Written by Senior Associates Jo Ottoway and Rod Aldus
Late last year, APRA released the implementation schedule for its long-awaited Prudential Standard CPS 226 Margining and risk mitigation for non-centrally cleared derivatives. While the final rules for the Prudential Standard CPS 226 were released in October 2016, the release of the implementation schedule confirmed what was suspected by the industry – the requirement to exchange variation margin would commence for APRA-regulated entities from 1 March 2017. The exchange of variation margin refers to the requirement of a party to provide, on a net basis, sufficient collateral to cover its counterparty's mark-to-market exposure in respect of non-centrally cleared derivatives and vice versa.
We've been tasked specifically to look at what this all means for superannuation funds a few times already and wanted to share some of our thoughts.
Registrable superannuation entities are specifically targeted by CPS 226 and therefore prima facie are required to exchange variation margin on their non-centrally cleared OTC derivatives entered into with other APRA-regulated entities and 'Covered Counterparties' (as defined in CPS 226). Further, other types of trusts and funds may fall into the broad definition of 'Covered Counterparty', which includes, but is not limited to, those engaged substantively in one or more of the following activities:
- issuing credit cards;
- portfolio management (including asset management and funds management);
- management of securitisation schemes;
- equity and/or debt securities;
- futures and commodity trading and broking;
- custodial and safekeeping services;
- insurance; and
- similar activities that are ancillary to the conduct of these activities,
Additionally, hedge funds, trading firms, and foreign deposit-taking institutions are considered to be Covered Counterparties. While there are some exemptions for special purpose vehicles which may apply to certain funds and trusts, it is important for trustees to have properly considered whether their trust or fund is a Covered Counterparty.
Helpfully in Australia, there is also a threshold for non-centrally cleared OTC derivatives which an entity must exceed before it becomes subject to CPS 226 (which is A$3 billion for variation margin). However, this threshold is calculated on the 'margining group' of an entity, which means all of the entities who are in the same consolidated financial reporting group. Further, the corresponding legislation in the European Union, Hong Kong, Singapore, Canada, Japan, Switzerland and the United States do not have such a threshold, so funds may be exempt in Australia but still subject to margining requirements for OTC derivatives with offshore counterparties.
Other considerations for trustees of superannuation funds
Importantly, in addition to getting their heads around the new margining requirements themselves, trustees of superannuation funds caught by the new rules also need to ensure that they are complying with the SIS derivative charging provisions.
A trustee of a superannuation fund is prohibited from giving a 'charge' over, or in relation to, fund assets, subject to certain exceptions for derivative contracts. Due to the broad definition of 'charge' under SIS, margining arrangements related to OTC derivatives, which are typically undertaken by way of title transfer, may involve the giving of a 'charge' over fund assets. Therefore, it is important for trustees to structure their trading in OTC derivatives so that they can rely on one of the derivative charging exceptions (for details regarding the exceptions, please see our earlier Unravelled article).
In our experience, if the trustee's investment manager is willing to be involved in collateral management on the trustee's behalf, relying on the exception in Regulation 13.15A(1B) is the simplest solution. Alternatively, it may be possible to negotiate a Credit Support Deed (as opposed to the usual Credit Support Annex) with counterparties to address the SIS charging issues in reliance on Regulation 13.15(1C), however to date, this approach have proved more challenging and time consuming.