Response to joint Consultation on draft RTS on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP
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The requirement for initial margin will apply subject to a threshold value of EUR 8 billion for gross notional outstanding of OTC derivatives. A key point is the scenario where at least one party to the trade is below the threshold. In this case, it is clear that it should not be forced to post initial margin without consenting. It is of paramount importance to ensure that the larger counterparty will not force collateral to be posted unilaterally by the fund or exchanged bilaterally. Otherwise, costs may still fall disproportionately on smaller market participants.
The requirement for the implementation of internal initial margin models and the resulting obligation to agree on the outcomes of different models will lead to a sub-optimal situation. We would rather recommend the use of the standardized method or the election of a single initial margin model (market best practice) that would only need to be validated once by a third party and / or the regulator.
In general, we would like to put more emphasis on the fact that small and medium size players should not suffer from decisions taken by larger players or support substantial costs to mitigate systematic risk inferred by those larger players.
Grand fathering clause: we insist on the necessity to fully establish the fact that the regulation will only apply for transactions conducted after 1st December 2015 and for the IM, depending on the thresholds defined in article 1 FP; it should not only be mentioned under recital 18 but also included in the text of the regulation itself. Furthermore, we consider that a precision should be added to make sure that “genuine amendments” as referred to in the BCBS/IOSCO final report (§ 8.9 and footnote 20, p. 24) made to existing derivative contracts shall not be in the scope of the new regulation. An explicit mention in article 1 FP § 4 shall bring the necessary clarification. As a matter of fact, investment funds often amend existing contracts to reduce their notional amount to adjust their exposure, as a consequence of redemptions. Thus, it is very important for them to keep these existing contracts outside the scope of the regulation.
Reverse the presumption that IM will not be collected: in article 1FP §3, the current wording says that the possibility to exempt transactions between counterparties under the threshold requires a prior formal agreement. The default rule should be that, in the absence of a specific agreement between the parties, there is no IM posted. Legal services are overworked and this suggestion would simply make things workable.
100 million € of collateral as Threshold for concentration rules; alignment with UCITS collateral diversification rules: if concentration rules were to apply,- and we strongly suggest that there should be a realistic threshold under which they should not, simply because it is not workable to ask for a split over different issuers of collateral on smaller amounts than 100 million-, they should be coherent with existing requirements. ESMA guidelines asks for UCITS to spread received collateral in order not to exceed an exposure higher than 20% of the NAV of the fund on one single issuer. The denominator of the ratio is what is important in the fund, i.e. the net asset value or the net capital available in the fund. The proposed regulation refers to the total amount of the collateral when computing the diversification ratio. It is inconsistent to consider that there is a risk on the collateral of small amount that could be mitigated with a diversification rule; it is not workable to ask counterparties to split small amounts of collateral on several issues for even smaller amounts, uneasy to manage and costly to transfer.
Group consolidated eligibility thresholds: In the case of portfolio management for a client, it would be impossible for an asset manager to calculate group consolidated eligibility thresholds of its client. In addition, the fact that a client may have signed several mandates with several Asset Managers brings additional difficulties in calculating margin. Which entities will be responsible for calculating and paying the required amount of margin on behalf of the client?
The application of two different methods by the parties to evaluate and calculate haircuts may result in discrepancies. It seems that there is no procedure in the RTS to solve those discrepancies.
As asset managers, we believe that a standardized margin schedule may be the preferred approach as a standardized margin schedule used by both parties would lessen the risk of disputes as compared to quantitative portfolio models developed by counterparties.
UCITS derivative close out rule: The funds are required in Europe to negotiate a possibility to ask for an exit out of a derivative at any time. It implies the possibility to put to an end the initial operation with the initial counterparty. The point is that if for the sake of best execution the asset manager has a better price with another counterparty for an opposite transaction it will have to post collateral for two opposite exposures as long as a netting is not accepted between counterparties (and there is no possibility to force such a netting). This is not an issue if no initial margin is exchanged but may become an obstacle to best execution if there is.
The proposed regulation suggests a Minimum Transfer Amount (MTA) of 500 000 €. This amount includes the net variation of IM and VM exchanged between 2 counterparties. Some of our members monitor IM and VM separately and we would prefer to have two MTAs. We hence suggest that be added if it is possible to follow two MTAs of 500 000€.
On the legal point of view, we fear that the ability to return excess collateral to the liquidator of the defaulting counterparty that posted it might be difficult to guarantee in all jurisdictions. We think that it requires a full monitoring of the local legal framework and depends also very much on the type of segregation that is provided for.
Our members agree to the requirement that banks communicate on the models they use and the data they take when running these models. Our members’ responsibility towards their clients includes the verification of the prices of the financial instruments used and the level of collateral is within the scope of the controls. We would advocate for a specific requirement to discuss the key structure of the models and the source of data used and we suggest they should be as often as possible public data. As we fear that it might be difficult to receive the necessary information, we would consider as a good leverage that the client be recognized the possibility to seize the competent authority if he cannot obtain satisfactory explanations.
Managing money for third party implies not only to comply with supervisory authorities, but also to ensure that customers’ money is managed within a defined risk framework. Therefore one must ensure that both the client needs and the supervisory rules are understood. Sufficient information and appropriate transparency would imply due diligence made by the Asset Manager on the IRB used by the counterparty. When managing money for third parties, the validation of the IRB by a supervisory body is an important step that should be supplemented by the Asset Manager’s due diligence. When deciding the list of allowed counterparties to trade OTC derivatives, the client can also carry out a due diligence on the IRB counterparties.
The collateral should be used as a guarantee should the counterparty default on its commitment. The quality of collateral rated by a “failed” counterparty may make its sale very difficult (and thus limit considerably the purpose of posting collateral). Typically, if the IRB is used for non-rated securities it can make the sale of the collateral in a stress period more difficult in the absence of an external rating.
For this reason, combined with the fact that small/medium size asset managers will not be able to have approved IRB models nor to monitor their counterparties IRB models, we feel that the advantage given to IRB models as opposed to external ratings is not fair and that the acceptable CQS should be positioned at the same level, level 3 for usual bonds, in both cases.
It should also be mentioned that the use of margin models may put the small & medium size players (e.g. small investment managers, non-financial counterparties) at comparative disadvantage compared to other larger players (e.g. large investment firms, broker /dealers) because they may not have the necessary operational resources to develop those models. They may have to agree on the results of margin models developed by their counterparties and / or third parties and suffer a lack of information to assess the appropriate calibration and the integrity of the model. This lack of transparency may lead to frequent disputes regarding the amount of initial margin to be posted.
For both the IRB model (eligible collateral and haircut) and the internal model of Initial Margin calculation small and medium size players will be exposed to non-transparent models.
In order to avoid such comparative disadvantage faced by Asset Manager some tools may be proposed
- to cap the difference between the internal model and the standard model;
- to entrust a third party for the calculation with a commitment to stability of the model.
- the possibility to use specialized models issued by professional provider such as Rating Agencies used for securities ratings;
- to exclude OECD Govies from eligibility rating requirements to avoid the cliff risk criteria;
Regarding the Initial Margin calculation, the regulation should require Banks to leave the choice for the client and for each transaction between internal model and standard.
AFG members have the view that BCBS/IOSCO principles have taken a prudent and pragmatic approach when strongly limiting the possibility to re-use or rehypothecate received collateral. We think that there is no reason not to follow these principles. OTC derivatives are traded between professionals. If a counterparty agrees that the re-use of collateral will be positive and made for the benefit of its clients, re-use should not be prohibited.
AIFs are currently permitted to re-use collateral (certain disclosure requirements are necessary). These new rules are therefore inconsistent with the rules applying to AIFs and with the way existing AIFs have been structured.
The interdiction of collateral re-use would pose a business problem for some types of funds. If prime brokers are unable to re-use the collateral they receive, access to financing will become more difficult for these funds, and much more expensive.
An example of circumstances where re-use will be helpful is to be found in the case of back to back transactions where a counterparty A manages the exposition it took from a derivative contract with a fund through a reverse transaction with counterparty B; the collateral received from the fund by A may be re-used and posted in favour of B that finally takes the market risk. The more so if A is a financial institution that provides the fund with a guarantee.
The required prior explicit approval by the poster of the collateral (transaction by transaction), the fact that it can check that the re-use is made in conjunction with a further transaction aiming at managing the risk initially taken from the fund and not to take further exposure, the possibility to earmark the collateral…all is made to limit the re-use to a very few cases when professionals fully agree.
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.
We indeed think that some particular requirements may be addressed in a more appropriate manner or still need to be clarified, in order to reduce the costs and avoid any comparative disadvantage for small and medium size players. Here is a brief summary of our thoughts:The requirement for initial margin will apply subject to a threshold value of EUR 8 billion for gross notional outstanding of OTC derivatives. A key point is the scenario where at least one party to the trade is below the threshold. In this case, it is clear that it should not be forced to post initial margin without consenting. It is of paramount importance to ensure that the larger counterparty will not force collateral to be posted unilaterally by the fund or exchanged bilaterally. Otherwise, costs may still fall disproportionately on smaller market participants.
The requirement for the implementation of internal initial margin models and the resulting obligation to agree on the outcomes of different models will lead to a sub-optimal situation. We would rather recommend the use of the standardized method or the election of a single initial margin model (market best practice) that would only need to be validated once by a third party and / or the regulator.
In general, we would like to put more emphasis on the fact that small and medium size players should not suffer from decisions taken by larger players or support substantial costs to mitigate systematic risk inferred by those larger players.
Grand fathering clause: we insist on the necessity to fully establish the fact that the regulation will only apply for transactions conducted after 1st December 2015 and for the IM, depending on the thresholds defined in article 1 FP; it should not only be mentioned under recital 18 but also included in the text of the regulation itself. Furthermore, we consider that a precision should be added to make sure that “genuine amendments” as referred to in the BCBS/IOSCO final report (§ 8.9 and footnote 20, p. 24) made to existing derivative contracts shall not be in the scope of the new regulation. An explicit mention in article 1 FP § 4 shall bring the necessary clarification. As a matter of fact, investment funds often amend existing contracts to reduce their notional amount to adjust their exposure, as a consequence of redemptions. Thus, it is very important for them to keep these existing contracts outside the scope of the regulation.
Reverse the presumption that IM will not be collected: in article 1FP §3, the current wording says that the possibility to exempt transactions between counterparties under the threshold requires a prior formal agreement. The default rule should be that, in the absence of a specific agreement between the parties, there is no IM posted. Legal services are overworked and this suggestion would simply make things workable.
100 million € of collateral as Threshold for concentration rules; alignment with UCITS collateral diversification rules: if concentration rules were to apply,- and we strongly suggest that there should be a realistic threshold under which they should not, simply because it is not workable to ask for a split over different issuers of collateral on smaller amounts than 100 million-, they should be coherent with existing requirements. ESMA guidelines asks for UCITS to spread received collateral in order not to exceed an exposure higher than 20% of the NAV of the fund on one single issuer. The denominator of the ratio is what is important in the fund, i.e. the net asset value or the net capital available in the fund. The proposed regulation refers to the total amount of the collateral when computing the diversification ratio. It is inconsistent to consider that there is a risk on the collateral of small amount that could be mitigated with a diversification rule; it is not workable to ask counterparties to split small amounts of collateral on several issues for even smaller amounts, uneasy to manage and costly to transfer.
Group consolidated eligibility thresholds: In the case of portfolio management for a client, it would be impossible for an asset manager to calculate group consolidated eligibility thresholds of its client. In addition, the fact that a client may have signed several mandates with several Asset Managers brings additional difficulties in calculating margin. Which entities will be responsible for calculating and paying the required amount of margin on behalf of the client?
The application of two different methods by the parties to evaluate and calculate haircuts may result in discrepancies. It seems that there is no procedure in the RTS to solve those discrepancies.
As asset managers, we believe that a standardized margin schedule may be the preferred approach as a standardized margin schedule used by both parties would lessen the risk of disputes as compared to quantitative portfolio models developed by counterparties.
UCITS derivative close out rule: The funds are required in Europe to negotiate a possibility to ask for an exit out of a derivative at any time. It implies the possibility to put to an end the initial operation with the initial counterparty. The point is that if for the sake of best execution the asset manager has a better price with another counterparty for an opposite transaction it will have to post collateral for two opposite exposures as long as a netting is not accepted between counterparties (and there is no possibility to force such a netting). This is not an issue if no initial margin is exchanged but may become an obstacle to best execution if there is.
The proposed regulation suggests a Minimum Transfer Amount (MTA) of 500 000 €. This amount includes the net variation of IM and VM exchanged between 2 counterparties. Some of our members monitor IM and VM separately and we would prefer to have two MTAs. We hence suggest that be added if it is possible to follow two MTAs of 500 000€.
On the legal point of view, we fear that the ability to return excess collateral to the liquidator of the defaulting counterparty that posted it might be difficult to guarantee in all jurisdictions. We think that it requires a full monitoring of the local legal framework and depends also very much on the type of segregation that is provided for.
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?
We comment hereafter the use of a counterparty IRB model, but also the use of the IM model of the counterparty.Our members agree to the requirement that banks communicate on the models they use and the data they take when running these models. Our members’ responsibility towards their clients includes the verification of the prices of the financial instruments used and the level of collateral is within the scope of the controls. We would advocate for a specific requirement to discuss the key structure of the models and the source of data used and we suggest they should be as often as possible public data. As we fear that it might be difficult to receive the necessary information, we would consider as a good leverage that the client be recognized the possibility to seize the competent authority if he cannot obtain satisfactory explanations.
Managing money for third party implies not only to comply with supervisory authorities, but also to ensure that customers’ money is managed within a defined risk framework. Therefore one must ensure that both the client needs and the supervisory rules are understood. Sufficient information and appropriate transparency would imply due diligence made by the Asset Manager on the IRB used by the counterparty. When managing money for third parties, the validation of the IRB by a supervisory body is an important step that should be supplemented by the Asset Manager’s due diligence. When deciding the list of allowed counterparties to trade OTC derivatives, the client can also carry out a due diligence on the IRB counterparties.
The collateral should be used as a guarantee should the counterparty default on its commitment. The quality of collateral rated by a “failed” counterparty may make its sale very difficult (and thus limit considerably the purpose of posting collateral). Typically, if the IRB is used for non-rated securities it can make the sale of the collateral in a stress period more difficult in the absence of an external rating.
For this reason, combined with the fact that small/medium size asset managers will not be able to have approved IRB models nor to monitor their counterparties IRB models, we feel that the advantage given to IRB models as opposed to external ratings is not fair and that the acceptable CQS should be positioned at the same level, level 3 for usual bonds, in both cases.
It should also be mentioned that the use of margin models may put the small & medium size players (e.g. small investment managers, non-financial counterparties) at comparative disadvantage compared to other larger players (e.g. large investment firms, broker /dealers) because they may not have the necessary operational resources to develop those models. They may have to agree on the results of margin models developed by their counterparties and / or third parties and suffer a lack of information to assess the appropriate calibration and the integrity of the model. This lack of transparency may lead to frequent disputes regarding the amount of initial margin to be posted.
For both the IRB model (eligible collateral and haircut) and the internal model of Initial Margin calculation small and medium size players will be exposed to non-transparent models.
In order to avoid such comparative disadvantage faced by Asset Manager some tools may be proposed
- to cap the difference between the internal model and the standard model;
- to entrust a third party for the calculation with a commitment to stability of the model.
- the possibility to use specialized models issued by professional provider such as Rating Agencies used for securities ratings;
- to exclude OECD Govies from eligibility rating requirements to avoid the cliff risk criteria;
Regarding the Initial Margin calculation, the regulation should require Banks to leave the choice for the client and for each transaction between internal model and standard.
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?
Our members believe that the prohibition or authorization of re-use should not be determine on a regulatory level but on case by case basis within a bilateral agreement between the parties.AFG members have the view that BCBS/IOSCO principles have taken a prudent and pragmatic approach when strongly limiting the possibility to re-use or rehypothecate received collateral. We think that there is no reason not to follow these principles. OTC derivatives are traded between professionals. If a counterparty agrees that the re-use of collateral will be positive and made for the benefit of its clients, re-use should not be prohibited.
AIFs are currently permitted to re-use collateral (certain disclosure requirements are necessary). These new rules are therefore inconsistent with the rules applying to AIFs and with the way existing AIFs have been structured.
The interdiction of collateral re-use would pose a business problem for some types of funds. If prime brokers are unable to re-use the collateral they receive, access to financing will become more difficult for these funds, and much more expensive.
An example of circumstances where re-use will be helpful is to be found in the case of back to back transactions where a counterparty A manages the exposition it took from a derivative contract with a fund through a reverse transaction with counterparty B; the collateral received from the fund by A may be re-used and posted in favour of B that finally takes the market risk. The more so if A is a financial institution that provides the fund with a guarantee.
The required prior explicit approval by the poster of the collateral (transaction by transaction), the fact that it can check that the re-use is made in conjunction with a further transaction aiming at managing the risk initially taken from the fund and not to take further exposure, the possibility to earmark the collateral…all is made to limit the re-use to a very few cases when professionals fully agree.