Response to joint Consultation on draft RTS on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP

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Question 2. Are there particular aspects, for instance of an operational nature, that are not addressed in an appropriate manner? If yes, please provide the rationale for the concerns and potential solutions.

2.1 Clarity around the definition of a ‘new’ contract
Recital 18 (page 21) of the consultation paper states that “in order to avoid any retrospective effect the margin requirements apply to new contracts not cleared by a CCP entered into after the relevant phase-in dates. Exchanges of variation margin and initial margin on contracts not cleared by a CCP entered into before these dates are subject to existing bilateral agreements”. We support this recital as we believe that back-loading existing trades would be both operationally and financially burdensome to investors. However, there remains some ambiguity as to what constitutes a ‘new’ contract. We suggest that a ‘new’ contract should not include a contract which has been transferred, even if from a legal perspective this means that the contract is deemed to have been terminated and replaced by an exact substitute with a different counterparty. If it is not clear that transferred contracts are out of scope, and this will hinder counterparties’ ability to transfer contracts in order to manage exposure limits and credit risk. We ask that the recital be enshrined in the body of the draft regulatory technical standards and that clarity be provided as to what constitutes a ‘new’ contract.

2.2 Clarity around the definition and application of the minimum transfer amount (MTA)
We note that article 2(6)GEN appears to be a definition of the total collateral amount, whereas 2(4) GEN cross-refers to that article as though it defines the minimum transfer amount (MTA). The MTA, though, is a different concept. The MTA relates to any amount of collateral requirement that arises, including by virtue of a change in the mark-to-market value of a contract or portfolio thereof. Thus, it does not necessarily refer to the total collateral amount but to an incremental change in that total collateral amount, which may or may not be operationally worth transferring. In other words, the MTA is relevant when the change in total amount of collateral is below a de minimis level (in this case, a proposed level of €500,000). We suggest the European Supervisory Authorities amend the text so that it is clear that 2(4) GEN refers to the MTA, and not the total collateral amount.

2.3 Potential for increased costs if lack of international consistency on collateral requirements and FX
As indicated in our response to Question 1, if the proposed risk management procedures for non-centrally cleared derivatives are not implemented on a consistent basis with other jurisdictions globally, they are likely to lead to increased operational costs and add unnecessary complexity to firms’ internal processes and procedures.

For example, when it comes to scope of the application of variation margin requirements for non-centrally cleared FX derivatives, there is inconsistency between the current US approach and the proposals set out in the consultation for the EU. In the US, physically settled FX forwards and swaps are not in scope for variation margin requirements, in accordance with the November 2012, US Treasury determination ( However, in the EU, physically settled FX forwards and FX swaps are in scope for variation margin. This inconsistency increases the risk of regulatory arbitrage and it will put EU investors and businesses at a competitive disadvantage.

Ensuring global consistency of these risk-management procedures will minimise both the cost and regulatory burden on these global entities. In order to ensure consistency of approach, operational requirements (over and above when margin should be posted and what collateral is eligible), should be limited and kept to a high level in order to maintain flexibility for investors to operate on a global basis. Too much prescription in each jurisdiction will inevitably lead to inconsistencies and increased operational costs with little overall benefit. Further detail on our suggested solution to the international inconsistency in relation to FX forwards and swaps is set out below.

2.4 Operational difficulties in implementing variation margin requirements for short-dated FX
The proposed draft regulatory technical standards subject physically-settled FX forwards and swaps to variation margin, but not initial margin. These requirements mean that counterparties would need to collect variation margin on at least a daily basis, starting from the business day following the execution of the contract.

Whilst we support the application of variation margin to FX forward and swap contracts which have a medium to long-term duration (i.e. at least over three months and preferably much longer), we do not see the benefit of requiring variation margin to be posted in respect of contracts which are short dated. This is inconsistent with the variation margin requirements in the US, as noted in our comments above. Further, we do not believe that FX contracts are exactly comparable to other OTC derivative contracts. We note that the FX market has found ways to mitigate the key risks associated with these transactions, notably via settlement under CLS. Settlement risk will always dominate in physical settlement contracts, because 100% of the value will, by definition, change hands, whereas the replacement cost or counterparty / pre-settlement risk will be a fraction of that amount, in the order of a few percent, merely reflecting changes in the market rate.

More generally, the FX market has already attained, under its current regulatory structure, the goals of transparency, liquidity, financial security and efficiency, due in part to the proliferation of electronic trading platforms where market participants can view real time pricing data and facilitate straight through processing and confirmation of trades.

The biggest risk for FX, though, remains settlement risk, as outlined above. This is acknowledged under EMIR in Article 19. In instances where counterparties have dealt with this by using formal settlement systems such as CLS, we suggest that for short tenor contracts of three months or less, margin exchange should not be necessary. This would be consistent with the IOSCO/BCBS framework which promotes a risk-based approach to the collection of variation margin for FX contracts requiring banks to consider whether it is required in relation to replacement risk.

Rather than increasing regulatory requirements in the manner proposed, banks should be encouraged to join settlement platforms and these platforms should be encouraged to extend the range of currencies covered.

Unlike many other derivative instruments whose payment obligations fluctuate daily in response to changes in underlying variables, such as interest rates, the payment obligations of physically settled FX swaps and forwards are fixed at the onset of the agreements and involve the actual exchange of full principal for settlement. Further, the vast majority of FX swaps and forwards have short average maturities, posing significantly less counterparty risk than other derivatives, while trades are largely cash covered.

The operational consequences of implementing margining for short dated forward FX contracts may also pose material risks to systems. This is because the number of collateral transfers will increase greatly. In addition, provision of collateral is likely to result in funds whose only use of derivatives are forward FX derivatives having to maintain higher levels of cash / near cash equivalents resulting in lower returns for investors’ assets.

2.5 Phase-in needed for variation margin
The current proposed start date, for the variation margin requirements, of December 2015, does not appropriately address the operational and technical requirements that investors will need to implement to ensure compliance with the regulatory technical standards. Whilst, OTC trades (other than forward FX) are likely to already be subject to bilateral variation margin requirements, the legal and operational changes required by the draft regulatory technical standards make the implementation timeframe quite difficult.

We believe a phase-in similar to that for initial margin requirements would be helpful, so that most buy-side firms will have until December 2019 to implement the variation margin requirements. This is consistent with the European Supervisory Authorities’ aim of minimising the regulatory impact on small to medium sized firms.

Implementation of the proposals will require a significant amount of work for counterparties, at a time when they are also still in the process of implementing quite substantial changes in other areas of EMIR, such as putting in place clearing arrangements. In particular the proposals are likely to require the following steps:
• a wholesale review of legal requirements and documentation in place between counterparties and in many cases, the negotiation of new documentation;
• changes to local laws to ensure that the provisions, for instance of Article 2 LEC can be implemented by counterparties;
• a complete review of operational and collateral management processes and procedures;
• review, agreement and implementation of ratings models and initial margin models;
• implementation of new account structures with custodians in respect of the holding of collateral received, including new documentation or changes to existing documentation; and
• establishment of arrangements to enable liquidation or transformation of collateral assets (for instance with repo counterparties).

2.6 Initial margin requirements
There are a couple of operational challenges in relation to the implementation of initial margin requirements:
• The proposed draft regulatory technical standards specify that initial margin needs to be collected within the business day following the execution of a new derivative contract. We request that this obligation be clarified, to state that it is the call for collateral that must be made by the end of following business day, rather than settlement of that call. We note in this regard that even cash transfers will typically settle a full day after a call, while non-cash collateral takes longer, and calls would currently be made a day after execution. An alternative would be to push the deadline back to T+3, in order to minimise any operational difficulties.
• Implementing the €50 million consolidated group level initial margin threshold is likely to create significant operational difficulties.

There remains some uncertainty as to the permanence of the €8 billion threshold in relation to the final phase-in period for initial margin. Under the BCBS-IOSCO framework, the €8 billion threshold proposed for phasing in initial margin applies on a permanent basis from 1 December 2019 (Paragraph 8.7, page 24: “On a permanent basis (i.e. from 1 December 2019), any covered entity belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives for June, July and August of the year exceeds €8 billion will be subject to the requirements described in this paper during the one-year period from 1 December of that year to 30 November of the following year when transacting with another covered entity (provided that it also meets that condition). Any covered entity belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives for June, July and August of the year is less than €8 billion will not be subject to the initial margin requirements described in this paper”, However, in the draft Regulatory Technical Standards, under Article 1, Final Provisions, paragraph 3(e) states that “From 1 December 2019, when at least one of the counterparties belongs to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives for June, July and August of the year is below €8 billion” and then in paragraph 4 that: “Only contracts entered into during the one-year period from 1 December of the year referred to in subparagraphs (a) to (e) to 30 November of the following year, may include an agreement that initial margins are not collected in accordance with the procedures prescribed in this Regulation”. We note that this is inconsistent with the BCBS-IOSCO framework provisions and request that the European Supervisory Authorities amend the draft Regulatory Technical Standards to ensure that the €8 billion threshold applies on a permanent basis.

2.7 Appropriate use of internal models for eligible collateral and haircuts and initial margin calculation
The current proposals regarding the use of internal model for collateral and haircuts and initial margin are more appropriate for the requirements of the banking sector, and do not meet the specific needs or position of investors.

Whilst we welcome the possibility of developing internal models for initial margin and haircuts calculation, we note that the requirement that models be developed by one of the two counterparties, or jointly by the two counterparties, will in practice be unworkable. Banks are likely to be reluctant to share their models with their counterparties and whilst both parties may agree to use a bank’s model, the other requirements proposed in the draft regulatory technical standards will mean that the buy-side counterparty will need to carry out due diligence on the bank’s models, in order to be comfortable that they comply with the requirements specified in the draft regulatory technical standards. Banks are unlikely to provide the level of detail required to undertake this assessment. Ironically, the more banking counterparties across which a buy-side firm diversifies its counterparty exposures, the greater the challenge as the related due diligence will need to be repeated for each counterparty. Further detail on the concerns we have with respect to the use of a counterparty internal rating based (IRB) model and the information available to buy-side counterparties is included in our response to Question 4.

2.8 Investment managers acting on behalf of institutional clients
When investment managers act on behalf of their institutional clients, they may not have sight of the details of all of the institutional clients’ derivative trading relationships (notably, where a client has appointed more than one investment manager). As a result, it will be difficult for an investment manager to calculate the total outstanding derivatives notional for an institutional client with multiple investment managers; or whether the €50 million threshold for initial margin posting has been exceeded by their institutional client (who may be part of a wider group entity) at an entity level. Obtaining this information from the institutional client will be hard to document or implement operationally.

In addition, it is likely that most institutional clients with multiple investment managers will not be able to net positions with the same counterparty across separate portfolios for margin purposes. This will cause excessive margining that would be detrimental to the performance of funds.

2.9 UCITS & AIFs issues
Article 51 (1) of the UCITS Directive (2009/65/EC) requires a management or investment company to “employ a risk-management process which enables it to monitor and measure at any time the risk of the positions and their contribution to the overall risk profile of the portfolio.

It shall employ a process for accurate and independent assessment of the value of OTC derivatives.

It shall communicate to the competent authorities of its home Member State regularly in regard to the types of derivative instruments, the underlying risks, the quantitative limits and the methods which are chosen in order to estimate the risks associated with transactions in derivative instruments regarding each managed UCITS.”

In addition, Article 15.2 of the AIFMD requires AIFMs to “implement adequate risk management systems in order to identify, measure, manage and monitor appropriately all risks relevant to each AIF investment strategy and to which each AIF is or may be exposed.

AIFMs must also “implement an appropriate, documented and regularly updated due diligence process when investing on behalf of the AIF, according to the investment strategy, the objectives and risk profile of the AIF (Article 15.3)

Therefore, both UCITS and AIFs are already subject to strict requirements in this area.

UCITS should be exempt from the proposed initial margin obligations. Article 52.1 of the UCITS Directive limits counterparty exposure to a maximum of 10% of the value of the UCITS. Furthermore, under Article 51.3, a UCITS must ensure that its global exposure relating to derivative instruments does not exceed the total net value of its portfolio. These risk measures reduce the impact of any counterparty default.

The ban of the re-use of initial margin is also inconsistent with the requirements of ESMA’s Guidelines on ETFs and other UCITS Issues (ESMA/2012/832). Paragraph 43(j) requires cash collateral to be placed on deposit with entities prescribed in Article 50(f) of the UCITS Directive; invested in high-quality government bonds; used for the purpose of reverse repo transactions provided the transactions are with credit institutions subject to prudential supervision and the UCITS is able to recall at any time the full amount of cash on accrued basis or invested in short-term money market funds as defined in ESMA’s Guidelines on a Common Definition of European Money Market Funds.

Question 4. In respect of the use of a counterparty IRB model, are the counterparties confident that they will be able to access sufficient information to ensure appropriate transparency and to allow them to demonstrate an adequate understanding to their supervisory authority?

The use of a counterparty IRB model for credit risk assessment is not common among insurers and other investors. In most cases, they will lack the resources and expertise to develop these internal rating models. The more common industry practice is the use of external credit ratings and additional risk management tools.

However, the current proposals differentiate (in terms of collateral eligibility) between assets in relation to which one utilises an internal model to make a credit risk assessment and those where one utilises an external provider. Whilst we understand that this is the intention of the European Supervisory Authorities, we do not believe that users of external credit risk assessments should be penalised in terms of collateral eligibility. When it comes to determining collateral eligibility, there should be no discrimination between IRB models and external credit ratings.

In instances where the banking counterparty uses an internal model, it is unclear how the buy-side counterparty will gain access to key information required in order to assess the model. In some instances, credit ratings generated by internal models could be considered intellectual property of the banking counterparty, and so they are unlikely to share this information with their buy-side counterparts.

We support an industry wide, standardised approach for both collateral and haircuts and initial margin. This will limit the potential for disputes arising between counterparties and enable greater transparency and certainty between the sell-side and buy side. The use of a standardised approach will, of course, be consistent with the centrally cleared / CCP environment.

Question 6. How will market participants be able to ensure the fulfilment of all the conditions for the reuse of initial margins as required in the BCBS-IOSCO framework? Can the respondents identify which companies in the EU would require reuse or re-hypothecation of collateral as an essential component of their business models?

We believe that the reuse of initial margins should be permitted as outlined in the BCBS IOSCO framework, as long as both counterparties give explicit consent.

Name of organisation

Investment Management Association