Examining RBI’s new margin framework helps one understand the evolution of OTC derivatives regulation
Significantly for India’s financial markets, the Reserve Bank of India (RBI) has published the RBI (Margining for Non-Centrally Cleared OTC Derivatives) Directions, 2024, set to take effect from November 2024. Originally proposed during the Pittsburgh Summit of 2009, the G20’s Reform Program depends critically on this regulatory structure. Particularly in tackling systemic risks that became obviously clear after the 2008 Global Financial Crisis, the new directives represent a significant change in India’s attitude to over-the-counter (OTC) derivatives regulation.
Historical Context and Global Framework
The 2008 Financial Crisis exposed the weaknesses in OTC derivative markets, therefore acting as a turning point in financial control. Lehman Brothers’ collapse made clear how uncollateralized derivative positions might set off disastrous market collapse. Reacting, the G20 countries gathered at Pittsburgh in 2009 to create a thorough reform plan. This was underlined even further at the 2011 Cannes Summit when the reform agenda included margin requirements for non-centrally cleared OTC derivatives (NCCD).
Development of minimal criteria for margin requirements fell to the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commission (IOSCO). This international cooperation underlined the worldwide character of OTC markets and the necessity of harmonised rules. Since then, national authorities—including the RBI—have turned to the resulting BCBS-IOSCO framework as their guide in developing their own rules.
Knowing Clearing Mechanisms and Margin Needs
OTC derivative trades revolve on the idea of “clearing”. A Central Counterparty (CCP) serves as an intermediary in conventional centrally cleared derivatives, therefore fulfilling the legal counterparty function to both sides of the transaction. This configuration requires margins to be sent to the CCP, therefore building a strong risk control system. NCCDs run without such central clearing systems, hence historically they lacked defined margin requirements until the RBI’s intervention via its 2022 Variation Margin Directions.
Comprising both Initial Margin (IM) and Variance Margin (VM) standards, the revised 2024 Directions show a more all-encompassing approach. This twin-margin strategy generates a tiered defence against counterparty risk. Variance margin covers daily market changes; initial margin addresses possible future risk at close-out periods. This strategy improves OTC derivative risk management in India and conforms with international best standards.
Calculation Techniques and Collateral Framework
Two methods for computing Initial Margin are offered by the RBI’s framework: the quantitative portfolio margin model described in Annex II and the standardised technique covered in Annex I of the Directions. Especially for margin computations, market players have traditionally turned to the International Swaps and Derivatives Association (ISDA) SIMM Model. The revised Directions recognise this practice by permitting ongoing use of the ISDA SIMM Model, therefore meeting the criteria of the quantitative portfolio margin model.
An important component of the framework relates to the instruments qualified as collateral mentioned in paragraph 10 of the Directions. Still, the inclusion of government securities as qualified collateral creates special difficulties. Under Section 13 of the Government Securities Act, 2006, conflicts concerning government securities belong only under Indian courts’ jurisdiction. This generates a possible clash with the inclination of the market for arbitration in derivative conflicts, as advised by ISDA.
Examining government securities’ non-arbitrability using the four-fold test set in Vidya Drolia v. Durga Trading Corporation (2021) 2 SCC 1 begs serious questions. The Supreme Court’s test underlines that situations involving rights in rem, thereby influencing third party rights, or necessitating centralised adjudication are generally non-arbitrable. Government securities fit quite nicely in this category since they are instruments influencing public interest and sovereign rights.
Collateral Service Provider Challenges and Infrastructure
Paragraph 8 of the Directions specifies that segregation of Initial Margin from the collector’s proprietary assets is a fundamental component of the new system. Usually, Collateral Service Providers (CSPs) apply this separating concept. Unlike the developed infrastructure in the Exchange Traded Derivatives (ETD) market, India’s OTC market today lacks a thorough regulatory framework for CSPs.
Although the RBI has let scheduled commercial banks operate as CSPs, lack of thorough governance structures presents practical difficulties. While offering a temporary fix, the regulatory void has allowed foreign CSPs to be approved, which might not be best for building domestic market infrastructure. This scenario has similarities with the evolution of custodial services in India’s securities market, which changed under the cautious regulatory support under the Securities and Exchange Board of India (SEBI) system.
Operational Challenges and Implementation Schedule
The RBI’s attitude to implementation deadlines differs from international best standards. Usually covering 6–8 years, the BCBS-IOSCO framework advises a phased deployment based on Average Aggregate Notional Amount (AANA) of NCCDs. This slow method lets market players properly control liquidity needs and change their operations.
But the RBI’s choice to apply the criteria consistently among all market players over a six-month period presents serious operational difficulties. Against ISDA’s advice of an 18-month implementation period, this compressed timeline would disproportionately harm smaller market participants with insufficient resources and infrastructure.
One can compare the implementation strategy with experiences of other countries. For example, the U.S. Dodd-Frank Act and the European Union’s EMIR rules both set gradual implementation timelines acknowledging the operational complexity required in building margin infrastructure.
Cross-border considerations and alternative compliance
OTC derivatives markets’ multinational character calls for rigorous evaluation of cross-border effects. Under the Dodd-Frank Act, the U.S. Commodity Futures Trading Commission developed the idea of substituted compliance, which presents a possible fix for the difficulties of many jurisdictional rules. By proving conformity with similar foreign rules, this strategy lets market players satisfy domestic compliance needs.
Given standardised ISDA documentation, which usually names English or New York law as the prevailing law, the use of substituted compliance becomes very important. Particularly in view of the Foreign Exchange Management Act, 1999 (FEMA) requirements and the RBI’s foreign exchange policies, the framework of the RBI has to address how such cross-border arrangements would be recognised and controlled.
Suggestions for Improvements
Several important areas demand focus to improve the new margining framework’s efficiency:
Development of Local CSP Infrastructure: The RBI should take into account creating a thorough legislative framework for domestic CSPs, maybe based on SEBI’s experience supervising custodians under the SEBI (Custodian) Regulations, 1996.
Spread of Qualified Collateral: While addressing the arbitrability issues of government securities, the narrow spectrum of qualified collateral instruments should be expanded. This could involve creating particular dispute resolution systems for conflicts involving collateral interests.
- The implementation schedule is: Based on AANA norms, a more gradual implementation plan would let market players create operational capacity and required infrastructure without endangering market stability.
- Framework for Cross- Borders: Clear policies on substituted compliance and acceptance of foreign regulatory compliance would let players in international markets properly negotiate several jurisdictional obligations.
Simplifying procedural needs like stamp duty and registration of charges can help margining arrangements to be implemented more easily.
In essence, conclusion
With its new margining structure, the RBI is making a major step towards matching India’s OTC derivatives market with world standards. Although the system uses several BCBS-IOSCO ideas and ISDA techniques, some issues still exist in its use. The success of this legislative effort will rely on filling infrastructure deficiencies, especially in the CSP area, fixing collateral-related problems, and creating reasonable implementation schedules.
The framework has to strike a compromise between operational efficiency and market safety, two conflicting goals. The regulatory environment for OTC derivatives would have to remain dynamic and responsive to market needs while keeping strong risk management standards as the Indian financial markets keep changing and merging with worldwide markets.
These rules represent a pivotal point in the evolution of India’s financial markets. Their success will rely on the technical fit of the framework as well as on the capacity of the market to grow the required infrastructure. Market players and authorities have to cooperate as the November 2024 implementation date gets closer to solve these issues and guarantee a seamless change to the next government.
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