Margin Requirements for Non-Centrally Cleared OTC Derivatives

[The following guest post is contributed by Rishi A., who is a 5th year
law student at HNLU, Raipur]
At the end of
2008, the world, especially the United States, witnessed one of the worst
financial crises. The tipping point in this crisis was not the bad credit
quality of the household mortgages that were losing their value because of a
number of reasons including the growing interest rates of the mortgages. The
issue here was that there were layers of other instruments, derivatives like mortgage
backed securities (MBSs) and collateralized debt obligations (CDOs), which were
created keeping these mortgages as the underlying securities. Hence, once the
underlying assets deteriorated in their value, these derivatives too started
losing their value and the rest is history.[1]
During this
time, private banks and other financial institutions had major holdings in
these MBSs and CDOs. Thus, when the instruments started losing value and when
it became difficult to find buyers, the banks found themselves under extraordinary
liability. As a result of this, we saw Lehman Brothers file for bankruptcy and
other major banks relying on the government for a bail-out. The banks and
financial institutions generally conducted their trades Over-The-Counter (OTC),
whereby they could keep the transactions private. Furthermore, these
transactions did not require disclosures to be made to the central securities
regulator as they were not conducted on exchanges. The fact that these
transactions were conducted in the absence of a central counterparty was considered
to be one of the reasons for their default and thus the crisis.[2]
A derivative
without any counterparty poses two primary risks – first of default and second
of systemic risks, as was evidenced from the 2008 financial crisis.[3]
Thus, to counter these risks posed, it was decided to implement a margin
requirement. Such a requirement would require a party, buying a derivative, to
pay a margin amount or provide a security that could be used to absorb any
losses that could arise because of a party’s default; in turn it would also
help the party from keeping its financial resources being used to make good the
OTC transactions
are transactions between two private entities which are not cleared by a central
counterparty. However, in the last year or so, the Basel Committee on Banking
Supervision and the International Organization of Securities Commissions

came up with a framework on margin requirements for non-centrally cleared
derivatives.  In May 2016, the Reserve
Bank of India too came up with a Discussion
on the same subject and has requested market participants for their
requirements will require one party to deposit an initial margin with the other
party, so that the risk of default is adequately protected by the collateral
provided as the initial margin. The amount of the initial margin would be
assessed after evaluating the potential exposure of the contract being
transacted. Thereafter, a variation margin would become applicable, which would
work as a ‘Mark-to-Market’ requirement that would be computed on a daily basis,
thus covering the current exposure of that contract. While a mark-to-market is
required to be settled on a daily basis, the discussion paper proposes to allow
the settlement of the variation margin on a regular basis.
Similar to the international
framework, physically settled derivatives like commodity derivatives, which
provide the commodities as collateral, have been excluded from calling for
initial margins.[5]  More importantly, the discussion paper has
also provided a list of eligible collaterals that can be exchanged as initial
or variation margins and they include: cash; securities issued by the Central
or State Government; and corporate bonds above BBB rating. The international
framework on the other hand allows equities in major stock indices and also gold
to be used as collateral for the margins. Further, the margin requirement would
be made applicable to OTC derivative transactions conducted by scheduled banks
and other entities under the purview of the RBI. The discussion paper proposes
to restrict the application of the margin requirements to transactions of
derivatives which are not centrally cleared with the view to contain any
potential systemic risks and to promote central clearing. However, with an aim
to implement the requirement phase-wise, the RBI has proposed to make the
requirement applicable to all financial entities and certain large
non-financial entities, wherein large non-financial entities have been used to
mean non-financial entities which have an aggregate notional amount of
outstanding non-centrally cleared derivatives at or more than INR 1000 billion.
While the international framework makes the margin requirement applicable to
every entity participating in non-centrally cleared derivative transactions,
the RBI has also proposed to extend the application over all interested
entities but only in a phased manner.
One major difference
that needs to be highlighted is that while the international framework allows
for the re-hypothecation of the Initial Margin collected (only once, that too
to hedge that particular position’s risk) the RBI’s discussion paper does not
allow for the same. It however, does allow the re-hypothecation of the Variable
Margin.  The RBI reasons it out by
stating that the Initial Margin, which by itself is supposed to be treated as a
security against the chances of default by the opposite party creating third
party charges over the same, would defeat the purpose of creating the margin.
The discussion paper
also proposes to exempt intra-group transactions between group entities from
calling for initial or variation margin. Furthermore, the RBI has offered to
coordinate with foreign jurisdictions in implementing these margin
requirements. It has stated that for cross-border transactions, if the host
country has its margin requirement regulations, those would be imposed on the
transactions, and if the host country does not have any such regulations, then
the RBI’s requirement would be applicable on the transaction.
A Quantitative
Impact Study conducted before the release of the international framework
estimated that close to 600 billion Euros would be mobilised for the purposes
of providing initial margin.[6]
Assuming that the initial margin requirement applicable on RBI regulated
transactions mobilises a similar amount, it was prudent for RBI to restrict that
capital from being re-pledged or re-hypothecated. On the other hand, allowing
the pledge or hypothecation of the variation margin, which would effectively
represent the mark-to-market payments made for centrally cleared derivatives,
makes more sense as it is nominal in comparison with the initial margin. More
importantly, a default in producing the variation margin is less likely to
create systemic risks as compared to the default in the producing the initial
studies also suggest that large market participants would eventually move out
of the non-centrally cleared OTC derivatives segment as the transaction costs
have substantially increased.[7] This
could effectively lead to the elimination of speculators who would now look to
invest in less capital intensive segments and encourage financial institutions
like banks to shift to trading standardized contracts which are floated on the
exchanges, thus bringing the transactions under regulatory purview.
The RBI had
asked the interested parties to send their comments on the discussion paper by
June; we can therefore hope to see the final regulations on the margin
requirement soon.
– Rishi A.

[1] For extra reading please refer
or see the 2015 Hollywood movie, ‘The Big Short’.

[2] Dr. Shrawan Kumar Singh, ‘U.S. Sub-Prime Crisis & Its Total
Global Consequences’,
Available at:

[3] ‘Margin Requirements for non-centrally cleared derivatives’, Basel
Committee on Banking Supervision and International Organisation of Securities
Commission, March, 2015, Available at:
[4] Ibid.
[5] Ibid.
[6] ‘Quantitative Impact Study on Margin Requirements for Non-Centrally
Cleared OTC Derivatives’,
Appendix C, Second Consultative Document: Margin
Requirements for Non-Centrally Clear Derivatives, February, 2013, Available at:
[7] ‘OTC Derivatives: The New Cost of Trading’,  EMEA Centre for Regulatory Strategy, Available at:

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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