Master Direction – Reserve Bank of India (Margining for Non-Centrally Cleared OTC Derivatives) Directions, 2024

Introduction:

On May 08, 2024, the Reserve Bank of India (RBI) issued vide notification dated bearing No. FMRD.DIRD.02/14.01.023/2024-25 titled “Master Direction – Reserve Bank of India (Margining for Non-Centrally Cleared OTC Derivatives) Directions, 2024”. This notification establishes guidelines for margining non-centrally cleared OTC derivatives, replacing the previous Master Direction on Variation Margin from June 01, 2022. These directions, based on the powers conferred by Section 45W of the Reserve Bank of India Act, 1934, and Sections 10(4) and 11(1) of the Foreign Exchange Management Act, 1999, will come into force on November 08, 2024. The provisions apply to various non-centrally cleared derivative contracts, including foreign exchange, interest rate, and credit derivatives specified by the RBI.

In these Directions, the Initial margin is collateral for potential future derivative contract exposure that could arise from future changes in the market value of a derivative contract during the time it takes to close out and/or replace the position in the event of a counterparty default. and non-centrally cleared derivatives are contracts lacking central counterparty guarantee, and the Variation margin reflects current derivative contract mark-to-market exposure changes and Unspecified terms defer to Reserve Bank of India Act, 1934 definitions.

Comprehensive Margining Framework for Non-Centrally Cleared OTC Derivatives:

Entities regulated by a financial sector regulator in India with an Average Aggregate Notional Amount (AANA) of ₹25,000 crore and above and other resident entities with an AANA of ₹60,000 crore and above are classified as Domestic Covered Entities for Variation Margin (VM). Non-resident financial entities with an AANA of USD 3 billion and above, and other non-resident entities with an AANA of USD 8 billion and above, are classified as Foreign Covered Entities for VM. For Initial Margin (IM), domestic entities with an AANA of ₹60,000 crore and above and non-resident financial entities with an AANA of USD 8 billion and above are classified accordingly. AANA is calculated as the average notional amount of outstanding NCCDs at the end of March, April, and May. Covered Entities must exchange VM and IM with counterparties classified similarly but may opt out for certain transactions. These regulations exclude intra-group transactions, certain government entities, and specified financial institutions.

 Variation Margin must fully collateralize or settle the mark-to-market exposure of an NCCD contract daily, using an alternative process if marking to market is impossible. It is calculated on an aggregate net basis across all NCCD contracts under a single netting agreement. Initial Margin is calculated at the start of a transaction and regularly thereafter based on potential future exposure, including portfolio changes, market disruptions, and model recalibrations, to be recalculated within 10 working days. It can be determined using a standardized approach or a quantitative portfolio margin model chosen consistently within the same asset class. The Reserve Bank can require the use of the standardized approach if deemed necessary.

Variation Margin is exchanged on a net basis across all NCCD contracts under a single netting agreement. The initial Margin is exchanged on a gross basis without netting. A threshold of up to ₹450 crore applies to the Initial Margin at the consolidated group level, with the excess exchanged if the total exceeds the threshold. A minimum transfer amount (MTA) of ₹4.5 crore may be set for combined Variation and Initial Margins, with the entire margin exchanged if it exceeds the MTA. Margins should be exchanged within three local business days after the transaction or recalculation date. For Domestic and foreign-covered entity transactions, margins can be posted/collected in India or overseas as per relevant circular provisions.

Cash collateral received as Variation Margin is exempt from certain RBI provisions and may accrue interest per the credit support annex. It can be rehypothecated or reused. The initial Margin must be post-default, legally protected, and segregated from proprietary assets. It can’t be reused but can be reinvested with consent. Interest on Initial Margin accrues to the posting party. Cash collateral for both margins is exempt from specified RBI provisions.

Covered entities can place an Initial Margin in India or abroad, with eligible collateral service providers being Scheduled Commercial Banks and CCIL in India. These providers must segregate the Initial Margin from proprietary and other posting entities’ assets. For foreign jurisdictions, collateral service providers must be duly authorized. Eligible collateral for Variation Margin between domestic entities includes Indian currency, government debt securities, AAA-rated rupee bonds, CDs, and A1-rated commercial papers. Initial Margin between domestic entities uses Indian currency and government debt securities. Variation Margin with foreign entities adds freely convertible foreign currencies and high-rated foreign sovereign debt. Initial Margin with foreign entities also includes these types. Collateral must undergo risk-sensitive haircuts, with additional haircuts for currency mismatches. Securities issued by counterparties, or their affiliates are ineligible. Collateral risks must be managed, and substitutions are allowed if they meet the criteria. Compliance with foreign jurisdiction margin requirements is permitted using their eligible collateral types.

Domestic Covered Entities (DCEs) in NCCD transactions with Foreign Covered Entities can comply with domestic or foreign margin requirements if the foreign framework is deemed comparable. DCEs must assess the foreign margining framework based on principles such as membership in the BCBS-IOSCO, alignment with BCBS-IOSCO policy, and enforceable netting. This assessment requires a Board-approved policy, reviewed periodically by the Risk Management Committee. The Reserve Bank may also assess and impose additional conditions on foreign margining frameworks. DCEs must not exchange margins with foreign-covered entities if the enforceability of netting or collateral arrangements is doubtful and supported by a legal review and appropriate controls.

Counterparties must have dispute resolution policies and procedures before NCCD transactions, including processes for identifying and resolving discrepancies and escalating material disputes to senior management or the Board. For margin disputes, non-disputed amounts should be exchanged first, and efforts should be made to resolve and exchange the remaining disputed margin promptly.

The Reserve Bank can request information or clarifications from any agency involved in the NCCD markets, including covered entities and collateral service providers. These agencies must provide the requested information and clarifications within the specified timeframe.

For each netting agreement, the net standardized Initial Margin amount is calculated by multiplying the gross notional size of each derivative contract by the margin rate, summing these amounts across all asset classes, and then adjusting this sum using the ratio of the net replacement cost to gross replacement cost (NGR). The formula used is Net standardized IM = (0.4 + 0.6 × NGR) × gross standardized IM. The net replacement cost is the sum of all positive and negative mark-to-market values, floored at zero, while the gross replacement cost is the sum of positive mark-to-market values. Transactions with no counterparty risk can be excluded from this calculation.

The quantitative portfolio margin model for Initial Margin calculation must capture relevant risk factors, estimate potential future exposure with 99% confidence over 10 days, calibrate using up to 5 years of historical data with a stress period, consider netting agreements, diversification, and hedging, undergo independent validation and continuous monitoring, be approved by the Board, and documented to ensure compliance. Third-party models must also adhere to these standards.

Conclusion:

Reserve Bank of India’s “Master Direction – Reserve Bank of India (Margining for Non-Centrally Cleared OTC Derivatives) Directions, 2024” establishes a comprehensive framework for margining non-centrally cleared OTC derivatives, effective from November 08, 2024. This framework mandates the exchange of Variation Margin and Initial Margin to mitigate potential future exposure and current exposure in derivative contracts. The guidelines set stringent requirements for margin calculations, eligible collateral, and compliance, ensuring robust risk management and legal protections. These directions, issued under the RBI Act, 1934, and FEMA, 1999, aim to enhance the stability and transparency of India’s financial markets by addressing counterparty risk in non-centrally cleared derivatives transactions.