New APRA requirements for super fund trustee l Mercer Australia

New APRA requirements for super fund trustee l Mercer Australia

Our Thinking / Super / Governance Update

New APRA requirements for super fund trustees when using OTC Derivatives
Calendar20 August 2017

A trustee that uses or permits over-the-counter (OTC) derivatives in its investment portfolio will need to comply with APRA Prudential Standard CPS 226 Margining and risk mitigation for non-centrally cleared derivatives (CPS 226) released on Monday 7 August 2017. 

CPS 226 is a cross-industry prudential standard that applies to APRA regulated bodies, including RSE Licensees, who transact in “non-centrally cleared derivatives” (NCC derivatives). It reflects global regulatory changes imported into the Australian regulated arena.

A NCC derivative is a derivative transaction between two parties that is not cleared by any central counterparty or exchange but instead is traded (and negotiated) directly between the parties. These types of derivatives are sometimes referred to as “over-the-counter” (or “OTC”) derivatives and examples include interest rate swaps, foreign exchange forwards and swaps, commodity swaps, options or forward contracts.  NCC derivatives exclude any exchange traded derivatives, securities financing transactions, or derivatives that are cleared indirectly through a clearing member of an exchange on behalf of a client fund.

The new requirements impose two types of obligations: risk mitigation standards and margin requirements. These requirements are very detailed and complex but some key points are briefly noted below.

Risk Mitigation Standards

Express Risk Mitigation Standards apply in all cases where NCC derivatives may be used, that is, there are no minimum qualifying levels of NCC derivatives activity required.

As a result the new standards apply where a trustee utilises OTC derivatives in its investment portfolio or if a manager mandate permits the use of OTC derivatives.

The new key obligation is to have express policies and procedures in place for risk mitigation standards for NCC derivative transactions.  These need to be in place by 1 March 2018 and must address APRA minimum requirements relating to:

  • trading and relationship documentation
  • trade confirmations
  • portfolio reconciliation
  • portfolio compression
  • valuation processes
  • dispute resolution.

Effefectively, Trustees will need to review and revise their existing investment risk management policies (including their Investment Management Framework) and agreements with their managers to include express provisions addressing these new requirements.

As noted above, the risk mitigation requirements apply for all NCC derivative transactions, irrespective of the level of NCC derivative activity.

Margin Requirements

Margin requirements require the trustee and the counterparty to post collateral when entering into a NCC derivative contract. The purpose of this collateral is to provide protection and offset against the risk of losses caused by the default of a NCC derivative counterparty. That is, in the event of a counterparty default, margin protects the surviving party by absorbing losses using the collateral provided by the defaulting entity.

CPS 226 requires parties entering into a NCC derivative to exchange two types of margins. The first is a variation margin which is collateral intended to cover current exposure of a NCC derivative.  The second is an initial margin which is collateral intended to protect against potential future exposure.

In practice, due to the significant thresholds involved, the variation margin requirements will apply to some but by no means all RSE Licensees utilising NCC derivatives and the initial margin requirements will apply to only the very largest RSE licensees.

APRA’s objective (consistent with the global regulatory initiative) is to mitigate systemic risk arising from off market derivative transactions between larger counterparties and for this reason the new margin requirements do not apply in all cases but only where NCC derivative activity exceeds certain qualifying levels.

The lowest qualifying level at which variation margin requirements apply is where the trustee and the counterparty are each part of a group whose average month-end notional outstanding NCC derivatives exceeds AUD$3 billion.  This obligation comes into effect on 1 September 2017.

The initial margin requirements have a much higher qualifying level but are phased in between 1 September 2017 and 1 September 2020 depending on the level of NCC derivative activity.  The qualifying level commences from 1 September 2017 at AUD$4.5 trillion and reduces to AUD$12 billion by 2020.

Key aspects of the margin requirements include requirements to:

  • exchange variation margin using a zero threshold (so that the mark-to-market exposure of the NCC derivative transactions is fully collateralised)
  • post and collect initial margin on a gross basis calculated by either the standardised schedule or a model approach approved by APRA
  • collect eligible collateral as margin and apply risk sensitive “haircuts” on collateral collected
  • ensure that initial margin is held in a manner that provides legal certainty to both counterparties in the event of insolvency or bankruptcy.

Variation margin requirements may already apply in practice to some existing arrangements.  The new standards make such arrangements mandatory, if the relevant thresholds are exceeded.

Substitute Compliance

APRA has permitted substituted compliance with respect to margin requirements where the obligation to exchange margins under both CPS 226 and equivalent foreign margin requirements apply. This means that counterparties subject to both CPS 226 and equivalent foreign rules will only need to comply with one set of requirements.

However, APRA has made it clear that substituted compliance does not extend to the risk mitigation standards requirements in CPS 226. Consequently, a trustee will need to be satisfied that it has taken the necessary steps to meet the risk mitigation requirements in all cases where NCC derivatives may be used.  

How can Mercer help?

  • Review your existing arrangements, policies  and manager mandates where OTCs may be permitted;
  • Provide detailed advice on the new requirements and how they impact your fund, including a gap analysis and recommended actions;
  • Assist you in preparing the risk mitigation standards, policies and procedures, including:
  • Drafting the required policies and procedures in accordance with the requirements of CPS 226.
  • Performing a risk management health check of your NCC derivative activity.
  • Aligning the new policies and procedures to your broader Risk Management and Investment Management Framework.
  • Review, and if required, renegotiate your Investment Management Agreements/Mandates to ensure appropriate conditions are in place consistent with the new requirements.
  • Assist with the operational controls component of NCC derivatives management, with the expertise of Mercer Sentinel.  Mercer Sentinel is a dedicated, investments specialist team focused on advising on all aspects of investment manager operational efficiency.

For further information, please contact us using the form below, 

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