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.

There are several areas of concern that are not addressed in the draft RTS and which would need to be clarified before firms can start the implementation process. Many of these are covered in detail in the International Swaps and Derivatives Association’s (“ISDA”) response but we would like to draw ESAs’ attention in particular to the issues of legal nature, related to the mechanics of how margin has to be collected from counterparties in jurisdictions where the local legislative regime does not support netting or collateral enforceability and, as a subset of the latter, segregation opinions.
Collateral enforcement
ISDA currently has collateral enforceability opinions in relation to 51 countries. However, there are some jurisdictions which do not support close-out netting or collateral enforceability. (If a jurisdiction does not support netting, its insolvency and other laws typically do not support enforceability under the ISDA credit support documentation.) These include China and the Middle Eastern countries such as UAE, Qatar and Saudi Arabia.
We appreciate that the regulatory requirement is on the EU firms to collect margin, rather than to post it. However, this does not mean that the jurisdiction of the counterparty can be disregarded, either as a matter of regulation or of commercial reality. While it is market practice that many collateral arrangements under standard ISDA documentation are governed by English or New York law over collateral assets held or located in western jurisdictions (e.g. England, New York, Belgium), the jurisdiction of the posting counterparty remains relevant.
This is for two reasons. First, even if collateral is taken in Europe, absent a ‘clean’ opinion or legal certainty covering the posting counterparty’s jurisdiction, there remains a risk that collateral will not be immediately available (as the draft RTS require), or that it can be clawed back. In other words, if a counterparty defaults, we may not be able to liquidate their collateral quickly if enforcement stays are imposed under the local law (speed of liquidation being one of main reasons for collecting margin in the first place). Alternatively, we may be prevented from retaining the collateral posted to us at all, because an insolvency official or other third party may be able to enforce a claim to it.
It would not be reasonable to expect firms to simply ‘take’ collateral from these jurisdictions in the face of uncertainty about their rights to it. This is why the existing prudential regulatory requirements for the recognition of financial collateral state that there needs to be legal certainty on enforceability of agreements, including in relation to the posting counterparty’s jurisdiction. It is also worth noting that the European Financial Collateral Directive was an attempt to deal with some of the problems inherent in cross-border enforcement of collateral. As there is no equivalent legislation in many jurisdictions outside the EU, these issues remain unresolved.
Second, it is unlikely that all counterparties will be willing to accept asymmetrical margin arrangements. For any margin we collect, we may also have to post. Although the posting leg of the transaction will not be subject to the regulatory requirements as prescribed by the RTS, and although collateral may in fact be kept with a third party custodian, we will nevertheless be posting margin to counterparties from jurisdictions where there is a risk it may not be protected. This would increase our risk exposure – and arguably systemic risk too – which is the opposite of what the margin rules are aiming to achieve.
The draft RTS are silent on the consequences of not being able to obtain ‘clean’ opinions or legal certainty. It is not clear whether trading would have to cease in circumstances described above. Article 1 SEG requires that margin is immediately available to the collecting entity, and that satisfactory legal opinions must be obtained on whether the segregation arrangements meet the prescribed requirements. Neither of these conditions will be met in the case of non-EU jurisdictions described above.
If a policy decision is taken that banks have to margin all trades and can no longer choose to take credit risk and hold capital instead, European firms may effectively be shut out of some emerging market jurisdictions – including China and the Middle East. We would therefore urge ESAs to consider alternative ways of dealing this issue. We believe that the only realistic solution is to introduce a full exemption, or a transitional period of some kind, and for supervisors to continue to closely monitor firms’ exposures. Any transitional should not be subject to fixed end dates, as the change of local law is not within the counterparties’ control. Local legislators should also be encouraged, via international bodies, to change their legal regimes to support the exchange of collateral.
VM phase-in
We suggested in our response to the second BCBS IOSCO consultation that a phase-in period should be permitted for variation margin. The exchange of variation margin is by no means universal practice and it would, for some counterparties, require a significant shift in current practice. This could be particularly acute in emerging market jurisdictions.
We would therefore support the proposal put forward in the ISDA response that VM should be phased in, and we would urge regulators to re-consider their approach to timing in the context of the Working Group on Margining Requirements (“WGMR”) set up by BCBS IOSCO.
Intra-group
EMIR defines intra-group trades in Article 3 and, in cases of group entities outside Europe, that definition is in part founded on jurisdictional equivalence. No country has so far been deemed equivalent by the European Commission. Without clarity on which of their group entities are likely to be covered by the definition, firms will find it difficult to plan for implementation. Even if the Commission publishes its initial round of determinations this year, this is likely to be limited to a small number of jurisdictions initially. It seems unlikely that the list will grow in the short to medium term - not only because of the slow progress of implementation globally (even among WGMR jurisdictions), but also because of the limited resources available at the European Commission to undertake the assessments.
We would propose that the final standards either exempt intra-group transactions in their entirety, irrespective of whether the equivalence test of Article 3 is met, or allow for a longer transitional in cases where the other group entity is from a non-EU jurisdiction.
In any case, the examples of restrictions in the legal impediment definitions in Article 3 IGT are too restrictive. Most countries have restrictions on the movement of capital when a business is in insolvency. However, while such restrictions may be in place, the transfer of own funds or repayment of liabilities would still be possible up to the point of insolvency. In addition, the existence of currency and exchange controls may not in themselves prevent the repayment of loans. The language as stated in examples (a) to (d) would effectively seem to disallow any intra-group entity that is a regulated entity or is subject to international accounting rules from applying the exemption, which seems at odds with the spirit of the exemption. Intra-group entities are considered to be safer due to the consistent risk management framework that is required to be applied across the group, which ensures greater security against a group entity becoming insolvent compared to a third party. All entities must still operate within the legal framework of the country in which they are incorporated.
Initial margin thresholds
The final RTS should clarify that intra-group trades are not be included in the gross notional thresholds used for IM phase-in. As the threshold is determined on a group-wide basis, and such trades would be ignored when determining the consolidated position of the group, there seems to be no reason to include them.
Physically settled FX forwards and swaps should also be excluded from the calculations. EMIR Level 1 recognises that the risk posed by these products is different to that of other OTC derivatives, and the draft RTS permit FX forwards and swaps to be taken out of scope for initial margin. It would seem odd if those products were then counted towards the initial margin notional calculations – the same logic should apply throughout.
FX haircuts
The FX haircut should not apply to VM. This is because, unlike securities, cash in most currencies can be liquidated quickly. For securities denominated in a different currency, the haircut on the security would cover the possible loss of value during the foreclosure process.

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?

Although we appreciate the ESAs’ attempt to simplify the process and move away from over-reliance on external ratings, we are not convinced that the proposal to allow the use of a counterparty’s IRB model is workable in practice.
IRB models are proprietary and therefore unlikely to be shared in the level of detail that would likely be required by counterparties. More importantly, any discrepancy between internal ratings could risk regulatory arbitrage: firms may choose to accept a counterparty’s rating only if it is advantageous to them, and dispute it if it is not. The process would therefore face many of the same issues inherent in the proposal to use proprietary IM models, and it is precisely this potential for disagreements and disputes that led the industry to start developing the Standard Industry Initial Margin (“SIMM”) via ISDA.
If the aim is to reduce reliance on external ratings, it may be better to consider setting up or endorsing an independent body to aggregate ratings and produce an industry average. This would preclude the need to share proprietary data with counterparties and would be based on models approved by supervisors. (Similar initiatives already exist – for example, PECDC (http://www.pecdc.org/) has been created by member banks to collect data to assist with the measurement of Loss Given Default and Exposure at Default.)

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?

The limited use of rehypothecation as proposed in the final BCBS IOSCO standards did not seem workable in practice. One-time rehypothecation would be overly complex to operationalise and control, especially across global markets and timezones - it would be too expensive for the limited benefits it would provide. We were therefore not surprised that the ESAs chose not to allow any rehypothecation at all in the European rules.
However, as with all the other proposals where the EU rules diverge from the BCBS IOSCO standards, there remains a risk that other jurisdictions do not restrict rehypothecation in the same way. This should be closely monitored by the WGMR and by the European regulators in order to avoid creating an unlevel playing field.
More generally, we have from the outset maintained that rehypothecation should not be prohibited in principle. As the ESAs will be aware from discussions in the context of the BCBS IOSCO consultation, the inability to reuse collateral will have an impact on the price of services provided to clients. The choice of asset treatment should be left to clients, with additional disclosure of risks and closer regulatory scrutiny if warranted.

A ban on rehypothecation, combined with a higher demand for high quality liquid assets as a result of both regulatory and commercial pressures, will also have an effect on liquidity more generally. This may require a policy intervention in the future, so we would urge regulators to monitor the market developments closely.

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Standard Chartered Bank