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

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Respondent are invited to provide comments on whether the draft RTS might produce unintended consequence concerning the design or the implementation of initial margin models.

The proposed text is still ambiguous regarding the asset classes. The text seems to indicate that each contract should be assigned to one asset class, by opposition to each risk factor. The model may account for risk offset in one asset class. Does this means that if an instrument has been assigned to one asset class but depends on risk factors typical from another asset class, the diversification effect of all risk factors related to that instrument should be taken into account? Or does it mean that only the risk factor associated to the assigned asset class should be taken into account and the others should be ignored? The current text does not provide an unambiguous description of the requirements.

Does this approach address the concerns on the use of cash for initial margin?

Cash is probably understood here as emph{electronic cash} and not as emph{banknotes cash}. It is not clear what the alternative to re-investment is for cash. The cash will always be at least in a cash account with a financial institution -- e.g. a central bank. There is no alternative to re-investment for cash.

Does this article also allows the re-use of cash to invest in non-cash instruments? For example in short term bills or bonds?

Respondents are invited to comment on the requirements of this section concerning treatment of FX mismatch between collateral and OTC derivatives.

FX risk is not different from other risks and cash is not different from other assets. There is no reason to make a difference for them. The fact that a VM is settled in cash does not settle the claim. It is only a collateral to guarantee future settlement. When receiving the VM in cash, one could argue that the receiver could convert the amount into the currency that settle the claim at best for him. This argument does not stand a further analysis, as in absence of default, the receiver of the VM as to return it in the original currency. If the instrument cash flows and the VM are not all in the same currency, the receiver of the VM will always have a currency risk. If the VM is not converted, in case of default, there is a mismatch between the VM amount in currency and the MtM, even in absence of movement in the market underlying the OTC derivative. If the VM is converted, in absence of default, the original amount in the original currency should be returned and the receiver of the VM face the currency risk of not being able to return the full amount in the original currency.

The treatment of the FX mismatch for VM does not match the requirements for a safe exchange of margin. The complexity around the cash for VM question arise from the segregation between the OTC portfolio risk and the margin portfolio risk, which is a fundamental flaw of the proposed regulation, as explained in the first section. As long as the flaw is not corrected, it will be difficult to propose a coherent and robust treatment of the FX mismatch.

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