with the VM requirements and the required documentary changes.