It is worth noticing that the RTS, as proposed, will require the implementation of minimum standards that significantly surpass current market practices, in particular;
a) counterparties on OTC derivatives traded on a bilateral basis will have to exchange collateral, not only to cover the market value (variation margin, which is a current broad market practice) but also to cover, on a gross basis, the potential adverse movement of the market value over a liquidation period (initial margin);
b) collateral exchanged will have to respect minimum credit quality standards, wrong-way risk and concentration limits;
c) collateral collected as initial margin will have to be segregated and not be re-hypothecated, re-used or re-pledged.
The proposed standards will consume liquidity resources for participants in the OTC derivatives market in a regulatory environment that already puts pressure on the liquidity profile of banks (core participants in the derivatives markets) that will have the challenge to comply with the Basel III liquidity framework, such as the Liquidity Coverage Ratio (”LCR”).
In addition to the pressure in terms of size of the collateral required, it is important to highlight the fact that such additional stress will be focused on the same type of high quality liquid assets (“HQLA”) as the Basel liquidity regulation; this may generate some distortion in the HQLA markets whose systemic effect is not easy to assess.
At this moment, it is hard to estimate the definitive impact, in terms of price, of this new regulation. Even if, in principle, a collateralized transaction should be cheaper than a non-collateralized transaction (i.e.: reduction of counterparty risk), the potential scarcity of collateral could revert this trend and in the worst case scenario could even predominate. Therefore, under this extreme scenario, some small and medium-sized entities could struggle to stay in the market.
In addition, the totality of these requirements (including operational ones) will increase the cost of entering into non-centrally cleared OTC derivatives. Although this will help accomplishing one of the main purposes of the RTS, i.e. promoting central clearing, it will also reduce the availability of risk-management tools accessible for non-financial players to manage or hedge their risks. It will also hinder financial innovation, to the extent that new financial instruments useful for the real economy tend to emerge first on a bilateral basis, until they reach a critical mass that allows standardization and sufficient liquidity to be cleared through a CCP.
Small financial counterparties, whose business model includes the absorption of financial risks from their clients, will be the most affected by the implementation of these minimum margin standards, as they will need to make use of derivative financial instruments to manage their risks but they may not have the capacity to deal with all the complexity these standards impose.
In addition, non-financial companies (except corporates that are treated as financial companies under EMIR, NFC+) are exempt to the mandatory margin requirements (initial and variation margin) when they are the result of hedging activities, but this exception is not extended to financial companies. Consideration should be given to the idea of extending this exemption to the hedging activities of financial companies also below a given threshold in derivatives positions. Furthermore, the exception does not affect non-EU non-financial companies, a restriction that is probably unintended, and should therefore be corrected.
To sum up, small financial counterparties do not individually pose systemic risk, but the application of this framework may disproportionally affect the viability of their business as they may not have the sophistication to (i) manage their risks through standardized (CCP-cleared) derivatives, (ii) use quantitative models to optimize the consumption of collateral, and (iii) adapt their processes to deal with all the requirements on the collateral. For small financial players, the obligation to exchange initial margin may force them out of this business, giving more market share to large financial counterparties and, thus potentially increasing concentration and systemic risk.
In addition to the effects on market liquidity, the new margin requirements demand a strengthening of the operational processes that will be costly both on the implementation period and on an on-going basis. Entities will have to develop more sophisticated processes to calculate margins, control the quality of collateral posted and collected, increase protection on collateral collected and be ready to access and manage collateral when counterparties default.
Agreements between counterparties will also have to be expanded to include all new arrangements required by this new framework. The amount of work market participants will have to develop to update contracts with their counterparties is unnecessarily increased, as all the exemptions included in the proposed RTS will have to be agreed in writing in their bilateral arrangements.
The cost of implementing the new minimum margin standards would be less burdensome if the exemptions were directly applicable, having the counterparties only to reflect in their arrangements the cases in which they agree not to make use of them.
The treatment in the consultation of derivatives done with CB issuers or CB pools for hedging purposes is broadly appropriate. The solution proposed ensures a high degree of protection to the derivatives counterparty, requiring some specific conditions to the covered bond issuer or cover pool to be exempted from collateral posting.
The requirements proposed are comprehensive and ensure the needed protection for derivative counterparties should the collateral exemption apply. To be more precise, requiring that the derivative contract should not terminate in case of default of the covered bond issuer or the existence of a certain amount of legal overcollateralization in the respective legal frameworks for covered bonds enhances the protection of the derivatives counterparties.
The rates for the standardized tables on the calculation of initial margin and haircuts on collateral proposed by the RTS (same rates as proposed by the BCBS-IOSCO framework) are disproportionally high with respect to the expected outcome of the application of quantitative models (see results of the BCBS-IOSOC QIS). This provides a great advantage to the users of quantitative models. However, these models are difficult to design and handle, which in turn gives a competitive advantage to the larger and more sophisticated market players, which may lead to a concentration of the OTC derivatives market into a small number of large players.
Moreover, the use of models in bilateral agreements requires the agreement of both counterparties on very specific details of the models to be used for each type of derivative. As small differences of parameters or data may lead to material discrepancies in the outcome of the model, a large number of disputes may arise between counterparties.
The RTS does not contemplate approval of the initial margin model by EU competent authorities (as called for by paragraph 3.3 of the BCBS-IOSCO framework document). This introduces a regulatory uncertainty for counterparties relying on the initial margin model, exposing them to a liquidity risk if their competent authority deems the model not to be appropriate subsequent to its adoption.
Another area where the EU framework deviates from the international standards is on the concentration limits on eligible collateral which is not a feature of the BCBS-IOSCO framework document. This may dissuade non-EU entities from trading uncleared OTC derivatives with EU entities.
While the inclusion of concentration limits in order to reduce the risks generated by counterparties posting non-diversified collateral (and thus generating the risk of a concentrated exposure for their counterparty) is a sound risk management practice, it may generate a series of operational issues and distortions in the liquidity markets. In this sense, considering the composition of the balance sheet of the derivatives’ users, small and medium sized financial entities subject to the regulation (not to mention non-financial corporates) will probably have serious problems in generating sufficiently diversified collateral to avoid the concentration limits.
In this regard, we would suggest applying the proportionality principle allowing therefore some exceptions in the concentration limits for small and medium-sized players in this market. To enhance consistency across prudential rules, collateral labeled as Level 1 under LCR legislation may be exempted from this limit as well.
It is important to note that the concept of rehypothecation is also currently used in the context of the European Commission’s proposal for a Securities Financing Transactions Regulation, in the discussion about implementing measures for MiFID2 in ESMA and, at global level, in the context of the 2013 FSB policy recommendations on securities lending and repos. In this respect, it is crucial to ensure consistency and coordination between these parallel political and legislative developments. Rehypothecation generally plays an important role in providing liquidity to markets, which is already under pressure from other regulations such as the LCR and initial margining requirements. Understanding and monitoring the interactions of these rules as they enter into force will remain important for the supervisory community.
The new requirements regarding the segregation of initial margins and the ban on re-use/rehypothecation will require fundamental changes to established collateral management procedures and to the contractual documentation currently in use for margining.
These changes will be extremely challenging and time consumingThe timeline foreseen for the implementation is unrealistic and will only be met with great difficulty (not just by industry, but also by national authorities, given the potentially large volume of model approvals needed, either to approve adjustments to existing models or in view of the need to approve a unified modelling approach which is expected to be developed).
A phase-in period with possibly less formalistic requirements would significantly help reduce these time constraints.