Response to public hearing on the Consultation paper on the RTS on IMMV
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The introduction of proportionality in the model validation process is justified with regard to the characteristics of the above two types of counterparties.
Nevertheless, we would like to recall the elements stated in our letter of May 2019 justifying the need for a carve out for the counterparties using the ISDA-SIMM model that is already approved and used. Moreover this model is reviewed on a yearly basis by ISDA based on a backtesting campaign.
a. Remove back-testing and internal governance process requirements for use of globally approved IM models for smaller end users
We believe that regulators should reduce the compliance and operational burdens for smaller counterparties to use quantitative models to calculate regulatory IM, including internal back-testing and model governance processes. These requirements, which we refer to as “prudential-style governance”, are based on mechanics already utilized by banks to comply with capital requirements and include: internal initial validation for conceptual soundness; model documentation (including limitations and assumptions); ongoing monitoring and back testing; and independent auditing of all of the above. They are similar to the provisions of the CRR (EU 575/2013) limiting the use of prudential internal models.
Under the EU rules, however, the requirements directly apply to all in-scope counterparties. For the non-brokers investment funds brought into scope in UMR phases 5 and 6, compliance with these banking-like requirements may prove impossible, as they will need to develop and manage expensive monitoring and governance capabilities from scratch. These obstacles and obligations present a significant impediment to the expanded use of internal models – including the ISDA SIMM.
The use of the ISDA SIMM has been widely approved and accepted by global regulators and has to date been the primary margin methodology used for uncleared margin rules implementation. SIMM implementation standards are well-known by regulators and markets participants alike, and SIMM model performance monitoring on actual portfolios takes place on a global basis. Management and development of the SIMM is governed through a well-established framework, which involves consultation and reporting to regulators. For these reasons, where non-brokers investment funds are relying on a broadly used model that has already been reviewed or approved by regulatory or supervisory authorities to calculate their regulatory IM (either directly, or by a third party on their behalf), individual model governance requirements should not be necessary and regulators should exempt all phase 5 and 6 non-brokers from both the internal back-testing requirements of Article 14 (provisions 3-6) and the Article 18 requirement for an internal governance process, in the CDR 2016/2251.
b. Restrict initial margin model approval under EMIR
Article 11(15)aa of EMIR now includes provision regarding the initial and ongoing validation of risk-management procedures, that includes IM Models.
Broadly adopted IM models, like SIMM not only enable a degree of collateral-efficiency but also prevent considerable operational obstacles to firms as they seek to comply with EU margin rules. National competent authorities (NCAs) have already reviewed this model and checked its compliance with EMIR margin rules through compliance testing. The current compliance testing processed by NCAs should suffice to assure full compliance of the models with the EMIR margin rules. If the existing compliant models are ignored in favour of the new model approval requirement, market participants would face a new uncertainty that would hamper efforts to comply with the existing phase-in schedule in relation to IM under EU and other jurisdictions’ rules.
In addition, the new EMIR Refit provision would force both the brokers and their clients to obtain IM model approval, which would create a disproportionate burden for clients compared with other jurisdictions.
A phase-in approach is proposed for the implementation: 2 years for phase 5, 3 years for phase 6.
a. the types of counterparties and the reason why their business models are using OTC derivatives.
b. the specificities of the asset classes underlying the OTC derivatives
c. Need of flexibility in the collateral re-use limitations
a. Business models of counterparties
ESMA recently issued a discussion paper on the review EMIR clearing thresholds. It provides statistics on the types of counterparties subject to the clearing obligation: 52% UCITS, 24% AIFs. Investment funds eligible to the UMR are all in phases 5 or 6, save for a couple of exceptions.
Investment funds are net buyers of financial instruments with respect to their respective investment policies. OTC derivatives are mostly used for hedging purposes.
b. Assets classes
UCITS funds proceed to hedging operations, in particular through the use of Foreign Exchange (FX) physically settled derivatives (FX Forwards, FX Swaps) in order to hedge their investment classes denominated in different currencies, in line with the ESMA opinion of 30 January 2017.
Art. 50 of the UCITS Directive provides strict investment restrictions in liquid financial instruments. Art. 1(2)a of the Directive emphasises the role of these investment restrictions as the shares of a UCITS fund can be subscribed by the public (i.e. including natural persons).
Thus, these hedging transactions play an important role to protect individuals against currency risk.
In light of the above provisions outlining the safety of the UCITS framework, we keep on recommending to the policy makers exclusion of these FX hedging transactions from the calculation of the exposure against the clearing threshold, similarly to the regime benefiting to the NFCs.
Such considerations about are very much in line with Rec. 19 of EMIR (EU) 648/2012 that underlines the specific characteristics of FX derivatives as follows: In determining which classes of OTC derivative contracts are to be subject to the clearing obligation, due account should be taken of the specific nature of the relevant classes of OTC derivative contracts. The predominant risk for transactions in some classes of OTC derivative contracts may relate to settlement risk, which is addressed through separate infrastructure arrangements, and may distinguish certain classes of OTC derivative contracts (such as foreign exchange) from other classes. CCP clearing specifically addresses counterparty credit risk, and may not be the optimal solution for dealing with settlement risk.
Moreover, these considerations would represent a simple carve out with regards to the principle of interconnectedness between the different asset classes stated in Rec. 7 of EMIR 2019/834.
Against his background, we also recommend the exclusion on these FX hedging transactions from the calculation of the AANA in the meaning of the UMR framework, knowing these short term transactions are not subject to mandatory VM exchange. For this request, we refer to the 5 June 2019 letter sent by EFAMA to the ESAs and Commission (see Annex 2 in appendix).
c. Need of flexibility in the collateral re-use limitations applicable to UCITS and ETFs
The IM exchange requirement under the UMR represents a new need of funding for the concerned investment funds.
In light of the liquidity constraints faced by the investment fund industry, illustrated by the March-2020 measures to manage redemptions linked to the pandemic, we would like to reiterate our advocacy for a recalibration of the ESMA guidelines 2014/937 on collateral re-use limitations applicable to ETFs and UCITS funds. In the attached letter sent to ESMA in December 2019 (see Annex 3 in appendix), we explained the necessity to update Art. 43 §i and j of these guidelines to authorise collateral reuse to satisfy the new collateral needs implied by the EMIR and UMR frameworks, which entered into force after the drafting of these guidelines.
Q1: What are the stakeholders’ views regarding the split between standard and simplified validation processes?
A split is justified to consider separately the most significant counterparties in terms of exposure from the small and medium sized ones, the latter -including investment funds- not representing systemic risk.The introduction of proportionality in the model validation process is justified with regard to the characteristics of the above two types of counterparties.
Nevertheless, we would like to recall the elements stated in our letter of May 2019 justifying the need for a carve out for the counterparties using the ISDA-SIMM model that is already approved and used. Moreover this model is reviewed on a yearly basis by ISDA based on a backtesting campaign.
a. Remove back-testing and internal governance process requirements for use of globally approved IM models for smaller end users
We believe that regulators should reduce the compliance and operational burdens for smaller counterparties to use quantitative models to calculate regulatory IM, including internal back-testing and model governance processes. These requirements, which we refer to as “prudential-style governance”, are based on mechanics already utilized by banks to comply with capital requirements and include: internal initial validation for conceptual soundness; model documentation (including limitations and assumptions); ongoing monitoring and back testing; and independent auditing of all of the above. They are similar to the provisions of the CRR (EU 575/2013) limiting the use of prudential internal models.
Under the EU rules, however, the requirements directly apply to all in-scope counterparties. For the non-brokers investment funds brought into scope in UMR phases 5 and 6, compliance with these banking-like requirements may prove impossible, as they will need to develop and manage expensive monitoring and governance capabilities from scratch. These obstacles and obligations present a significant impediment to the expanded use of internal models – including the ISDA SIMM.
The use of the ISDA SIMM has been widely approved and accepted by global regulators and has to date been the primary margin methodology used for uncleared margin rules implementation. SIMM implementation standards are well-known by regulators and markets participants alike, and SIMM model performance monitoring on actual portfolios takes place on a global basis. Management and development of the SIMM is governed through a well-established framework, which involves consultation and reporting to regulators. For these reasons, where non-brokers investment funds are relying on a broadly used model that has already been reviewed or approved by regulatory or supervisory authorities to calculate their regulatory IM (either directly, or by a third party on their behalf), individual model governance requirements should not be necessary and regulators should exempt all phase 5 and 6 non-brokers from both the internal back-testing requirements of Article 14 (provisions 3-6) and the Article 18 requirement for an internal governance process, in the CDR 2016/2251.
b. Restrict initial margin model approval under EMIR
Article 11(15)aa of EMIR now includes provision regarding the initial and ongoing validation of risk-management procedures, that includes IM Models.
Broadly adopted IM models, like SIMM not only enable a degree of collateral-efficiency but also prevent considerable operational obstacles to firms as they seek to comply with EU margin rules. National competent authorities (NCAs) have already reviewed this model and checked its compliance with EMIR margin rules through compliance testing. The current compliance testing processed by NCAs should suffice to assure full compliance of the models with the EMIR margin rules. If the existing compliant models are ignored in favour of the new model approval requirement, market participants would face a new uncertainty that would hamper efforts to comply with the existing phase-in schedule in relation to IM under EU and other jurisdictions’ rules.
In addition, the new EMIR Refit provision would force both the brokers and their clients to obtain IM model approval, which would create a disproportionate burden for clients compared with other jurisdictions.
Q2: What are the stakeholders’ views regarding the Euro 750 bn threshold selected?
We understand that counterparties below the 750 Bn threshold, i.e. those eligible to UMR phases 5 and 6 would benefit from a slightly lighter validation process.A phase-in approach is proposed for the implementation: 2 years for phase 5, 3 years for phase 6.
Q37: What are the stakeholders’ views regarding the transitional and final provisions in general? Are there aspects that should further be considered?
We are of the view that three major dimensions are not sufficiently developed:a. the types of counterparties and the reason why their business models are using OTC derivatives.
b. the specificities of the asset classes underlying the OTC derivatives
c. Need of flexibility in the collateral re-use limitations
a. Business models of counterparties
ESMA recently issued a discussion paper on the review EMIR clearing thresholds. It provides statistics on the types of counterparties subject to the clearing obligation: 52% UCITS, 24% AIFs. Investment funds eligible to the UMR are all in phases 5 or 6, save for a couple of exceptions.
Investment funds are net buyers of financial instruments with respect to their respective investment policies. OTC derivatives are mostly used for hedging purposes.
b. Assets classes
UCITS funds proceed to hedging operations, in particular through the use of Foreign Exchange (FX) physically settled derivatives (FX Forwards, FX Swaps) in order to hedge their investment classes denominated in different currencies, in line with the ESMA opinion of 30 January 2017.
Art. 50 of the UCITS Directive provides strict investment restrictions in liquid financial instruments. Art. 1(2)a of the Directive emphasises the role of these investment restrictions as the shares of a UCITS fund can be subscribed by the public (i.e. including natural persons).
Thus, these hedging transactions play an important role to protect individuals against currency risk.
In light of the above provisions outlining the safety of the UCITS framework, we keep on recommending to the policy makers exclusion of these FX hedging transactions from the calculation of the exposure against the clearing threshold, similarly to the regime benefiting to the NFCs.
Such considerations about are very much in line with Rec. 19 of EMIR (EU) 648/2012 that underlines the specific characteristics of FX derivatives as follows: In determining which classes of OTC derivative contracts are to be subject to the clearing obligation, due account should be taken of the specific nature of the relevant classes of OTC derivative contracts. The predominant risk for transactions in some classes of OTC derivative contracts may relate to settlement risk, which is addressed through separate infrastructure arrangements, and may distinguish certain classes of OTC derivative contracts (such as foreign exchange) from other classes. CCP clearing specifically addresses counterparty credit risk, and may not be the optimal solution for dealing with settlement risk.
Moreover, these considerations would represent a simple carve out with regards to the principle of interconnectedness between the different asset classes stated in Rec. 7 of EMIR 2019/834.
Against his background, we also recommend the exclusion on these FX hedging transactions from the calculation of the AANA in the meaning of the UMR framework, knowing these short term transactions are not subject to mandatory VM exchange. For this request, we refer to the 5 June 2019 letter sent by EFAMA to the ESAs and Commission (see Annex 2 in appendix).
c. Need of flexibility in the collateral re-use limitations applicable to UCITS and ETFs
The IM exchange requirement under the UMR represents a new need of funding for the concerned investment funds.
In light of the liquidity constraints faced by the investment fund industry, illustrated by the March-2020 measures to manage redemptions linked to the pandemic, we would like to reiterate our advocacy for a recalibration of the ESMA guidelines 2014/937 on collateral re-use limitations applicable to ETFs and UCITS funds. In the attached letter sent to ESMA in December 2019 (see Annex 3 in appendix), we explained the necessity to update Art. 43 §i and j of these guidelines to authorise collateral reuse to satisfy the new collateral needs implied by the EMIR and UMR frameworks, which entered into force after the drafting of these guidelines.