Almost there? A bumpy road to the margining regime for non-centrally cleared derivatives in Europe
The 10th of July 2015 consultation deadline marked another milestone in the European margining rules implementation. The financial industry had got only one month to comment on the European Supervisory Authorities’ (ESAs) second draft1 Regulatory Technical Standards (RTS) outlining the framework of the risk mitigation techniques for OTC derivative contracts not cleared by a CCP on the basis of Article 11(15) of Regulation (EU) No 648/2012 (EMIR).
The received contributions following the close of the consultation are of interest not only to the regulators. They highlight major concerns to be faced by the industry should the proposed rules be adopted in their current form. Indeed, there are reasons to believe that ESAs may find difficult to remove entire provisions of the RTS or principles on which they have reached a broad agreement reflected through the second consultation paper. The tweaks or practical improvements suggested by the industry may however still be possible. Beyond, the industry will have to come up with own implementing solutions. This may prove to be a challenge in many respects.
ESAs have asked 8 questions2, the industry responses have highlighted a few other “issues” and requested a number of clarifications. This article3 focuses only on the major sticking points outlined through the consultation, which are (i) a too short timing for collection of collateral; (ii) the difficulties concerning the concentration limits on collected collateral; (iii) a quasi-prohibition of cash as initial margin; (iv) the obligation to post margin to third country entities, even in absence of close-out netting; closely linked with the obligation to put in place “alternative arrangements” where close-out netting and segregation are not otherwise enforceable; (v) obligation to conduct legal review of netting arrangements annually; (vi) practical details of the FX haircut; or (vii) covered bond issuers obligation to collect variation margin; and some other bumps on the road.
Bump n.1: timing for collateral collection
The industry responses flagged that the proposed timing for margin collection is not operationally feasible. It does not reflect the market standard settlement cycles and discriminates against the asset classes with longer settlement periods. Most of securities but also certain currencies cannot currently meet the collection deadline set to one business day after the calculation date. The extension to three business days is only available to large entities which also collect the initial margin – this is not justified. The proposal does not take into account the time zone differences between the relevant locations of the counterparties. It does not leave time for useful data reconciliation prior to calculation of the margin call. If maintained in the current form, the timing for collection would cause liquidity and funding concerns, especially for smaller participants.
Bump n.2: concentration limits
As the industry pointed out already in the first consultation, the concentration limits on eligible collateral are not a feature of the margining standards set internationally in the BCBS-IOSCO framework document.4 To the industry’s disappointment, ESAs have introduced only small tweaks to the diversification requirement and a limited exemption was granted to non-systematically important entities collecting government and municipal bonds. Some comments were critical of the exemption scope - not including the covered bonds while these are arguably also high quality liquid assets. Others were concerned of the exemption’s criteria, opening new interpretation questions with respect to the scope of entities eligible for exemption or the practical details of the thresholds computation5. In brief, once the scope of the exemption is clarified, its application generates additional operational burden and requires monitoring routines for collection of government bonds. Under the microscope, the government bond exemption looks much less appealing than on its surface. The industry responses instead suggested a general exemption from the proposed concentration limits for counterparties with low exposure6.
Bump n. 3: initial margin in cash
The industry disapproved of the restrictions imposed on the use of cash as initial margin. The new requirement to protect initial margin from the insolvency of the custodian results in a de-facto ban of cash as eligible collateral for initial margin (because cash cannot be so protected from the insolvency estate of the account holder). The solution of reinvestment into non-cash collateral proposed by the second draft RTS is operationally complex and time consuming. Even where the cash is not used, the issue arises again when it comes to “incidental cash” such as distributions, redemptions and other cash generated by the reinvestment.
This is surprising since cash was internationally recognized by the BCBS- IOSCO framework as a major safety net in case of a liquidity squeeze. Moreover, the custodian risk was not the focus of G-20 mandate and therefore arguably not the issue required to be addressed in the RTS7.
Also, the description of the segregation model is too restrictive where exclusively referring to the segregation arrangements made by the collecting party. However, many entities were planning to use the model of segregation at the posting party level (i.e. an account at a third party banks in the name of the posting party that is charged in favor of the collecting party).
Bump n. 4: cross-border concerns
In the second draft RTS, ESAs extended the exemption of the EU non-financial entities below the clearing threshold (so called NFC) to the equivalent third country entities. But the good news comes with strings attached - the requirement for EU in-scope entities to post8 margin to all other non-exempted third country entities (i.e. third country FC or NFC+ equivalent). This causes several issues.
First, the third country entity may not be willing or able (for operational reasons for example) to receive the collateral assets in the way compliant with the EU regulations where no/different margining regime is imposed by its home authority.
Second, the outflow of collateral outside EU raises the question of enforceability of netting and collateral arrangements on which the whole risk mitigation objective can fail. Indeed, if upon the collateral receiver insolvency the collateral arrangement is not enforceable in accordance with its terms, the collateral poster may end up with double loss – an obligation to pay the gross exposure under all derivative transactions to the receiver's bankruptcy and an unsecured claim against the collateral posted to the insolvent receiver (and not netted against the exposure). As it may not always be possible to find an “alternative arrangement” to secure a safe posting to counterparty in a “dirty” (non-netting) jurisdiction, the industry responses have highlighted the increased credit risk as a result of the new proposal and suggested that such relationships should be exempted.
The ESAs have recognized that posting margin actually increases counterparty risk if the receiver is located in the jurisdiction where the legal mechanisms on which the collateral arrangements rely are not enforceable. However, instead of granting an exemption from posting margin in such case, the authorities have left the industry with a considerable challenge to identify what alternative arrangements can remedy the absence of legal enforceability of the netting and segregation agreements. The RTS mentions posting collateral to international custodians. In the ESAs public hearing, the possibility to elect the application of the laws of other jurisdictions was mentioned as a further example. The industry is expected to be creative and come up with new structures allowing posting collateral safely in all circumstances. The availability of those mechanisms has been questioned by the public responses. Indeed, it is difficult to circumvent the mandatory bankruptcy legislation applicable upon the collateral receiver’s and/or custodian’s insolvency. If no bulletproof alternative arrangement can be found while the obligation to post collateral to the third country entities still applies, the resulting legal risk creates a disincentive to cross-border trading with certain jurisdictions. Notwithstanding, the industry call for removing the requirement where the posted margin cannot be safely netted or segregated is not likely to meet with much enthusiasm by the regulators.
Bump n.5: legal review of netting arrangements
The industry responses abundantly commented on the newly introduced requirement to conduct an annual legal review of the netting arrangements to confirm their enforceability in all relevant jurisdictions. Everyone expressed concerns about the feasibility of the annual review on such scale given the current legal resources.
The pertinence of the legal analysis while the close-out netting is known not to be available has also been challenged.
In practical terms, the banks are already subject to a similar requirement under the capital adequacy framework (CRR). ISDA is helpfully issuing the netting and collateral opinions and mutualizing their members ' legal costs. But the EMIR legal review goes beyond the CRR review – both in its frequency (annual under RTS; versus if and when required under CRR) and its scope (all jurisdictions and counterparties under RTS; versus sole exposures capitalized on net basis under CRR). The unanimous industry view is that RTS shall not introduce a supplementary legal review process which is not fully consistent with the capital adequacy framework. Should the requirement be maintained, the frequency shall be aligned with the position of the Article 296 of Regulation (EU) No 575/2013 (leaving the assessment to the internal policies on “if and when required” basis). And the legal review conducted under CRR is requested to be recognized without duplication.
The requirement hits the prudentially unregulated entities even harder. Not able to reuse existing processes and not having access to industry opinions in most cases, they may find the new legal burden unsustainable.
Some suggested a pure and simple removal of the netting review requirement; others, an exemption for collateral arrangements not relying on netting (i.e. other than CSA type structure as a basis for posting collateral)9. A third alternative was to seek clarification that the clean netting status in all relevant jurisdictions is not a precondition, implying that an exemption shall be granted from posting collateral to non-netting relationships)10. In all cases, the ESAs are interrogated on the meaning of the “independent legal review”, with a suggestion to clarify that such review can be conducted purely internally by the legal functions within the in-scope counterparties’ organizations.
The individual nature of the assessment has not been much commented in the responses. But it remains to be an issue should one entity come up with a different legal enforceability conclusion than another. Some responses have suggested a public register of jurisdictions and entities with clean netting status.
The proposed remedies were diverse, but all questioned the rationale of the symptom.
Bump n. 6: FX haircut
The calls for removal of the FX haircut were not entirely heard by the regulators. As a result, the haircut on mismatch between the currency in which the collateral assets are denominated and either the termination currency agreed in the netting agreement (where collateral posted as IM) or transfer currency of the variation margin (where collateral posted as VM) remains a singularity of the EU margining regime. The new formulation however implies that no FX haircut would be imposed on cash margin. Also, the new proposal moves away the operationally complex exchange of collateral in “currency silos”11. The comments reminded me of the previous advocacy in passing, then resignedly focused on the interpretation issues and the practical implementation of the haircut provisions12.
Bump n.7: collection of one way variation margin from counterparties hedging the covered bonds
The industry is concerned that the proposal may change the economics of the covered bond markets. The second RTS confirmed that the EU covered bond issuers, exempted in certain circumstances from posting margin and collecting the initial margin, must still collect the variation margin. Consequently, the cost of hedging the covered bonds would significantly increase should their hedging counterparties start posting collateral one way. It will be interesting to see whether and how the covered bond market will be affected since the hedging firms are likely to pass through the cost of collateral. The same applies to the third country bond issuers, where the EU hedging counterparties would have duty to post such variation margin.
Bump n.8: phase-in provisions
The timing of margin rules application substantially replicates the agreed BCBS-IOSCO timeframes. However, the RTS leaves some practical points open. For example, which trade lifecycle events (such as compression, novation or notional amount increase) would cause a trade to fall under scope of the margin rules.
Mountain ahead: overall cross-border concerns
In general, the requirement to collect collateral from a third party (FC/NFC+ equivalents) will disadvantage the EU entities in comparison with third country traders not required to collect margin. Trading derivatives with EU based entities will therefore become more expensive and more cumbersome unless and until all other countries implement the similar regulations. Even then, the discrepancies between the regimes will create scope for regulatory arbitrage in favor of the entities subject to a less stringent regulatory regime. As of today, despite the announced harmonization work at the international level, major discrepancies persist between the EU and US margining regimes13.
Complying with multiple regimes at the same times is a challenge from documentation and operational perspective. The dual regulated firms may be caught by both set of rules and would face major difficulties to comply with both of them until and unless the substituted compliance is in place. Single regime firms will also face difficulties in their cross-border trading where, for example, one side is collecting under the EU rules while the other side is collecting under the (non-harmonized) US rules.
The complex interaction of inconsistent regimes is likely to cause market fragmentation. This trend has already been observed as the counterparties, preparing for the implementation on both sides, anticipate difficulties (see ISDA Insight of 23 April 2015 at report http://www2.isda.org/functional-areas/research/ sur veys/end-user-sur veys/).
It remains to be seen whether and how much the industry responses to the consultation can influence the final rules. The ex- pectation is that ESAs will now present the final margining rules for endorsement to the European Commission in autumn 201514. While it will take a few more legislative steps to bring the RTS into force, the implementation deadlines have been set independently to September 2016/March 2017 for variation margin compliance and phased-in from September 2016 onwards for initial margin (in line with the IOSCO BCBS timeline http://www.bis.org/bcbs/publ/d317.html). The road to the final rules may now be almost over, but the trip continues with the industry implementation phase.
1 The first draft was released more than a year ago, 14th of April 2014
3 This article is based on the analysis of three consultation responses - by International Swaps and Derivatives Association, European Banking Federation and Swedish Securities Dealers Association.
4 “Margin requirements for non-centrally cleared derivatives”, 2 September 2013 (revised March 2015)
5 In particular, a claim that the EUR 1 billion threshold for determination of exempted entities should be based solely on OTC derivatives between two individual counterparties and not at the group level
6 i.e. proposal that “concentration limits will not apply to a counterparty that is not subject to the IM requirements” (ISDA) or “posting less than EUR 100 million” (EBF)
7 ISDA proposed some examples of alternative custodian risk mitigation e.g. a credit quality assessment on the custodian; or custodian not an affiliate of parties
8 The RTS refers to the obligation to “exchange” i.e. not only collect but also post.
9 “To the extent that counterparty relies on close-out netting as part of a collateral arrangement...” (ISDA)
10 The issue goes beyond the third country entities highlighted by the ESAs. Indeed, there are several EU member states without clean netting opinions; also there are entity types in clean jurisdictions against which the contractual netting provisions would nevertheless not be enforceable.
11 While the currency silo margining may still be incentivized by the future leverage ratio. 12 Request to clarify that FX haircut does not apply to cash collateral; request to clarify the new concept of “transfer currency” etc.
13 For example, the EU and US regimes are inconsistent in their (i) scope of covered transactions, (ii) scope of eligible collateral types, (iii) scope of covered counterparties, (iv) applicable thresholds etc.
14 Such final rules were not released when this article was submitted to the editor.
This article was first published in edition 5 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.
To save your address into your profile:
- Visit the home page
- Click Account (in the middle of the row of black buttons)
- Click Edit Profile (in the row of buttons at the top)
- Click Reader (top right)
- There you can see your profile, with a box for your address - complete it accurately, and click Save