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Aritra Chatterjee*
I. INTRODUCTION
The Reserve Bank of India (RBI) recently finalised the regulations for exchanging initial margin for non-centrally cleared derivatives (Indian Initial Margin Regulations or the Regulations), which will come into force on 8 November 2024. The culmination of nearly four years of forethought by the RBI, including two years of consultation, the Indian Initial Margin Regulations represents a significant milestone in the regulatory landscape of the Indian financial sector. This is particularly noteworthy given the exponential growth of the Indian derivatives market over the past decade. According to industry estimates, the notional value of the Indian derivatives market stood at approximately USD 9.3 trillion as of 2022, making it one of the largest derivatives markets globally. Given this context, developing a robust regulatory framework to mitigate risks associated with non-centrally cleared or over-the-counter (OTC) derivatives, while mirroring the steps taken in other major global jurisdictions, was imperative. This article intends to, first, offer a concise overview of the legislative background of initial margin regulations worldwide, second, outline the principal features of the Indian Initial Margin Regulations, third, underscore how the Indian Initial Margin Regulations diverge from comparable regulations in other jurisdictions, and fourth, discuss potential challenges and uncertainties that market participants may encounter.
II. LEGISLATIVE BACKGROUND
After the global financial crisis in 2008, leaders of the G-20 met in Pittsburgh in 2009, following which new laws were introduced in most major economies to regulate over-the-counter (OTC) derivatives. These new laws/regulations implement various safeguards to prevent potential future destabilisation of the financial system, including enhanced reporting requirements and additional risk mitigation requirements for non-centrally cleared derivatives (NCCDs).[1] NCCDs, also called OTC derivatives, are financial contracts traded (and typically privately negotiated) directly between two parties without going through an exchange or other intermediary. This is in contrast to centrally cleared derivatives, where a central counterparty (CCP) stands between the buyer and seller.[2]
Non-centrally cleared derivatives carry a higher degree of counterparty risk (the risk that the other party will not fulfil their contractual obligations), as there is no CCP to guarantee the transaction. To mitigate this risk, laws were introduced in various jurisdictions so that parties involved in non-centrally cleared derivatives enter into collateral arrangements where assets (usually securities or cash in a separate custodian account) are pledged to cover potential losses. This exchange of collateral for NCCDs is called margining. Margining ensures that parties entering one or more derivatives trades hold sufficient collateral to cover their losses if their counterparty defaults. The main legislations requiring margining for NCCDs include the Dodd-Frank Wall Street Reform and Consumer Protection Act, simply called the Dodd-Frank Act in the US and the European Market Infrastructure Regulation or EMIR in the EU (and its post-Brexit identical twin UK EMIR in the UK). Similar regulations were also introduced in other major economies, including Australia, Canada, Hong Kong, Japan, and Singapore.
Regulatory margining can broadly be classified into two categories: (i) Variation Margin (VM) and (ii) Initial Margin (IM). VM is intended to cover the current market value of derivatives transactions, which are subject to daily fluctuations; therefore, the collateral for VM is exchanged daily. IM, on the other hand, is designed to protect a party and cover its current and potential future exposure in the interval between the last collection of VM and the liquidation or the re-hedging of derivatives transactions following a default of the other party.[3] RBI introduced regulations in relation to VM in June 2022, and now, with the introduction of the Initial Margin Regulations, the regulatory framework related to margining for OTC derivatives transactions in India is somewhat similar to the regulatory framework of other leading economies. The IM and the VM regulations together have been consolidated into the Reserve Bank of India (Margining for Non-Centrally Cleared OTC Derivatives) Directions, 2024.
In terms of documentation to comply with regulatory margining requirements, market participants globally use standard agreements developed and published by the International Swaps and Derivatives Association (ISDA), which are designed to work alongside the primary form of contract used by market participants in relation to OTC derivatives, the 2002 and 1992 versions of the ISDA Master Agreement.
III. KEY FEATURES OF THE INDIAN INITIAL MARGIN REGULATIONS
The Indian Initial Margin Regulations, like most other regulatory regimes including the Dodd-Frank Act and EMIR, follow the key principles for IM, which were set out by the Basel Committee for Banking Supervisions (BCBS) – Board of International Organisation for Securities Commission (IOSCO), which were first published in 2013. The most important of these principles are:
Segregation: The collateral posted as regulatory IM must be segregated from other assets and held in a third-party custodian account. Segregation is essential to ensure that assets posted to comply with IM regulations do not co-mingle with other assets of the parties to ensure it is insulated from default or credit risks.
Transferability: The collateral posted as Regulatory IM must be freely transferable from the pledgor to the pledgee or back to the pledgor if the pledgee has transferred any excess collateral. The collateral should not be subject to any re-hypothecation.
Eligibility Criteria: Only certain assets (such as cash and securities that meet specific credit quality requirements) can be posted as collateral. The eligibility criteria are particularly important as the risk of counterparty default is heightened during market stress (e.g. 2008 financial crisis), and the value of securities tends to erode faster during such periods of market stress. Allowing only high-quality securities provides some comfort as their value is less likely to erode significantly during market stress.
Models for calculation of Initial Margin: To determine how much collateral to post as IM, parties must follow the specific grid or table set out in the relevant regulations or an industry standard quantitative model which meets specific criteria.
Adhering to these fundamental principles of Initial Margin (IM) regulations is vital for ensuring harmony across different jurisdictions. This is particularly important in today's interconnected financial markets, where entities often engage in derivative transactions with counterparties located in various parts of the world, each governed by its own set of rules. Therefore, an entity that trades with counterparties across jurisdictions may require exchanging IM in accordance with each regime that applies to its regulated counterparties, even if that entity is not itself directly subject to the margin regulation of that jurisdiction.
The other main provisions of the Indian Initial Margin Regulations and how they compare with other global regulations are set out below:
A. Covered Entities
Section 4 of the Regulations set out the entities to whom these Regulations are applicable. The 'in-scope' or covered entities under Indian Initial Margin Regulations, who are required to comply with the Indian Initial Margin Regulations and exchange IM, are classified as 'Domestic Covered Entities' and 'Foreign Covered Entities'. 'Domestic Covered Entities' are entities regulated by a financial sector regulator (e.g. banks, mutual funds, insurance companies, etc.) whose average aggregate notional amount on outstanding derivatives trades is ₹60,000 crores and above, on a consolidated group-wide basis. Notably, Indian branches of foreign banks are classified as Domestic Covered Entities. Foreign Covered Entities are non-residential financial counterparties whose average aggregate notional amount on outstanding derivatives trades is USD 8 Billion and above.
Unlike EMIR (and UK EMIR) and the IM regulations of some other jurisdictions (e.g. Hong Kong), the Indian Initial Margin Regulations do not include large non-financial entities in their scope. The ₹60,000 crore and USD 8 billion threshold for Domestic Covered Entities and Foreign Covered Entities are in line with similar regulations elsewhere, including EU, Singapore, and Hong Kong.
The Indian Initial Margin Regulations also exempts physically settled FX forward transactions, which are transactions that involve the exchange of two different currencies on a specific future date at a fixed rate which is agreed on the trade date at the beginning of the contract / transaction. Physically settled FX forwards are excluded from major IM regulations in the world, including in the EU, US, Japan and Canada, though in certain jurisdictions it is subject to Variation Margin or VM regulations. This is presumably because physically settled FX transactions have a shorter tenure and carries relatively less counterparty risk compared to other types of derivative transactions.
B. Calculation of Margin
The Indian Initial Margin Regulations follows the other major IM regulations and sets out that IM to be posted by the covered entities can be calculated either by referencing the table set out in Annex I to the Regulations (commonly referred to as the 'grid'), which sets out the IM requirement as percentage of notional exposure based on the residual maturity and asset class of the products being traded, or a quantitative portfolio margin model Annex II to the Regulations explicitly set out parameters for the quantitative portfolio model. The quantitative model should calculate the future exposures of OTC derivatives based on 99 percent confidence interval over a 10- day time horizon. Practically, market participants, if they want to avoid following the grid, generally follow the ISDA SIMM model developed by ISDA to calculate the Initial Margin. Market participants would not need to reinvent the wheel as the ISDA SIMM model adheres to the parameters set out in the Regulations.
C. Eligible Collateral
As stated above, only certain types of securities of good credit quality can be posted as Initial Margin. The Indian Initial Margin Regulations state that only Indian currency and debt securities issued by the central and state-governed are eligible collateral types for the exchange of Initial Margin between domestic covered entities. When one of the parties is a foreign-covered entity, this list is expanded to include freely convertible foreign currency and debt securities issued by foreign sovereigns with a minimum credit rating of AA- (if rated by S&P) or Aa3 (if rated by Fitch).
The types of collateral permitted by the Indian Initial Margin Regulations are significantly limited compared to most initial margin regulations globally. For example, EMIR (and consequently UK EMIR) allows securities issued by multilateral development banks, local municipal bodies and corporates to be exchanged as Initial Margin. Closer to home, Hong Kong and Singapore regulations allow gold and even publicly traded equities to be exchanged as eligible collateral. The RBI has ignored the recommendations of industry bodies like ISDA and has prescribed a relatively limited list of collateral types which can be exchanged as IM.
Practically, the types of collateral allowed by margin regulations act as a superset for collateral types for market participants. Market participants typically negotiate certain types of collateral from this list and agree upon parameters like credit rating, tenor, etc. (based on their internal policies and risk appetite) when they put in place agreements for the exchange of initial margin with their counterparties. The limited scope of eligible collateral set out in the Indian Initial Margin Regulations might require market participants to reconsider their collateral management strategies, as the Indian Initial Margin Regulations exclude certain types of collateral allowed by regulations elsewhere.
D. Collateral Service Providers
To ensure segregation of securities exchanged as Initial Margin, most regulations globally require collateral to be segregated and held by a third-party custodian. The Indian Initial Margin Regulations have similar provisions and allow collateral to be placed with third-party custodians in India or abroad. However, in practice, there is little incentive to place Indian government securities outside of India as they are subject to the laws and jurisdiction of the courts of India as per the Government Securities Act, 2006, in any case. The Clearing Corporation of India and scheduled commercial banks have been permitted by the Indian Initial Margin Regulations to act as third-party custodians. However, the Indian Initial Regulations are not as detailed as the regulations elsewhere in terms of principles that govern third-party custodians.
Third-party custodians for OTC derivatives are not as common in India as they are in other markets. Therefore, there are no separate rules governing third-party custodians that address critical issues like how third-party custodians will ring-fence their operations if they are also actively trading in derivatives or acting as payment service providers. Ring fencing of custody-operations, robust procedures for segregation and transfer of securities posted as margin or collateral as well as procedures for prompt redelivery of excess collateral are some of the key principles for governance of third-party custodians in the context of Initial Margin.
E. Compliance with the Requirement of a Foreign Jurisdiction
The concept of substituted compliance in the context of Initial Margin implies that if the regulatory requirements of a foreign jurisdiction in relation to the exchange of Initial Margin are similar or stricter than the requirements of the home jurisdiction, compliance with the requirements of the foreign jurisdiction is sufficient.
In the initial draft of the IM rules, which was released for consultation in 2022, substituted compliance was permitted for transactions between branches of foreign banks and other offshore entities. However, this provision was not extended to transactions between two local branches of foreign banks or between a local branch of a foreign bank and an Indian entity. RBI, however, has now allowed substituted compliance when one of the parties involved is a local branch of a foreign bank. This could be a reason for much respite for Indian branches of foreign banks, which otherwise would have been subject to different and potentially overlapping margin requirements when transacting with a domestic firm.
IV. LEGAL AND MARKET INFRASTRUCTURE-RELATED UNCERTAINTIES
The introduction of the Indian Initial Margin Regulations was highly anticipated, but despite the Regulations being along the expected lines, market participants should be prepared to tackle uncertainties as the exchange of collateral for OTC derivatives is still a novel concept in India. Some of these uncertainties relate to market infrastructure and market awareness, while others stem from legal issues due to the interplay of various other existing laws and regulations. Some of these uncertainties are set out below.
A. Lack of Custodian Infrastructure in India
As mentioned above, collateral posted as an Initial Margin is held and segregated by third-party custodians. In the global markets, a few reputed financial institutions like HSBC, JP Morgan, BNYM, etc., provide such custodian services. Typically, the parties involved in exchanging Initial Margin (as pledgor and pledgee) enter into a tri-partite account control agreement with third-party custodians to agree, among other things, how the collateral will be segregated, when can the third-party custodian transfer the collateral following an event of default and liability and indemnity provisions related to discharge of the custodian's functions. The market infrastructure related to the third-party custodian, as well as the legal framework for their operation, has developed over a prolonged period of time. Terms of the account control agreements have also been broadly standardised.
In India, on the other hand, there is no existing framework for the operation of third-party custodians in the context of Initial Margin. There are no established OTC custodians in the Indian market, and there is a lack of standardised documentation published by ISDA or any other industry body in relation to third-party custodians. This needs to develop sooner rather than later, and the custodian infrastructure and the legal framework for the operation of third-party custodians have to match the existing infrastructure and legal framework of other jurisdictions to provide comfort to foreign-covered entities as well as local branches of foreign banks. Addressing custodian infrastructure is imperative for the successful operation of Initial Margin Regulations but seems very challenging at the moment, as exchanging collateral for OTC derivatives is still a novelty in India.
B. Legal Uncertainties Around the Judicial Treatment of Debt Securities and Government Securities
The securities posted as initial margin will be pledged and, therefore, would be subject to the provisions of the Indian Contract Act, 1872. The law around a contract of pledge in India has still not been developed in the context of debt securities. The existing jurisprudence in India is around pledges over shares. There are no clear precedents that address the issue of the pledgee taking control of securities in dematerialised form, especially when such securities are held by a third party (a custodian in the case of Initial Margin). One might argue that the industry standard documents published by ISDA for the exchange of Initial Margin are governed by foreign laws, including English law. However, it is pertinent to note that as per the Government Securities Act, 2006, government bonds issued by central or state governments are subject to the laws of India and the jurisdiction of Indian courts. Therefore, as an example, the ISDA credit support deed for exchange of Initial Margin may be governed by English law, but if it includes Indian government securities as eligible collateral, such Indian government securities will still be governed by Indian law. This is similar to Japanese government securities, and to include an element of contractual certainty, ISDA has published specific Japanese security provisions which can be incorporated into English law-governed collateral documentation. However, there is no industry-wide consensus around contractual terms for Indian securities included as eligible collateral. Therefore, foreign-covered entities and local branches of foreign banks might be tempted to steer clear of Indian securities for the purpose of Initial Margin. Moreover, the creation as well as invocation of the pledge of government securities is a complicated process and would require the involvement of the RBI as per the procedure set out in the Government Securities Regulations, 2007.
C. Additional Perfection Requirements
Market-participants would need to take additional steps to ensure that the securities posted as collateral have been perfected as per Indian laws. This includes payment of stamp duty, which may be required for the execution of IM agreements like the ISDA Credit Support Deed, account control agreement, and any ancillary documents like notices. Stamp duty may also be required for the transfer of securities from the third-party custodian to the secured party or the pledgee. An Indian company or an Indian branch of a foreign bank may be required to register any charges created for the purpose of posting Initial Margin with the Registrar of Companies. Failure to do so may attract penalties and affect the enforceability of the security interest. Some jurisdictions, e.g. the UK, have regulations to exempt such registration requirements, but no such exemptions are currently available in India.
V. CONCLUSION
On balance, the Indian Initial Margin Regulations adhere to the BCBS-IOSCO principles and take a step forward towards mitigating systematic risks which may affect the OTC derivatives market in India. However, market participants might get caught off-guard by the effective date of 8 November 2024 due to a lack of custodian infrastructure, industry-wide consensus on the treatment of government securities as Initial Margin, as well as lack of exemptions related to perfection of charges which are available in other jurisdictions. To facilitate compliance with margin regulations in India, RBI, as well as market participants, including industry bodies like ISDA, need to come together to first, develop a legal framework and market infrastructure for the operation of third-party custodians, second, develop industry-standard documentation like account control agreements and contractual provisions in relation to Indian government securities for the existing ISDA standard documentation, and third, develop a regime for exemption of certain registration/stamp duty requirements to facilitate timely exchange of collateral. It would not be surprising to see most local branches of foreign banks and foreign entities rely on substituted compliance provisions of Regulations to fulfil their regulatory obligations.
(Views expressed in this article are personal and do not represent the views of any firm or organisation. The article may not be construed as a legal advice)
[1] Basel Committee on Banking Supervision, Board of the International Organization of Securities Commission, Margin requirements for non-centrally cleared derivatives (Bank for International Settlements 2013), Part A < https://www.bis.org/publ/bcbs261.pdf> accessed 3 September 2024.
[2] Simon Firth, Firth of Derivatives Law and Practice (Sweet & Maxwell 2021), ch 1.
[3] Basel Committee on Banking Supervision, Board of the International Organization of Securities Commission, Margin requirements for non-centrally cleared derivatives (Bank for International Settlements 2015), Key Principle 3 <https://www.bis.org/bcbs/publ/d317.pdf> accessed 8 September 2024.
*Aritra Chatterjee is a Manager in the Digital Legal Delivery department at Herbert Smith Freehills (HSF), based in their Belfast office. His area of expertise lies in derivatives, banking and finance. Before joining HSF, he has worked in the derivatives teams of Clifford Chance, JP Morgan, and HSBC.
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