VM directions bring local flavour to global swap markets

Announcing new guidelines over derivative transactions, the Reserve Bank of India (RBI) issued Master Direction – Reserve Bank of India (Variation Margin) Directions, 2022 (VM directions) on 1 June. While broadly based on the Basel Committee on Banking Supervision-International Organisation of Securities Commissions Framework on margin requirements for non-centrally cleared derivatives (BCBS-IOSCO framework), the VM directions contain unique features adding complexity to swap relationships with Indian counterparties.

Regime features

Variation margin (VM) is the margin that parties to non-centrally cleared derivative (NCCD) transactions periodically exchange to reduce exposure to each other to zero. VM is required to be exchanged for NCCDs permitted by the RBI, namely forex derivatives (other than physically settled forwards and swaps), interest rate derivatives, and credit derivatives between domestic covered entities (DCEs) and foreign covered entities (FCEs).

VM is calculated daily on aggregate net basis across all qualifying NCCDs under a single netting agreement (generally an International Swaps and Derivatives Association master agreement) and exchanged within three days. VM exchange is exempted for intra-group NCCDs and those with any branches central or state governments of India, foreign sovereigns, central banks, the Bank for International Settlement and multilateral development banks.

DCEs are Indian regulated financial entities with NCCDs of average aggregate notional amount (AANA) across consolidated groups worth more than INR250 billion, or Indian non-financial entities with AANA of more than INR600 billion. FCEs are foreign financial entities with AANA of more than USD3 billion, or foreign non-financial entities with AANA of more than USD8 billion. VM between DCEs may only be exchanged in specified INR-denominated collateral (onshore collateral), while VM between a DCE and FCE may also additionally be exchanged in specified collateral denominated in any freely convertible currency (offshore collateral).

Substituted compliance is only available for DCEs trading with FCEs, subject to a margin regime assessed by the DCE as comparable to the VM directions. The RBI has not provided a list of comparable margin regimes, but has set out principles – including netting certainty and BCBS-IOSCO framework-based margin regime – for regime comparability analysis, placing the onus on each DCE to make its own assessment. DCEs would need to decide on the supporting material backing their comparability assessment, including independent legal opinions.

The analysis

Indian branches of foreign banks are classified as DCEs, while their foreign branches are classified as FCEs. Substituted compliance with their home jurisdictions is not available for such foreign bank DCEs in trading relationships with other DCEs, even if their home jurisdiction has a comparable margin regime. Such dual classification for the same legal entity and VM exchange split between onshore and offshore collateral would require parties to monitor and value two NCCD sets and execute separate credit support annexes (CSAs) for each set. This marks a departure from the “global single CSA” model under which VM for all NCCDs from multiple branches under the same netting agreement is exchanged under a single CSA, which is general practice in the cross-border swap market.

In swap relationships with Indian entities and banks with Indian branches, parties now require separate India-specific CSAs, or significantly customised single CSAs, to ensure onshore collateral exchange for trades between DCEs. While such a VM split may be commercially neutral, it adds to documentation and operational complexity, including monitoring minimum threshold amounts for VM exchange across two CSAs and currencies.

While VM exchange has been exempted for trading relationships with a foreign sovereign, the term “foreign sovereign” has not been specifically defined. This may lead to uncertainty in assessing VM applicability for sovereign instrumentality entities such as wealth funds, state-owned oil companies, and pension and investment funds. Coverage of non-financial firms in the VM directions may also require Indian subsidiaries of offshore entities having negligible standalone AANA to exchange VM in India due to high consolidated group AANA, even though other constituents of the group contributing the major chunk of the consolidated AANA may not be required to exchange VM, due to their home jurisdictions exempting non-financial firms.

Similarly, non-financial entities in jurisdictions not requiring them to exchange VM would be required to do so when dealing with an Indian bank (including its offshore branch), and not with any other banks, serving as a disincentive for them to deal in NCCDs with Indian banks and their foreign branches.

Jian Johnson is a partner at Cyril Amarchand Mangaldas in Mumbai