The aim of the Draft regulatory technical standards on risk-mitigation techniques for OTC-derivatives contracts not cleared by a CCP is to implement robust risk mitigation techniques to bilateral relationships in order to reduce counterparty credit risk and mitigate systemic risk.
The spirit of the technical standards is to avoid unnecessary costs and negative effects without jeopardizing the global objective of risk mitigation and the harmonization of the international regulatory framework.
Nonetheless, the implementation of the RTS will be at cost.
We have identified the below three main types of costs to be supported by market participants:
• Legal and documentation cost, as agreements must be negotiated or amended to take on board new requirements as far as collateral is concerned; legal teams are overbooked with other new developments mainly linked to the implementation of EMIR and AIFM but also the future MIF requirements in terms of distribution and some we may have to solicit external advice which tend to increase the cost of compliance;
• Operational cost exposed in order to establish and then run processes for orderly collateral management; operational costs could be reduced if the suggestions expressed in the answer to the following question were accepted. These costs are related to need of higher operational capabilities (sophisticated collateral management tools, operational staff, daily pricing capability,…) as well as to the development of initial margin models and internal rating-based models (model calibration, back-tests, audit,…);
• Financial costs related to the lower yield realized on the assets; For example, the reduced facility to sell assets transferred as collateral makes the process of arbitrage positions more difficult and might prevent the manager from seizing opportunities; the securities held in the portfolio which are used as collateral will no longer be available for securities lending activities that improve the return for the fund and its client holder; Structured Funds will have the reduce the allocation to receive the performance in order to source new bilateral collateral requirements.
According to the proposed RTS collected Initial Margin should be segregated from proprietary asset. Consequently both counterparties will have to open separate account from proprietary asset with a consequence of an additional cost.
Eligibility and treatment of collateral
The requirement that the counterparties of OTC transactions have the operational capabilities to collect collateral and manage the collateral in the event of the default of the other counterparty implies that the collateral receiving party will face operational costs such as:
- The daily re-evaluation of collateral;
- The necessary legal arrangement and an effective collateral holding structure;
- An alternative custody account for all asset types in the list of acceptable collateral (in case where the collateral is maintained with the provider) to manage the assets following the default of the provider;
- The access to an active outright sale or repurchase agreement market (in case where the collateral provider defaults);
- Cash accounts in all acceptable currencies with a party other than the collateral provider for depositing cash collateral and crediting the proceeds of repurchase agreements on the collateral;
- The ability to return the unused collateral proceeds to the liquidator;
- The necessary arrangements to ensure that the accepted collateral is freely transferable.
- The development of an approved internal model (thus reducing the reliance on external rating);
- The documentation of detailed procedures in case that the credit quality of the collateral collected no longer meets the requirement of the RTS;
- The ability to identify collateral assets which quality fall below the required level;
- The ability to define a schedule for the replacement of collateral assets already accepted following a downgrade (in order to mitigate the risk of introduction of “cliff effects”);
- The ability to assign haircuts to collateral assets and monitor the value of the haircuts to ensure consistent valuation of the collateral held.
The introduction of proportionality threshold for the application of the concentration limits may help to achieve a good balance between costs and benefits.
In order to fulfil the concentration limit requirements, counterparties will have to support significant operational costs:
- They will have to monitor all collateral flows (including initial and variation margin) on a daily basis to ensure that the amount of collateral collected for each eligible asset class is not above the limit;
- They must have the ability to propose a large range of asset classes as initial and / or variation margin to their counterparties who would have to avoid going over the same limits and may refuse eligible assets as collateral due to that limit;
- The requirement on the concentration limit will increase time delays in collateral exchanges and ultimately risk.
The RTS requires robust risk management procedures to be in place to ensure the timely exchange of collateral for contracts not centrally cleared. Those risk management procedures relate to:
- The policy and procedures regarding the exchange of collateral
- The escalation process with counterparties
- The reporting of exceptions to senior management
- The operational process for the exchange of collateral
- The storing of all agreements
- The timely settlement of margin calls
- The mitigation of risks arising from collateral assets collected
- The setting of collateral levels
- The verification of the liquidity of the eligible collateral
- The periodic testing of the risk management procedures
- The substitution of collateral.
These requirements will result in significant costs in terms of higher operational burden for market participants. They will have to supports higher costs (collateral management tools, operational staff and front to back proprietary management systems) to be able to meet those requirements.
Segregated Initial Margin from proprietary assets on the books and records of a custodian and for the collecting counterparty to provide the posting counterparty with the option to individually segregate its collateral may also come at significant costs for the collecting counterparty. This will probably be transferred into higher custody fees for the collecting counterparty.
The full ban of the initial margin re-use will prevent market participant from using repurchase agreements to transform securities received as collateral into cash and pursue higher yield investment opportunities. In the same fashion they won’t be able to use reverse repurchase agreements to loan the cash received as collateral. This will result in an opportunity cost for market participants.
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:
Requirement for initial margin will apply subject to a threshold value of EUR 8 billion for gross notional outstanding of OTC derivatives. In the scenario where a party to OTC transaction is below the threshold, but the other is above will result in a two way payment Initial Margin. The party below the threshold should not support the same rules as its counterparts and should not be forced to post initial margin. 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.
One should emphasise 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: Exchange of collateral requirement as of 1st December 2015 for new contract should be reinforced; it should not only be mentioned under recital 18 but also included in the text of the regulation itself. Furthermore, we consider that a clarification 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 euros of collateral as Threshold for concentration rules; alignment with UCITS collateral diversification rules: if concentration rules were to apply, they should be coherent with existing requirements. ESMA guidelines require 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 issuers for even smaller amounts, uneasy to manage and costly to transfer.
Group consolidated eligibility thresholds: It would be impossible for an asset manager to calculate group consolidated eligibility thresholds on behalf of its client. In addition, the fact that a client may have signed several mandates with several Asset Managers brings additional difficulties in calculating such 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. 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.
For both the IRB model (Eligible Collateral and Haircut) and the internal model of Initial Margin calculation small and medium size player will be exposed to non-transparent models of the Banks.
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 Agencies Rating used for securities ratings;
- To exclude OECD Government Bonds from eligibility rating agencies to avoid the cliff risk criteria;
- As regard to Initial Margin calculation, require Banks to leave the choice for the client and for each transaction between internal model and standard.
Before discussing concentration limits it is of prime importance to open the discussion about eligible collateral. We are of the opinion that the list of eligible collateral should be large, diversified and include funds. A large list prevent from the procyclicalilty risk of the collateral. The problem is that a large list of eligible collateral may include assets with a worst quality and liquidity. Quality of the collateral is assessed on the basis of its liquidity and creditworthiness.
Liquidity: the purpose of collateral is to be able to convert it into cash when the counterparty defaults. There is a difference between the price on which the derivative contract was settled and the last level of the variation margin. Liquidity tends to fade or increase very quickly. However, it is a fact that large cap stocks are among the most liquid assets in any circumstances and that government bonds are usually very actively traded as well. But the recent experience has shown that Government Bonds might become totally illiquid overnight. Liquidity should include the possibility to use securities lending and Repo markets to gain it.
Credit quality: Even if we agree that investors should not rely overly on credit rating agencies analysis and that they should develop internal credit assessment capacities, we do not consider that it is fair to introduce a difference when the eligible collateral is determined on an internal rating or an external one provided by a CRA. This causes a particular concern on our part as we will rely on models developed by banks and as such taking into consideration their internal credit estimates. In order to challenge these models we want to be able to take rating published by CRA as reference, especially because the CRAs produce extensive research on credit performance of rated issues over a long period of time.
We consider that the entire field of the investment grade (as defined by CRAs) issues should be considered as eligible. Since they do not show the same level of safety, it is clear that appropriate haircuts have to be provided. We feel that the proposed schedule can be used as a reference.
We do not share the idea to include shares of components of the main indices in the 40% limit that is suggested for convertible, shares and other instruments. First, this proposal is not consistent with the fact that shares are highly liquid and remain one of the few actively traded instruments in periods of stress, probably because of the diversity of types of shareholders. Secondly, this limitation would alter the investment strategy of many funds that are required to invest exclusively or to a very large proportion in shares: hundreds of Structured Funds in France for example have to show a minimum investment of 75% in eligible shares. They might be prevented to use derivative contracts and dramatically reduce the investment universe of their holders. This is particularly true if the 40% ratio were computed on the basis of total collateral and not NAV for funds.
As regard to concentration limits, we strongly believe that they should not apply below a threshold of 100 million € in collateral. Managing concentration limits below 100 million euros would be an operational nightmare, which introduce delays, high complexity and risk in collateral management. We also suggest that the diversification calculation be computed on the basis of the NAV for funds (and each sub-fund if any), both UCITS and AIFs (when of course those investment funds individually are above the threshold).
We would like to highlight that as per the “Guidelines on ETFs and other UCITS issues” published by ESMA on the 18th December 2012, a UCITS is bound to invest the cash collateral it receives. Therefore, banning the re-use of cash received as initial margin is in contradiction with other guidelines and rules imposed to UCITS funds.
Cash collateral should be placed on deposits, invested on high quality investment bonds, used for the purpose of reverse repo or invested in short term money market funds. Such investments must be in compliance with additional security constraints. We consider this regime adequately secures transactions and avoid risk in case of default of the receiving party. Asset managers cannot be subject to a double layer of constraints. Therefore we kindly ask the regulator to choose between the two set of rules - Guidelines on ETFs and other UCITS issues and the proposed RTS in order apply the diversification of collateral rules.
We 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.
We are of the opinion 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 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 prohibition 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.
Another negative effect of this prohibition is that it would deprive the collecting party of a way to generate interests that must be paid to the posting party. How will the collecting party be able to pay interest on collateral that it may not reinvest? In addition and depending of the margin method used, UCITS may be required to post more IM than they may receive from banks. Consequently they would receive less remuneration for such asset transfer.