Legal Updates

On 4 November 2021, the EBA¹ published a consultation paper on its draft Regulatory Technical Standards on Initial Margin Model Validation (IMMV) under the European Market Infrastructure Regulation (EMIR)². The consultation paper sets out the supervisory procedures for initial and ongoing validation of initial margin models.

Since 1 September 2016, initial margin (IM) requirements for non–cleared derivative transactions have been progressively entering into force. The IM requirements do not apply to all counterparties but only to those counterparties whose aggregate average notional amount (AANA) of non-cleared derivatives exceed a certain threshold level. The final phase, Phase 6, will commence from 1 September 2022 and will capture counterparties with an AANA between €8bn and €50bn. Counterparties falling within scope will be required to comply with the EMIR IM requirements as and from that date.

For “in scope” Irish UCITS/AIFs, the draft Regulatory Technical Standards on IMMV (RTS) will have important implications. Under EMIR, counterparties may use either: (1) internal models, such as ISDA’s Standard Initial Margin Model (SIMM); or (2) grid-based models. EMIR requires that counterparties using internal models must secure approval for the use of such models from their applicable national competent authority (NCA).

It is anticipated that the vast majority, if not all, of the Irish UCITS/ AIFs falling within scope of the IM requirements will choose to use the ISDA SIMM model for IM. Prior to the issue of the RTS, such industry participants had hoped that they would be exempted from the initial margin model validation requirements, similar to the position in the United States for smaller buy-side entities.

On 17 May 2019, a group of industry bodies, led by ISDA, published a letter³ addressed tothe ESAs⁴ (Letter) requesting that the authorities specify in the RTS that; (1) pre-approval should not apply to existing models that have been reviewed by NCAs in the EU (such as the ISDA SIMM model); and (2) that the requirement for pre-approval should exclude buy-side counterparties (i.e. those falling within Phases 4 onwards such as Irish UCITS/ AIFs).

Unfortunately, the draft RTS do not replicate the proposals set out in the Letter. Instead, the draft RTS provide for two distinctive processes: a standard and a simplified one, both to be carried out by the NCAs to validate the IM models. This proportionate approach is as follows:

• Larger firms with an AANA of €750 billion or above will fall under the scope of
  standard model validation; and
• smaller firms with an AANA below €750 billion will fall under a simplified modelvalidation.
  

The simplified validation process follows the structure as for the standard process, but with substantial simplifications with respect to it. These simplifications can be summarised as a less stringent threshold for model changes, a simplified backtesting programme (dynamic backtesting as opposed to the more onerous static backtesting) and less granular governance requirements. It is also proposed that NCAs will be allowed discretion to apply the standard model validation to a counterparty where the AANA is greater than €50 billion
based on the complexity and interlinkages of the counterparty activity in OTC derivatives.

The draft RTS propose that a two-year transitional provision will apply for the validation of IM models already in place immediately before the date of application of the rule (e.g. ISDA SIMM).

The draft RTS are set out in chapter 3 of the consultation paper. The deadline for responses is 4 February 2022.

If you have any queries about the information contained in this article, please contact the Financial Regulation Team or your usual Dillon Eustace contact.

Dillon Eustace

¹ European Banking Authority

²Regulation (EU) No 648/2012 as amended by Regulation (EU) 2019/834

³ September 2019 letter sent by ISDA, SIFMA, SIFMA Asset Management Group and ALFI.
⁴ European Securities and Markets Authority, European Banking Authority and the European Insurance and
Occupational Pensions Authority.