We welcome the amendment to treat non-systemically important third country corporates similarly to EU NFCs-.
The new proposal in the updated draft RTS for a margin posting and collection requirement is also welcome with respect to jurisdictions with equivalent margin rules in place for uncleared derivatives, such as the US, as it should help facilitate a positive substituted compliance determination by reducing the structural differences between the EU and US rules on collecting and posting. However, with respect to non-netting jurisdictions (e.g. many emerging markets), such a requirement could introduce risk for EU counterparties as they will now need to post collateral, both VM and IM if appropriate, to counterparties in jurisdictions where the “legal enforceability of the netting and segregation agreements” may be at risk. The draft RTS attempts to address this risk by stating that “alternative arrangements such as posting collateral to international custodians” must be applied in order make the requirement workable. This is not a straightforward solution however.
Although a suitable custodian may protect posted assets, such an arrangement will require complex multi-jurisdictional legal analyses, and will also introduce the additional cost associated with the segregation of IM. With respect to netting, posting to an international custodian will not immunize a counterparty from the risk of a local jurisdiction cherry-picking transactions in an insolvency proceeding. In such a case, the amount of collateral posted may not match the close-out amount determined after cherry-picking. This will therefore result in considerably increased credit risk. As transacting in non-netting jurisdictions also incurs a capital cost, the effect would be to force EU counterparties to post collateral without receiving any corresponding Risk Weighted Asset benefit. An exemption from the posting requirement for non-netting friendly jurisdictions should therefore be considered.
The current VM timing proposals are most likely unachievable for many counterparties covered by the draft RTS when the settlement period for the delivery of collateral and time needed to reconcile margin calculations are considered. Where counterparties (and their respective custodians, if applicable) are located outside the EU in different time zones, the difficulty in meeting the requirement will be compounded.
The rules should focus on requiring that margin is calculated on time and on ensuring documentation is in place requiring margin delivery within the prescribed time rather than on obliging the collector to have received margin by the specific margin delivery time. As a practical solution, the RTS could be framed in a way where more systemically important counterparties (those captured by the IM phase-in) are required to comply with whatever current best practice is in terms of calculation and delivery times of collateral while counterparties only subject to VM requirements (many of whom will be new to posting VM) should be able to deliver up to t+3 given the challenges outlined above. The calculation date that begins the three day period should be the earliest the two counterparties can have a common calculation while a ‘business day’ should be defined from the perspective of the collector. Even where the above flexibility is provided counterparties should still have the right to call for margin at t+1 or the same day (depending on type of client and operational constraints).It should also be made explicitly clear in the RTS that the posting party is responsible where they fail to meet margin delivery requirements.
The draft RTS appears to require that if a model does not comply with any of the requirements then counterparties have to switch to the standardized method (SM). This could have disproportionate effects even where the overall risk management objective is still satisfied but where challenges arise around minor details.
Where the IM model ceases to comply with the requirements, transitional arrangements should be available in the first instance before the use of the SM is required in order to allow counterparties to engage in dialogue with their supervisors and determine what action to take. This is important as the SM would result in a significant increase in the calculated margin and could result in ‘cliff effects’ and potential market disruption.
In order to comply with Article 6 LEC (1) it should be stated explicitly in the RTS that receiving counterparties can rely on representations from a posting counterparty that the securities they are posting are not from entities to which they have close links. This is necessary as it would be very difficult for a counterparty to carry out the necessary level of diligence and ensure ongoing monitoring of their counterparty’s group structure. Further, while Article 291 of the Capital Requirements Regulation (CRR) defines general and specific wrong way risk (WWR), it does not provide sufficient clarity on the definition of significant WWR. Moreover, whilst the draft RTS states that the EMIR definition of ‘group’ applies (preamble 16), it is still not sufficiently clear what constitutes a ‘group’ absent the RTS stating that ‘groups’ shall be determined in accordance with IFRS/GAAP/similar accounting principles.
Under Article 4 LEC the use of internal rating models in determining collateral eligibility may have an unintended market impact of releasing non-public information to the market further to the requirement to communicate to the other counterparty the credit quality step (CQS) associated to the securities that are posted as collateral. The internal IRBA approved rating models of banks will be based on a combination of public and non public information, and the use of these models to indicate collateral eligibility may result in the collateral taker releasing non public information to the counterparty, particularly where a request for collateral substitution is required due to a change in CQS.
Article 2 OPD requires an independent legal review of netting procedures and Article 1 SEG (5) requires independent legal review of segregation arrangements. The final RTS should explicitly state that “independent” can mean an internal review provided there is sufficient independence or that satisfaction of the netting opinion requirements under an entity’s regulatory regime will be sufficient to satisfy the Article 2 OPD (2) requirement.
Per the requirements under Article 2 OPD (1) confirmation would also be welcome that confirmations for types of trades which might be made via SWIFT are sufficient for documentation purposes.
The draft RTS requires “robust risk management procedures shall be in place” including with respect to payment and close-out netting. In addition, the draft RTS requires a counterparty to perform an independent legal review at least on an annual basis to “verify the legal enforceability of the bilateral netting arrangements”. Thus, as explained in response to Q1, the collateral requirements in regards to non-netting jurisdictions remain problematic. The RTS ‘Executive Summary’ section implies two-way exchange of margin is required even in non-netting jurisdictions, so long as suitable alternative arrangements are in place. However, the parties cannot contract into an enforceable netting arrangement where one does not exist under the insolvency laws of the relevant jurisdiction. Collateral should not have to be posted bilaterally on a gross basis as this would exacerbate risks faced by EU counterparties. Certainly, the policy approach should not have the effect of blocking the access of European counterparties to many non-EU and emerging markets and ceding such markets to local/international banks.
The requirement to perform an independent legal review at least on an annual basis would be excessively burdensome, particularly for jurisdictions not covered by industry opinions. Instead of an annual review, such review could be conducted every three years absent some material change in legislation – this would be in line with legal review updates pursuant to CRR netting.
Article 1 SEG requires that IM is protected from the default or insolvency of a third party holder or custodian. Given the difficulty of segregating cash, Article 1 REU states that IM posted as cash can be reinvested to satisfy the segregation requirement. These provisions should be amended as, firstly, addressing custodian risk is not within scope of the BCBS-IOSCO framework and secondly, the reinvestment requirment amounts to a de-facto ban on the posting of cash as IM, which is clearly contrary to the ESA’s stated objective to avoid such an unintended consequence.
Cash is one of the most liquid and high quality assets so any restriction which has the effect of limiting its use as collateral is clearly contrary to the overarching objective of reducing counterparty credit risk. Cash IM must be permitted to be posted without requiring reinvestment.
We strongly support ISDA’s response and proposals in relation to this specific consultation question.
The final RTS should explicitly confirm that the FX haircut is only to be applied to non-cash. Cash is the most fungible of all collateral and thus should be exempt in its entirety from any FX haircut. It should also state that FX risk for cash or collateral VM may be included in the IM calculation instead of calculating an FX haircut.
Given the absence of a definition of termination currency" and "transfer currency", counterparties should be able to define the transfer and termination currency in their agreement since European counterparties will most likely want to deliver cash and securities in a European currency while the US counterparty they are facing would prefer to deliver US securities or cash. This would allow counterparties to designate a termination currency for each party that can match the collateral they are expecting to post in.
As drafted the FX haircut would be additive to the asset class haircut, i.e. if the collateral is an equity then the collateral value is haircut by 23% (15+8). This is disproportionate and should rather be applied independently to the reduced value of the asset after asset class haircuts have been applied."
